inflation notes

INFLATION

MR JOSHEEL KUMARS11066159

INFLATION: DEMAND-PULL AND COST-PUSH

Inflation is the process in which the price level is rising and money is losing value.

Inflation is not the increase in the price of one item.

Inflation is the increase in the price of all items by similar percentages.

A one-time jump in the price level is not inflation.

Inflation is an ongoing process

2002 2003 2004 2005 2006 2007

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2003

/04

= 1

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90

100

110

120

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Inflation, ongoingprocess of rising price level

A one-time risein the price level

Year

INFLATION VERSUS A ONE-TIMERISE IN THE PRICE LEVEL

Figure 29.1


To calculate the inflation rate, the difference in the price level of the two years is divided by the first year’s price level.


For example if this year’s price level is 126 and last year’s was 120, then inflation is:

100120

120 – 126 RateInflation

= 5 percent per year.


Inflation can result from either an aggregate demand shock or an aggregate supply shock

These two sources of impulses are called

1. Demand pull inflation

2. Cost push inflation


Demand-Pull Inflation

Demand-pull inflation is inflation that results from an initial increase in aggregate demand.

This can result from an: Increase in the quantity of money Increase in government expenditures Increase in exports



Initial Effect of an Increase in Aggregate Demand If an event leads to an increase in

aggregate demand when the real GDP equals full employment real GDP, both GDP and the price level will increase initially.

AD1

Real GDP (billions of 2003/04 dollars)

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95

105

125

800 900 950 1,050850 1,000

LAS

108

SAS0

AD0

Increase in AD raises price leveland increasesreal GDP...

0

A DEMAND-PULL RISE IN THE PRICE LEVEL (A) INITIAL EFFECT

Figure 29.2(a)

SAS1

AD1

95

105

125LAS

108

SAS0

AD0

116

…wages rise, andSAS shifts leftward.Price level risesfurther, and real GDP declines

0

A DEMAND-PULL RISE IN THE PRICE LEVEL (B) WAGES ADJUST

800 900 950 1,050850 1,000Real GDP (billions of 2003/04 dollars)

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Figure 29.2(b)


Demand-Pull Inflation Money Wage Rate Response

However, a shortage of labour exists and wages begin to rise.

Short-run aggregate supply begins to decrease and the SAS curve shifts leftward.

The price level rises, and real GDP begins to decrease toward full employment real GDP.

AD2

SAS1

AD1

105

128

LAS

108

SAS0

AD0

116110

SAS2

Repeated increasesin AD create a price-wage spiral

0

A DEMAND-PULL INFLATION SPIRAL


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800 900 950 1,050850 1,000

Figure 29.3



A Demand-Pull Inflation Process For inflation to persist, aggregate demand

must increase repeatedly, and.. …the quantity of money must persistently

increase.


Cost-Push Inflation

Cost-push inflation is inflation that results from an initial increase in costs.

This can result from an: Increase in money wage rates Increase in the money prices of raw

materials


Initial Effect of a Decrease in Aggregate Supply Assume there is a sharp increase in the

prices of key raw materials like oil Cost of production rises leading to firms to

decrease the quantity of labour employed and to cut down production

The short run aggregate supply curve shifts leftwards leading to a fall in output and a rise in prices, resulting in a situation called stagflation

95

105

125

LAS

112SAS0

AD0

115

SAS1

Factor price riseshifts SAS leftwardand causes stagflation

0

A COST-PUSH RISE IN THE PRICE LEVEL


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Figure 29.4


Cost-Push Inflation

Aggregate Demand Response When real GDP falls, unemployment rises

above the full employment rate. The RBA may respond by increasing the

money supply. Aggregate demand increases. Full employment has been restored, but

prices have increased further.

105

125

LAS

112SAS0

AD0

116

SAS1

The Reserve Bank increases AD to restore full-employment and the price level rises again

0

AD1

AGGREGATE DEMAND RESPONSE TO COST PUSH


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Figure 29.5


Cost-Push Inflation

A Cost-Push Inflation Process As a result of this second increase in the

cost of production, the oil companies raise the price of oil a second time.

