Topic 9 Notes

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TRIMESTER 2 2023 ECON106/ECON406 Economics for Date: Thursday, 28 September 2023, 12:30 PM
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Book: Topic 9 Notes
 Description

Notes for: Inflation.

 Table of contents

Learning Objectives

Introduction and Readings

Aggregate Demand

Aggregate Supply

Equilibrium Price Level and GDP

Demand-pull Inflation

Cost-push Inflation

Relationships between Output Growth, Unemployment and Inflation

 Learning Objectives

After completing this topic, you should be able to:

Understand the aggregate demand;

Recognise the origin of shifts in aggregate demand;
Appreciate the aggregate supply;
Recognise the origin of shifts in aggregate supply;
Appreciate the equilibrium of price levels and GDP;
Understand effects in the short and long run of demand-pull inflation;
Recognise the origin and effects of cost-push inflation;
Appreciate the relationship between inflation and unemployment; and
Understand the Phillips curve.
 Introduction and Readings
In parallel with the Topic Notes:

Chapter 12 from your textbook (Sloman, Norris & Garret, 2014)

Make your own notes to complement these topic notes.

Review questions at the end of chapter 12 of the textbook.
Try out the self-assessment multiple choice questions.
 Aggregate Demand
Aggregate demand (AD) is total spending on a country's products & services and is composed of consumer spending (C), private investment (I), government
expenditure (G) and expenditure on exports (X) less expenditure on imports (M):

AD = C + I + G + X - M

The quantity demanded at each level of price is illustrated in Figure 10.1.

Figure 10.1. Aggregate demand curve

Source: Sloman et al. (2014).

When the price level rises, there will be a reduction in the amount of products and services demanded in an economy due to:

Reduction in real income: if prices rise and wage rates do not change in the same proportion, there will be a decrease in real income, and consequently in
consumption, caused by price increases that are not compensated for by proportionate increases in income.

International effect: reduced Australian exports and increased imports because Australian products become more expensive than
imports.

Real balance effect: when people try to spend less and protect the real value of their money balances.

Rise in the interest rates: can occur through the increase in demand for money resulting from the rise in the prices as more money is needed to undertake
transactions. Higher interest rates results in less investment by firms and, consumer spending financed by borrowings also falls.

Aggregate demand can shift inward or outward if there is a change in consumption, investment, government expenditure or exports net of imports.
 Aggregate Supply
The aggregate supply curve shows the quantity of goods and services (GDP) that firms are willing to supply at each price level. It slopes upwards in the short-run
assuming constant wage rates, prices of inputs, technology and labour force and capital stock. Figure 10.2 illustrates the aggregate supply curve in the short-run.

Figure 10.2. Aggregate supply curve in the short-run.

Source: Sloman et al. (2014).

At higher prices, more is produced, reflecting firms' profitability increasing at each price level. The limits in the increase in aggregate supply are determined by:

Diminishing returns: In the short run some factors of production are fixed, such as equipment, which makes the marginal cost curves of firms upward
sloping.

Growing shortages of certain variable factors: As firms increase their production, there may be shortages of some factors such as skilled labour in the
short-run.

The aggregate supply curve can shift inward or outward if there is a change in any of the variables held constant. Technology, the labour force and the stock of
capital generally change slowly in the short-run and increases in these variables move the curve outward, while changes in the wage rate and other input prices
vary significantly in the short-run.
 Equilibrium Price Level and GDP
There is an equilibrium between price level and GDP when there is no shortage or surplus in the economy. This situation is illustrated in Figure 10.3.

Figure 10.3. Determination of the equilibrium level of prices and GDP.

Source: Sloman et al. (2014).

In this figure equilibrium is at P1 and GDP1. At other combinations of prices and GDP the economy is not in equilibrium, then changes will take place for the
economy to reach the equilibrium. For example, if aggregate demand exceeds aggregate supply, resulting shortages put upward pressure on prices, encouraging
firms to produce more and generate inflation.

