Inflation can also result from an initial decrease in aggregate supply caused by an increase in the real price of an important factor of production, such as wages or energy.

Figure 2 illustrates the effect on output and the price level of a decrease in aggregate supply. The reduction from SRAS] to SRAS, increases the pricc level to P-, and with no initial change in aggregate demand, reduces output to GDP-,. The impact on output is the key difference between the demand-pull and cost-push effects: the demand-pull effect increases GDP above full-employment GDP, while cost-push inflation from a decrease in aggregate supply initially decreases GDP.

If the decline in GDP brings a policy response that stimulates aggregate demand so output returns to its long-run potential, the result would be a further increase in the price level to Pj.

The increase in the price ievel would only represent inflation if it persisted. For that to happen, the supply shock that caused SRAS to decrease would have to be repeated, and policy makers would have to keep responding by expanding the money supply. The oil crisis of the 1970s is an example of a cost-push inflation spiral.

Figure 2: Cost-Push Inflation

LOS 25.c: Distinguish between anticipated and unanticipated inflation, and explain the costs of anticipated inflation.

P-jcall that in the aggregate demand - aggregate supply model, when workers' inflation expectations were different from actual inflation, equilibrium real GDP was not equal to potential (full-employment) real GDP. When workers' expectations about inflation rates in the next period are correct, we say that inflation is anticipated. In Figure 3 we illustrate an increase in the price level from an initial level of 100 that is correctly anticipated. Aggregate demand is expected to increase from ADQ to ADj and since workers (and owners of other important factors of production) anticipate inflation of 5%, money wage demands will increase by 5% and the short-run aggregate supply curve shifts up (decreases) from SAS0 to SASj. The new equilibrium at the end of the period is on the long-run aggregate supply curve, but at a price level of 105, that is 5% higher. As long as the rate of price inflation is anticipated correctly, this process can continue and output will grow at the rate of growth of LRAS (full-employment or potential GDP) without cyclical behavior.

Figure 3: Inflation Anticipated Correctly

Price Level

LRAS

SAS,

LRAS

SAS,

Figure 4 shows the effects of unanticipated inflation. II aggregate demand increases more than expected (inflation is higher than workers and owners oi other (actors of production expect), the result will he real GDP that is greater than potential real GDP (GDP<jR) in the short run. The price level rises more than 5% in the short run to 106, and rises more in the long run to 107 as expected inflation catches up with actual inflation and output returns to the full-employment level. This is illustrated in Panel a) of Figure 4. In Panel b) we illustrate the opposite case where inflation (and the increase-in aggregate demand) is less than expected. The short-run effect here is a recessionary gap with real GDP at GDP<jR, an increase in the price level to 104, and full-employment output reached in the long run as inflation expectations are adjusted to equal actual inflation.

Figure 4 shows the effects of unanticipated inflation. II aggregate demand increases more than expected (inflation is higher than workers and owners oi other (actors of production expect), the result will he real GDP that is greater than potential real GDP (GDP<jR) in the short run. The price level rises more than 5% in the short run to 106, and rises more in the long run to 107 as expected inflation catches up with actual inflation and output returns to the full-employment level. This is illustrated in Panel a) of Figure 4. In Panel b) we illustrate the opposite case where inflation (and the increase-in aggregate demand) is less than expected. The short-run effect here is a recessionary gap with real GDP at GDP<jR, an increase in the price level to 104, and full-employment output reached in the long run as inflation expectations are adjusted to equal actual inflation.

