INFLATION - Increase in the level of prices in goods and services (price inflation).

It is generally true that the money

supply grows faster than the total RGDP then it will generally increase the level of prices. But there are also things
such as supply shocks. Such as the oil crisis in the 1970s

Quick Quiz!

What is the difference between Inflation and Supply Shock?

What is the difference between Headline Inflation and Core Inflation?

Usually inflation is measured by the Consumer Price Index (what is the definition?)

The Consumer Price Index measures the overall change in consumer prices based on a representative basket of
goods and services over time. a measure of the average change in prices over time in a fixed market basket of goods
and services.

Other Indexes you need to know about!

● The Laspeyres Price Index - an index formula used in price statistics for measuring the price development of
the basket of goods and services consumed in the base period. The question it answers is how much a basket
that consumers bought in the base period would cost in the current period.

● The Paasche Price Index - an index formula used in price statistics for measuring the price development of the
basket of goods and services that is consumed in the current period. The question it answers is how much a
basket that consumers buy in the current period would have cost in the base period.
 ● The Fisher Price Index - an index formula used in price statistics for measuring the price development of
goods and services, on the basis of the baskets from both the base and the current period.

MONETARY AND FISCAL POLICY

Monetary policy involves using interest rates and other monetary tools to influence the levels of consumer spending
and aggregate demand (AD). In particular monetary policy aims to stabilize the economic cycle – keep inflation low
and avoid recessions.

Fiscal policy involves the government changing the levels of taxation and government spending in order to influence
aggregate demand (AD) and the level of economic activity.

AGGREGATE DEMAND AND SUPPLY

Aggregate demand is a term used in macroeconomics to describe the total demand for goods produced domestically,
including consumer goods, services, and capital goods. It adds up everything purchased by households, firms,
government and foreign buyers (via exports), minus that part of demand that is satisfied by foreign producers
through imports.

Quick Quiz!

What is the difference between Demand and Aggregate Demand?

The Aggregate Demand is a downward sloping curve because it explains economic cycles. There are 3 major theories
why economists believe that it’s a downward sloping curve.

● The Wealth Effect - If all things are equal.

● Savings and Interest Rate Effect - Low price level, more savings. More savings, low borrowing interest rates.
 ● Foreign Exchange Rate

If firms desire high levels of investment and/or consumers are eager to spend rather than save, then aggregate
demand will be high. But if consumers are anxious to save while firms are reluctant to invest, then aggregate demand
will be low.

More generally, Keynesians see the flow of spending in terms of injections and leakages. Investment, government
spending, and exports all inject demand into the economy. Saving, taxes, and imports all leak demand out of the
economy. When demand is weak, the government can remedy this by injecting more of its own spending or by
reducing leakage by cutting taxes. In either case, its own budget moves in the direction of deficit.

Quick Quiz!

What shifts the aggregate demand curve?

Explain the possible reasons for the fall in AD.

Aggregate supply is the relationship between the overall price level in the economy and the amount of output that will
be supplied. As output goes up, prices will be higher.
Quick Quiz!

Why does aggregate supply rise with price level?

One theory of the aggregate supply curve is that it has three segments. When the economy is deep in a recession, with
high unemployment, an increase in aggregate demand will result in little or no increase in price. Instead,
unemployed resources will be put to work to fill the demand. When the economy is growing but not yet at full
employment, an increase in aggregate demand will raise both output and prices. When the economy is at full
employment, supply cannot increase further, so an increase in aggregate demand will primarily raise prices.

Long-run aggregate supply

In the long run, RGDP does not actually rely on prices. The long run aggregate supply curve (LRAS) is determined by
all factors of production – size of the workforce, size of capital stock, levels of education and labor productivity.

● If showing a change in wage costs or oil prices, I would use a SRAS.

● For showing long run economic growth, and an increase in capital stock and investment I would show a
shift in LRAS.
Factors determining LRAS

1. Available land and raw materials

2. Quantity and productivity of labor
3. Quantity and productivity of capital
4. Technological improvements which affect productivity and output.
5. The level of entrepreneurship in the economy.

Short-run Aggregate Supply

In the short-run, capital is fixed. Firms can alter variable factors of production, such as labour.The SRAS is viewed as
elastic, because in the short-run firms can increase output by getting workers to do overtime.
Factors affecting the SRAS curve

1. Price of raw materials, e.g. oil, food, metals

2. Cost of labor, (wages, taxes, regulation
3. Levels of tax and subsidies
DEMAND -PULL INFLATION

Demand-pull inflation is a period of inflation which arises from rapid growth in aggregate demand. It occurs when
economic growth is too fast.

