Inflation.pptx for manaement students in uni

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1. Inflation AS Economics

2. What is Inflation? Inflation refers to a persistent and sustained increase in the general price level of an economy. The general price level can also be though of as the average price level. The general price level refers to a weighted average of some prices. Prices refer to the rates at which money is exchanged for different goods and services. An increase in a small number of prices does not constitute inflation, as it does not necessarily increase the general price level. For instance, an increase in the price of 5 goods that no one consumes has no impact on the general price level.

3. What is Inflation? The increase in prices must have a measurable effect on the spending of consumers, producers, and so on to be considered inflation. However, some goods are so vital to an economy, that an increase in their price causes the prices of many other goods to increase. For instance, an increase in the price of fuel will raise the production costs of virtually all goods, thereby increasing the prices of those goods. Moreover, the increase in price must be sustained over a period of time, say a year. For instance, if prices rise for a day and go back to what they were prior after the day passes, this rise would not be considered inflationary. The inflation rate measures the degree or severity of inflation. It measures the rate at which the price level changes relative to some base price level.

4. The Kinds of Inflation Creeping Inflation: This refers to inflation at a rate of around 2% or 3%. This inflation is mild, often expected, and can be beneficial for the economy by stimulating producers to increase production or ‘greasing the wheels’ of the labor market by enabling real wages to adjust to decreasing demand and supply. Suppressed Inflation: This occurs when all the conditions that would cause inflation are present but the government fixes prices, imposes strong price controls, or rations. In essence, the government suppresses inflation, such as through price controls, or the factors that would cause inflation, such as through rationing. Stagflation: This refers to a situation in which there is inflation and unemployment. Some economists believed there was a trade-off between inflation and unemployment. At high levels of inflation, unemployment would be low (because demand pushes up prices and encourages firms to increase production, which increases employment). Stagflation violates this belief. It is known as stagflation because it combines economic stagnation (falling output and employment) and rising prices (inflation). Deflation: This is also known as negative inflation. It refers to a sustained and persistent decrease in the price level. This typically occurs during recessions.

5. The Kinds of Inflation Hyperinflation: Hyperinflation is typically defined as inflation that is over 50% per month. Since inflation compounds every month, hyperinflation leads to very large increasing in prices over a year. This can result in a country’s currency becoming worthless, high menu and shoeleather costs, lost real tax revenue, and more. For perspective, under hyperinflation, carrying money to a grocery store can become as difficult as carrying the grocery bags home. Since money loses all value, it may cease to perform its functions, leading to the reemergence of barter trade or commodity monies. Accelerated and Stable Inflation: Accelerated inflation refers to a situation in which the inflation rate repeatedly rises after each financial period. Stable inflation refers to a situation in which the inflation rate does not change by much after each financial period. Accelerated inflation typically occurs when demand outstrips supply, pulling up prices. Due to the rapidly decreasing purchasing power, producers avoid investing while consumers bring their purchases forward. This reinforces the shortage that caused accelerated inflation. Stable inflation permits easier planning and accommodating inflationary pressures. Disinflation: Disinflation refers to the deceleration of the inflation rate. Prices continue to rise, but they rise at a slower rate.

6. The Kinds of Inflation Expected and Unexpected Inflation: Inflation alters the real value of wages, interest, and other incomes. Many people rely on expectations about inflation to make their decisions. For instance, if laborers expect an inflation rate of 4%, they may demand a 4% increase in their nominal wages, so that their real wages remain unchanged. When inflation is as expected, economic actors can adjust. In contrast, when inflation is not as expected, the adjustments are not appropriate and there are changes in peoples’ real incomes. Some peoples’ real incomes decrease, while others’ increase. Suppose that the nominal interest rate is 4% and the inflation rate is 10%. Consider a loan of $1000 for 1 year at the nominal interest rate. With $1000 at the beginning of the year, you can purchase 10 horses. Consequently, the real value of $1000 is 10 horses. At the end of the year, you can only purchase 9 horses due to inflation. To buy 10 horses, you need $1100. At the end of the year, you receive the principal, $1000, and the interest, $40. You can no longer purchase 10 horses with $1040, so your real income has decreased. This loss in income is transferred to the borrower, as they now need to pay a lower real amount. At the beginning of the year, $40 could purchase 0.4 horses. At the end of the year, $40 can purchase 0.36 horses. Therefore, the borrower has to pay you less at the end of the year. This arbitrary redistribution of wealth is undesirable.

7. Measuring Inflation Inflation is measured using various price indices. There are many different price indices that have different calculations and are based on different mathematics. Despite that, many price indices are constructed in a similar way since they are all normalized weighted averages of the prices of some set of goods and services (known as a basket). A price index measures the change in the cost of some basket of goods and services due to changes in price. It is a single figure showing how a set of prices has changed. These indices differ based on the products included in the basket, the weights assigned to each product, the base year, and so on.

8. Measuring Inflation – Constructing a Price Index The first step in constructing a price index is choosing a base year. This year’s prices are used as the standard against which future prices are compared. The second step involves selecting a basket of goods and services (also known as a commodity bundle or market basket). This basket contains goods and services that represent what a typical economic agent (such as a producer or consumer) purchases in a given area and time period. For instance, apples may be part of the basket for consumers as it is something on which consumers regularly spend money. The basket also contains the quantities in which these goods and services are purchased.

9. Measuring Inflation – Constructing a Price Index The third step involves assigning weights to each item in the basket. Weights are used to account for the relative importance of each product in a typical economic agent’s expenditure. They are, then, effectively measured by their shares in the total expenditure of the appropriate agent (i.e., they are expenditure shares). For instance, housing makes up a greater percentage of total expenditure than onions. Consequently, the price index of housing has a greater impact on the cost of the basket of goods and services than the price index of onions because housing determines a larger proportion of the basket’s cost than onions. To account for this, housing is given a greater weight than onions. A price index with a fixed basket is one where the weights are calculated using quantities in the base year. This is known as a Laspeyres Index. A price index with a variable basket is one where the weights are calculated using the quantities in the current year. This is known as a Paasche Index.

10. Measuring Inflation – Constructing a Price Index The fourth step is to collect the relevant data. This includes prices in the current and base years, as well as the information needed to determine the weights. Weights differ depending on how products are defined. For instance, the weight of food and beverages will likely be different from the weight of just beverages or the weight of rice. Similarly, weights may differ between regions and outlets. To collect this data, surveys of expenditures need to be developed and conducted, which has several steps such as choosing which products to sample, how to divide expenditures, and so on.

11. Measuring Inflation – Calculating the Price Index The price index is an index that measures the cost of the chosen basket of goods and services relative to the cost of the same basket in some base year. Suppose that the basket only consists of apples and oranges. Moreover, suppose that, on average, households buy 5 apples and 10 oranges a year. To calculate the price index, we do the following: To calculate the price index, we need the prices.  

