Chapter 16 Chapter 15 4th Edition

1
Chapter 16 (Chapter 15 - 4th Edition)

• Learning Objectives
• What is inflation?
• What is demand-push and cost-pull inflation?
• Relation between inflation and interest rates.
• The inflation-employment trade-off.

2
Inflation and the Price Level

• A one-time jump in the price level is not
  inflation.
• Inflation is an ongoing process.

160
150
Inflation, ongoing process of rising price level
140
130
Price level (1992 100)
120
A one-time rise in the price level
110
100
90
1992
1993
1994
1995
1996
1997
3
Inflation and the Price Level

• For example if this years price level is 126 and
  last years was 120, then inflation is
• There are two sources of shocks to the price
  level
• 1) Demand pull (Over-employment ?)
• 2) Cost push (Increase in Oil Prices ?)

120

126
100
?
?
120
5 percent per year.




4
Inflation and the Price Level

• But inflation arises from continuing money-supply
  growth.
• 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

5
A Demand-Pull Rise in the Price Level
LAS
Increase in AD raises price level and
increases real GDP...
130
Price level (GDP deflator, 1992 100)
SAS0
121
113
110
AD1
100
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
6
A Demand-Pull Rise in the Price Level
LAS
130
SAS1
Price level (GDP deflator, 1992 100)
SAS0
121
wages rise, and SAS shifts leftward. Price level
rises further, and real GDP declines
113
110
AD1
100
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
7
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.
• Example When the government runs budget
  deficits, it might finance this by printing new
  money.
• Demand-Pull Inflation in the United States
• A series of events similar to an inflation spiral
  occurred in the U.S. during the 1960s.
• Government spending increased for Vietnam and
  social programs.
• The growth rate of money increased.

8
A Demand-Pull Inflation Spiral
LAS
SAS1
133
125
Price level (GDP deflator, 1992 100)
SAS0
121
113
AD2
110
Repeated increases in AD create a price-wage
spiral
AD1
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
9
A Demand-Pull Inflation Spiral
LAS
SAS2
133
SAS1
125
Price level (GDP deflator, 1992 100)
SAS0
121
113
AD2
110
Repeated increases in AD create a price-wage
spiral
AD1
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
10
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.
• A Cost-Push Inflation Process.
• An increase in oil prices causes the short-run
  aggregate supply curve to shift leftwards.
• The Fed increases Aggregate Demand to restore
  full-employment and the price level rises again.

11
A Cost-Push Rise in the Price Level
LAS
Factor price rise shifts SAS leftward causes
stagflation
130
SAS1
Price level (GDP deflator, 1992 100)
SAS0
120
117
110
100
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
12
Aggregate DemandResponse to Cost Push
LAS
130
SAS1
Price level (GDP deflator, 1992 100)
SAS0
121
117
110
AD1
100
The Fed increases AD to restore full- employment
and the price level rises again
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
13
A Cost-Push Inflation Spiral
SAS2
LAS
Oil producers and the Fed feed cost-price inflatio
n spiral
133
SAS1
129
Price level (GDP deflator, 1992 100)
SAS0
121
117
110
AD1
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
14
A Cost-Push Inflation Spiral
SAS2
LAS
Oil producers and the Fed feed cost-price inflatio
n spiral
133
SAS1
129
Price level (GDP deflator, 1992 100)
SAS0
121
117
110
AD2
AD1
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
15
Money and Inflation Cross-Country Data
16
Interest Rates and Inflation

• The Effects of Inflation on Borrowers and Lenders
• The nominal interest rate is the money price of
  borrowing 1 (how much cash must I pay back
  tomorrow?)
• The real interest rate is the goods price of
  borrowing 1 (how much stuff must I pay back
  tomorrow?)
• When inflation is anticipated, the nominal
  interest rate increases by an amount equal to the
  expected inflation rate. The real interest rate
  remains constant.
• But forecasting inflation is not easy!
• Two effects of unanticipated inflation
• Redistribution of income from workers to
  employers wages set too low from lenders to
  borrowers nominal interest rates too low.
• Departure from full employment labor supply
  lower than normal, demand higher.

17
Interest Rates and Inflation
18
Costs of Inflation

• Anticipated Inflation
• If people correctly anticipate inflation
  correctly, they will adjust their money wage
  rates and interest rates to compensate for
  inflation.
• High rates of anticipated inflation can be
  costly.
• Potential GDP declines for three reasons
• Transactions costs During the 1920s, when
  inflation in Germany reached rates of more than
  50 a month, wages were paid and spent twice a
  day.
• Tax effects High anticipated inflation leads to
  high nominal interest rates. Since dollar
  returns are taxed, the effective tax rate
  increases!
• Increased uncertainty Will inflation continue
  to remain high, or will price stability return?

19
Anticipated Inflation
LAS
133
Price level (GDP deflator, 1992 100)
SAS0
121
110
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
20
Anticipated Inflation
LAS
Anticipated increases in AD bring inflation but
no change in real GDP
133
SAS1
Price level (GDP deflator, 1992 100)
SAS0
121
110
AD1
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
21
Anticipated Inflation
SAS2
LAS
Anticipated increases in AD bring inflation but
no change in real GDP
133
SAS1
Price level (GDP deflator, 1992 100)
SAS0
121
110
AD2
AD1
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
22
Inflation and UnemploymentThe 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 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
• 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.

23
A Short-Run Phillips Curve
20
15
b
Inflation rate (percent per year)
a
10
c
SRPC
Expected inflation rate
Natural unemployment rate
5
3
6
9
12
0
Unemployment rate (percentage of labor force)
24
AS-AD and the Short-Run Phillips Curve
LAS
SAS1
113
Price level (GDP deflator, 1992 100)
SAS0
a
110
107
100
AD1
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
25
AS-AD and the Short-Run Phillips Curve
LAS
SAS1
b
113
Price level (GDP deflator, 1992 100)
SAS0
110
107
100
AD2
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
26
AS-AD and the Short-Run Phillips Curve
LAS
SAS1
113
Price level (GDP deflator, 1992 100)
SAS0
c
110
107
100
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
27
Short-Run and Long Run Phillips Curves
LRPC
20
15
Inflation rate (percent per year)
a
10
SRPC0
5
3
6
9
12
0
Unemployment rate (percentage of labor force)
28
Inflation and UnemploymentThe 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.
• 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.

29
Short-Run and Long Run Phillips Curves
LRPC
20
Decreases in expected inflation shifts
short-run Phillips curve downward
15
Inflation rate (percent per year)
a
10
c
7
SRPC0
d
5
SRPC1
3
6
9
12
0
Unemployment rate (percentage of labor force)
30
A Change in theNatural Unemployment Rate
LRPC
20
Increase in natural unemployment rate shifts
LRPC and SRPC rightward
15
Inflation rate (percent per year)
a
e
10
SRPC1
SRPC0
5
3
6
9
12
0
Unemployment rate (percentage of labor force)
31
Inflation vs. Employment
32
The Volcker Recession

• Inflation rates
• 1980 13 (highest ever peace-time rate!)
• 1986 4
• Costs of 13 inflation?
• Small and avoidable
• Solution Fed reduced aggregate demand
• total cost 20 of annual GDP.
• 1981 GDP 5000 billion cost 1 trillion!

33
The Cost of Stopping Inflation