Lecture 1 Inflation Causes and Cures PDF

Macroeconomics Second Semester Lecture 1 Inflation: Its Causes and Cures Dr. Zeeshan Atiq [email protected] Department of Economics, University of Karachi  Introduction Explaining the Inflation Rate Explaining the Inflation...

Macroeconomics Second Semester Lecture 1 Inflation: Its Causes and Cures Dr. Zeeshan Atiq [email protected] Department of Economics, University of Karachi  Introduction Explaining the Inflation Rate Explaining the Inflation Rate Continuous Inflation: Sustained increase in aggregate demand causes inflation. Single events causing price jumps do not explain continuous inflation. Impact of Inflation: Long-term small annual inflation rates can significantly increase the price level. It erodes purchasing power and savings. Causes of Inflation: Driven by shifts in aggregate demand and supply. Demand shocks primarily affect inflation and GDP fluctuations. Economic Trade-offs: Reducing inflation may require recessionary periods. The Fed may implement restrictive policies to manage excessive aggregate demand. 2/35  Introduction How Is Inflation Related to the Output Ratio? How Is Inflation Related to the Output Ratio? Understanding the Output Ratio: The output ratio compares actual real GDP to natural real GDP. Above 100%: Actual real GDP is higher than natural real GDP. Below 100%: Actual real GDP is lower than natural real GDP. 3/35  Introduction Understanding Demand Shocks and Supply Shocks Understanding Demand Shocks and Supply Shocks Demand Shocks: Positive Demand Shock: - Increases aggregate demand, raising both inflation and the output ratio temporarily above 100%. Negative Demand Shock: Decreases aggregate demand, lowering both inflation and the output ratio. Example: Recessions in 2008–10, resulting in sharp reductions in inflation. Supply Shocks: Adverse Supply Shock: Increases inflation while reducing the output ratio. Example: Oil price hikes in 1974–75 and 1979–81, causing economic slowdowns and higher inflation. Beneficial Supply Shock: - Decreases inflation while increasing the output ratio. - Example: Technological advancements in the late 1990s, improving productivity and reducing inflation. 4/35  Introduction Understanding Demand Shocks and Supply Shocks Understanding Demand Shocks and Supply Shocks Key Insights: Inflation and the output ratio can rise or fall together during demand shocks. Supply shocks can cause inflation and the output ratio to move in opposite directions. 5/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve Real GDP, Inflation Rate, and the Short-Run Phillips Curve Demand-Pull Inflation: Continuous increase in demand raises the price level. Caused by factors like large government budget deficits and rapid money supply growth. Known as demand-pull inflation, where rising demand “pulls up” the price level. 6/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve Real GDP, Inflation Rate, and the Short-Run Phillips Curve Understanding the Graph (Figure 2): Aggregate Demand and Supply: Both curves are drawn as straight lines for simplicity. AD (Aggregate Demand): Shows total demand in the economy. SAS (Short-Run Aggregate Supply): Shows the relationship between output and price level in the short run. Output Ratio: Measures the ratio of actual to natural real GDP. When the output ratio is 100%, actual GDP equals natural GDP. Initial Equilibrium (E0): Initial intersection point of AD0 and SAS0 curves. Initial price index (P0 ) and nominal wage rate (W0 ) are both 1.0. Real wage rate is initially at equilibrium value of 1.0 (W0 /P0 ). Short-Run and Long-Run Supply Curves: SAS Curve: Positively sloped, higher output raises price level. LAS Curve: Vertical at 100% output ratio, long-term supply not affected by price level. 7/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve Real GDP, Inflation Rate, and the Short-Run Phillips Curve Effects on Wage and Output: Rising Output Ratio: If the output ratio exceeds 100%, it indicates higher actual GDP than natural GDP. Leads to upward pressure on wages, shifting SAS curve upward. Long-Run Implications: Over time, wages adjust, returning the output ratio to 100% and restoring long-term equilibrium. 