Transcript Types of inflation (and deflation)

Types of inflation
(and deflation)
Ch. 10, p. 280-283
What causes demand-pull and cost-push inflation?
How do these types of inflation affect aggregate
demand and aggregate supply?
How do you graph the types of inflation?
Understanding the main causes
of inflation

Inflation can come from both the demand and the supply-side of an
economy, and can arise from internal and external events

Some inflationary pressures come from:
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the domestic economy, for example the decisions of utility businesses
providing electricity or gas or water on their tariffs for the year ahead, or
the pricing strategies of the food retailers based on the strength of demand
and competitive pressure in their markets.
A rise in the rate of VAT would also be a cause of increased domestic
inflation in the short term because it increases a firm’s production costs.

Inflation can also come from external sources, for example a sustained rise
in the price of crude oil or other imported commodities, foodstuffs and
beverages.

Fluctuations in the exchange rate can also affect inflation – for example a
fall in the value of the pound against other currencies might cause higher
import prices for items such as foodstuffs from Western Europe or
technology supplies from the United States – which feeds through directly
or indirectly into the consumer price index.
Demand-pull inflation
D-P Inflation is an excess of AD over AS at the full
employment level of output. It’s caused by an
increase in AD, a rightward shift on the AD curve.
The graph above also shows a demand-side shock
(when AD increases quickly in the short-run)

Demand pull inflation occurs
when aggregate demand is
growing at an unsustainable rate
leading to increased pressure on
scarce resources and a positive
output gap

When there is excess demand,
producers are able to raise their
prices and achieve bigger profit
margins because demand is
running ahead of supply

Demand-pull inflation becomes a
threat when an economy has
experienced a boom with GDP
rising faster than the long-run
trend growth of potential GDP

Demand-pull inflation is likely
when there is full employment of
resources and SRAS is inelastic
Demand-pull inflation, v. 2.0

Initial increase in price level
due to increased AD does not
necessarily mean inflation, but
could set the stage for d-pi.

Inflationary expectations cause
AD to feed on itself, as firms’
and households’ spending
plans increase in anticipation
of higher future prices. AD
increases from AD2 to AD3;
price increases to P3.

This is unsustainable in the longrun, since higher final prices cause
laborers to suffer real wage loss;
wages are bid up.
This results in higher labor costs for firms and decrease in AS from SRAS1
to SRAS2. The economy has moved towards LR equilibrium (Y1) but at a
higher price level, P4. The original shift in AD sets off a round of d-pi
where AD increases beyond LR potential output.
D-PI “Spiral”
If AD continues to rise
(due to continued
expectations of high
inflation), then the
economy can expect a
process where:
1. prices increase
2. labor adjusts by bidding
up wages
3. Firms scale back on
production due to lower
margins between input
prices (i.e., labor costs)
and final output prices

Households anticipate higher
inflation at A; AD increases to
AD1; leads to another dp-i
round (see last slide) and
creates a spiral effect…
Main causes of Demand-pull
inflation

A depreciation of the exchange rate increases the price of imports and reduces the
foreign price of a country’s exports.

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Higher demand from a fiscal stimulus e.g. lower direct or indirect taxes or higher
government spending.
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If direct taxes are reduced, consumers have more disposable income causing demand to
rise.
Higher government spending and increased borrowing creates extra demand in the
circular flow
Monetary stimulus to the economy: A fall in interest rates may stimulate too much
demand –like raising demand for loans or in leading to house price inflation.


If consumers buy fewer imports, while exports grow, AD in will rise
Monetarist economists believe that inflation is caused by “too much money chasing too
few goods” and that governments can lose control of inflation if they allow the financial
system to expand the money supply too quickly.
Fast growth in other countries – providing a boost to exports overseas.

Export sales provide an extra flow of income and spending into the circular flow – so
what is happening to the economic cycles of other countries definitely affects the home
country
The Quantity Theory of
Money
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“the cornerstone of monetarism”

QTM states that there is a direct relationship between the
quantity of money in an economy and the level of prices of
goods and services sold.
If the amount of money in an economy doubles, price levels
also double, causing inflation (the percentage rate at which
the level of prices is rising in an economy).
 consumer therefore pays twice as much for the same amount
of g/s
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Another way to understand this: money is like any other
commodity: increases in its supply decrease marginal value
(the buying capacity of one unit of currency).
 Increase in money supply causes prices to rise (inflation) as
they compensate for the decrease in money's marginal value.
Assumptions: QTM
In its simplest form, the theory
is expressed as:
MV = PT
M = Money Supply
V = Velocity of Circulation (the
number of times money
changes hands)
P = Average Price Level
T = Volume of Transactions of
Goods and Services
Principle of "equation of
exchange":
Amount of Money x Velocity
of Circulation (due to price
levels) = Total Spending

1. Logic to equation of exchange: assumes that V
(velocity of circulation) and T (volume of
transactions) are constant in the short term.

2. Assumes that the quantity of money, which is
determined by outside forces, is the main influence
of economic activity in a society. A change in money
supply results in changes in price levels and/or a
change in supply of goods and services.

