Chapter 53: Causes and consequences of inflation and ...goodbadecon.com/.../3116093/ch_53_-_causes_and_cons... · o Cost-push inflation An increase in factor costs on a macro scale

Chapter 53: Causes and consequences of inflation

and deflation (2.3)

“Having a little inflation is like being a little pregnant – inflation feeds on itself and quickly passes the

‘little’ mark.” Dian Cohen.

Causes of inflation Two main causes of inflation are Keynesian in origin; cost push inflation arising from higher factor costs to

firms, and demand-pull inflation which arises when aggregate demand in the economy outstrips available

aggregate supply. A third, neo-classical/monetarist view, posits that inflation is demand-pull in nature, but

that it is the underlying variable of increased money supply which is the root cause.

o Demand pull inflation Aggregate demand might rise for a number of reasons; stimulatory monetary/fiscal policies, greater

consumer confidence, ‘animal spirits’ of firms…etc.

Demand-side shock, A to B: When aggregate demand increases swiftly in the short run due to,

say, greater demand for exports, there will be a demand-side shock and concomitant (= associated)

increase in the price level, shown in figure 53.1 (diagram I) as the shift form AD0 to AD1. [And

again, this is a perfectly acceptable way to illustrate demand-pull inflation!]

Key concepts

Causes of inflation

o Demand pull inflation

o Cost-push inflation

o Excess money supply

Causes and consequences of deflation

Counter-inflationary policies

Evaluation of counter-inflationary policies

Consequences of deflation

• Discuss the possible consequences of deflation including high levels of cyclical unemployment and bankruptcies

Types and causes of inflation

• Explain, 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

• Evaluate government policies to deal with the different types of inflation

Figure 53.1 Demand-side shock, demand-pull inflation and demand-pull spiral

Demand-pull inflation, A to D: Once again, the initial increase in the price level (P0 to P1) due to

increased aggregate demand does not mean inflation per definition, but might rather set the stage

for demand-pull inflation.

o Diagram II in figure 53.1shows how inflationary expectations cause aggregate demand

to feed on itself, as firms’ and households’ spending plans increase in anticipation of

higher future prices. Aggregate demand increases further, from AD1 to AD2, and the price

level increases to P2.

o This is untenable (= unsustainable) in the long run, since higher final prices cause

labourers to suffer real wage loss, and subsequently they start to bid up wages.

o This results in higher labour costs for firms and a decrease in aggregate supply from

SRAS0 to SRAS1. The economy has moved towards long run equilibrium (YNRU) but at a

higher price level, P3. The original shift in AD sets off a round of demand-pull inflation

where aggregate demand increases beyond long run potential output.

Demand pull spiral, D to H: If aggregate demand continues to rise – due to continued expectations

of high inflation – then the economy can expect a process where prices increase labour adjusts

by bidding up wages and firms scale back on production due to lower margins between input

prices (e.g. labour costs) and final output prices. This is a demand-pull spiral, as illustrated in

figure 53.1, diagram III.

↑

↓

o Cost-push inflation An increase in factor costs on a macro scale can cause prices to rise due to the increase in costs. This causes

cost-push inflation and is frequently associated with ‘one-off’ increases in price level, known as supply-

side shocks. There are a number of possible causes of cost-push inflation; wages rising faster than

productivity gains in the economy; a fall in the exchange rate driving up the price of imported raw

materials and components; or an increase in factor prices, say the price of oil. All of these will shift

aggregate supply to the left, shown in diagram I, figure 53.2.

Figure 53.2 Supply-side shock, cost-push inflation and cost-push spiral

Supply-side shock, A to B: The price increase in key factors of production shifts the short run

aggregate supply curve from SRAS0 to SRAS1 (diagram I, figure 53.2) which increases the price

level from P0 to P1. This combination of a fall in output and inflation is known as stagflation (i.e.

stagnating and inflationary economy). [Note: many textbooks and teachers use diagram I to

illustrate cost-push inflation. This is perfectly acceptable!]