Inflation could be the result from demand-pull inflation, which originates from rightwards shifts in aggregate demand ('demand-side' inflation), or from upward
shifts in aggregate supply that can cause cost-push inflation ('supply-side' inflation). The demand-pull inflation and the cost-push inflation will be analysed in the
next two sections.

There are different approaches to analyse the relationship between inflation and GDP. The approach presented above is very intuitive, while other economists
prefer to use the aggregate demand-inflation curve as presented in Figure 10.4.

Figure 10.4. Equilibrium output and inflation using the aggregate demand-inflation approach: the case of an expansionary gap.

Source: Bernanke et al. (2011).

For each rate of inflation, the aggregate demand-inflation curve shows the economy's equilibrium level of output. In the case presented in Figure 10.4 an
expansionary gap exists, therefore inflation will rise gradually (the short-run aggregate supply curve will move up) and output will fall. Under this approach the
adjustment of inflation and output to economic disturbances will depend on whether the aggregate demand-inflation curve is relatively flat or steep. The slope of
the aggregate demand-inflation curve depends on how the reserve bank adjusts the interest rates and the impact of the real interest rate on the decisions made by
households and firms about how much to spend on consumption and investment. The aggregate demand-inflation curve shows the short-run equilibrium level of
output for each level of inflation, where higher rates of inflation are associated with higher real interest rates, lower aggregate expenditures and lower equilibrium
output. These linkages are summarised in Figure 10.5 below:

Figure 10.5. Relationship between inflation and short-run equilibrium GDP represented by the aggregate demand-inflation curve.

Source: Stiglitz et al. (2014).

The aggregate demand-inflation curve can shift due to changes in fiscal policy, variations in the monetary policy rule or changes in investment or consumption
behaviour. Changes in fiscal policy such as increases in government spending can increase the aggregate demand-inflation curve, while increases in taxes can
reduce the disposable income which will shift the curve to the left. In the case of variations in monetary policy rule, such as a cut in the interest at each rate of
inflation, without any previous change in the rate of inflation, there will be a shift to the right of the aggregate demand-inflation curve. Finally, greater optimism and
pessimism about the future can encourage or discourage consumption and investment spending, affecting the aggregate demand. Inflation tends to vary relatively
low from year to year in low-inflation industrial economies, which is referred as inflation inertia due to inflation expectations and long-term wage and price contracts.
Figure 10.6 presents the effects of inflation expectations on the future inflation rate.

Figure 10.6. Relationship between expected inflation and future inflation rate.

Source: Bernanke et al. (2011).

Low inflation rate leads to low inflation expected in the future, as a consequence workers will agree to accept a small increase in wage rate and the prices of
goods and services will also increase slowly, which keeps inflation low.
 Demand-pull Inflation
Demand-pull inflation is due to persistent right-ward shifts in the aggregate demand curve. If aggregate demand increases, firms increase prices, output and
employment in the short-run. Figure 10.7 illustrates demand pull inflation in the short-run.

Figure 10.7. The demand-pull inflation.

Source: Sloman et al. (2014).

The effect of a single increase in demand (or 'demand shock') is a single one off increase (a spike) in the price level. If the increase in aggregate demand persists
it causes inflation to persist. Alternatively, if prices rise, short-run aggregate supply starts shifting upward as wages increase to compensate for higher prices
making firms' costs higher. Figure 10.8 illustrates this process in a situation of GDP at full employment level.

Figure 10.8. Short and long-run aggregate supply curves.

Source: Sloman et al. (2014).

In Figure 10.8 GDP cannot remain above its full employment level in the long-run. In the long-run, the aggregate supply curve is vertical so it leaves GDP unaltered.
The dynamics are that the equilibrium moves from a to b initially and then from b to c in the long-run. This long-run curve will only shift to the right as the potential
or full employment level of GDP grows due to technological changes or increases in the capital stock and the labour supply.