The short-run aggregate supply curve shifts leftward and stagflation begins again.

The process repeats itself.

105

110

128

LAS

112SAS0

AD0

116

SAS1

Oil producers and the Reserve Bank feed the cost-price inflation spiral

0

AD0

SAS2

AD2

124

A COST-PUSH INFLATION SPIRALPr

ice

leve

l(G

DP

defl

ator

, 200

3/04

= 1

00)

Real GDP (billions of 2003/04 dollars)800 900 950 1,050850 1,000

Figure 29.6

THE QUANTITY THEORY OF MONEY

The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.

This theory is based on the concept of the velocity of circulation and on the equation of exchange.

GDP = PY

GDP equals the price level (P) times real GDP (Y), or:


The velocity of circulation is the average number of times a dollar of money is used annually to buy goods and services that make up GDP.


Call the quantity of money M. The velocity of circulation V is determined by:

The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP:

V = PY/M

MV = PY


By virtue of the definition of the velocity of circulation, the equation of exchange is always true.

The equation of exchange becomes the quantity theory of money by making two assumptions: 1. The velocity of circulation 2. Potential GDP

This can be shown by using the equation of exchange to solve for the price level. Divide both sides by Y:

P = (V/Y) x M


Assuming this is true, the equation of exchange tells us that a change in the quantity of money causes an equal proportional change in the price level.

D P = (V/Y) x D M


In the long run, real GDP equals potential GDP. If potential GDP and velocity are not

influenced by the quantity of money, then the relationship between the change in the price level and the change in the quantity of money is:

D P/P x 100 = D M/M x 100

The percentage increase in the price level and the quantity of money are equal.


Divide this equation by P = (V/Y)M and multiply by 100 to get

THE EFFECTS OF INFLATION

Unanticipated Inflation in the Labour Market Two consequences of unanticipated

inflation in the labour market are:

Redistribution of income Departure from full employment


Unanticipated Inflation and the Labour Market

Redistribution of Income If inflation increases unexpectedly, wages

have not been set high enough. Business profits will be higher than

expected, and real income will be less than expected.

Businesses gain and workers lose.



Redistribution of Income If inflation is below what had been

anticipated, workers gain and employers lose.

Therefore, it is beneficial for both groups to correctly anticipate the rate of inflation.



Departure from Full Employment Underestimating the inflation rate leads

to: Less real incomes for workers: Employers cannot find adequate labour Employees begin to quit Firms incur labour turnover costs

Production is below what it would have been had the inflation rate been correctly anticipated.

EFFECTS OF INFLATION

Departure from Full Employment Overestimating the inflation rate leads

to: More real incomes for workers: Employers lay off workers Unemployment rate increases

Production is below what it would have been had the inflation rate been correctly anticipated.


Unanticipated Inflation in the Market for Financial Market Two consequences of unanticipated

inflation in the capital market are:

1) Redistribution of income

2) Too much or too little lending and borrowing


Unanticipated Inflation in the Market for Financial Market Redistribution of Income

Unanticipated inflation leads to interest rates not being set high enough to compensate lenders.

Borrowers gain, lenders lose.


Redistribution of Income If inflation is below what had been

anticipated, interest rates will be set too high.

Lenders gain, borrowers lose.


Too Much or Too Little Lending and Borrowing If inflation is higher than expected:

Borrowers wish they had borrowed more Lenders wish they had lent less


Forecasting Inflation Inflation is difficult to forecast correctly. People devote considerable resources

in the attempt to improve the forecasts. Rational expectation is the most

accurate forecast possible and is based on all relevant information.


Anticipated Inflation Money wages are assumed to be sticky

while an economy is experiencing demand-pull and cost-push inflation.

Correctly anticipating increases in the price level, people will adjust their money wage rates to compensate.

