Inflation and Unemployment

Topics: Inflation, Unemployment, Monetary policy Pages: 15 (2481 words) Published: March 19, 2013
Inflation and Unemployment

Definition

Inflation

• Refers to a continuous rise in general price level “In inflation everything gets more valuable except money”

Types of Inflation
(i) Moderate Inflation or Creeping Inflation: The general level of prices rise at a moderate rate over a long period of time • A single digit inflation is considered moderate and people continue to have faith in monetary system

Types of Inflation
(ii) Galloping Inflation: Inflation that proceeds at an exceptionally high rate (Average annual inflation 1050%) (iii) Hyper Inflation: Inflation more than three-digit rate per annum (very high or ‘out-of-control). (Average annual inflation of more than 50%) Currency become worthless and very less demand for money E.g.: During Jan. 1922 to Nov. 1923, the prices in Germany shoot up by 100 million percent. Hyperinflation in Zimbabwe

Hyperinflation

Causes of Inflation (Theories of Inflation)
• Demand Pull Inflation – caused by demand factors

• Cost Push Inflation – caused by cost factors

Causes of Inflation
Demand Pull Inflation (Demand-side Theories of Inflation) Inflation is caused by an increase in any of the components of aggregate demand i.e., increase in C or I or G or (X-M)

• Usually it is an increase in G the primary cause of demandpull inflation • As demand increases prices and output both increase • When the economy is close to potential output (peak) price rise is steeper compared to output

• When there is excess capacity, vice versa

Demand Pull Inflation in an AD-AS framework
P
P2 P* AS

An increase in demand shifts AD curve to the right AD increases to Y1 from Y* Since AS is not changing, the excess demand Y1 – Y*, is eliminated with an increase in price level to P2 This brings back the AD-AS equilibrium

• •
AD1 AD0

Y*

Y2

Y1

Y

As we have seen, both real (an increase in govt. expenditure or reduction in tax) and monetary factors (increase in money supply or decrease in demand for money) can cause a shift in the AD

Demand Pull Inflation
Monetarists (the neo-classical) view
• ↑ in demand because of ↑ money supply
• Spending power of people > capacity of the country to produce goods and services • High budget deficit (Govt. spending > its revenue) → printing more money or borrowing → ↑ money supply.

• Govt. Policies should address the supply side of goods.
• Provide incentives for more efficiency to satisfy the higher demand without inflation

Demand Pull Inflation
Non-monetarists (the neo-Keynesian) view
• Dispute the link between ↑ money supply and inflation
• Controlling money supply need not control spending because

spending = money supply * velocity of money circulation
• ↑ money supply → ↑ spending → ↑ employment → ↑ output • Any ↑ in spending above the full employment level of output • Demand-pull inflation is caused by real factors (due to changes in C or I or G or (X-M))

Cost Push Inflation (Supply-side Theories of Inflation)
• ↑cost of production → supply shock

Causes
– ↑ factor prices – ↑ in wages excess of productivity – Devaluation or depreciation of currency → ↑ in import prices – ↑ interest rates → ↑ cost of borrowing – ↑ taxation or removal of subsidies demand for ↑wages ↑interest rate

↑cost

↑prices

Cost Push Inflation
• Depending on the cause, three types of cost-push inflation are identified (1) Wage-push Inflation: as a result of labour (union) pressure increase in money wage rate is greater than the labour productivity (2) Profit-push Inflation: the use of monopoly power by the monopolistic or oligopolistic firms to enhance their profit margin (3) Supply-shock Inflation: a drastic, unexpected reduction in the supply such as a crop failure due to bad weather, reduction in crude oil supply, reduction in key inputs supply

Cost Push Inflation in an AD-AS framework
P
P1 P0 AS1 AS0

An increase in costs shifts AS curve to the left, i.e. from AS0 to AS1 With AD remains the...
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