12. Measuring Inflation – Calculating the Price Index Commodity Year 0 Prices (Base Year) Year 1 Prices Year 2 Prices Apples Rs.10 Rs.12 Rs.15 Oranges Rs.20 Rs.25 Rs.32      

13. Measuring Inflation – Interpreting the Price Index The index provides an easy way to eyeball the level of inflation relative to some base year. In the base year, the price index is 100. We measure inflation by comparing the index in any year to the base year’s price index. In year 1, the price index is 124. This means that the cost of the basket has increased by 24% relative to the base year. In other words, the inflation rate is 24%. In year 2, the price index is 158. This means that the cost of the basket is 58% greater than its cost in the base year. To calculate the inflation rate, we need to compare it to the index in year 1. Specifically, the inflation rate in year 2 would be:  

14. Measuring Inflation – Price Index with Weights In the previous example, the use of weights was absent. This is because weights are only used with price indices. Instead of calculating the index as we did before, suppose we construct two separate indices for oranges and apples. The price index for apples in year 1 is 12/10=1.2. The price index for oranges in year 1 is 25/20=1.25. Further suppose that in the base year, our total expenditure was Rs.250. Consequently, we spend four fifths of our income on oranges and one fifth on apples.  

15. Price Indices As mentioned at the beginning, there are multiple price indices used to measure inflation. The most popular include: Retail Price Index Consumer Price Index Producer Price Index GDP Deflator Personal Consumption Expenditure Deflator

16. Price Indices – Retail Price Index The retail price index was the principal measure of inflation in the United Kingdom. It has been phased out from this role by the consumer price index. This measure relies on household expenditures data collected by the Living Costs and Food Survey. The basket of goods and services is primarily composed of products that households regularly purchase. The survey includes costs such as food, clothing, and mortgage payments. There are three variations on the original retail price index: RPIX: This RPI measure excludes mortgage payments from the overall index. Mortgage payments were excluded because they distorted inflation figures. RPIX inflation figures are useful for comparison with countries where housing costs are low. RPIJ: This RPI measure averages price indices in a different way from the standard RPI measure. Specifically, the standard RPI measure calculates the arithmetic mean of price indices, while the RPIJ calculates the geometric mean of price indices. The method used is known as the Jevons method of averaging, hence the ‘J’ in RPIJ. RPIY: This RPI measure excludes various indirect taxes (such as VATs and excise duties) and mortgage payments to give a more accurate measure of inflation.

17. Price Indices – Retail Price Index The retail price index was suspected of providing inaccurate inflation figures when a review identified issues in the underlying mathematics and statistical procedures. This was the impetus behind the introduction of the RPIJ. The index has undergone amendments and been replaced by other indices for some purposes, such as acting as the measure of inflation. This may raise questions about the utility of studying this index. Nevertheless, the index still has some uses with regards to studying inflation.

18. Measuring Inflation – Consumer Price Index Despite the RPI’s uses, the most prevalent measure of inflation is the consumer price index. Like the RPI, the CPI measures the cost of a basket of goods and services regularly purchased by a typical household. Consequently, it measures variations in the prices of products regularly purchased by consumers. The CPI addresses the shortcomings of the original RPI. For instance, the CPI uses geometric means to average price indices and includes spending by foreigners. There are different kinds of CPIs. These are some of them: CPI-U: This refers to the CPI for urban consumers. This limits the determination of baskets and weights to the spending of urban consumers. CPI-E: This refers to the CPI for the elderly. For example, the elderly spend more on healthcare than the typical citizen, so other CPI figures would understate the weight of healthcare in the price index. C-CPI: This stands for Chain-Weighted CPI. Weights are adjusted monthly for this measure to account for changes in consumer preferences and expenditures in response to changing relative prices. In contrast, the weights of the previous two measures are changed every 24 months.

19. Measuring Inflation – Consumer Price Index The consumer price index is composed of many smaller, sub-indices. For instance, at the highest level, the consumer price index may have weights for the divisions of goods in a basket, such as food and beverages or clothing. These divisions can be broken down into smaller groups, such as just food. These groups can be divided into classes, such as cereals and bread. Those classes can be divided into even simpler sub-classes, such as rice. Finally, these sub-classes can be divided into smaller elements, known as elementary aggregates, by dividing by regions and outlets. Some sub-classes cannot be divided, in which case they become elementary aggregates. These small divisions have price indices and weights attached to them. The consumer price index is the sum of all these smaller indices.

20. Measuring Inflation – Producer Price Index The producer price index measures the changes in the selling prices received by domestic producers. In essence, then, it measures price changes from the perspective of producers, whereas CPI measures price changes from the perspective of consumers. The basket for PPI includes all domestic goods and services sold. This includes finished goods purchased by consumers, as well as raw materials and semi-finished products typically purchased by producers and goods and services exported. Some covered sectors include mining, agriculture, manufacturing, and utilities. One use of PPIs is to adjust contracts. When a producer signs a contract with a raw material supplier, this agreement typically includes the prices of the materials supplied. Moreover, these contracts are for long time periods, periods long enough for prices to significantly change. Consequently, the parties to the contract include clauses to adjust prices based on different price indices, such as producer price indices. Another use is to deflate revenue (i.e., adjust revenue for changes in prices) to measure growth in real output. The producer price index was known as the wholesale price index until 1978.

21. Measuring Inflation – GDP Deflator The GDP deflator (also known as the implicit price deflator for GDP) is the most general measure of inflation, as it measures the change in the prices of all output (i.e., GDP) in a given time period. Two statistics are needed to calculate the GDP deflator: Nominal and Real GDP. Nominal GDP refers to the value of output at current prices, while real GDP is adjusted for changes in prices so that GDP reflect changes in quantities produced. Real GDP is calculated using a constant set of prices. For instance, suppose that an economy produces 10 bananas for Rs.100 in a base year. The real and nominal GDP of this year is Rs.100 or 10 bananas. Next year, 10 bananas are produced, but worth Rs.120. In this year, nominal GDP is Rs.120, whereas real GDP is still Rs.100.  

22. Measuring Inflation – GDP Deflator The formula for the GDP deflator is: The second formula shows that nominal GDP is the product of real GDP (which measures changes in output) and the GDP deflator (which measures changes in prices). In sum: Nominal GDP measures the value of output at current prices. Real GDP measures the value of output at some constant, base prices. The GDP Deflator measures the current price of output relative to its price in the base year.  