8/35 Real GDP, Inflation Rate, and the Short-Run Phillips Curve 9/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve Effects of an Increase in Aggregate Demand Increase in Aggregate Demand: The AD curve shifts from AD0 to AD1 , as shown in Figure 2. Initial movement to point E1 , where the price level rises to 1.03. Impact on Price Level and Wages: The higher price level at E1 creates upward pressure on nominal wages. Point E1 is to the right of the LAS curve, indicating an overheating economy. Upward pressure on wages causes the SAS curve to shift upwards. Adjustment of the SAS Curve: SAS curve shifts from SAS0 to SAS1. The new SAS1 curve reflects a 3% increase in nominal wages. 10/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve How Continuous Inflation Occurs Impact on Output Ratio and Price Level: When the supply curve shifts from SAS0 to SAS1 , there are two potential outcomes for the output ratio and price level. Scenario 1: One-Time Increase in Aggregate Demand Initial Movement: Aggregate demand shifts to AD1 , moving the economy from point E1 to point D. Necessary Adjustment: To prevent a decline in the output ratio, aggregate demand must shift upward again to maintain equilibrium. Outcome: This results in a higher price level with upward pressure on wages. 11/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve How Continuous Inflation Occurs Scenario 2: Continuous Increase in Aggregate Demand Constant Adjustment: To maintain the output ratio, aggregate demand must continuously increase. Visual Path: The economy follows an upward path, indicated by black arrows, depicting continuous inflation. Bottom Frame Insight: Shows the inflation rate rising continuously as the price level increases. Conclusion: Continuous inflation requires a steady increase in aggregate demand and price levels, maintaining a high output ratio. Illustrated by the vertical movement in the top frame and corresponding inflation rate in the bottom frame. 12/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve SP Curve Overview: The SP curve plots the inflation rate against the output ratio, showing the relationship between real GDP and inflation. The curve is named after A. W. H. Phillips, who discovered the statistical link between these variables. Key Characteristics of the SP Curve: Upward Slope: The SP curve slopes upward, indicating that higher output ratios are associated with higher inflation rates. Continuous Inflation: To keep the output ratio above 100%, aggregate demand must continuously increase, leading to continuous inflation. Point E1 shows an inflation rate of 3% with an output ratio above 100%. Non-Equilibrium State: At points above 100% output ratio, the economy is not in long-run equilibrium due to wages lagging behind prices. Wage contracts often assume zero expected inflation, failing to account for continuous inflation. 13/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve Why the SP Curve Slopes Upward: Sensitivity to Demand: Higher aggregate demand raises raw material prices, contributing to increased inflation. Wage Pressure: Continuous upward pressure on wages due to insufficient anticipation of inflation in labor contracts. 14/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve The Adjustment of Expectations Inflation and Expectations: Initially, people do not anticipate inflation in their labor contracts. The price level continuously rises faster than nominal wages, as shown by the arrows in Figure 2. This lack of anticipation means that labor contracts fail to include inflation adjustments. Impact on the SP Curve: When people start to expect inflation, the short-run Phillips Curve (SP curve) shifts upward. Figure 3: Shows how the SP curve adjusts when inflation expectations change. The initial SP curve (SP0 ) assumes no inflation expectations (expected inflation pe = 0). At point E0 , the actual inflation rate matches expectations—zero—indicating a long-run equilibrium. 15/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve The Adjustment of Expectations Shift Due to Expected Inflation: When a 3% inflation rate is expected (p = pe = 3%), the SP curve shifts upward to SP1. Point E1 now represents an actual inflation rate of 3% that exceeds the initial expected rate of zero. The new long-run equilibrium point is E2 , where the expected inflation matches the actual rate at 3%. Equilibrium and Expectations: In long-run equilibrium, such as at points E0 and E2 , the actual and expected inflation rates align. At E0 , both inflation and expectations are zero; at E2 , both are 3%. Both points maintain an output ratio of 100%, indicating no pressure for further change. 