Inflation cycles

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Intros
Lessons
  1. Demand-Pull Inflation
    • Starting effect
    • Adjustment of Money Wage
    • Demand-Pull Inflation Process
  2. Cost-Push Inflation
    • Starting Effect
    • Response of Fed
    • Cost-Push Inflation Process
  3. Expected Inflation
    • No Demand-Pull or Cost-Push
    • Real GDP = Potential GDP
    • Natural Rate = Unemployment Rate
  4. Relationship Between Inflation & Business Cycle
    • Inflation forecast correct = full employment
    • Real GDP > potential GDP = demand-pull inflation
    • Real GDP < Potential GDP = cost-push inflation
Topic Notes
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Demand-Pull Inflation

Demand-Pull Inflation: is when inflation happens due to an increase in aggregate demand.

Recall that aggregate demand can be increased by one of the following influences:
  1. Cut in interest rate
  2. Cut in taxes
  3. Increase in government expenditure
  4. Increase in exports
  5. Increase in investments

When any of these influences happens, it starts the effect of demand-pull inflation.

Starting Effect: Suppose we have a short and long-run aggregate supply and aggregate demand, and the aggregate demand increases by one of these influences. The aggregate demand shifts to the right.

Inflation Cycles

We see that the price level and real GDP increases, and unemployment rate < natural rate. We have an above full-employment equilibrium

Rise in Money Wage Rate: With higher price levels, workers want higher pay, causing a rise in the money wage rate. This shifts the aggregate supply to the left.

Inflation Cycles

We see that real GDP is back to potential GDP, and the price level has increased again.

Demand-Pull Inflation Process: is when the starting effect of demand-pull inflation and rise in money wage rate happens persistently (more than once).

Suppose the aggregate demand increases again.

Inflation Cycles

Real GDP is now greater than potential GDP. With higher price levels again, workers want to increase the money wage rate again, shifting aggregate supply to the left.

Inflation Cycles

Once again, real GDP = potential GDP, and the price level has risen again.

We know that if this cycle keeps repeating, then the result is an ongoing increase in the price level.

Cost-Push Inflation

Cost-Push Inflation: is when inflation happens due to an increase in costs, which decreases aggregate supply. The two main influences for costs to increase are

  1. An increase in the money wage rate

  2. An increase in the price of raw materials

When any of these influences happens, it starts if the effect of cost-push inflation.

Starting Effect: Suppose we have a short and long-run aggregate supply and aggregate demand, and the aggregate supply decreases by one of the influences. The aggregate supply shifts to the left.

Inflation Cycles

See that the price level has increased, but real GDP has decreased and unemployment rate > natural rate. This causes a recessionary gap. With real GDP < potential GDP, the Fed needs to respond.

Response of Fed: To restore full employment, the Fed must cut interests to increase aggregate demand. This causes the aggregate demand to shift to the right.

Inflation Cycles

We see that real GDP is back to potential GDP, and we are back to full employment. However, the price level has increased again.

Cost Push-Inflation Process: is when the starting effect of cost-push inflation and response of fed happens persistently (more than once)

Suppose the aggregate supply decreases again.

Inflation Cycles

Real GDP is less than potential GDP, causing a recessionary gap and unemployment rate > natural rate. Once again, Fed responds by cutting interests again to restore full employment. This shifts the aggregate demand to the right.

Inflation Cycles

If this cycle keeps repeating, then the result is an ongoing increase in the price level, which is a result of inflation.

Expected Inflation

If the inflation is to be expected, then demand-pull and cost-push inflation and its process does not occur.

With expected inflation, we will always have:

  1. Real GDP = Potential GDP

  2. Unemployment rate = Natural rate of Unemployment.

Why? Suppose we have a short and long-run aggregate supply and aggregate demand of today.

Inflation Cycles

We expect the Fed to cut interest to increase the aggregate demand next year. So, that means we should also expect an increase in the money wage rate. This means we expect a decrease in aggregate supply.

Inflation Cycles

Let’s say that we expect the same thing to happen the year after. Then we should expect the aggregate demand to increase and aggregate supply to decrease again.

Inflation Cycles

As a result, we have inflation, but we always maintain real GDP = potential GDP and full employment.

Forecasting Inflation

For inflation to be expected, inflation must be forecasted. This requires economists who have studied for many years in macroeconomics, and have worked for macroeconomic forecasting agencies, banks, etc.

Rational Expectation: is the best forecasting one can provide with all the relevant information given.

Rational expectation is the best forecast, but it is not always a correct forecast. In fact, it is often wrong. Therefore, sometimes inflation can be unexpected.

If inflation forecast is incorrect, then one of the following things can happen.

  1. Aggregate demand grows faster than expected, then real GDP > potential GDP. This cause a demand-pull inflation.

  2. Aggregate demand grows slower than expected, then real GDP < potential GDP. This slows down the inflation rate.

If the inflation forecast is correct, then real GDP = potential GDP, and we are at full employment.