23. Measuring Inflation – CPI and GDP Deflator CPI and the GDP Deflator differ in at least three ways: The GDP Deflator measures changes in the prices of all goods and services, whereas the CPI measures changes in the price of goods and services purchased by consumers. The GDP Deflator only accounts for goods and services produced domestically. Consequently, imports have no impact on the GDP Deflator. In contrast, if consumers import some goods, then those imported goods affect the market basket and, by extension, the CPI. The CPI typically assigns fixed weights to the prices of goods, while the GDP Deflator assigns variable weights by allowing the market basket to change as the composition of GDP changes. For instance, suppose a storm wipes out all palm trees in the country, causing coconut prices to skyrocket and coconut production to become zero. Since the output of coconuts is zero, it is no longer part of the GDP, and the changes in its price do not show up in the GDP Deflator. In contrast, because the CPI is computed using a fixed weight, the change in price increases the CPI.

24. Measuring Inflation – Personal Consumption Expenditure Deflator The PCE Deflator is calculated like the GDP deflator, except the statistics needed are nominal and real consumption expenditure. In other words, the PCE Deflator uses the ‘consumption’ component of GDP. The formula for the PCE Deflator is: The PCE Deflator shares some properties with the CPI and GDP Deflator. Like the CPI, it only includes consumption expenditure (including the prices of imported goods and services). Like the GDP Deflator, the PCE Deflator allows the basket of goods and services to vary with consumer expenditure.  

25. Measuring Inflation – Limitations of Price Indices Price indices are very important from a policy perspective, as they are the primary method for governments to gain information about inflation. Central banks use inflation figures to set monetary policy. Commercial banks use these figures to determine nominal interest rates. Trade unions rely on this information to maintain or increase real wages. Consequently, there are two demands on price indices. The first is that the data funneled into the calculation of price indices must be accurate. The second is that the resultant price indices should accurately measure inflation. We have discussed some problems with specific price indices. For instance, there are issues with the mathematics underlying the original RPI, which leads it to overstate inflation rates. However, there are more general limitations and difficulties with price indices that need to be acknowledged when using them.

26. Measuring Inflation – Limitations of Price Indices Changing Preferences: This is arguably the most significant limitation of price indices. Over time, as incomes change, technologies improve, and so on, consumption patterns change. For instance, the introduction of a new production technique may alter the basket of products typically purchased by producers. Similarly, as goods become cheaper or new products are introduced, households begin substituting and shifting their consumption. To account for this, weights need to be regularly revised. However, it is costly to acquire the information needed to revise weights. Consequently, weights are not revised as frequently as they should be. Some indices, such as chain-weighted consumer price indices, are overcoming these issues by revising weights more regularly. Non-Price Factors: Suppose that we are examining a consumer price index. This measures the cost of a consumer basket, thereby tracking the cost of living. By extension, we may say the CPI measures the cost of a particular standard of living. When prices increase, the cost of that standard of living increases. However, if this increase in price is more than matched by an increase in quality, it is not clear whether the cost of living has actually increased. The cost of the basket may have increased, but so has the typical consumer’s standard of living. Consequently, while the nominal cost of living has increased, in real terms, the cost of living may in fact be lower. Recently, methodologies have emerged that attempt to quantify the changes in quality, thereby overcoming this limitation. The CPI, for instance, tries to account for quality changes. However, quantifying changes in quality is difficult, leaving these figures somewhat inaccurate.

27. Measuring Inflation – Limitations of Price Indices A ‘Typical’ Agent: Part of the difficulty with a market basket answering the question of whom the basket is for. If we suppose a typical agent is the average agent, that does not significantly help. For instance, the average age of a person in a room full of 10 20-year-olds and 10 30-year-olds is 25. Yet, everyone is 5 years away from the average. This is the rationale behind the criticism that price indices do not capture variations between regions, groups, and so on. For instance, a man living in DHA (a relatively expensive residential area) will likely have markedly different spending patterns and budgets to a man living in Orangi Town (a relatively cheaper residential area). Many governments have recognized this limitation. For instance, in the US, the CPI-W is calculated to separate urban wage earners from other urban consumers captured by the CPI-U. In Pakistan, the Sensitive Price Index is used to track changes in the cost of living of those living close to or at the poverty line. This index tracks weekly changes in the costs of some necessities (such as onions and diesel). The Base Year: The base year needs to be chosen carefully. Specifically, this year cannot be one experiencing high inflation, high deflation, or several significant price fluctuations, as these would distort the soundness of the calculated price indices.

28. Measuring Inflation – Limitations of Price Indices Statistical Difficulties: Due to the reliance on statistics and mass data, the results of index calculations can never be completely accurate. Statistical analyses typically includes the possibility of some degree of error. While this itself is not a problem (as one should not expect mathematical precision from the social sciences), when the degree and possibility of error are high, it can leave data useless. Moreover, errors during the data collection process can compound these errors. Unclear instructions and faulty budget management can lead to the collection of incomplete and inaccurate information. Inaccurate Figures: Laspeyres indices, by using a fixed basket, fail to account for the ability of consumers to substitute expensive goods for cheaper goods. For instance, in the coconut example, CPI failed to account for peoples’ ability to substitute coconuts for oranges. Consequently, CPI rose much quicker than the actual cost of living, thereby overstating inflation. Paasche indices, in contrast, account for the ability of consumers to adjust their consumption. In the process, however, they fail to account for the changes in the price of the more expensive products. The purpose of price indices is to measure inflation, so, in the coconut example, if the GDP Deflator (a Paasche index) accurately measures inflations, it should show the effect of the rise in the price of coconuts, as this negatively affects peoples’ living standards. However, it does not, thereby understating inflation.

29. Causes of Inflation – Keynesian There are several competing perspectives on what causes inflation. We will study two of these: Keynesian and Monetarist. Keynesians argue that inflation is caused by demand and supply shocks. Inflation caused by positive demand shocks (i.e., increases in aggregate demand) is known as demand-pull inflation. Inflation caused by negative supply shocks (i.e., decreases in short or long run aggregate supply) is known as cost-push inflation. These shocks can be isolated or repeated. There is a third cause of inflation, whereby inflation occurs and persists due to past events. This is known as built-in inflation. Together, these three factors constitute the triangle model of inflation.

30. Causes of Inflation – Demand-Pull Demand-pull inflation is caused by positive demand shocks that increase aggregate demand. As the economy approaches full employment output, positive demand shocks lead to more and more intense increases in prices (i.e., inflation). Aggregate demand shocks can be due to increases in consumption (income increases, availability of credit, etc.), investment (business optimism, political stability, pro-market policies, etc.), government spending (deficit spending, merit and public goods, infrastructural development, expansionary demand-side policies, etc.), and net exports (depreciating exchange rate, tastes and preferences, etc.). This is known as the non-monetary explanation of inflation.

