471
C h a p t e r
14
INFLATION
O u t l i n e
From Rome to Rio de Janeiro
A. Inflation is a very old problem and some countries even
in recent times have experienced rates as high as 40% per
month.
B. The United States has low inflation now, but during the
1970s the price level doubled.
C. Why does inflation occur, how do our expectations of
inflation influence the economy, is there a tradeoff
between inflation and unemployment, and how does
inflation affect the interest rate?
I.
Inflation and the Price Level
A. Inflation is a process in which the price level is rising
and money is losing value.
1. Inflation is a rise in the price level, not in the
price of a particular commodity.
2. Figure 29.1 (page 678/332) illustrates the distinction
between inflation and a one-time rise in the price
level.
3. The inflation rate is the percentage change in the
price level; that is, the inflation rate is [(P1 –
P0)/P0]  100 where P1 is the current price level and P0
is last year’s price level.
4. Inflation can result from either an increase in
aggregate demand--demand-pull—or a decrease in
aggregate supply—cost-push.
II. Demand-Pull Inflation
A. Demand-pull inflation is an inflation that results from an
initial increase in aggregate demand.
1. Demand-pull inflation may result from any factor that
increases aggregate demand.
2. Two factors controlled by the government are increases
in the quantity of money and increases in government
purchases.
3. A third possibility is an increase in exports.
A. Initial Effect of an Increase in Aggregate Demand
1. Figure 29.2 (page 679/333) illustrates the start of a
demand-pull inflation
2. Starting from full employment, an increase in
aggregate demand shifts the AD curve rightward.
3. Real GDP increases, the price level rises, and an
inflationary gap arises.
4. The rising price level is the first step in the
demand-pull inflation.
B. Money Wage Rate Response
1. The higher level of output means that real GDP exceeds
potential GDP—an inflationary gap.
2. The money wages rises and the SAS curve shifts
leftward.
3. Real GDP decreases back to potential GDP but the price
level rises again.
C. A Demand-Pull Inflation Process
1. Figure 29.3 (page 680/334) illustrates a demand-pull
inflation spiral.
2. Aggregate demand keeps increases and the process just
described repeats indefinitely.
3. Although any of several factors can increase aggregate
demand to start a demand-pull inflation, only an
ongoing increase in the quantity of money can sustain
it.
4. Demand-pull inflation occurred in the United States
during the late 1960s and early 1970s.
III. Cost-Push Inflation
A. Cost-push inflation is an inflation that results from an
initial increase in costs. There are two main sources of
increased costs: an increase in the money wage rate or an
increase in the money price of raw materials, such as
oil.
A. Initial Effect of a Decrease in Aggregate Supply
1. Figure 29.4 (page 682/336) illustrates the start of
cost-push inflation.
2. A rise in the price of oil decreases short-run
aggregate supply and shifts the SAS curve leftward.
3. Real GDP decreases and the price level rises—a
combination called stagflation.
4. The rising price level is the start of the cost-push
inflation.
B. Aggregate Demand Response
1. The initial increase in costs creates a one-time rise
in the price level, not inflation. To create
inflation, aggregate demand must increase.
2. Figure 29.5 (page 682/336) illustrates an aggregate
demand response to stagflation, which might arise
because the Fed stimulates demand to counter the
higher unemployment rate and lower level of real GDP.
3. The increase in aggregate demand shifts the AD curve
rightward.
4. Real GDP increases and the price level rises again.
C. A Cost-Push Inflation Process
1. Figure 29.6 (page 683/337) illustrates a cost-push
inflation spiral.
2. If the oil producers again raise the price of oil to
try to keep its relative price higher, and the Fed
responds with a further increase in aggregate demand,
the process of cost-push inflation continues.
3. Cost-push inflation occurred in the United States
during 1974–1978.
IV. Effects of Inflation
A. Unanticipated Inflation in the Labor Market
1. Unanticipated inflation has two main consequences in
the labor market: it redistributes income and brings
departures from full employment.
2. Higher than anticipated inflation lowers the real wage
rate and employers gain at the expense of workers.
3. Lower than anticipated inflation raises the real wage
rate and workers gain at the expense of employers.
4. Higher than anticipated inflation lowers the real wage
rate, increases the quantity of labor demanded, makes
jobs easier to find, and lowers the unemployment rate.
5. Lower than anticipated inflation raises the real wage
rate, decreases the quantity of labor demanded, and
increases the unemployment rate.
6. Unanticipated inflation imposes costs on both workers
and firms.
B. Unanticipated Inflation in the Market for Financial
Capital
1. Unanticipated inflation has two main consequences in
the market for financial capital: it redistributes
income and results in too much or too little lending
and borrowing.
2. If the inflation rate is unexpectedly high, borrowers
gain but lenders lose.
3. If the inflation rate is unexpectedly low, lenders
gain but borrowers lose.
4. When the inflation rate is higher than anticipated,
the real interest rate is lower than anticipated, and
borrowers want to have borrowed more and lenders want
to have loaned less.
5. When the inflation rate is lower than anticipated, the
real interest rate is higher than anticipated, and
borrowers want to have borrowed less and lenders want
to have loaned more.