Cost-push inflation, A to D: Technically speaking, the supply-side shock illustrated in diagram I

does not comprise inflation, since it is a one-off increase rather than consistent. One could say that

the supply shock “sets the scene” for cost-push inflation:

o When labourers realise that real wages have fallen due to a higher price level, individual

wage bargaining and unions will drive up wages to regain lost purchasing power.

↑ ↑

↑

o The higher cost of labour will shift aggregate supply even further to the left, from SRAS1

to SRAS2 in figure 53.2, diagram II. The price level rises from P1 to P2.

o Ultimately, the increase in wages (perhaps accompanied by expansionary policies in

order to countermand increased unemployment) increases consumption and increases

aggregate demand from AD0 to AD1. The increased spending (and possible expansionary

policies) move the economy towards equilibrium at YFE but at a higher price level. We

have now had a round of cost-push inflation.

Cost-push spiral, D to H: Now, consider that final prices have risen to P3 (now continued in

diagram III in figure 53.2) due to increased consumption and fiscal stimuli. Real wages have

once again fallen due to the effects of inflation. Another period of bidding-up wages could lead to

a further decrease in aggregate supply, shown by the shift from SRAS2 to SRAS3, and another

round of cost-push inflation. Diagram III shows how successive shifts in SRAS and AD create an

upward spiral, known as a cost-push spiral or wage-price spiral. The basic effect is; price level

wages costs to firms price level …etc.

(Type 5 Smallest heading) The (in-) famous 1970’s cost-push spiral The most (in-) famous of supply-side shocks occurred during 1973 and ’74 when OPEC managed to force

oil prices upwards by 300%, the first oil crisis. Oil is vital to production since it provides energy,

transportation, compounds for plastics etc, and when the price of oil quadrupled, firms’ costs increased

greatly, causing a severe supply shock and stagflation in most industrialised countries. When stagflation hit

industrial countries, many responded by stimulatory policies which drove prices higher and resulted in cost-

push inflation. Many countries saw repeated rounds of higher costs and wages which led to cost-push

spirals.

The effect on the global economy was tremendous, with falling output levels and rising unemployment in

most of the world. It also spelled the end of pure Keynesian demand-side policies; see long run Phillips

curve following. As a most illuminating final footnote; recently declassified documents (December 2003)

in Great Britain paint a most illustrative picture of just how serious the oil crisis was regarded by the

President of the US in 1973/’74, Richard Nixon. In a copy of a report sent to British Prime Minister

Edward Heath (dated 12th

December 1973), Nixon put forward serious plans for the military occupation of

Saudi Arabia, Kuwait and Abu Dhabi.1 Perhaps the world is lucky that Nixon got his hands tied by the

Watergate scandal around the same time.

o Excess money supply Assume an economy with only one firm, which produces 1,000 Widgets per year at a price of $1 per

Widget. Additionally, the supply of money is $1,000. Assuming all Widgets are sold, what is national

income? Easy; it’s $1,000 – the same amount spent (E) and earned (Y) on output (O).

What if the supply of money doubled to $2,000 but output remained the same? Quickly check

Section 3.1 (Nominal and real income) to realise that nominal national income will increase but

real income will remain the same. Assuming that the additional $1,000 flows around the economy

at the same rate as the original $1,000, we can also fairly safely assume that the price of Widgets

goes from $1 to $2 – the price level has doubled.2

1IHT, January 2 2004, page 5; US considered seizing Arab oil fields.

2 Dear colleagues, I am aware that I am cutting a few corners in the cornerstones of the quantity theory of

money and the Fischer equation.

However, what if the ability of the firm to produce Widgets also increases during the time period,

say that new technology and production methods enables the firm to produce twice as many

Widgets at the same cost as before? Assuming that all are sold and that, once again, people use

their notes and coins at the same rate as before, the price of Widgets will remain at $1, and real

income will double to $2,000.

The above is a highly simplified and of course exaggerated example of how excess money supply causes

demand-pull inflation.3 Neo-classical/ monetarist economists view inflation as primarily demand-driven

and caused by an increase in the supply of money (i.e. monetary growth) above and beyond the long run

ability of the economy to increase the supply of goods – LRAS at the natural rate of unemployment (NRU).

In simple terms; if the increase in the supply of money is above productivity gains the result will be

inflation. The mechanism herein can be explained by the monetary transmission mechanism.