According to 'Keynesian' economists, wages and prices are not flexible and this process of settlement of the economy into a new equilibrium can take
considerable time (a matter of years), so the economy adjusts only slowly and the short-run is significant in terms of calendar time. Under the Keynesian view,
workers suffer from 'money illusion' and do not realise the inflation from a demand shock has eroded the spending power of their wages. This gives firms the
opportunity to benefit from the higher prices for output by continuing to pay lower wages in real terms. Gradually, workers overcome their money illusion and
output falls back to the long run equilibrium in Figure 10.8.

In contrast, 'new classical' economists argue prices and wages are more flexible and that people use all available information to form expectations about the
future level of prices and other economic variables. There is no 'money illusion'. Such 'rational expectations' cause firms to anticipate that if people spend x%
more money, and prices rise by x% the volume of sales does not change. Output and employment only rise following a demand shock if people make errors in their
predictions and under predict the rate of inflation. However they could over predict inflation and, in that case, output and employment both fall. According to this
point of view, the short-run is very short in terms of calendar time and we are always in the long-run.
 Cost-push Inflation
Cost-push inflation is due to leftward (or upward) shifts in the aggregate supply curve as a consequence of increases in production costs. Firms increase prices
and reduce the quantity produced and their employment of labour. A single shift in aggregate supply from a supply shock will cause temporary inflation, while a
shift that is sustained produces inflation over a period. Figure 10.9 illustrates cost-push inflation.

Figure 10.9. The cost-push inflation.

Source: Sloman et al. (2014).

The rise in production costs could be due to:

Wage-push inflation: Unions push up wages independently of the demand for labour.

Profit-push inflation: Firms use their monopoly power to make bigger profits by pushing up prices independently of consumer demand.

Import price-push inflation: Import prices rise independently of the level of aggregate demand.
 Relationships between Output Growth, Unemployment and Inflation
The Okun's law was developed by the economist Arthur Okun who found a negative relationship between unemployment rate and percent change in real GDP.
Therefore, increases in output growth will reduce the unemployment rate in the short-run, but in the long-run growth in GDP is mainly determined by technological
progress. In consequence, the long-run trend in output growth is not associated with the unemployment rate, while in the short-run, movements in GDP are related
to the level of utilisation of the labour force.

A negative relationship between inflation and unemployment was found by the New Zealand economist A. W. Phillips in 1958. According to the Phillips curve if
aggregate demand rises, inflation also rises and unemployment falls in the short-run. In this case there is an upward movement along the curve. Alternatively, if
aggregate demand falls, inflation falls and unemployment rises with a downward movement along the curve. Figure 10.10 illustrates the Phillips curve.

Figure 10.10. Original Phillips curve.

Source: Littleboy et al. (2013).

The Phillips curve indicates a trade off between inflation and unemployment so if the government wishes to reduce unemployment it must increase inflation, and
vice versa. This curve is 'bowed in' to the origin because as aggregate demand rises first there would be plenty of labour that could be employed to meet the extra
demand without the need to raise wage rates very much. However, as labour becomes scarcer, firms need to pay higher wages resulting in inflation. Shifts in the
Phillip's curve occur if there are changes in non-demand factors causing inflation and unemployment, these include frictional and structural unemployment and
cost-push inflation.

Later two American economists, Edmund Phelps and Milton Fridman argued that the relationship between unemployment and inflation was only temporary,
because as reviewed in the demand-pull inflation, initially as prices rise unemployment fall as GDP increases, but later on wages and other input costs increase,
and both prices and unemployment rise in the long-run. Accordingly, two Phillips curves have been developed to present the relationship between inflation and
unemployment rates in the short-run and long-run, which are shown in Figure 10.11.

Figure 10.11. Phillips curves in the short-run and long-run.

Source: Littleboy et al. (2013).

From Figure 10.11 can be said that in the short-run a negative relationship exists between inflation and unemployment rates, but in the long-run, given that wage
rates are flexible there is no relationship between inflation and unemployment.

A summary, of the relationships between output growth, unemployment and inflation in the short-run is presented in Figure 10.12.

Figure 10.12. Short-run relationships between output growth, unemployment and inflation.

Source: Blanchard & Sheen (2009).