16/35 Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve 17/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve Nominal GDP Growth and Inflation To understand the output ratio and inflation rate, we need two relationships between them. The first is the short-run Phillips curve (SP curve). The second is the growth rate of nominal GDP. Nominal GDP (X ) is the product of the price level (P) and real GDP (Y ): X = P × Y The growth rate of nominal GDP (x) equals the sum of the inflation rate (p) and the growth rate of real GDP (y ): x = p + y Example: If x = 6%, then various combinations of p and y can satisfy this growth rate. Table 1 illustrates this with examples where p varies and y adjusts accordingly. 18/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve Example: Nominal GDP Growth Scenarios Scenario Inf. Rate (p) RGDP Gr (y ) NGDP Gr (x) A 9% -3% 6% B 6% 0% 6% C 3% 3% 6% Table: Nominal GDP Growth and Real GDP Growth In Scenario A, high inflation (9%) consumes more than nominal GDP growth (6%), causing real GDP to fall. In Scenario B, inflation matches nominal GDP growth, leaving no room for real GDP growth. In Scenario C, lower inflation (3%) allows for real GDP to grow by 3%. 19/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve Key Takeaways The SP curve represents the relationship between inflation and the output ratio. A consistent increase in aggregate demand results in continuous inflation. For any given growth rate of nominal GDP, inflation and real GDP growth are inversely related. When inflation is less than nominal GDP growth, real GDP must increase. When inflation exceeds nominal GDP growth, real GDP must decrease. 20/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve Expectations and the Inflation Cycle Forward-Looking Expectations Forward-looking expectations use economic models to predict future inflation. Example: If nominal GDP growth increases from 0% to 6%, expectations of inflation rise immediately to 6%. This quick adjustment shifts the Short-Run Phillips Curve (SP) upward and moves the economy to a new equilibrium without exceeding the output ratio of 100%. 21/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve Expectations and the Inflation Cycle Backward-Looking Expectations Backward-looking expectations adjust based on past inflation rather than predicting future trends. Two main reasons for this: 1 Uncertainty about the permanence of changes in nominal GDP growth. 2 Existence of long-term contracts that delay the response of actual inflation. Adaptive Expectations Adaptive expectations update based on discrepancies between past expectations and actual outcomes. Example: If last period’s actual inflation was 2%, then this period’s expected inflation is set to 2%. Formula: p e = p−1 (Expected inflation = Last period’s actual inflation). 22/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve Recession as a Cure for Inflation Achieving Disinflation Disinflation refers to a significant decrease in the inflation rate. One method to achieve disinflation is by reversing the process that caused inflation. Slowing down demand growth (x) can help in reducing inflation. 23/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve Recession as a Cure for Inflation The “Cold Turkey” Remedy for Inflation The “cold turkey” approach involves a sudden reduction in demand growth. Example: Reducing demand growth from 10% to 4% abruptly. Initial conditions: Expected inflation at 10% and the economy at point E 5 (SP2 line). Immediate effects: Inflation decreases from 10% to 8%. The output ratio declines, leading to a recession (output ratio falls from 100 to 96). This method involves economic sacrifice, as reducing inflation quickly can lead to significant reductions in real GDP. 24/35  Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve Recession as a Cure for Inflation Figure Explanation Figure 6: The diagram assumes initial inflation at 10% and explores the effects of a sudden policy shift on inflation and output. Moving from point E 5 to K demonstrates the direct impact of reduced demand growth on inflation and real GDP. 25/35 Real GDP, Inflation Rate, and the Short-Run Phillips Curve The SP Curve: Short-Run Phillips Curve 26/35  The Importance of Supply Shocks Types of Supply Shocks Supply Inflation Supply inflation occurs due to sharp changes in business costs unrelated to prior changes in nominal GDP growth. Oil Shocks Significant cause of supply inflation, especially in the 1970s and early 1980s. Examples: Adverse Shocks: Price increases in 1970s, 1990, 1999–2000, and 2003–08. Beneficial Shocks: Price declines in 1986, 1996–98, and 2009–10. 