(Type 3 Medium heading) The monetary transmission mechanism Monetarists view inflation as primarily caused by demand-pull, often phrased as ‘too much money chasing

too few goods’. One of the pillars of monetary theory is the overriding importance attached to the supply of

money in the economy. Monetarists view the demand for money as relatively inelastic, so an increase in the

supply of money will have a large impact on firms’ investment and households’ consumption via falling

interest rates.

The series of diagrams in figure 53.3 illustrate how an increase in the supply of money and lower interest

rates feed through to an increase in investment and aggregate demand in the short run.

Diagram I: Increasing the supply of money from Sm0 to Sm1 forces interest rates down from r0 to

r1.

Diagram II: Lower interest rates induce an increase in investment, which is shown by the

movement along the investment schedule. Investment increases from I0 to I1.

Diagram III: The increase in investment causes an increase in aggregate demand; AD0 to AD1.

This is the transmission mechanism, where an increase in the supply of money is “transmitted”

to an increase in real output. (There is also a direct link between the lower interest rate and greater

household expenditure which also fuels aggregate demand.)

In summa: ↑∆Sm → ↓∆r → ↑∆I and ↑∆C → ↑AD and ↑∆ price level (inflation)

The resulting inflation caused by increased money supply can thus be viewed as ‘...too much money

chasing too few goods’.

3For more depth on this – outside the syllabus (and this book) – look up ‘quantity theory of money’ and/or ‘the

Fisher equation’.

Figure 53.3 The (monetary) transmission mechanism

(Type 3 Medium heading) The neo-classical view of money-driven inflation – LR effects It is important to realise that monetarist theory views any increase in money that is not matched by an

increase in real potential output (LRAS) as being solely inflationary in the long run. As the increase in AD

(figure 53.3) has pushed equilibrium output beyond LRAS, the increase in real GDP shown in diagram III

will not last, since wages will rise to match labour demand, serving to increase costs for firms and thus

push the AS curve to the left (SRAS0 to SRAS1) as in figure 53.4. Output returns to the natural level of

output, YNRU but at a higher price level.

Milton Friedman coined a main monetarist article of faith by stating that “Inflation is always and

everywhere a monetary phenomenon”.4

4 One of my many cheeky students, Ms O’Connor, once sent me a picture of two machines; one had numerous dials,

knobs, levers, wires, connections, scales and indicators on it while the other machine had a single button, ‘On-Off’. The

first machine was labelled ‘Woman’ and the second ‘Man’. I often think of monetarist policy as a ‘Man’ machine, since

all the various forms of fiscal policies are basically replaced with a single knob labelled ‘Money: More Less’.

Figure 53.4 The (monetary) transmission mechanism

While I am oversimplifying, the basic idea of steering the economy primarily by regulating the money

supply is in keeping with neo-classical theory since it advocates minimum government intervention in

favour of a few simple rules and guidelines such as the Central Bank openly setting target rates of monetary

growth and allowing the economy to adapt in terms of inflation and output. (See Chapter 59 for some depth

on monetary policies available to the central bank.) Alternatively, the Bank can set inflation ceilings and

then adjust money supply to keep inflation under control. A common ‘rule of thumb’ – simple but quite

effective in fact – is that monetary policy should be tightened when nominal interest rates are lower than

nominal GDP growth and vice versa.

POP QUIZ 3.5.4: CAUSES OF INFLATION

1. Why might governments in high inflation countries actually gain from the effects of inflation? Hint;

governments issue bills and bonds to borrow money.

2. An economy ‘imports’ inflation due to the increase in price of irreplaceable raw materials. Unions

push for higher wages to counter the cost of living increase and…now what? Use a diagram to

explore possible outcomes.

3. Over a five year period, the following changes are noted in an economy:

Time period Increase in money supply Inflation Real GDP growth

t1 7.0% 6% 4%

t2 10.5% 6.5% 2.8%

t3 18.4% 8.5% 1.4%

t4 9.6% 11.5% -0.8%

t5 9.0% 10.5% -1.5%

Use the viewpoint of a neo-classical/monetarist economist to explain the pattern of inflation rates

and growth during the five year period.