3. Number of transactions (T) is determined by
factors of production, knowledge and organization.
The theory assumes an economy in equilibrium
and at full employment.
Essentially, the theory's assumptions imply that the
value of money is determined by the amount of
money available in an economy.
An increase in money supply results in a decrease
in the value of money because an increase in
money supply causes a rise in inflation. As inflation
rises, the purchasing power, or the value of money,
decreases. It therefore will cost more to buy the
same quantity of goods or services.
Cost-push inflation

Cost-push inflation occurs when
firms respond to rising costs, by
increasing prices to protect their
profit margins.

There are many reasons why costs
might rise:
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Component costs: e.g. an increase in
the prices of raw materials and
other components.
This might be because of:
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C-P Inflation is caused by a decrease in AS due to
increases in costs of production (among others), a
leftward shift on the AS curve=a supply-side shock
(when AS decreases quickly in the short-run). This
combination of a fall in output along with inflation is
called stagflation.
a rise in commodity prices such as
oil, copper and agricultural
products used in food processing.
Rising labor costs caused by wage
increases (when unemployment is
low), greater than improvements in
productivity.
Wages might increase when people
expect higher inflation:
• ask for more pay to protect real
incomes
• unions may use their
bargaining power to bid for
and achieve increasing wages
C-PI v. 2.0

As with demand shocks, the
supply shock sets the stage for
cost-push inflation.

When laborers realize real wages
have fallen due to higher price
level, individual wage
bargaining and unions will drive
up wages to regain lost
purchasing power.

Higher cost of labor will shift AS
even further left from SRAS1 to
SRAS3. Price level rises from P2
to P3.

The increase in wages (perhaps
also with expansionary policies
coupled with increased
unemployment) increases
consumption and AD from AD1
to AD2.
C-PI “Spiral”


1.
2.
3.
4.
If final prices continue to
rise due to increased
consumption and fiscal
stimuli, real wages have
also fallen due to
inflation.
Another period of
bidding up wages starts,
creating successive shifts
in SRAS and AD—the
cost-push (wage-price)
spiral.
Increased price level
Increased wages
Increased costs to firms
Increased price level…
Causes of cost-push inflation
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Expectations of inflation are important in shaping what
actually happens to inflation. When people see prices are rising
for everyday items they get concerned about the effects of
inflation on their real standard of living.
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Higher indirect taxes –Depending on the price elasticity of
demand and supply for their products, suppliers may choose to
pass on the burden of the tax onto consumers.
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One of the dangers of a pick-up in inflation is “the wage-price
effect” i.e. an initial rise in prices triggers a burst of higher pay
claims as workers look to protect their way of life.
for example a rise in the duty on alcohol, fuels and cigarettes,
or a rise in Value Added Tax.
A fall in the exchange rate –leads to an increase in the prices of
imported products such as essential raw materials, components
and finished products
Monopoly employers/profit-push inflation – where dominants
firms in a market use their market power (at whatever level of
demand) to increase prices well above costs
Main consequences of inflation

Many governments have a target for a low but positive rate of inflation.
They believe that persistently high inflation can have damaging economic
and social consequences.
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Income redistribution: One risk of higher inflation is that it has a
regressive effect on lower-income families and older people in society.

i.e., prices for food and domestic utilities rises at a rapid rate
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Falling real incomes: With millions of people facing a cut in their wages
or at best a pay freeze, rising inflation leads to a fall in real incomes
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Negative real interest rates: If interest rates on savings accounts are lower
than inflation, people who rely on interest from their savings will be
poorer.
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Cost of borrowing: High inflation may lead to higher interest rates for
businesses and people needing loans and mortgages; this as financial
markets protect themselves against rising prices and increase the cost of
borrowing on short and longer-term debt
Main consequences of inflation

Risks of wage inflation: High inflation can lead to an
increase in pay claims as people look to protect their real
incomes.
 Can lead to a rise in labor costs and lower profits for firms

Business competitiveness: If one country has a much
higher rate of inflation than others for a considerable period
of time, this will make its exports less price competitive in
world markets.
 This may create reduced export orders, lower profits and
fewer jobs, lower trade balance.

Business uncertainty: High and volatile inflation is not
good for business confidence partly because they cannot be
sure of what their costs and prices are likely to be.
 This could lead to a lower level of capital investment
spending
Final thought: a “third” view of
money-driven inflation
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Simplified version: monetarist view
says that any increase in money not
matched in real potential output (LRAS)
as solely inflationary in the long run.
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Ad the increase in AD has pushed
equilibrium output beyond LRAS,
the increase in real GDP will not
last, since wages will rise to match
labor demand, increasing costs for
firms, pushing SRAS curve left.
Steering the economy primarily by
regulating the money supply
advocates minimum gov’t
intervention in favor of a few simple
guidelines, such as a central bank
setting rates of monetary growth or
inflation ceilings:

Monetary policy should be
tightened when nominal interest
rates are lower than nominal GDP
growth (and vice versa).