27/35  The Importance of Supply Shocks Types of Supply Shocks Farm Price Shocks Supply inflation can also result from rising prices of other raw materials, especially farm products. Examples: Crop failures causing sharp increases in farm prices. These shocks are usually temporary, typically lasting a year or two. Exception: The OPEC oil shocks were considered permanent, with lasting effects from 1974 to 1986. 28/35  The Importance of Supply Shocks Types of Supply Shocks Import Price Shocks The foreign exchange rate of the dollar is flexible and affects import prices. Dollar Depreciation: When the dollar depreciates, it buys less foreign currency. Imports become more expensive, leading to higher domestic inflation. Dollar Appreciation: When the dollar appreciates, it buys more foreign currency. Imports become cheaper, leading to lower domestic inflation. Historical Context: 1995–2002: Dollar appreciation held down inflation. 2003–08: Dollar depreciation pushed up inflation. 29/35  The Importance of Supply Shocks Types of Supply Shocks Productivity Growth Shocks Productivity Growth: Rapid productivity growth means each worker produces more, making it cheaper to hire workers. Long-Term Trends: Slowed from 1965 to 1980, contributing to high inflation. Recovered after 1980, reducing inflation during 1980–85. Surged in 1995–2004, keeping inflation low in the late 1990s. 30/35  The Importance of Supply Shocks Types of Supply Shocks Adverse and Beneficial Supply Shocks Adverse Shocks: Increase inflation and decrease real GDP (e.g., oil price spikes in the 1970s). Beneficial Shocks: Decrease inflation and increase real GDP (e.g., oil price drops in 1986, 1997–98, 2009). Policy Challenges: Adverse shocks require balancing inflation control with maintaining GDP. Beneficial shocks still demand careful policy decisions to maximize benefits. 31/35 How Is the Unemployment Rate Related to the Inflation Rate? Relationship Between Unemployment Rate and Inflation Rate Trade-Off Between Unemployment and Inflation Economists often discuss a trade-off between unemployment and inflation. There is a strong negative correlation between the unemployment rate and the output ratio. This implies: The relationship between output ratio and inflation rate mirrors the relationship between unemployment rate and inflation rate. The relationship can be positive, negative, vertical, or horizontal, meaning there is no systematic negative relationship between unemployment and inflation. 32/35 How Is the Unemployment Rate Related to the Inflation Rate? Relationship Between Unemployment Rate and Inflation Rate Mirror Image of Real GDP Unemployment Rate and Real GDP: Inversely related to real GDP or the output ratio. High output ratio implies low unemployment; low output ratio implies high unemployment. Economic Prosperity: Low unemployment or a high output ratio indicates strong economic conditions. High unemployment or a low output ratio indicates weak economic conditions and recessions. 33/35 How Is the Unemployment Rate Related to the Inflation Rate? Relationship Between Unemployment Rate and Inflation Rate Factors Affecting Unemployment Aggregate Demand Factors: Private Sector: Business and consumer optimism, increases in foreign income boosting net exports. Government Sector: Higher government spending, lower tax rates, higher money supply. All these factors increase the output ratio and reduce unemployment. 34/35 How Is the Unemployment Rate Related to the Inflation Rate? The Unemployment Rate, Output Ratio, and Okun’s Law Okun’s Law Arthur M. Okun: Introduced the relationship in the 1960s. Negative Slope: Reflects that as output ratio decreases, unemployment rate increases. Formula: Change in Unemployment: 0.5 times the percentage change in the output ratio, in the opposite direction. Example: A drop in the output ratio from 100% to 96% results in a 2.0 percentage point increase in unemployment. 35/35