31. Causes of Inflation – Demand-Pull Each demand shock (shift) is of the same magnitude, yet the magnitude of the changes in price increases with each shift. The increasing magnitude is evident from the color of the lines representing the price change. The blue line represents the first change, the green line the second, and the red line the third. As demand increases and output reaches full employment output, aggregate supply becomes more inelastic because the spare capacity in the economy decreases. Consequently, it becomes harder to respond to increases in demand with increases in output. This is evident from the fact that each demand shock causes a smaller increase in real GDP relative to the previous shock. Real GDP GPL O SRAS AD AD 1 AD 2 AD 3

32. Causes of Inflation – Demand-Pull Demand-pull inflation is typically most apparent in economies operating at or close to full capacity (i.e., economies that are booming). At those levels of output, firms are unable to respond to increases in aggregate demand with increases in output because there are fewer unemployed factors of production than at lower levels of output. Consequently, the response is in the form of increased prices. For demand-pull inflation to be sustained, there have to repeated demand shocks. This could be due to a continuously increasing real income. As people have higher incomes, they will, all other things being equal, consume more.

33. Causes of Inflation – Cost-Push Cost-push inflation is caused by negative supply shocks (i.e., decreases in aggregate supply) due to an increase in costs. In the short run, the aggregate supply curve shifts in response to changes in the prices, quantity, and quality of the factors of production. In the long run, however, only changes in the quantity and quality of the factors of production available shifts the supply curve. Changes in costs lead to some important kinds of cost-push inflation: Wage-Push Inflation Profit-Push Inflation Imported Price-Push Inflation Tax-Push Inflation

34. Causes of Inflation – Cost-Push Imported price-push inflation refers to inflation caused by an increase in the prices of imported factors of production. Though all factors of production are imported in varying amounts, not all factor imports cause inflation. If an imported factor of production is used so widely that a change in its price causes a change in the production costs of a large section of the economy, then this factor can cause inflation. The most obvious example is oil. Since oil is used as an input in virtually every industry, a change in its price changes the production costs in every industry, which alters the supply of every industry. Since aggregate supply is the sum of all this output, if all this output decreases at every price, then aggregate supply decreases at every price level. In the 1970s, OPEC doubled oil prices twice, which led to stagflation throughout the world.

35. Causes of Inflation – Cost-Push Sectoral cost-push inflation refers to inflation that occurs due to structural or sectoral changes in the economy. Since wages can be sticky, it follows that in a declining industry, wages may not fall (due to minimum wages, trade unions, and so on). However, as some industries decline, others grow, and this leads to greater demands for labor and, more importantly, higher wages. As wages rise in some industries but do not fall in other industries, the overall trend in wages is upwards. Since wages comprise costs, costs rise, and this causes cost-push inflation.

36. Causes of Inflation – Cost-Push Tax-push inflation refers to the effect of an economy-wide increase in indirect taxation. These taxes will increase production costs, thereby shifting the short run aggregate supply curve to the right and raising price levels. Profit-push inflation refers to an increase in costs due to an increase in the profit margins demanded by the owners of firms. Since prices include a profit component, an increase in that component will raise prices. If the demand for greater profit margins is widespread enough, this will raise the economy’s price level. Given that this demand for higher profits is at every output level, the short run aggregate supply curve shifts to the left.

37. Causes of Inflation – Cost-Push Suppose that in the short run, workers successfully negotiate an increase in wages. The increase in wages increases every firm’s cost of production. By extension, it reduces their profits at each and every price, thereby reducing supply at each and every price. Consequently, the short run aggregate supply curve shifts to the left from SRAS to SRAS 1 . The aggregate demand curve would also shift due to the increase in income, but we will ignore that now for the sake of simplicity. Real GDP GPL O SRAS AD SRAS 1

38. Causes of Inflation – Cost-Push In the long run, however, the firm is able to change its product prices by the same percentage that wages increased, thereby restoring its real profits to its pre-wage-increase level. For instance, if wages increased by 10%, and prices remained the same, then profits decreased. In the long run, however, firms are able to increase their prices by 10% and, if wages remain at their initial 10% increase, then the firms profits also increase by 10%. However, their real profits remain unchanged because the percentage change in profits and prices is the same. Since real profit is what incentivizes firms to increase production and real profits have not changed, long run supply remains unchanged.

39. Causes of Inflation – Cost-Push In the short run, there was an increase in nominal wages, but no increase in prices. Consequently, real wages and, by extension, real income, increases. This shifts the aggregate demand curve to the right from AD to AD 1 . The magnitude of the shift is explained by changes in real income. Since all prices are variable in the long run, real income in the long run is equal to real income before the shift in supply. Since consumption is a function of disposable income and real disposable income is the same as before the shift, the output consumed must be the same as the output consumed prior to the shift. However, because nominal income has increased, the real income at every price level has also increased, thereby increasing consumption at every price level. This shifts the aggregate demand curve. Real GDP GPL O SRAS AD SRAS 1 AD 1 LRAS

40. Causes of Inflation – Cost-Push The previous example was an instance of wage-push inflation. Since wages change costs, they do cause inflation in the short run (and seemingly in the long run), but they do not shift the long run aggregate supply curve. However, natural disasters, wars, and other factors that reduce the productive capacity of an economy will cause inflation in the short and long run by shifting both the short and long run aggregate supply curves to the left.

41. Causes of Inflation – Wage-Price Spiral The previous example of wage-push inflation showed that cost-push inflation can cause demand-pull inflation. Similarly, demand-pull inflation can also cause cost-push inflation by altering real incomes. Recall that the increase in wages shifted the short run aggregate supply curve to the left, but it also increased real income. This shifts the aggregate demand curve to the right. However, there is nothing in the market preventing this cycle from repeating itself. For instance, suppose that workers see the rise in price and think, incorrectly, that there has been a decrease in their real income. They may then demand higher wages, and the cycle repeats itself.

42. Causes of Inflation – Wage-Price Spiral The spiral can begin due to government policies, population changes, increases in production costs, and so on. The price level will continue to rise until the government intervenes by imposing price controls, freezing incomes and wages, weakening labor unions, and so on. The persistent inflation and constant fluctuations in GDP are bad for the long-term health of the economy. Real GDP GPL O SRAS AD SRAS 1 AD 1 AD 2 AD 3 SRAS 2 SRAS 3

43. Causes of Inflation – Wage-Price Spiral The wage-price spiral is considered an instance of built-in inflation. Built-in inflation is caused by past events and tends to persist. Here, the inflation is the result of past changes in wages or prices, and it persists. Due to the repeated shocks, inflation can become a normal part of the economy. You can think of it as being ‘built into’ the economy. Remedying built-in inflation requires policies besides monetary and fiscal policies, as these can be extremely expensive (in social and monetary terms).

44. Causes of Inflation – Monetarist The monetarist perspective on inflation is reducible to a simple identity: the quantity equation. M refers to money supply. We will use the simplest definition of money supply, where money supply is the sum of currency (cash in hand or held by households) and deposits (cash at bank or kept with banks by households). V refers to the transactions velocity of money. It tells us how often cash changes hands in a given time period. P refers to the typical price of a transaction (i.e., the price level). T refers to the number of transactions in a given time period (i.e., the number of times money is exchanged for goods and services in a time period).  

