Inflation, Unemployment, and Growth

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Inflation, Unemployment, and Growth

• Why Does Inflation Occur?
• Expectations of Inflation
• Differing Views (Classical vs. Keynesian)
• Changing Financial Environment

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Why Does Inflation Occur?

• Cost-Push Inflation
• Demand-Pull Inflation

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Why Does Inflation Occur? Cost-push inflation

• Supply restrictions
• Full-employment of labor (increase wage demand
  leads to increased prices)
• Supply reductions due to natural disasters or
  political/economic decisions (OPEC oil cartel)
• Price increases lead to money supply increases.

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Cost-Push Inflation
S
0
P
Price
P
0
D
0
B
0
Q
a
(A-B)
Quantity
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Why Does Inflation Occur? Demand-pull inflation

• Excessive demand in the government and/or the
  consumer sector
• (GDP C I G X-M).
• Price increases lead to money supply increases.

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Demand-pull inflation
S0
Price
P0
D0
Q0
Quantity
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Inflation, Unemployment, and Growth

• Why Does Inflation Occur?
• Expectations of Inflation
• Differing Views (Classical vs. Keynesian)
• Changing Financial Environment

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Expectations of Inflation

• Expectations of inflation by the public is based
  on
• Conditions that already exist or have recently
  existed.
• Understanding of the economy, predictions of
  inflation, and past experience.

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Expectations of Inflation

• Example of Extrapolating Inflation

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Expectations of Inflation

• Expectations of inflation may cause inflation
• firms may increase prices
• Financial institutions may raise rates
• Wage earners may demand increases

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Expectations of Inflation

• Two key factors influencing inflation
• Wage Rate Increases
• Productivity Increases

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Expectations of Inflation
Price Level
P1 P
AD
Output (Q)
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Expectations of Inflation
Price Level
P P1
AD
Output (Q)
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Expectations of Inflation

• Inflationary Rule of Thumb
• Inflation Nominal Wage Increase Productivity
  Growth

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Expectations of Inflation

• Regardless of the cause, economists agree that
  for substantial inflation to continue, the money
  supply must rise.

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Inflation, Unemployment, and Growth

• Why Does Inflation Occur?
• Expectations of Inflation
• Differing Views (Classical vs. Keynesian)
• Changing Financial Environment

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Differing Views Classical vs. Keynesian

• Classical View
• Monetary policy should be used only to achieve
  long-run objectives, the most important of which
  is price stability.
• Changing policy creates confusion in the private
  sector and the results are unpredictable in the
  short-run.

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Differing Views Classical vs. Keynesian

• Monetary Rule
• Money supply should be increased by a
  predetermined percentage to allow for changes in
  productivity and real growth.

Milton Friedman
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Differing Views Classical vs. Keynesian

• Keynesian View
• Change monetary policy to adapt to economic
  conditions

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Inflation, Unemployment, and Growth

• Why Does Inflation Occur?
• Expectations of Inflation
• Differing Views (Classical vs. Keynesian)
• Changing Financial Environment

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Changing Financial Environment

• Enormous changes in financial institutions,
  technological changes and changing regulations
  made it difficult to use M1 targets.
• Fed shifts from money supply target to Fed Funds
  target.

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Inflation, Unemployment, and Growth
The End