1. ECONOMICS 5e CHAPTER 16 Inflation Michael Parkin
Chapter 33 in Economics 1

2. Learning Objectives
Distinguish between inflation and a one- time rise in the price level
Explain the different ways in which inflation can be generated
Describe how people try to forecast inflation 2

3. Learning Objectives (cont.)
Explain the short-run and long-run relationships between inflation and unemployment
Explain the short-run and long-run relationships between inflation and interest rates 3

4. Learning Objectives
Distinguish between inflation and a one- time rise in the price level
Explain the different ways in which inflation can be generated
Describe how people try to forecast inflation 4

5. Inflation and the Price Level
Inflation is a 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. 5

6. Inflation and the Price Level
A one-time jump in the price level is not inflation.
Inflation is an ongoing process. 6

7. Inflation Versus a One-Time Rise in the Price Level
160
150
Inflation, ongoing
process of rising
price level
140
Price level (1992 = 100)
130
120
Instructor Notes:
Along the red line, an economy experiences inflation because the price level is rising persistently.
A one-time rise
in the price level
110
100 90
1992
1993
1994
1995
1996
1997 9

8. Inflation and the Price Level
To calculate the inflation rate, the difference in the price level of the two years is divided by the first year’s price level. 10

9. Inflation and the Price Level
For example, if this year’s price level is 126 and last years was 120, then inflation is:
100
120 –
126 
Rate
Inflation 
 5 percent per year. 11

10. Learning Objectives
Distinguish between inflation and a one- time rise in the price level
Explain the different ways in which inflation can be generated
Describe how people try to forecast inflation 12

11. Inflation and the Price Level
There are two sources of pressure on the price level and inflation:
1) Demand pull
2) Cost push 13

12. 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 money supply
Increase in government purchases
Increase in exports 14

13. Demand-Pull Inflation
Inflation Effect of an Increase in Aggregate Demand
If an event leads to an increase in aggregate demand when the real GDP equals potential GDP, both GDP and the price level will increase initially. 15

14. Demand-Pull Inflation
Wage Response
However, a shortage of labor 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 potential GDP. 16

15. A Demand-Pull Rise in the Price Level
Increase in AD
raises price level
and increases
real GDP...
LAS
130
SAS1
AD1
(GDP deflator, 1992 = 100)
Price level
(cont.)
(cont.)
SAS0
121
…wages rise, and
SAS shifts leftward.
Price level rises
further, and real
GDP declines
113
110
Instructor Notes:
1) Starting from above full employment, wages begin to rise and the short-run aggregate supply curve shifts leftward toward SAS1.
2) The price level rises further, and real GDP returns to its long-run level.
100
AD0
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars) 20

16. Demand-Pull Inflation
A Demand-Pull Inflation Process
For inflation to persist, aggregate demand must increase repeatedly, and..
…the quantity of money must persistently increase. 22

17. A Demand-Pull Inflation Spiral
LAS
SAS2
AD2
133
SAS1
Repeated increases
in AD create a
price-wage spiral
AD1
(GDP deflator, 1992 = 100)
Price level
125
SAS0
121
113
110
Instructor Notes:
1) Each time the money supply increases, aggregate demand increases, and the aggregate demand curve shifts rightward from AD0 to AD1 to AD2, and so on.
2) Each time real GDP goes above potential GDP and unemployment goes below the natural rate, the money wage rate rises and the short-run aggregate supply curve shifts leftward from SAS0 to SAS1 to SAS2, and so on.
3) As aggregate demand continues to increase, the price level rises from 110 through 112, 121, 125, to 133, and so on.
4) There is a perpetual demand-pull inflation.
5) Real GDP fluctuates between $7 trillion and $7.5 trillion.
AD0
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars) 27

18. Demand-Pull Inflation
Demand-Pull Inflation in the United States
A series of events similar to this occurred in the U.S. during the 1960s.
Government spending increased for Vietnam and social programs.
The growth rate of money increased. 19 28

19. 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. 29

20. Cost-Push Inflation Initial Effect of a Decrease in Aggregate Supply
If the price of oil were to increase dramatically (supply shock) the short-run aggregate supply curve would shift leftward.
The price level would rise and real GDP would decline. 30

21. Cost-Push Inflation Initial Effect of a Decrease in Aggregate Supply
Stagflation is the combination of a rise in the price level and a decrease in real GDP.
This one time event is not inflation.
Other things must occur for this to be converted into a process of money supply growth and ongoing inflation. 31

22. A Cost-Push Rise in the Price Level
Resource price rise
shifts SAS leftward
and causes stagflation
LAS
130
SAS1
(GDP deflator, 1992 = 100)
Price level
SAS0
120
117
110
Instructor Notes:
1) A decrease in aggregate supply (for example, resulting from an increase in the world price of oil) shifts the short-run aggregate supply curve to SAS1.
2) The economy moves to the point where the short-run aggregate supply curve SAS1 intersects the aggregate demand curve AD0 .
3) The price level rises to 117, and real GDP decreases to $6.5 trillion.
4) The economy experiences inflation and a contraction of real GDP--stagflation.
100
AD0
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars) 33