If aggregate demand (AD) rises faster than productive capacity (LRAS), then firms will respond by putting up prices,
creating inflation.

● Inflation – a sustained increase in the price level.

● Demand-pull inflation – inflation caused by AD increasing faster than AS.
Demand-pull inflation means:

● Excess demand and ‘too much money chasing too few goods.’
● The economy is at (or very close to) full employment/full capacity.
● The economy will be growing at a rate faster than the long-run trend rate.
● A falling unemployment rate.

How demand-pull inflation occurs

If aggregate demand is rising at 4%, but productive capacity is only rising at 2.5%; firms will see demand outstripping
supply. Therefore, they respond by increasing prices.

Also, as firms produce more, they employ more workers, creating a rise in employment and fall in unemployment.
This increased demand for workers puts upward pressure on wages, leading to wage-push inflation. Higher wages
increase the disposable income of workers leading to a rise in consumer spending.
When evaluating this type of inflation it is important to understand the main cause of the positive AD shift. This is
because if the AD shift was caused by increased consumption brought on by higher consumer confidence, then it is
likely to create an inflationary spiral, in which real output remains unchanged but the price level increases
significantly. This is essentially an inflationary movement up the LRAS curve without any real gains for economic
agents. However, if the AD curve shift was brought about through higher investment, this is likely to have strong
productivity links to the economy (e.g. increase in rate of capital accumulation). As a result, it can create pressure for
the LRAS curve to outwardly shift and the economy goes through a period of disinflationary growth. So it is
important to consider what factor has driven the demand-pull inflation to evaluate its impact on the performance of
the economy.
COST-PUSH INFLATION

Cost-push inflation occurs when we experience rising prices due to higher costs of production and higher costs of
raw materials. Cost-push inflation is determined by supply-side factors, such as higher wages and higher oil prices.

Cost-push inflation is different to demand-pull inflation which occurs when aggregate demand grows faster than
aggregate supply.

Cost-push inflation can lead to lower economic growth and often causes a fall in living standards, though it often
proves to be temporary.
Many cost-push factors like rising energy prices, higher taxes, and the effect of devaluation may prove temporary.
Therefore, Central Banks may tolerate a higher inflation rate if it is caused by cost-push factors.

Other economists may fear that temporary cost push factors may influence inflation expectations. If people see
higher inflation, they may bargain for higher wages and thus the temporary cost-push inflation becomes sustained.

How the spiral happens:

Production decreases because there is an increase in production costs. This means it’s more expensive to produce. If
so, companies can either fire employees or increase their wages. Either way this can lead to an increase of production
which will then boost the disposable income of the company. This results in an increase in spending and economic
activity which will then shift the aggregate demand curve which will lead to an increase in RGDP but the price levels
are now higher. Higher prices lead to an increase in production costs, so on and so forth.
THE PHILLIPS CURVE

The Phillips curve suggests there is an inverse relationship between inflation and unemployment.

However, Monetarists have always been critical of this Phillips curve trade-off. They argue that in the long run there
is no trade-off as Long Run AS is inelastic. Monetarists argue that if there is an increase in aggregate demand, then
workers demand higher nominal wages. When they receive higher nominal wages, they work longer hours because
they feel real wages have increased. (their price expectations are based on last year)

However, this increase in AD causes inflation, and therefore, real wages stay the same. When they realize real wages
are the same as last year, they change their price expectations, and no longer supply extra labor and the real output
returns to its original level. Therefore, unemployment remains unchanged, but we have a higher inflation rate. The
short-run Phillips curve shifts upwards to SRPC 2.
The increase in AD only causes a temporary increase in real output to Y1. After inflation expectations increase, SRAS
shifts to the left (SRAS2), and we end up with higher inflation (P3) and output of Y1. This AD/AS model explains why
we only get a temporary fall in unemployment.

● Adaptive expectation monetarists argue there is only a short-term trade-off between unemployment and
inflation.
● Rational expectation monetarists argue there is no trade-off, even in the short term. The rational
expectation model suggests that workers see an increase in AD as inflationary and so predict real wages
will stay the same.