C. Forecasting Inflation
1. To minimize the costs of incorrectly anticipating
inflation, people form rational expectations about the
inflation rate.
2. A rational expectation is one based on all relevant
information and is the most accurate forecast
possible, although that does not mean it is always
right; to the contrary, it will often be wrong.
D. Anticipated Inflation
1. Figure 29.7 (page 686/340) illustrates an anticipated
inflation.
2. Aggregate demand increases, but the increase is
anticipated, so its effect on the price level is
anticipated.
3. The money wage rate rises in line with the anticipated
rise in the price level.
4. The AD curve shifts rightward and the SAS curve shifts
leftward so that the price level rises as anticipated
and real GDP remains at potential GDP.
E. Unanticipated Inflation
1. If aggregate demand increases by more than expected,
inflation is higher than expected. Money wages do not
adjust for all the inflation, and the SAS curve does
not shift leftward enough to keep the economy at full
employment. Real GDP exceeds potential GDP. Wages
eventually rise, which leads to a decrease in the SAS.
The economy experiences more inflation as it returns
to full employment. This inflation is like a demandpull inflation.
2. If aggregate demand increases by less than expected,
inflation is less than expected. Money wages rise too
much and the SAS curve shifts leftward more than the
AD curve shifts rightward. Real GDP is less than
potential GDP. This inflation is like a cost-push
inflation.
F. The Costs of Anticipated Inflation
1. Anticipated inflation occurs at full employment with
real GDP equal to potential GDP.
2. But anticipated inflation, particularly high
anticipated inflation, inflicts three costs:
a) Transactions costs. People spend money more rapidly
when they anticipate high inflation and so transact
more frequently.
b) Tax consequences. Anticipated inflation reduces the
after-tax return from saving, which decreases
capital accumulation and long-term economic growth.
c) Increased uncertainty. A high inflation rate
increases uncertainty, which makes long-term
planning for investment more difficult and causes
people to spend time forecasting inflation rather
than undertaking more productive activities. Both
of these effects reduce the economy’s long-term
growth rate.
V. Inflation and Unemployment: The Phillips Curve
A. A Phillips curve is a curve that shows the relationship
between the inflation rate and the unemployment rate.
There are two time frames for Phillips curves.
B. The Short-Run Phillips Curve
1. The short-run Phillips curve shows the tradeoff between the
inflation rate and unemployment rate holding constant
the expected inflation rate and natural rate of
unemployment.
2. Figure 29.8 (page 688/342) illustrates a short-run
Phillips curve (SRPC)—a downward-sloping curve.
3. Figure 29.9 (page 689/343) shows that the negative
relationship between the inflation rate and
unemployment rate is explained by the AS-AD model. An
unexpectedly large increase in aggregate demand raises
the inflation rate and increases real GDP, which
lowers the unemployment rate. So a higher inflation is
associated with a lower unemployment, as shown by a
movement along a short-run Phillips curve.
C. The Long-Run Phillips Curve
1. The long-run Phillips curve shows the relationship between
inflation and unemployment when the actual inflation
rate equals the expected inflation rate.
2. Figure 29.10 (page 690/344) illustrates the long-run
Phillips curve (LRPC) which is vertical at the natural
rate of unemployment.
3. Along the long-run Phillips curve, because a change in
the inflation rate is anticipated, has no effect on
the unemployment rate.
4. Figure 29.10 (page 690/344) also shows how the shortrun Phillips curve shifts when the expected inflation
rate changes. A higher expected inflation rate shifts
the short-run Phillips curve upward by an amount equal
to the increase in the expected inflation rate.
D. Changes in the Natural Rate of Unemployment
1. A change in the natural rate of unemployment shifts
both the long-run and short-run Phillips curves.
2. Figure 29.11 (page 691/345) illustrates.
E. The U.S. Phillips Curve
1. The data for the United States are consistent with a
shifting short-run Phillips curve. It has shifted
because of changes in the expected inflation rate and
changes in the natural rate of unemployment.
2. Figure 29.12 (page 691/345) shows the actual path
traced out in inflation rate-unemployment rate space
[panel (a)] and interprets this as four separate
short-run Phillips curves [panel (b)].
VI. Interest Rates and Inflation
A. Interest rates and inflation rates are correlated,
although they differ around the world. Figure 29.13 (page
346) plots U.S. data over time and international data,
showing that other things the same, higher inflation
correlates with higher nominal interest rates.
B. How Interest Rates are Determined
1. The nominal interest rate and real interest rate
differ.
2. The real interest rate is determined by investment
demand and saving supply in the global capital market.
a) The real interest rate adjusts to make the quantity
of investment equal the quantity of saving.
b) National rates vary because of differences in risk.
3. The nominal interest rate is determined by the demand
for money and the supply of money in each nation’s
money market. The nominal interest rate adjusts to
make the quantity of money demanded equal to the
quantity supplied.
C. Why Inflation Influences the Nominal Interest Rate
The key relationship is that the nominal interest rate
equals the real interest rate plus the expected inflation
rate.