SAS2

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LAS

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Anticipated increasesin AD bring inflationbut no change in real GDP

0

ANTICIPATED INFLATION


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Unanticipated Inflation If aggregate demand increases by

more than expected, wage increases likely will lead to a demand-pull inflation spiral.

If aggregated demand increases by less than expected, wage increases may lead to a cost-push inflation spiral.


The Costs of Anticipated Inflation High rates of anticipated inflation can

be costly. Potential GDP declines for three

reasons: Transactions costs Tax effects Increased uncertainty


Transactions Costs The velocity of circulation of money

increases. People spend time in the attempt to

avoid incurring losses from the decline in the value of money.

People seek alternatives to money — barter.


Tax Effects Nominal interest rates increase. Taxes are based on dollar returns. Returns on investments result in higher

taxes. The effective tax rate rises, and the

after tax real interest rate declines.


Increased Uncertainty High inflation rates result in uncertainty

about the long-term inflation rate. Investment falls Growth falls

UNEMPLOYMENT AND INFLATION:THE PHILLIPS CURVE

The Phillips curve shows the relationship between inflation and unemployment.

There are two time frames for Phillips curves: The short-run Phillips curve The long-run Phillips curve

INFLATION AND UNEMPLOYMENT:THE PHILLIPS CURVE

The Short-Run Phillips Curve The short-run Phillips curve is a

curve that shows the relationship between inflation and unemployment, holding constant: The expected inflation rate The natural unemployment rate

INFLATION AND UNEMPLOYMENT:THE PHILLIPS CURVE

The Short-Run Phillips Curve The negative relationship between

inflation and unemployment can be explained by the aggregate supply-aggregate demand model.

Unemployment rate (percentage of labour force)

Infl

atio

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te (

perc

ent p

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ear)

5

3 6 9 120

A

SRPCNatural unemploymentrate

Expectedinflationrate

10

15

20

A SHORT-RUN PHILLIPS CURVE

C

B

Figure 29.10


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AD1

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A

AS-AD AND THE SHORT-RUN PHILLIPS CURVE

800 900 950 1,050850 1,000

Figure 29.11(a)

100

LAS

SAS1

SAS0

AD0

113110107

AD2

0

B

A



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Figure 29.11(b)

100

LAS

SAS1

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AD0

113110107

0

A

C

B



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Figure 29.11(c)

THE LONG-RUN PHILLIPS CURVE

The long-run Phillips curve is a curve that shows the relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate. It shows that any anticipated inflation

rate is possible at the natural unemployment rate.

Therefore, when inflation is anticipated, real GDP equals potential GDP.

SRPC1


Infl

atio

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te (

perc

ent p

er y

ear)

5

3 6 9 120

Decreases in expectedinflation shifts short-runPhillips curve downward

10

15

20 LRPC

7 SRPC0

A

SHORT-RUN AND LONG RUN PHILLIPS CURVES

C

B

Figure 29.12

CHANGES IN THE NATURAL UNEMPLOYMENT RATE

The natural unemployment rate may change for many reasons.

This shifts both the short-run and long-run Phillips curves.

LRPC1


Infl

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te (

perc

ent p

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ear)

5

3 6 9 120

10

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20 LRPC0

Increase in natural unemployment rateshifts LRPC andSRPC rightward

SRPC0

SRPC1

EA

A CHANGE IN THENATURAL UNEMPLOYMENT RATE

Figure 29.13

INTEREST RATES AND INFLATION

Interest rates vary across countries partly because risk differences make real interest rates vary across countries, and partly due to the fact that inflation rates vary across countries.

The higher the expected inflation rate, the higher the nominal interest rate.

HOW INTEREST RATES ARE DETERMINED

Why Inflation Influences the Nominal Interest Rate As the expected inflation rate rises,

borrowers willingly pay a higher interest rate and lenders successfully demand a higher interest rate

The nominal interest rate adjusts to equal the real interest rate plus the expected inflation rate

inflation notes

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