23. Cost-Push Inflation Aggregate Demand Response
When real GDP falls, unemployment rises above the full employment rate.
The Fed may respond by increasing the money supply.
Aggregate demand increases.
Full employment has been restored, but prices have increased further. 34

24. Aggregate Demand Response to Cost Push
LAS
130
SAS1
AD1
Factor price rise
shifts SAS leftward
and causes inflation.
(GDP deflator, 1992 = 100)
Price level
121
SAS0
117
The Fed increases AD
to restore full-
employment and the
price level rises again.
110
Instructor Notes:
1) If the Fed responds by increasing aggregate demand to restore full employment, the aggregate demand curve shifts rightward to AD1.
2) The economy returns to full employment, but at the expense of more inflation.
3) The price level rises to 121.
100
AD0
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars) 36

25. 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. 37

26. A Cost-Push Inflation Spiral
SAS2
LAS
AD2
133
SAS1
AD1
129
Oil producers and the
Fed feed cost-price
inflation spiral
(GDP deflator, 1992 = 100)
Price level
SAS0
121
117
110
Instructor Notes:
1) The Fed responds again, and the cost-price inflation spiral continues.
AD0
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars) 42

27. Cost-Push Inflation Cost-Push Inflation in the United States
OPEC in the 1970s increased the price of oil four times its original price.
The Fed allowed the money supply to continually grow. 43

28. Cost-Push Inflation Cost-Push Inflation in the United States
In 1980 OPEC again increased the price of oil.
The Fed did not respond.
A recession followed, but inflation decreased. 44

29. Learning Objectives
Distinguish between inflation and a one- time rise in the price level
Explain the different ways in which inflation can be generated
Describe how people try to forecast inflation 2 45

30. Effects of Inflation Unanticipated Inflation in the Labor Market
Two consequences of unanticipated inflation in the labor market are:
1) Redistribution of income.
2) Departure from full employment. 46

31. Effects of Inflation 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. 47

32. Effects of Inflation 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. 48

33. Effects of Inflation Departure from Full Employment
Underestimating the inflation rate leads to:
Less real incomes for workers.
Employers cannot find adequate labor.
Employees begin to quit.
Firms incur labor turnover costs.
Production is below what it would have been had the inflation rate been correctly anticipated. 49

34. 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. 50

35. Effects of Inflation Unanticipated Inflation in the Capital Market
Two consequences of unanticipated inflation in the capital market are:
1) Redistribution of income.
2) Too much or too little lending and borrowing. 51

36. Effects of Inflation Redistribution of Income
Unanticipated inflation leads to interest rates not being set high enough to compensate lenders.
Borrowers gain, lenders lose. 52

37. Effects of Inflation Redistribution of Income (cont.)
If inflation is below what had been anticipated, interest rates will be set too high.
Lenders gain, borrowers lose. 53

38. Effects of Inflation 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. 54

39. Effects of Inflation Too Much or Too Little Lending and Borrowing
If inflation is lower than expected:
Borrowers wish they had borrowed less
Lenders wish they had lent more 55

40. Effects of Inflation 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. 56

41. Effects of Inflation 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. 57

42. Anticipated Inflation
SAS2
LAS
AD2
133
SAS1
AD1
Anticipated increases
in AD bring inflation
but no change in
real GDP
(GDP deflator, 1992 = 100)
Price level
SAS0
121
110
Instructor Notes:
1) Next year the process continues with aggregate demand increasing as expected to AD2 and wages rising to shift the short-run aggregate supply curve to SAS2.
2) Again, real GDP remains at $7 trillion, and the price level rises, as anticipated, to 133.
AD0
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars) 60

43. Effects of Inflation 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. 61

44. Effects of Inflation 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 62

45. Effects of Inflation 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. 63

46. Effects of Inflation 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. 64

47. Effects of Inflation Increases Uncertainty
High inflation rates result in uncertainty about the long-term inflation rate.
Investment falls.
Growth falls. 65

48. Learning Objectives (cont.)
Explain the short-run and long-run relationships between inflation and unemployment
Explain the short-run and long-run relationships between inflation and interest rates 3 66

49. Inflation and Unemployment: The Phillips Curve
The Phillips curve shows the relationship between inflation and unemployment.
There are two types of Phillips curves:
The short-run Phillips curve
The long-run Phillips curve 67

50. Inflation and Unemployment: The Phillips Curve
The Short-Run Phillips Curve
The short-run Phillips curve is a curve that shows the tradeoff between inflation and unemployment, holding constant:
The expected inflation rate
The natural unemployment rate 68

51. Inflation and Unemployment: The Phillips Curve
The Short-Run Phillips Curve (cont.)
The negative relationship between inflation and unemployment can be explained by the aggregate supply-aggregate demand model. 69