45. Causes of Inflation – Monetarist Suppose that only 50 loaves of bread are produced in an economy, they exchange for $2 per loaf, and each person only buys one loaf. The typical price of a transaction is $2, as the typical transaction is for one loaf and $2 is what is exchanged for the loaf. The number of transactions is 50 (assuming each loaf is sold). Therefore: This tells us that $100 is exchanged per year in this economy.  

46. Causes of Inflation – Monetarist Suppose further that the quantity of money in the economy is $50. We can rearrange the quantity equation to get: This means that for $100 worth of transactions to take place in a year with $50 of money, each dollar bill must change hands twice.  

47. Causes of Inflation – Monetarist Since it is practically very difficult to tell how many transactions occur in an economy, most economists replace T with Y, which refers to total income or output of the economy (i.e., real GDP). T and Y are related. The more goods produced, the greater the number of transactions taking place. However, T and Y are not the same. For instance, if I buy a used car from another person, this counts as a transaction. However, because the car was produced in some other year, it is not part of Y. The new quantity equation is: Here, V refers to the income velocity of money (note that you can refer to V as just velocity of circulation).  

48. Causes of Inflation – Monetarist Monetarists believe inflation is connected to the money supply in the economy. The quantity equation illustrates this connection given some assumptions: The economy is operating in the long-run. Since the economy is operating in the long-run, real GDP is fixed by the quantity of factors of production and the state of technology. The velocity of money is relatively fixed. Once it is assumed that the velocity of money is constant, this equation represents the quantity theory of money .

49. Causes of Inflation – Monetarist If V is fixed, then it cannot cause a change in PY (nominal GDP). Therefore, the only thing that can cause a change in PY is the money supply. Given that output (Y) is fixed by the factors of production and state of technology (in the long run) , the money supply cannot change Y. Therefore, the only thing that the money supply can change is P (i.e., prices). It further follows, that the percentage change in the money supply is equal the percentage change in price (assuming constant output). The percentage change in price is inflation rate. Therefore, the money supply also determines the inflation rate. Since the central bank controls the money supply, it controls inflation.

50. Causes of Inflation – Monetarist Suppose that there are, say, 10 chairs in the economy and a dollar bill changes hands once per year. Further suppose that the price of each chair is $10. If someone buys all the chairs, they pay $100, and this encapsulates all the spending in a year and all the money in the economy in that year. Now suppose the money in the economy rises to $200, but there are still only 10 chairs produced and each dollar bill changes hands only once per year. The only way each dollar bill can still change hands once for 10 chairs is if one has to pay more for each chair (i.e., if the price rises). Consequently, if output and the velocity of circulation are held constant, the only way more money can change hands the same amount of times for the same number of goods is if the goods cost more.

51. Causes of Inflation – Monetarist There are two primary reasons to demand money as we have defined it. These are related to income: Transaction Motive: Since money functions as a medium of exchange, people require it (either in currency or deposits) to exchange for goods and services. According to the Monetarists, this is the primary source of money demand. Precautionary Motive: This refers to money held for emergency expenditures. If we expand our definition of money, as Keynesians do, to include assets that are not as liquid, like savings account deposits or mutual funds, there is a third reason for demanding money. This is related to the cost of holding money: Speculative Motive: This refers to the demand for money as a store of value. This is based on the idea that wealth is held in either money or bonds. If people think the price of bonds will fall, they will sell their bonds and prefer to keep their wealth in the form of money to avoid incurring a capital loss.

52. Causes of Inflation – Monetarist Monetarists argue that when the money supply increases, it directly and indirectly pushes up aggregate demand. These are known as the direct and indirect monetary transmission mechanisms. Directly, the money supply increases aggregate demand by increasing spending. As people have more money, they spend more. Indirectly, the money supply increases aggregate demand by lowering the interest rate. The interest rate is the price of money. Consequently, when the money supply increases (i.e., the money supply curve shifts to the right), the interest rate falls. Nominal interest rates represent the cost of holding money. Instead of holding money as cash, people can buy alternative assets, like bonds, and earn a return. When the interest rate falls, the opportunity cost of holding money decreases. Therefore, people are more likely to hold money. Since they have more money, they spend more, pushing up aggregate demand. Besides this, lower interest rates also make investments cheaper, pushing up investment and, therefore, aggregate demand.

53. Causes of Inflation – Monetarist Consider the following intuition (assuming velocity is fixed): If the money supply increases, then either the price of a typical transaction increases or the number of transactions (or output) increases (we will ignore both the price and number of transactions changing together). If the price of a typical transaction increases, that means more money is needed to conduct a single transaction. Consequently, the price level for a given number of transactions increases. This shifts the aggregate demand curve to the right. If the price remains the same (as it would in the short run due to price stickiness), then people can conduct more transactions with the increased money that they have. Consequently, the number of transactions increases for a given price level, shifting the aggregate demand curve to the right.

54. Causes of Inflation – Monetarist For the previous reasons, demand-pull inflation is a monetary phenomena for monetarists (it is also sometimes called demand-push inflation). Since the money supply is what primarily causes aggregate demand to increase (according to the monetarists), demand-push inflation is a monetary phenomena. This is why monetarists recommend controlling inflation by altering monetary policy. The general prescription is to increase money supply by 2% to 4% per annum. This keeps inflation creeping and corresponding to increases in real GDP. Note that factors that affect the velocity of circulation can also shift the aggregate demand curve.

55. Government Role in Causing Inflation The previous slides make the general point that changes in aggregate demand and aggregate supply cause inflation. For now, we will ignore policies that alter long-run aggregate supply. Instead, we will focus on policies that affect aggregate demand and short-run aggregate supply. In particular, we will focus on two demand-side policies (that also indirectly affect short-run aggregate supply): fiscal and monetary policies. We are also assuming the economy we are looking at is a large and open economy. All this assumption means is that the interest rate is not entirely determined by the world interest rate. Rather, the demand and supply of money and the flow of capital determine the interest rate.

56. Fiscal Policy Fiscal policy refers to the government’s control over its spending and tax revenue. An expansionary fiscal policy is one where the government either reduces taxation, increases spending, or both. A contractionary fiscal policy is one where the government either increases taxation, reduces spending, or both. Expansionary fiscal policy tends to cause inflation by increasing aggregate demand.

57. Fiscal Policy – Government Expenditure and Consumption Suppose that the government decides to increase expenditure. This increases aggregate demand by increasing the government expenditure component of aggregate demand. However, in order for the government to increase its spending, there has to be something on which it can spend. The increase in demand by the government stimulates production, which increases employment. As employment increases, peoples’ disposable incomes also increase. Since consumption is a function of disposable income, it will also increase, further shifting aggregate demand to the right. This further stimulates production and employment, and the cycle repeats itself some more times.

