Escolar Documentos
Profissional Documentos
Cultura Documentos
This is equivalent
to a fall in the value or purchasing power of money. It is the opposite
of deflation.
Measuring inflation
Causes of inflation
Stopping inflation
Types of inflation:
One type has a big long row of zeros on the number. (like this:
"10,000,000,000").
Another type uses words for part or all of the number (like this: "10
Billion" or this: "Ten Billion")
Still others avoid the use of large numbers simply by declaring a new
unit of currency (so, instead of 10,000,000,000 Dollars, you might set
1 New Dollar = 1,000,000,000 old Dollars, so your new banknote
would read "10 New Dollars".)
Adaptive expectations
rates. For instance, they may begin demanding larger pay raises -
this in itself acts as a cost push, leading firms to push their prices
higher, and thus to another round of pay-raises. This "wage-price
spiral" builds some inflation directly into the economy! The theory of
adaptive expectations was popular in the 1980s, as an explanation of
some aspects of the economic crisis that the West went through after
the 1970s oil shock. The fact that some countries, particularly the
UK, took until the 1990s to achieve stable low inflation rates again
suggests there may well be something in the idea.
Effects of Inflation:
Regardless of whether inflation is demand pull or cost-push, the failure to correctly
anticipate it results in unintended consequences. These unintended consequences
impose costs in both labor markets and capital markets. Let's examine these costs.
Unanticipated inflation has two main consequences for the operation of the labor
market:
• Redistribution of income
• Departure from full employment
Redistribution of Income Unanticipated inflation redistributes income between
employers and workers. Sometimes employers gain at the expense of workers, and
sometimes they lose. If an unexpected increase in aggregate demand increases [he
inflation- rate, [hen wages will not have been set high enough. Profits will be higher
than expected, and wages will buy fewer goods than expected. In this case, employers
gain at the expense of workers. But if aggregate demand is expected to increase at a
rapid rate and it fails to do so, workers gain at the expense of employers. With a high
inflation rate anticipated, wages are set too high and profits are squeezed.
Redistribution between employers and workers creates an incentive for both firms and
workers to try to forecast inflation correctly.
Departures from Full Employment
Redistribution brings gains to some and losses to others. But departures from full
employment impose costs on everyone. To see why, let's return to the soda-bottling
plant in Kalamazoo.
If the bottling plant and its workers do not anticipate inflation, but inflation occurs, the
money wage rate does not rise to keep up with inflation. The real wage rate falls, and
the firm tries to hire more labor and increase production. But because the real wage rate
has fallen, the firm has a hard time attracting the labor it wants to employ. It pays
overtime rates to its existing work force, and because it runs its plant at a faster pace, it
incurs higher plant maintenance and parts replacement costs. But also, because the real
wage rate has fallen, workers begin to quit the bottling plant to find jobs that pay a real
wage rate that is closer to one that prevailed before the outbreak of inflation. This
Labor turnover imposes "additional costs on the firm. So even though its production
increases, the firm incurs additional costs, and its profits do not increase as much as
they other- wise would. The workers incur additional costs of job search, and those
who remain at the bottling plant wind up feeling cheated. They've worked overtime
to produce the extra output, and when they come to spend their wages, they discover
that prices have increased, so their wages buy a smaller quantity of goods and services
than expected.
If the bottling plant and its workers anticipate a high inflation rate that does not occur,
they increase the money wage rate by too much, and the real wage rate rises. At the
higher real wage rate, the firm lays off some workers and the unemployment rate
increases. Those workers who keep their jobs gain, but those who become unemployed
lose. Also, the bottling plant loses because its output and profits fall.
Unanticipated inflation has two consequences for the operation of the capital market.
They are:
• Redistribution of income
• Too much or too little lending and borrowing
Too Much or Too Little Lending and Borrowing If the inflation rate turns out to be
either higher or lower than expected, the interest rate does not incorporate a correct
allowance for the falling value of money and the real interest rate is either lower or
higher than it otherwise would be. When the real interest rate turns out to be too low,
which occurs when inflation is higher than expected, borrowers wish they had
borrowed more and lenders wish they had lent less-: Both groups would have made
different lending and borrowing decisions with greater fore- sight about the inflation
rate. When the real interest rate turns out to be too high, which occurs when inflation is
lower than expected, borrowers wish they had borrowed less and lenders wish they had
lent more. Again, both groups would have made different lending and borrowing
decisions with greater fore- sight about the inflation rate.
So unanticipated inflation imposes costs regard- less of whether the inflation turns out
to be higher or lower than anticipated. The presence of these costs gives everyone an
incentive to forecast inflation correctly. Let's see how people go about this task.
