Topic 10 Part 2
Inflation Overview
Topic 10: Inflation, Part 2
Types of Inflation
Demand-Pull Inflation
Definition: Demand-pull inflation arises due to an increase in aggregate demand when the economy is nearing or at its maximum (potential) output level.
Characteristics:
The aggregate demand (AD) curve shifts rightward.
Production levels cannot instantly meet the heightened demand, particularly if the economy is at full employment.
Prices and nominal wages experience upward pressure, which may lead to a wage-price spiral.
This spiral occurs when higher wages prompt firms to increase selling prices to cover wage costs, leading to demands for even higher wages by the workforce.
Graphical Representation:
When aggregate demand increases, the AD curve shifts from AD1 to AD2, resulting in demand-pull inflation as indicated in economic models that feature Price Level vs. Real GDP.
Example:
In a scenario where Real GDP was $1,200 billion, an increase in demand pushes equilibrium to a higher price level and a new GDP of $1,300 billion.
Cost-Push Inflation
Definition: Cost-push inflation occurs due to a negative supply shock that causes a decrease in the aggregate supply of goods and services.
Characteristics:
The short-run aggregate supply (SRAS) curve shifts leftward, resulting in higher price levels, reduced output, and increased unemployment.
Graphical Representation:
An increase in production costs leads to a leftward shift in SRAS from SRAS1 to SRAS2, moving the short-run equilibrium to a new point (B) with lower real GDP and a higher price level.
Causes of Cost-Push Inflation:
Higher wage growth surpassing productivity increases.
External input price shocks, e.g., spikes in oil prices.
Supply disruptions such as the COVID-19 pandemic, illness, and death that affect labor availability.
Inflationary expectations that lead businesses to preemptively raise prices.
Depreciation of the Australian dollar resulting in increased import prices.
Rising government charges and taxes.
Natural disasters (e.g., droughts, floods, earthquakes) and unnatural disasters (e.g., wars and conflicts).
Costs of Inflation
Anticipated vs. Unanticipated Inflation
Anticipated Inflation: When inflation is expected, the economic impacts tend to be less severe. However, it still reduces purchasing power for those on fixed incomes.
Unanticipated Inflation: If inflation happens unexpectedly, both borrowers and lenders may incur losses.
Real wages experience variation, affecting overall standards of living.
Costs related to inflation affect multiple sectors, notably:
Reduction in purchasing power, particularly for individuals on fixed incomes.
This creates an income redistribution effect as incomes do not keep pace with rising prices.
Individuals holding cash or in low-interest demand deposit accounts lose purchasing capacity as inflation rises.
Impacts on exports and imports:
Relative inflation rates can alter competitiveness in international markets.
Price elasticities of goods will influence buyers' responsiveness to price changes.
Creates investment uncertainty as businesses may hesitate to invest amid fluctuating price levels.
The ‘tax bracket creep’ phenomenon can lead to reductions in real incomes.
It consumes resources businesses need to adjust, such as costs associated with price changes (menu costs), wage bargaining, and money printing.
Summary of Costs
Real wages may decline with unanticipated inflation, causing reduced standards of living.
Inflation impacts fixed-income earners, distorting income fairness.
Inflation fluctuations create volatility that dissuades investments.
Costs of adjusting to inflation divert economic resources, inhibiting efficiency.