58. Fiscal Policy – Investment However, fiscal policy also affects investment by affecting the interest rate (since investment is negatively related to the interest rate). When incomes increase, the demand for money also increases. This pushes up the price of money (i.e., the interest rate). A higher interest rate increases the cost of borrowing to finance investments. Consequently, fewer investments are profitable, and investment decreases.

59. Fiscal Policy – Net Exports Lastly, fiscal policy affects net exports. An increase in government purchases raises income, which increases the demand for money. This increase in demand will raise the interest rate. This higher interest rate encourages foreign lenders to lend to our country (as they will earn a greater return on their loans). It also encourages domestic lenders to keep their money in the country. For foreign lenders to lend us money, they first need to acquire our currency. For instance, if an American plans on storing money in a savings account in Pakistan, they need to do so with Pakistani rupees. Given that foreign lenders are incentivized to lend, they will demand rupees. This increases the demand for the rupee, which raises its price (the exchange rate with the US Dollar). The appreciation of the rupee makes our exports less competitive (people have to give up more dollars to purchase the same products), reducing net exports and, therefore, aggregate demand.

60. Fiscal Policy – Summary In sum, an expansionary fiscal policy shifts aggregate demand outwards by increasing government spending and having a multiplied effect on consumption. However, this shift is partially reduced by the decrease in investment caused by an increase in the interest rate and the decrease in net exports caused by an appreciation of the domestic currency. AD 1 represents the shift in aggregate demand due to an expansionary fiscal policy. AD FC represents the shift in aggregate demand due to an expansionary fiscal policy if investment was fixed (so it would not be affected by a change in the interest rate) and the economy was closed (so net exports were zero). The shift from AD to AD 1 causes inflation. Real GDP GPL O SRAS AD AD FC AD 1 P 1 P Y Y 1

61. Fiscal Policy – Summary In contrast, a contractionary fiscal policy (say reducing taxation) shifts aggregate demand to the left from AD to AD 1 . Contractionary fiscal policies cause deflation by lowering the price level. They weaken the pull on prices. Real GDP GPL O SRAS AD 1 AD P P 1 Y 1 Y

62. Monetary Policy Monetary policy generally refers to the central bank’s control over interest rates and the money supply. Monetary policy is typically spoken about in terms of changes to the interest rate. However, to make these changes, the central bank must adjust the money supply. Changing the money supply is necessary for central bank to change the interest rate. An expansionary monetary policy is one that increases the money supply (and therefore lowers the interest rate). A contractionary monetary policy is one that reduces the money supply (and therefore increases the interest rate).

63. Monetary Policy Suppose the central bank decides to expand the money supply by buying up bonds. Further suppose that all prices are sticky. An increase in the money supply, when all prices are fixed, means real money balances increase. Suppose the interest rate is 10% and at this interest rate, you wish to keep $100 as currency. The money supply increases, giving everyone a total of $150 as currency. Since people are only willing to keep $100 on hand, they will put the additional $50 in the bank, as they can earn a return on this additional money. However, the bank, seeing an inflow of money, has to pay more as interest ($5 on each $50 deposit). Since the bank wants to make a profit, it will reduce the interest rate to maintain its profits.

64. Monetary Policy – Consumption, Investment, and Net Exports The reduction in the interest rate encourages more investment (which is a function of the interest rate). This increase in investment increases income, as investment stimulates production. The increase in income raises consumption (which is a function of income). However, the fall in the interest rate encourages people to store their money abroad, where they can earn a higher return. In order to do that, people need to exchange their, say, rupees for dollars in the foreign exchange market. This increases the supply of rupees, causing it to depreciate. This makes exports cheaper, further pushing up aggregate demand.

65. Monetary Policy – Summary In sum, an expansionary monetary policy shifts the aggregate demand curve outwards by initially increasing investment expenditure through its effect on the interest rate. The subsequent increase in income (due to the stimulus to production provided by increasing investment and exports) causes an increase in consumption expenditure, further shifting the aggregate demand curve outwards. Real GDP GPL O SRAS AD AD 1 P 1 P Y Y 1

66. Monetary Policy – Summary In contrast, a contractionary monetary policy (reducing the money supply) shifts aggregate demand to the left from AD to AD 1 . Contractionary monetary policies cause deflation by lowering the price level. They weaken the pull on prices. Real GDP GPL O SRAS AD 1 AD P P 1 Y 1 Y

67. Benefits of Inflation Though inflation is generally a bad thing, it does have some advantages. However, note that these advantages are almost exclusively advantages of low and stable inflation. Inflation is Better than Deflation: The first advantage has to do with what inflation is not: deflation. Deflation refers to a sustained fall in prices over some period of time. Deflation increases the real value of money and, therefore, the real value of debt. For instance, suppose someone takes on a loan of $100. At this time, $100 is worth 100 chickens (each costing $1). In a sense, then, the borrower has to repay 100 chickens. After a period of deflation, each chicken costs $0.5 and, therefore, $100 can buy 200 chickens. The borrower still needs to pay back $100 to the lender, but because of the deflation, the borrower now must, effectively, pay back 200 chickens instead of 100 chickens. Besides an increased real debt burden, deflation also discourages spending, as people think prices will continue to fall and, therefore, things will become cheaper in the future. As a result, people will wait for prices to fall before spending. This reinforces a recession, as consumption and investment expenditure continues to decrease. Note that deflation caused by decreasing aggregate demand is bad. Deflation caused by increasing aggregate supply (long and short run) is often desired.

68. Benefits of Inflation Encouraging Production and Consumption: Tied to the previous point, when the inflation rate is low, it encourages investment and consumption. Firstly, a stable inflation rate enables economic agents to plan more accurately, as due to the stability of the inflation rate, the expectations of economic agents regarding inflation will likely be in line with actual inflation. Secondly, the stability also increases the confidence people have in the economy, as stability reduces risk. Consequently, domestic and foreign investors will feel more confident about their investments, thereby increasing investment expenditure. Lastly, low inflation rates allow the price mechanism to function. Small price rises signify the presence of a shortage and the opportunity for profits. This stimulates production and employment, which further stimulates production and employment. However, one should note that low inflation only stimulates production in the short run. In the long run, when all prices are flexible, a rise in the price level leaves real profits unchanged and, therefore, does not stimulate production.

69. Benefits of Inflation Menu and Shoe-Leather Costs: Stable inflation rates will reduce menu costs, as firms do not have to constantly update their prices and print new menus. It also reduces shoe-leather costs, as the cost of holding money is low and, therefore, people have to visit banks fewer times to withdraw money. Essentially, a high inflation rate leads to a fall in the value of money people hold. To counter this, people store their money in bank accounts that earn interest. When the inflation rate is higher, people will store more money in banks. However, people will also spend the same amount of money. Since they do not keep as much money on hand or in deposits (these usually do not earn interest), they will need to visit the bank more often to withdraw money. In effect, the leather of their shoes wears down because they keep walking to the bank.