Figure 4: Inflation Not Well-Anticipated

(a) Inflation above expectations LRAS

(a) Inflation above expectations LRAS

Price Level

10S KM

(b) Inflation below expectations LRAS

(b) Inflation below expectations LRAS

10S KM

- | |

X" " | |

^ AD, | |

Real GDP GD1\ ## Real GDPWe generally assume that people adjust their expectations of inflation in a rational way. That is, they have rational expectations. Put another way, people cannot be easily and repeatedly fooled about future inflation. They may be wrong, but not predictably so and not forever. This is why we assume that expected inflation will equal actual inflation over time and return us to long-run equilibrium in our aggregate supply - aggregate demand model. While our model suggests that correctly anticipated rates of inflation are consistent with full-employment equilibrium real GDP without inflationary or recessionary gaps and cycles, high inflation can have negative effects on real output even when correctly anticipated. High inflation, even when anticipated, reduces economic output and the growth rate of GDP because it: • Diverts resources from other productive activities to deal with inflation's effects and uncertainty. • Decreases the value of currency in transactions and as a store of value. • Distorts returns in the investment and savings market and reduces capital investment in the economy. LOS 25.d: Explain the impact of inflation on unemployment, and describe the short-run and long-run Phillips curve, including the effect of changes in the natural rate of unemployment. Our analysis using the AS - AD model indicated that if expected inflation and actual inflation (based on the increase in aggregate demand) are equal, the economy remains at ftill-eniplovment GDP and the price level rises. If the increase in aggregate demand is greater than expected, two things happen. The price level increases more than expected (actual inflation is greater than expected inflation), and unemployment decreases to a level below its natural rate. This negative relationship between unexpected inflation and unemployment is depicted in the short-run Phillips curve shown in Figure 3. The decrease in unemployment in the short run changes unemployment from its natural rate along the long-run Phillips curve to a point like 1. Note that each short-run Phillips curve is constructed holding the expected rate of inflation constant and for a particular natural rate of unemployment. Figure 5: Long-Run and Short-Run Phillips Curve Inflation Inflation long-run Phillips curve GDPr long-run Phillips curve GDPr __ short-run Phillips curve ' with expected inflation = 8% ■ short-run Phillips curve with expected inflation = 6% - Unemployment In the long run, expected inflation and actual inflation are equal so the economy is at full employment and the rate of unemployment is equal to its natural rate. When a central bank unexpectedly decreases the rate of money supply growth to reduce inflation, the initial effect is to decrease aggregate supply as real wages rise, resulting in a short-run decrease in both GDP and employment. In this case, actual inflation is less than anticipated inflation, and unemployment increases as a result. This situation is represented by a movement along the short-run Phillips curve in Figure 3 to a point such as 2. If the reduced rate of growth of the money supply is maintained, eventually the new lower rate of inflation is correctly anticipated in wage contracts and the decrease in short-run aggregate supply and increase in aggregate demand are such that the economy remains at full-employment GDP. We represent this situation as a shift in the short-run Phillips curve to PC.,. Note that the short-run Phillips curve intersects the long-run Phillips curve at the expected rate of inflation. It is the short-run differences between expected inflation and actual inflation that are driving the relationship between unexpected inflation and unemployment in the short run. ## Changes in the Natural Rate of UnemploymentRecall that the natural rate of unemployment consists ol the frictional and structural unemployment that exists when cvclical unemployment is zero and output is at potential (full-employment) GDP. Changes in the natural rate can come from many sources, including the size and makeup of the labor force, changes that affect labor mobility, and advances in technology that replace some jobs and create new ones. An increase (decrease) in the natural rate would be represented as a shift to the right (left) in the long-run Phillips curve. LOS 25.e: Explain the relation among inflation, nominal interest rates, and the demand and supply of money. Recall that we previously defined the nominal risk-free interest rate as the sum of the real risk-free rate and the expected inflation rate. We now examine why this is necessarily so. The nominal rate of interest is the equilibrium rate determined in the market for savings and investment. If expected inflation is higher, business will expect greater returns on their investments because they will factor in higher prices for their output in the future. At the same time, savers will require a greater rare of return on their savings because they are considering the trade-off between current consumption and future consumption. Since they are concerned with real consumption, the}' will require a greater nominal rate of return when the expected rate ol inflation is higher, so that the real consumption that they receive in the future in return for not consuming now (saving) is the same. When presented in terms of nominal interest rates, this combination of an increase in demand for financial capital and a decrease in the supply of financial capital (savings) increases the equilibrium nominal rate of interest. We have also related the actual inflation rate and, eventually, the expected inflation rate to the rate of growth of the money supply. We can conclude that higher rates of growth of the money supply lead to higher rates of inflation, higher rates of expected inflation, and higher nominal interest rates. |

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