Unit 5.05 _ The Causes of Inflation

Unit 5.05: Inflation

Introduction To Inflation

• Definition: Inflation is defined as a persistent increase in the average price level of goods and services in an economy.

• Types of Inflation: There are two main types of inflation that will be discussed: Demand-Pull Inflation and Cost-Push Inflation.

Causes of Inflation

Demand-Pull Inflation

• Definition: Occurs when there is an increase in Aggregate Demand (AD) in the economy.

• Characteristics:

  • Increased AD can pull prices higher (from P1 to P2).

  • Associated with increased consumer confidence, high demand for exports, and increased government spending.

• The Monetarist View: Monetarists assert that inflation is caused by excessive growth of the money supply by the central bank.

Cost-Push Inflation

• Definition: Results from an increase in the costs of production.

• Characteristics:

  • Shifts the Short-Run Aggregate Supply (SRAS) curve leftward (from SRAS1 to SRAS2).

  • Increases price levels while reducing real output.

• Causes of Cost-Push Inflation:

  • Rising labor costs can lead to wage-push inflation.

  • Increasing costs of domestic raw materials and imported goods (import-push inflation) due to lower exchange rates.

Simultaneous Inflations

• Inflationary Spiral: The tendency of inflation to perpetuate itself.

  • Example scenario: Increased wealth leading to increased AD, heightened prices, rising production costs.

  • Higher wages driven by price levels can lead to further increases in AD, creating a cycle of inflation.

Government Attempts to Reduce Inflation

Short-Term Solutions

• Inflation is largely a short-run problem; supply-side policies may not be effective quickly.

• Demand-Pull Inflation Solutions: Contractionary fiscal and monetary policies to reduce AD.

• Cost-Push Inflation Solutions: More challenging as costs of production are not easily controlled.

Monetary vs. Fiscal Policy

• Monetary Policy: Considered more effective; adjustments in interest rates are a significant tool.

• Fiscal Policy: Often difficult for governments to implement due to public commitments.

• Monetarist Approach: Advocates for controlling the growth of money supply in line with real output growth.

Policy Trade-Offs

• Challenges: Reducing AD to combat inflation can increase unemployment. Conversely, increasing AD for economic growth may lead to inflation.

What Is Deflation?

• Definition: A persistent fall in the average price level in the economy.

• Types of Deflation:

  • Good Deflation: Linked to improvements and productivity growth in the economy, resulting in higher output and lower prices.

  • Bad Deflation: Driven by decreased AD, causing lower output and increased unemployment.

Effects of Deflation

Good vs. Bad Deflation

• Good Deflation:

  • Results from positive economic changes, leading to higher output and employment.

• Bad Deflation:

  • Leads to increased unemployment and reduced output.

  • Important distinction from disinflation, where the inflation rate decreases but prices still rise.

Costs of Bad Deflation

1. Unemployment: Businesses likely to lay off workers due to reduced AD, risking a deflationary spiral.

2. Deferred Consumption: Consumers may delay purchases in anticipation of falling prices, further reducing AD.

3. Falling Consumer Confidence: Pessimism about future economic conditions can lead to decreased spending.

4. Investment Decline: Reduced profits may lead businesses to cut costs, resulting in less investment and growth.

5. Increased Debt Burden: The real value of debt rises, making it hard for borrowers to pay off loans, leading to bankruptcies.

6. Ineffective Monetary Policy: Low or negative interest rates limit the effectiveness of expansionary monetary policy.