Forecasting Inflation:
Inflation is difficult to forecast. The reasons are, first, there are several sources of
inflation--the demand-pull and cost-push sources you've just studied. Second, the speed
with which a change in either aggregate demand or aggregate supply translates into a
change in the price level varies. This speed of response also depends, as you will see
below, on the extent to which the inflation is anticipated.
A rational expectation is not a correct forecast. 1t is simply the best forecast available.
It will often turn out to be wrong, but no ocher forecast that could have been made
with the information available could be predicted to be better.
You've seen the effects of inflation when people fail to anticipate it. And you've seen
why it pays to try to anticipate inflation. Let's now see what happens if inflation is
correctly anticipated.
Anticipated Inflation:
In the demand-pull and cost-push inflations that we studied earlier in this chapter,
money wages are sticky. When aggregate demand increases, either to set off a demand-
pull inflation or to accommodate cost-push inflation, the money wage does not change
immediately. But if people correctly anticipate increases in aggregate demand, they
will adjust money wage rates so as to keep up with anticipated inflation.
In this case, inflation proceeds with real GDP equal to potential GDP and
unemployment equal to the natural rate. Figure 32.7 explains why. Suppose that last
year the price level was 110 and real GDP was $7 trillion, which is also potential GDP.
The. aggregate demand curve. was ADo; the aggregate supply curve was SASo, and the
long-run aggregate supply curve was LAS.
Suppose that potential GDP does not change, so the LAS curve does not shift. Also
suppose that aggregate demand is expected to increase and that the expected aggregate
demand curve for this year is ADl' In anticipation of this increase in aggregate demand,
money wage rates rise and the short-run aggregate supply curve shifts leftward. If the
money wage rate rises by the same percentage as the price level rises, the short-run
aggregate supply curve for next year is SASl.
If aggregate demand turns out to be the same as expected, the aggregate demand curve
is ADl and with the short-run aggregate supply curve SASl the actual price level is 121.
Between last year and this year, the price level increased from 110 to 121 and the
economy experienced an inflation rate of 10 percent, the same as the inflation rate that
was anticipated. If this anticipated inflation is ongoing, in the following year aggregate
demand increases (as anticipated) and the aggregate demand curve shifts to AD2. The
money wage rate rises to reflect the anticipated inflation, and the short-run aggregate
supply curve shifts to SAS2. The price level rises by a further 10 percent to 133.
What has caused this inflation? The immediate answer is that because people expected
inflation, wages were increased and prices increased. But the expectation was correct.
Aggregate demand was expected to increase, and it did increase. Because aggregate
demand was expected to increase from ADo to ADl, the short-run aggregate supply
curve shifted from SASo to SASl. Because aggregate demand actually did increase by
the amount that was expected, the actual aggregate demand curve shifted from ADo to
ADl. The combination of the anticipated and actual increases in aggregate demand
produced an increase in the price level that was anticipated.
Only if aggregate demand growth is correctly forecasted does the economy follow the
course described in Fig. 32.7. If the expected growth rate of aggregate demand is
different from its actual growth rate, the expected aggregate demand curve shifts by an
amount that is different from the actual aggregate demand curve. The inflation rate
departs from its expected level, and to some extent, there is unanticipated inflation.
Unanticipated Inflation:
When aggregate demand increases by more than expected, there is some unanticipated-
inflation that looks just like the demand-pull inflation that you studied earlier. Some
inflation is expected, and the money wage rate is set to reflect that expectation. The
SAS curve intersects the LAS curve at the expected price level. Aggregate demand then
increases, but by more than expected. So the AD curve intersects the SAS curve at a
level of real GDP that exceeds potential GDP. With real GDP above potential GDP and
unemployment below the natural rate, the money wage rate rises. So the price level
rises further., If aggregate demand increases again, a: demand-pull inflation spiral
unwinds.
When aggregate demand increases by less than expected, there is some unanticipated
inflation that looks like the cost-push inflation that you studied earlier. Again, some
inflation is expected, and the money wage rate is set to reflect that expectation. The
SAS curve intersects the LAS curve at the expected price level. Aggregate demand then-
increases, but by less than expected. So the AD curve intersects the SAS curve at a level
of real GDP-below potential GDP. Aggregate demand increases to restore full
employment. But if aggregate demand is expected to increase by more than it actually
does, wages again rise, short-run aggregate supply again decreases, and a cost push
spiral unwinds
We've seen that only when inflation is unanticipated does real GDP depart from
potential GDP. When inflation is anticipated, real GDP remains at potential GDP. Does
this mean that an anticipated inflation has no costs?