1. 3/7/20161 Inflation: a continuing rise in the general level of prices. Cost more to purchase goods & services that it cost to produced Period of inflation increase of general prices outweigh decreases in some. Means that dollar will purchase less than it would in the past

2. 3/7/20162 Distinguish between two types Unanticipated inflation: an increase in the price level that comes as a surprise- decision-makers cannot anticipate the future Anticipated inflation: changes in price levels that are expected and can be predicted

3. 3/7/20163 Effects of Unanticipated Inflation Financial markets  Creditors are hurt because they receive payment in dollars which are less.  Borrowers are helped because they repay dollars that are less. Impact: Alters investment projects Distortion of price information

4. 3/7/20164 Effects of Unanticipated Inflation Product Markets: Producers can raise prices faster than cost, hence helped However hurt if they have long term contracts on prices, cost could rise faster than prices Consumers are hurt because real income will fall as prices increase NET EFFECT: Distorts information, and output

5. 3/7/20165 Effects of Unanticipated Inflation Labor markets: Employers benefit if output prices increase faster than labor cost Wage earners are hurt because wages have decreased.

6. 3/7/20166 AS/AD Model to explain inflation Assume LR equilibrium Price levels = 1.0 Output 2,000 Actual prices and expected price levels are 1.0 Assume AD increases by 600.

7. 3/7/20167 Two sources of inflation Demand pull – caused by a shift in the AD Cost push – caused by a shift in the SRAS Both cases are based upon Adaptive Expectations Hypothesis  People expect the future to be like the past and adapt their plans accordingly.  Firms expect level of input prices this year to be consistent with price levels of the final goods and services.

8. 3/7/20168 A case of demand pull Shift AD to right by 600 Note increase in GDP but only by 400; price levels increase by 1.2 Expected price levels were 1.0; actual price levels are 1.2

9. 3/7/20169 Input prices were expected to be 1.0, but actual inflation rate is 1.2 SRAS shifts upward (decreases) by 0.2 as price of inputs increases Expansion fiscal or monetary policy is effective in short run- stimulating increases in GDP and decreases in % U. Policy makers now face dilemma

10. 3/7/201610 Policy choice: Do nothing Economy is not at LR e Input prices will again adjust as actual rate of inflation > expected rate Expected rate of inflation was lower than actual rate of inflation SRAS shifts left by difference between expected and actual SRAS will continue to shift left until LR E is established e A

11. 3/7/201611 Policy #2: Increase AD to maintain current levels of output and employment To maintain level of output and employment, AD needs to increase at same rate as rate of inflation. Increases in G or decreases in T will be needed to increase AD continuously. Hence a sustain on-going demand pull inflation.

12. 3/7/201612 Inflation: Cost Push, SRAS shifts upward while AD stays in place – Supply Shocks Input prices increase because of major disasters, international restriction of inputs; increase in wages Cost Push also due to inflationary expectations– a continued increase in price levels Similar policy dilemmas – do nothing or increase AD

13. 3/7/201613 A supply shock SRAS shifts left by 600 due to increase in input prices. GDP decreases and price levels increase to 1.4; unemployment increases.

14. 3/7/201614 No Policy Excess capacity and excess unemployment places downward pressure on wages and prices of FOP’s SRAS shifts right back to initial Eq. Likely to be painful; real income loss

15. 3/7/201615 AD Maintenance Policy Increase in AD through monetary or fiscal policy Restores output but at higher price levels Problem is that policy initiates inflationary expectations.

16. 3/7/201616 Strategies for ending inflation: Conventional policies of F & M policies are slow Expectations are difficult to control – break the “psychology” of higher prices (WIN!) Wage and price controls – temporary to break expectations. Indexing – adjust nominal payments in response to price level changes