2.4 BTypes or Causes of INFLATION:

B & D pages 230-232

Learning ObjectiveExplain, using a diagram, that demand-pull

inflation is caused by changes in the determinants of AD, resulting in an increase in AD.

Explain, using a diagram, that cost-push inflation is caused by an increase in the costs of factors of production, resulting in a decrease in SRAS.

Explain the monetarists’ view of the cause of inflation.

Short Run Demand-Pull Inflation: is caused by “positive” changes in AD componentsPriceLevel

0

Aggregatesupply

Aggregatedemand

D2

Y2

P2

Y1

P1

GDP

D1

O

Pric

e le

vel

AD1Y1

P1

Y2

P2

AD2

AD4

P4

Yf

GDP / Y

Y3

AD3

P3

Using the Keynesian model, increasing AD leads to growth but “manageable” inflation – only on the “flat” portion of AS

A cause-effect “spiral” may result in ongoing inflation:a demand pull spiral occurs when inflationary expectations set in. Workers try to keep pace by….

Short Run Cost-Push Inflation: is caused by AS supply “shocks” of sudden rising producer costsPriceLevel

0

Aggregatesupply

Aggregatedemand

Y2

P2

Y1

P1

AS2

GDP

Stagflation may occur if a cost-push spiral sets in

Usually Aggregate Supply curves increase at a steady rate. Every now and then, however, a ‘supply shock’ occurs: a large, sudden event will cause the AS curve to contract.

Such as: crude oil price rise (transportation and energy

costs)Natural disaster (earthquake destroying

infrascuture)Increase Excise (indirect taxes) introduction

This combination of recession and inflation was named Stagflation back in the 1970s – as it was unprecedented and first exposed the weakness of Keynesian “demand side” macroeconomic management.

Task: illustrate and explain the steps in a cost-push spiralstarts with __________ AS “shock” such as…

then inflationary expectations feeds aggregate demand because….

And in turn causes _____________ inflation because…

Key differences with a cost-push spiral: starts with decreasing AS (cost push) “shock” such as…then inflationary expectations feeds demand-pull because…

#3 excess monetary growth inflation:Increases in AD beyond Yf will ultimately fail to

increase growth; and only “fuel” inflationPrice level

Real GDP

AS

Capacity GDP

Y

AS”

2. AS decreases due to rising wage and input costs

PL”

3. Price Level rises and Output returns to Capacity GDP.

A

B

4.In the long Run higher prices have resulted in a movement from A to B, giving us a vertical AS curve at capacity GDP

AD

Y’

PL

AD’

1.The increase in AD opens up the Inflationary Gap

Deflation: the Good, the Bad and the Ugly

How the economy responds to a malignant deflation:

Price level

Real GDP

AS

AD

Capacity GDP

Y

AS”

2. Wage and resource costs will eventually adjust downwards, increasing AS

A

AD’

1. If deflationary expectations set in, AD worsens a recessionary gap

Y’

PL’

PL”

3. Price Level falls further and while real output may increase, AD may decrease again.

B

By further deflation! What is the risk?

PL

Tasks: Quiz B and Explain and Evaluate the impact of Deflation!