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sg28 - Chapter 12 INFLATION Key Concepts Inflation and the...

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173 12 INFLATION* K e y C o n c e p t s Inflation and the Price Level Inflation is an ongoing process in which the price level is rising and money is losing value. Inflation is differ- ent than a rise in the price of one good or a one-time increase in the price level. The inflation rate equals , 100 0 0 1 × P P P where P 1 is the current price level and P 0 is last year’s price level. Demand-Pull Inflation An inflation that starts from an initial increase in ag- gregate demand is a demand-pull inflation. Figure 12.1 illustrates the start of a demand-pull inflation. The increase in aggregate demand raises the price level from 110 to 120. With no further increase in aggregate demand, in the long run the price level rises to 130 and then stops. This process is a one-time change in the price level. For the inflation to become established, the right- ward shift in the AD curve needs to continue. Per- sistent increases in the quantity of money result in persistent rightward shifts in the AD curve, so monetary growth is necessary for a demand-pull in- flation. The United States experienced demand-pull inflation through the middle of the 1970s, by which time the inflation rate was almost 10 percent per year. * This is Chapter 28 in Economics . Cost-Push Inflation A cost-push inflation starts as the result of an increase in costs. Money wage rates and the cost of raw materi- als are the main sources of cost-push inflation. The cost hike decreases short-run aggregate supply, raising the price level and decreasing GDP. The combination of a rising price level and decreasing GDP is called stagflation . If nothing else changes, in the long run the money wage rate adjusts and the price level stops rising. There is a one-time increase in the price level. If in response to the short-run decline in GDP, the Fed increases the quantity of money, aggregate de- mand increases and the price level rises still higher. The rise in the price level created by the increase in aggregate demand invites another cost hike. If it C h a p t e r
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1 7 4 C H A P T E R 1 2 ( 2 8 ) occurs and aggregate demand increases again, a cost-push inflation results. The United States experienced cost-push inflation in the late 1970s when OPEC hiked the price of oil higher and the Fed initially responded with an expan- sionary monetary policy. Effects of Inflation In the labor market, unanticipated inflation redistrib- utes income between workers and employers. In addi- tion, unanticipated inflation can hurt both workers and employers: Higher than expected inflation leads workers to quit their jobs to search for better paying positions. These workers have a period of unemployment and firms incur costs to hire new workers. Lower than expected inflation lowers firms’ profits, and they respond by laying off workers.
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