Causes and consequences of deflation “Inflation is taxation without legislation.” Milton Friedman

Deflation can be good, bad, and pretty darned ugly. Economists commonly differentiate between two types:

Good, or benign, deflation: This is caused by an increase in aggregate supply. Diagram I in

figure 52.1 shows how the price level falls when short run aggregate supply outpaces demand; the

price level falls from P0 to P1. Such deflation might result from increasing productivity and cannot

be considered harmful since the economy is growing and real incomes are increasing. In reality,

disinflation (falling inflation rates) has become the norm in industrialised countries, where

average inflation was 5% during the 1980s but had fallen to around 2% by the end of the ’90s.5

Bad, or malign deflation: However, if the price level falls due to a decrease in aggregate demand,

as in diagram II, figure 52.1, there can be serious and long-lasting negative consequences for the

economy; malign deflation. An economy experiencing a recessionary period that becomes

protracted might cause households and firms to decrease consumption and investment to ride out

the bad times and wait for the good times. This can actually prolong the recessionary period when

households and firms decrease expenditure in favour of saving. Remember, a fall in the price level

will increase the value of money. If households expect prices to continue to fall they will put off

expensive purchases in order to get more for their money. This fall in aggregate demand can

therefore confirm firms’ beliefs that less investment is necessary which together with the decrease

in consumption can become self-reinforcing in the economy.

5IHT, A new economic era – A global shift to deflation, May 22, 2003

Figure 53.5 ‘Benign’ and ‘malign’ deflation

One might say that malign deflation cures inflation something like lung cancer cures smoking and I dare

say that most economists would agree that deflation is a far greater threat to economic stability and growth

than inflation. The self-reinforcing loop – known as a deflationary spiral – created by falling prices

expectations of falling prices lower aggregate demand falling prices…etc is a most powerful force for

fiscal and monetary policy to overcome. In fact, many textbooks use the Great Depression of the 1930s to

describe the effects of continuously falling aggregate demand and resultant deflation. As prices,

expenditure, output and incomes fall there will be increasing unemployment which further dampens

aggregate demand and can quite possibly become permanent as some sectors fold and others see permanent

reductions in demand. This might lead to a higher natural rate of unemployment.

It seems that deflation, once it becomes entrenched (= deeply rooted) cannot be dealt with easily. The

‘trick’ is to create inflation by increasing the inflationary expectations of households and firms, but the

severity of the situation seems to resist standard monetary and fiscal policies. The solutions offered can

therefore be at the extremist end of policy-making, where common suggestions involve some or all of the

following: quickly lowering interest rates (see liquidity trap in Chapter 59) as soon as prices show a

tendency to fall; very publicly announcing that the Central Bank has increased the target rate of inflation;

large scale purchasing of bonds to create additional liquidity on the market; depreciating/devaluing the

currency to increase exports; and printing “funny money”, i.e. printing consumption certificates which can

only be used for consumption and then sending them to households in order to boost consumption and

aggregate demand.6

6In fact, Milton Friedman’s tongue-in-cheek suggestion for solving deflation was for the government to print

money and fly around in helicopters and unload the bills on a happy citizenry – the bills would be time-

limited in order to induce consumption rather than saving. This was actually attempted – without

helicopters – during the deflationary crisis in Japan.

POP QUIZ 3.5.3: INFLATION AND DEFLATION

1. Explain how an economist would regard an increase in cigarette taxes in terms of inflation.

2. How might the functions of money be put out of order during inflation?

3. Why might you, the student, stand to lose due to inflation?

4. Using a supply and demand diagram for your home currency, explain why double-digit inflation will

have a negative effect on your exchange rate – i.e. cause your currency to fall in value.

5. Why might deflation in fact be considered ‘good’ for an economy?

6. Outside the box question: Draw a demand curve for investment (investment schedule) showing how

the quantity of investment is totally unaffected by a decrease in the interest rate below 0.5%.

(Rory, please replace “malignant” with “malign.)

