Chapter 6 INFLATION. ECON 141: Macroeconomics Inflation Dr. Mohammed Alwosabi. Dr. Mohammed Alwosabi

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1 hapter 6 INFLTION Dr. Mohammed lwosabi DEFINITION OF INFLTION Inflation is a process of continuous (persistent) increase in the price Inflation results in a decrease of the value of money. In the definition of inflation we have to observe that: t 1. Inflation is an increase in the prices of all goods and services not only of a particular good or service. 2. Inflation is an ongoing process, not a onetime jump in the price INFLTION RTE: To measure the inflation rate, we calculate the annual percentage change in the price - Inflation Rate = we measure the price level () of a country using GD Deflator or I. GD Deflator - GD Deflator Inflation Rate = GD Deflator Inflation Rate = I I - I USES OF INFLTION The inflation can result from either 1. an increase in aggregate demand (demand-pull inflation), or 2. a decrease in aggregate supply (cost-push inflation) Nevertheless, the direct source of inflation is the high growth rate of money supply with. Milton Friedman proposed that "inflation is always and everywhere a monetary phenomenon". Demand-ull Inflation Demand-pull inflation is a result of the increase in spending is faster than the increase in production of output. Demand-pull inflation starts as D increases and D curve shifts rightward. n increase in aggregate demand d is caused mainly by 1. the increase in quantity of money (Qm), 2. the increase in any of, I, G, or X The rocess of Demand-ull Inflation LS SS 3 SS E 2 D SS 1 D 3 D 2 D 1 Y Y 0 Y 1 1

2 Suppose in the, the economy is at LR full employment equilibrium point, where LS, D0 and SS0 intersect with each other. t this point, RGD = GD and = 0. In the current year, an increase in Q m,, I, G, or X leads to an increase in D D curve shifts rightward from D 0 to D 1 the new SR equilibrium is at point, t, RGD is greater than GD, price level increases from 0 to 1, real wage rate has decreased and unemployment falls below its natural rate (above FE) there is a shortage of labor money wage rate starts to increase to attract more labor SS starts to decrease SS curve starts to shift leftward starts to increase and RGD starts to decrease until SS curve shifted to SS 1 where it intersects D 1 and LS at point t point, RGD goes back to its potential LR and FE level (Y 0 ) and the price level increase further to 2. This process is only a one-time rise in. For inflation to proceed, D must persistently increase. Since now the money wage is higher which means people can spend more and as a result is higher ( 2 ), the only result is the increase in Q m increase in D D curve will shift from D 1 to D 2 the process will continue higher price level (inflation) This is an ongoing process of rising price ost-ush Inflation ost-push inflation arises due to a decrease in supply as a result of the rise in the per unit cost of production, mainly because of the 1. increase in wage rates 2. increase in the prices of key raw materials (e.g. oil price) ost-push inflation starts as SS increases and SS curve shifts leftward. t a given price level, the higher the cost of production, because of an increase in the money wage rate or an increase in the prices of raw material, the smaller is the amount that firms are willing to produce SS decreases SS shifts leftward an increase in prices and unemployment and a decrease in RGD stagflation 2

3 The rocess of ost-ush Inflation Y 1 LS SS3 SS 2 E SS 1 D D 3 D 2 D 1 Y Y 0 Suppose price level was 0 and GD is Y 0, where D 0, SS 0 and LS intersect at point, LR FE equilibrium. If nominal wages or prices of other factors of production production cost firms reduce production SS SS curve shifts leftward to SS2 to point. t point, price level increases to 1 and RGD decreases to Y1 and therefore unemployment increases above its natural rate (below FE) the combination of a rise in and a fall in RGD (and a rise in unemployment) is called stagflation. s a response to the increase in and a decrease in RGD, government increases Q m D increases D curve starts to shift rightward until it reaches D 1 at point, where D 1 intersects with SS 1 and LS. t point, the economy is at higher price level ( 2 ) and RGD goes back to GD (Y 0 ) at full employment With the new higher price, money wage rate and prices of other productive resources start to increase again which leads to increase in the cost of production SS curve will shift leftward from SS 1 to SS 2 stagflation the process will be repeated higher price level (inflation) This is an ongoing process of rising price Note that a one-time increase in the price of one resource without any following change in D produces stagflation but not inflation. EFFETS OF INFLTION Inflation may be anticipated (expected) or unanticipated (unexpected) moderate anticipated (expected) has a small cost, but a rapid anticipated inflation is costly because it decreases potential GD and slow growth. Unanticipated (unexpected) inflation has two main consequences in the labor market. (1) It redistributes income and (2) It results in the departure from full employment 1. Higher than anticipated inflation (unexpectedly high) lowers the real wage rate employers gain at the expense of workers increases the quantity of labor demanded, makes jobs easier to find, and lowers the unemployment rate. 2. Lower than anticipated inflation (unexpectedly low) raises the real wage rate workers gain at the expense of employers decreases the quantity of labor demanded, and increases the unemployment rate. 3

4 3. If workers and employers base their wages on an inflation forecast that turns out to be correct, neither workers nor employers gain or lose from the inflation. Unanticipated inflation has two main consequences in the market for financial capital: it redistributes income and results in too much or too little lending and borrowing. 1. When the inflation rate is higher than anticipated (unexpectedly high) the real interest rate is lower than anticipated borrowers gain but lenders lose borrowers want to have borrowed more and lenders want to have loaned less. 2. When the inflation rate is lower than anticipated (unexpectedly low) the real interest rate is higher than anticipated lenders gain but borrowers lose borrowers want to have borrowed less and lenders want to have loaned more INFLTION ND UNEMLOYMENT: THE HILLIS URVE hillips curve shows the inverse relationship between inflation rate (IR) and unemployment rate (UR). There are two time frames for hillips curves The short-run hillips curve The long-run hillips curve Our focus here is only on the SR hillips curve. The SR hillips curve (SR) slopes downward to show the tradeoff between inflation rate and unemployment rate holding constant both the expected inflation rate (EIR) and the natural rate of unemployment (NRU). EIR 0 IR NRU SR UR If inflation rises above its expected rate, Unemployment falls below its natural rate. This is represented by the movement from point to point along SR. If inflation rate falls below its expected rate, unemployment rises above its natural rate. This is represented by the movement from point to point along SR. Movements downward along the short-run hillips curve result from unanticipated decreases in aggregate demand. 4

5 n increase in the expected inflation rate or natural rate of unemployment shifts the short-run hillips curve rightward. SR is like SS curve. movement along SS curve that brings a higher price level and an increase in RGD is equivalent to a movement along SR that brings an increase in the inflation rate and a decrease in the unemployment rate Similarly, a movement along SS curve that brings a lower price level and a decrease in RGD is equivalent to a movement along SR that brings a decrease in the inflation rate and an increase in the unemployment rate 5