70. Benefits of Inflation ‘Greasing the Wheels’ of the Labor Market: This refers to the ability of inflation to alter real wages in the presence of wage stickiness or rigidity. Wage rigidity prevents labor markets from functioning optimally because a fall in demand for workers is not followed by an appropriate fall in real wages. This prevents labor markets from clearing, causing higher-than-average unemployment. Suppose that there is a decrease in demand for a firm’s products. In response to the decrease in demand, the firm decides to lower its prices and cut production. This leads to a decrease in the demand for labor, as the firm does not need to produce as much. Typically, this would lead to a fall in wages and decrease in the number of people employed. However, workers are unwilling to accept decreases in their wages (in reality, decreases in nominal wages are rare). Suppose the firm wished to decrease nominal wages by 2% and that there was zero inflation. This amounts to a 2% decrease in real wages. However, workers may perceive such a decrease as a slight and not allow it to pass (through strikes, bargaining, etc.). Now suppose that the inflation rate was 5%. In order to decrease real wages by 2%, firms need to raise nominal wages by 3%. Workers are far more likely to accept the raise over the cut, even though in real terms, there is no difference. In this way, inflation enables labor markets to work better by reducing real wages.

71. Costs of Inflation While inflation has some benefits, these only manifest if inflation is controlled. Uncontrolled, inflation has several costs, which we can separate into two categories: the costs of expected and unexpected inflation. Expected inflation refers to inflation that people in the economy correctly predict and for which they can, therefore, plan. Unexpected inflation refers to inflation that is either below or above what people predict or expect. Since people plan their expenditure around their expectation of inflation, unexpected inflation’s greatest cost is that it arbitrarily redistributes wealth. Additionally, we will briefly consider the costs of hyperinflation.

72. Costs of Inflation – Expected Menu and Shoe-Leather Costs: As discussed previously, changing prices require firms to print new menus and catalogs and increase the cost of holding money in currency or deposits, requiring more trips to the bank. Both of these represent costs (the former represents menu costs while the latter represents shoe-leather costs). Changing Relative Prices: Consumers base their consumption decisions on relative prices. For instance, your decision to buy a burger or pizza depends on the price of one relative to the other. Menu costs and other factors may deter some firms from changing their prices. Suppose that there is an inflation rate of 10% per year. This means that as the year progresses, the price of such a firm’s products decreases relative to the price level. By the end of the year, the product will be 10% cheaper (in real terms). This means the firm will make most of its sales later in the year (when its product is relatively cheap). This leads to microeconomic inefficiencies with regards to resource allocation.

73. Costs of Inflation – Expected Tax Burden: Many tax laws do not account for inflation. Consequently, inflation can alter a person’s tax liability without a change in their wealth. Suppose that you buy a share in some firm worth $100. Suppose you sell this share for the same real price at the end of the year. Since you bought and sold it at the same real price, your wealth or real income has not changed at all, so it does not make sense for the government to charge you a greater income tax. If there was zero inflation, you would not be taxed. However, given an inflation rate of 10% per year, if you wish to sell it for the same real price, you must sell the share for $110. However, most tax codes ignore inflation and treat the $10 increase in sale price as a capital gain and, consequently, part of the tax base. Consequently, this $10 will be taxed despite the fact that there has been no change in your income.

74. Costs of Inflation – Expected Inconvenience: Imagine living in a world where the government determines the length of a meter. In 2019, they determine that it is equivalent to 100 cm, in 2020 150 cm, and in 2021 165 cm. Measuring something in meters becomes very inconvenient, as you have to specify which year’s meter length you are using. To compare the length of two things measured in different years, you would have to correct for the discrepancy in meter-lengths. Analogously, inflation makes it inconvenient to keep track of the relative prices of different products. For instance, deciding how much money to save for future expenditures would be easier if future prices were similar to current prices (i.e., inflation was very low).

75. Costs of Inflation – Unexpected Arbitrary Wealth Redistribution: Suppose that someone lends you $50 at a 10% interest rate and asks you repay at the end of the year. You repay this person $55. Is he better off? He clearly has more money than at the beginning of the year, but is he wealthier? This depends on the inflation rate. Whenever a borrower and lender negotiate, they typically account for inflation. For instance, if this lender expected a 5% inflation rate, and inflation was actually 5%, he is richer in real terms by 5% (i.e., his purchasing power has grown by 5%). However, lenders and borrowers rely on inflation being as expected. Suppose that the inflation rate, instead of being 5%, ended up being 15%. Consequently, the lender now has 10% more money, but this money is worth 15% less than what it was at the beginning of the year. The borrower pays back the loan with less valuable dollars. The lender has, in effect, lost some of their wealth, and this wealth has been redistributed to the borrower, as they have to give less than what they borrowed (in real terms). When inflation is greater than expected, wealth is transferred from lenders to borrowers (borrowers gain and lenders lose) and vice-versa when inflation is less than expected. In either case, wealth is redistributed in a way to which neither party consented.

76. Costs of Inflation – Unexpected Planning Difficulties: Suppose you are deciding on how much of your income to consume and save. You earn a fixed interest on your savings. In 30 years, you will surely have more dollars . However, inflation affects the value and purchasing power of each dollar. Consequently, while the number of dollars you have may have increased by, say, 20%, your purchasing power has not necessarily increased by 20%. For instance, if the inflation rate over those 30 years was 30%, your purchasing power has actually fallen by 10%. The ability to make decisions about the future is hampered by unexpected inflation, as this inflation makes it harder to predict the future. When inflation is unexpected, it can make some decisions that were lucrative if inflation was as expected, extremely costly.

77. Costs of Inflation – Unexpected Fixed Pensions: Many workers typically agree to a fixed nominal pension when they retire. Since these are fixed nominal pensions, they do not adjust for inflation. However, workers typically accommodate inflation by adjusting their pension for what they expect inflation to be at the time of their retirement. If inflation is greater than their expectations, then their pension is worth less at the time of their retirement. It may seem that this is not an issue, since some pension income is better than no income. However, a pension is deferred earnings, so the worker is entitled to them. You can think of a worker as providing a loan to a firm. They work for the firm, but they do not receive the entirety of their earnings until old age. As with all lenders, these workers lose out when inflation is greater than expected.

78. Costs of Inflation – Summary The main issue with expected inflation is it creates inconveniences, which create inefficiencies and impose unfair costs on people. The main issue with unexpected inflation is the unpredictability it fosters with regard to the real return on and cost of loans. Debtors and creditors are often risk-averse, which means that they inherently desire to minimize risks and dislike anything that increases risk. Unpredictability enhances risk and is, therefore, disliked by debtors and creditors.