52. A Short-Run Phillips Curve20 15 b
Inflation rate (percent per year) a 10
Expected
inflation
rate c
Instructor Notes:
An unanticipated decrease in aggregate demand increases unemployment and lowers inflation--a movement down the short-run Phillips curve.
SRPC 5
Natural
unemployment
rate 3 6 9 12
Unemployment rate (percentage of labor force) 73

53. AS-AD and the Short-Run Phillips Curve
LAS
AD2
SAS1
AD1 b
113
Price level
(GDP deflator, 1992 = 100)
SAS0
110 a
107 c
100
Instructor Notes:
1) If, with the same expectations, aggregate demand increases and shifts the aggregate demand curve from AD0 to AD2, the price level rises to 113, a 13 percent rise, and the economy is at point b in this figure and at point b on the short-run Phillips curve, as shown previously.
AD0
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars) 76

54. Inflation and Unemployment: The Phillips Curve
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 irate. 78

55. Inflation and Unemployment: The Phillips Curve
The Long-Run Phillips Curve
It shows that any anticipated inflation rate is possible at the natural unemployment rate.
Therefore, when inflation is anticipated, real GDP equals potential GDP. 79

56. Short-Run and Long Run Phillips Curves20
LRPC
Decreases in expected
inflation shifts short-run
Phillips curve downward 15
SRPC1
Inflation rate (percent per year) a 10 c
Instructor Notes:
1)A fall in expected inflation shifts the short-run Phillips curve downward,
2) For example, when the expected inflation rate falls from 10 percent a year to 7 percent a year, the short-run Phillips curve shifts downward from SRPC0 to SRPC1.
3) The new short-run Phillips curve intersects the long-run Phillips curve at the new expected inflation rate--point d.
4) With the original expected inflation rate (of 10 percent), an actual inflation rate of 7 percent a year would occur at an unemployment rate of 9 percent, at point c. 7 b
SRPC0 5 3 6 9 12
Unemployment rate (percentage of labor force) 81

57. Inflation and Unemployment: The Phillips Curve
Changes in the Natural Unemployment Rate
As studied earlier, the natural unemployment rate may change for several reasons.
This shifts both the short-run and long-run Phillips curves. 82

58. A Change in the Natural Unemployment Rate20
LRPC0
LRPC1
Increase in natural
unemployment rate
shifts LRPC and
SRPC rightward
SRPC1 15
Inflation rate (percent per year) e a 10
Instructor Notes:
1) A change in the natural unemployment rate shifts both the short-run and long-run Phillips curves.
2) Here the natural unemployment rate increases from 6 percent to 9 percent, and the two Phillips curves shift right to SRPC1 and LRPC1.
3) The new long-run Phillips curve intersects the new short-run Phillips curve at the expected inflation rate--point e.
SRPC0 5 3 6 9 12
Unemployment rate (percentage of labor force) 84

59. Phillips Curves in the United States
Instructor Notes:
1) In this graph, each dot represents the combination of inflation and unemployment for a particular year in the United States.
2) There is no clear relationship between the two variables. 85

60. Phillips Curves in the United States
Instructor Notes:
1) This graph interprets the data with a shifting short-run Phillips curve.
2) The black dots a, b, c, and d show the combination of the natural rate of unemployment and the expected inflation rate in different periods.
3) The short-run Phillips curve was SRPC0 during the 1960s and in 1996.
4) It was SRPC1 during the early 1970s and 1990s, SRPC2 during the late 1970s, and SRPC2 during the late 1970s, and SRPC3 (briefly) in 1975 and 86

61. Learning Objectives (cont.)
Explain the short-run and long-run relationships between inflation and unemployment
Explain the short-run and long-run relationships between inflation and interest rates 3 87

62. Interest Rates and Inflation
The Effects of Inflation on Borrowers and Lenders
The nominal interest rate is the price a borrower pays a lender for two things:
The amount loaned
The devaluing of the money that results from inflation 88

63. Interest Rates and Inflation
The Effects of Inflation on Borrowers and Lenders (cont.)
The real interest rate is the price paid by a borrower to compensate a lender only for the amount loaned.
The forces of demand and supply determine both the nominal and real interest rates. 89

64. Interest Rates and Inflation
The Effects of Inflation on Borrowers and Lenders (cont.)
When inflation is anticipated, the nominal interest rate increases by an amount equal to the expected inflation rate.
The real interest rate remains constant. 91

65. Interest Rates and Inflation
Inflation and Interest Rates in the United States
A positive relationship has existed between inflation rates and interest rates.
However, the real interest rate has not been constant. 92

66. Inflation and the Interest Rate
Instructor Notes:
1) Other things remaining the same, the higher the expected inflation rate, the higher is the nominal interest rate.
2) A graph showing the relationship between nominal interest rates and the actual inflation rate reveals that the influence of inflation on nominal interest rates is a powerful one. 93

67. Inflation and the Interest Rate
Instructor Notes:
1) Other things remaining the same, the higher the expected inflation rate, the higher is the nominal interest rate.
2) A graph showing the relationship between nominal interest rates and the actual inflation rate reveals that the influence of inflation on nominal interest rates is a powerful one. 93

68. The End