The Land of The Rising Sun, Japan, was the env y of

an astonished world during the 1960s,‘70s and ‘80s

due to its f antastic growth rates and low inf lation and

unemploy ment. GDP grew at an av erage of ov er 6%

during the period 1960 to 1990 with unemploy ment

rates hov ering around 2%. Yet during the beginning of

the 1990s, Japan was to become a case study in the

dif f iculties in getting out ofmalignant deflation. The

background is to be f ound in the property price bubble

of the late 1980s where property speculation and

loose monetary policy led to alarming lev els of property prices. (For example, the

classic story is that the land on which the Imperial Palace in Toky o stood was at one

point v alued at more than the entire American state of Calif ornia!)

When property prices started f alling in 1990 a goodly proportion of the loans taken by

speculators could not be serv iced, and this created a sev ere lack of loanable f unds –

which in turn had a negativ e ef f ect on inv estment. In spite of f alling interest rates,

Japan has experienced f alling prices, e.g. def lation, and stagnant or f alling GDP

during most of the period f rom 1995 to 2003.

The Central Bank, the Bank of Japan, loosened monetary policy to the point where

interest rates were v irtually zero during the period 1997 to 2003. This is explained by

some – but def initely not all – economists as being a classic example of the�liquidity

trap. When interest is zero and the economy continues to shrink, the Central Bank

basically ‘runs out of ammunition’ and there are f ew monetary policy tools lef t since

it is impossible to lower interest rates and stimulate the economy . In addition, recall

that real interest is nominal interest minus inf lation. Thus, ifnominal interest is zero

and inflation is below zero, there is anegative rate of real interest. The

repercussions are as astounding as they are simple:

• Negativ e real interest means that money increases in v alue ev en when y ou stick

it in y our mattress (or f uton, in Japan). For example, Japan had inf lation of -1%

(or def lation of 1%) during 2002 while nominal interest was zero. Thus sticking

money in a f uton actually meant a real interest of 1% ov er a y ear. Negativ e real

interest is theref ore a disincentiv e to spend money .

• Monetary policy becomes inef f ectiv e since it is impossible to lower interest rates

below zero – this would mean that banks would pay borrowers to take on debt!

• Corporate and household debt rises when prices f all, since a f all in prices

increases the negativ e real interest rate. This is a major disincentiv e to f irms and

households in taking on debt to f und inv estment and consumption.

In labour markets, f irms will need to increase productiv ity or cut wage costs in order

to stay competitiv e, since f alling f inal prices mean that prof it margins are squeezed.

In reality , f irms will not be able to lower wages and will resort to lay ing-of f workers.

The reason is that when inf lation is 6% a f irm can accomplish real wage cuts of 4%

by of f ering an increase of 2% nominal. To achiev e the same ef f ect when inf lation is

zero the f irm would hav e to cut nominal wages by 4%! This is not practically f easible

in most countries, wheref ore def lationary pressure inev itably leads to sizable lay of f s.

CASE STUDY, DEFLATION;

THE TEN YEAR SUNSET IN JAPAN

Counter-inflationary policies There is no “cure all” for inflation and the policies applied will depend on the type of inflation and the costs

government is willing to incur. The straightforward way to deal with inflation is to use demand-side

policies (adjusting AD) for demand-pull inflation and supply-side policies (shifting AS) for cost-push

inflation. Both have disadvantages, weaknesses and, as mentioned above, costs.

Using contractionary demand-side policies to combat inflation entails implementing policies which

decrease aggregate demand. Four key methods of dampening aggregate demand are:

Increasing the rate of interest: this monetary policy lowers consumption and investment and

thus decreases AD

Decreasing the supply of money: another monetary policy – this increases interest rates…etc…

Increasing taxes: the fiscal policy of higher income taxes will lower consumption, higher profit

taxes will decrease investment and both have a contractionary effect on AD

Decreasing government spending: the flip side of taxes, the fiscal policy of decreased

government spending has a direct effect in lowering AD

Figure 53.6 A shows how contractionary policies affect aggregate demand. Assuming general equilibrium

at YNRU and the average price level indexed at 100, AD is increasing at a rate indicating AD1 and inflation

of 5%. One or several contractionary policies are implement and AD settles instead at AD2, Y2 and an

inflation rate of 3%.