79. Hyperinflation The costs of inflation are most apparent during periods of hyperinflation. We will not discuss hyperinflation in detail, but consider the following anecdotes and explanations: Menu Costs: In Germany, during the hyperinflation engendered by the Treaty of Versailles, instead of printing new menus, waiters would stand on top of tables to announce new prices every 30 minutes. Measure of Value: Once again in Germany during the 1920s, people entering pubs would often buy multiple pitchers of beer. Even though a pitcher would lose value by warming, the currency held by people would lose value even faster. Tax Revenue Distortions: Since there is a time lag between when a tax is levied and when it is paid, tax revenue decreases significantly between when it is levied and when it is received by the government. For instance, if tax payments are quarterly, real tax revenue decreases substantially from the start of the quarter to its end. Inconvenience: In Zimbabwe, Germany, and other countries that have experienced hyperinflation, people often have to take money to buy groceries in bags or wheelbarrows. When carrying money to buy goods is more inconvenient than carrying the goods home, there is often uproar and a demand for reforms. For instance, one argument for the Nazi party’s rise to power is that the monetary dire straits in which Germany was left after world war 1 created an opportunity for the Nazi party to galvanize support by pledging to solve hyperinflation. Money Ceases to Function: The above reasons eventually lead to money ceasing to perform its functions. What follows is either the emergence of a new money-commodity (such as cigarettes) or barter trade.

80. Policies to Correct Inflation As we discussed before, contractionary fiscal and monetary policy can correct inflation by altering aggregate demand. However, such policies can have several negative effects (such as causing deflation and its associated costs). Consequently, governments rely on a mix of policies to correct inflation. These policies include the aforementioned demand-side policies, but also trade and supply-side policies.

81. Policies to Correct Inflation – Demand-Pull Contractionary (or deflationary) fiscal and monetary policy will counter demand-pull inflation by dampening the increase in aggregate demand. However, these policies will often also reduce GDP and employment. These effects reinforce each other, as reduced GDP and employment means reduced consumption, which means reduced GDP and employment, and so on. Governments can, instead, pursue supply-side policies (these shift the PPC outwards). These policies focus on increasing the quantity of factors of production or improving their quality by improving the state of technology. These shift the long and short run aggregate supply curve to the right, countering the effect of increased aggregate demand. Essentially, if aggregate supply grows faster than aggregate demand, the economy can benefit from higher GDP without inflation.

82. Policies to Correct Inflation – Demand-Pull The shift in aggregate demand from AD to AD 1 is caused by a deflationary fiscal policy (decrease in government spending or increase in taxes) or a deflationary monetary policy (decrease in money supply). Note the decrease in real GDP (i.e., real income). This can cause multiple reductions in aggregate demand, which can lead to a recession. Real GDP GPL O SRAS AD 1 AD P P 1 Y 1 Y

83. Policies to Correct Inflation – Demand-Pull The shift in the LRAS and SRAS curve is caused by a supply-side policy focused on improving technology (say by training workers or developing better machines). Another supply-side policy could be to increase the stocks of capital and labor. Note how inflation is accommodated or even overridden without a decrease in real GDP. Also note that it is a good idea to not draw both the LRAS and SRAS curve shifting in one diagram. Draw the SRAS curve to show changes in short-run equilibrium and the LRAS curve to show changes in long-run equilibrium. Real GDP GPL O SRAS AD P P 1 Y Y 1 LRAS LRAS 1 SRAS 1

84. Policies to Correct Inflation – Cost-Push Central banks may decrease the money supply to raise the national interest rate. The rise in domestic interest rates attracts foreign capital, which seeks the highest return. For foreigners to store money in our country, they need our currency. This raises the demand for our currency in the foreign exchange market, pushing up the exchange rate, making imports relatively cheaper. In situations where cost-push inflation is caused by costly imports, an appreciating currency can reduce the cost of said imports. Supply-side policies would also be successful in correcting cost-push inflation. Enhancing productivity through labor-augmenting technology can counter increases in the real wage. If productivity grows faster than real wages, then per unit costs will not rise (they will fall). A country can also engage in capital deepening. This refers to the process of increasing capital per laborer. This will improve efficiency and reduce per unit costs. Other than that, supply-side policies reducing costs, such as reducing taxes or giving subsidies, will also dampen the push on prices.

85. Policies to Correct Inflation – Cost-Push A decrease in the money supply would shift the aggregate demand curve to the left, but for the sake of simplicity, let’s ignore that. Suppose that all prices contain some competitive mark-up over costs. Since costs have decreased (due to the appreciating currency making oil imports cheaper) and firms are competitive (so they will cut prices when costs decrease to undercut their competitors), prices will also decrease. At a lower price level, there is greater demand in the economy, stimulating production. In this case, a reduction in the price of oil due to an appreciating currency causes the SRAS to shift to SRAS 1 . Real GDP GPL O SRAS 1 AD P P 1 Y 1 Y SRAS

86. Policies to Correct Inflation – Cost-Push In practice, this policy has several problems. The most significant problem is that aggregate demand will likely shift to the left due to an appreciating currency making exports more expensive and higher interest rates reducing investment expenditure. This means that the economy will have to go through a recession before price expectations adjust and bring the economy back to its natural level of output. Besides that, exporting countries can raise the price of their oil exports to importing countries, the reduced prices may breed inefficiency, and the reduction in the money supply or alteration to the country’s exchange rate will compromise other components of aggregate demand, such as investment (reduced money supply increases interest rate, which reduces investment). Real GDP GPL O SRAS 1 AD P P 1 Y 1 Y =Y 2 SRAS AD 1 P 2

87. Policies to Correct Inflation – Cost-Push Reductions in taxes and the provision of subsidies can reduce the push on prices by lowering costs. However, this is not guaranteed. If the economy is going through a recession and businesses are generally pessimistic, they are not likely to reinvest the additional profits they generate. Consequently, the tax breaks and subsidies may fail to generate a significant increase in production. Real GDP GPL O SRAS 1 AD P P 1 Y 1 Y SRAS

88. Policies to Correct Inflation – Cost-Push The problem can further be exacerbated if the reduction in taxes or increase in government spending causes demand to rise faster than supply. This will cause more inflation instead of controlling it. Real GDP GPL O SRAS 1 AD P P 1 Y 1 Y SRAS AD 1

89. Policies to Correct Inflation – Cost-Push Supply-side policies focused on improving the quality and quantity of the factors of production are arguably the best solution to preventing inflation from becoming a long-run phenomenon. However, there are still situations in which these policies may fail to correct inflation. For instance, if real wages rise faster than labor productivity, aggregate demand will grow faster than aggregate supply, cause the price level to rise.