Figure 53.6 Inflation and demand-side and supply-side policies

Using supply-side policies to lower cost-push inflation entails implementing policies which increase

aggregate supply. Common examples of supply-side policies are:

Lowering marginal income tax rates: higher net disposable incomes entices people to work

more

Labour market policy changes: legislation enabling easier hire rules for firms or decreasing

minimum wage

Incentives for capital formation: government can induce increased investment expenditure by

giving firms tax breaks – e.g. allowing firms to deduct portions of investment spending from

taxable profits

Interventionist policies: government skills and re-training workshops can improve labour quality

and also create better matches between labour supply and demand

Figure 53.6 B illustrates how SRAS1 results in cost-push inflation of 8%. Over time – yes, this is a rather

serious weakness – supply-side policies can shift SRAS back towards general equilibrium (SRAS1 to

SRAS2) and a price level of 105 rather than 108.

LRAS

Price level (index)

SRAS

AD0

AD2

100

YNRU Y2 Y1 GDPreal/t

AD1

103

105

LRAS

Price level (index)

SRAS0

AD0

SRAS1

100

Y1 Y2 YNRU GDPreal/t

SRAS2

108 105

A: Decreasing AD B: Increasing AS

Evaluation of counter-inflationary policies This is a major issue and will be dealt with in greater depth in Sections 2.4 – 2.6. I limit the discussion here

to the key points arising from the examples and diagrams used in Figure 53.6.

1) To start with, contractionary demand-side policies can be hugely unpopular with citizens and are

basically not much of a crowd pleaser for politicians hoping to get re-elected. President Nixon was

most reluctant to implement much-needed contractionary policies when inflation started rising in

the late 1960s.7

2) Contractionary policies often lead to increased unemployment and lower incomes.

3) There is the very real risk that contractionary policies are too severe and that the result is

recession.

4) Any policy used will be subject to time lags – it can take up to two years for the full effect of

interest rate changes to feed through in an economy. Fiscal policies can take even longer. There is

therefore a very real risk that the economy is already cooling down when the policies kick in,

which could in fact worsen the economic downturn.

5) Supply-side policies avoid the issue of decreased incomes but are generally long term solutions

and will not have any immediate effect on inflation. Instead the aim is more along the lines of

allowing for long term growth while limiting inflationary pressure.

6) Lowering income tax rates can have serious repercussions on governments’ ability to balance the

budget. (See Chapter 56.)

7) In reality the effect on the labour market of lower personal income tax cuts is very limited and

simply does not increase labour supply.

7 See some fascinating economic history at Professor Bradford DeLongs site:

http://econ161.berkeley.edu/econ_articles/theinflationofthes.html

Summary and revision 1. Economics identifies three causes of inflation:

a. Demand-pull inflation caused by increasing AD

b. Cost-push inflation caused by decreasing AS

c. Excess money supply leading to demand-pull inflation

2. The monetary transmission mechanism describes how a change in money supply “feeds

through” to a change in AD. A ↓∆Sm → ↑∆r → ↓I → ↓AD.

3. Deflation is a general and consistent fall in the average price level. It is far more damaging

to an economy than ‘reasonable’ inflation. There are two types of deflation:

a. Benign deflation caused by increasing AS – there is deflation but rising GDPr

b. Malign deflation caused by falling AD – prices and incomes both fall

4. Counter-inflationary policies are:

a. Contractionary policies (e.g. policies aimed at decreasing AD) include raising

interest rates, decreasing the supply of money, raising taxes on income and profits,

decreasing government spending.

b. Supply-side policies (increasing AS) include lowering marginal income tax rates,

easing up on labour market regulations, privatisation of national industries,

decreasing union power, increased education and skills in the work force…etc.

5. Demand-side contractionary policies have negative effects such as a decrease in

government tax receipts, increased unemployment, lower GDP and personal income, time

lags which make it difficult to time the policies correctly and the possibility of creating

recession instead.

6. Supply-side policies have some serious weaknesses, such as actually increasing

unemployment in the short run, can take a long time to implement and take effect, lower

marginal tax rates can have serious consequences on the government budget, and studies

show very limited effects of personal income tax cuts on labour supply.