Inflation 15, , o na GDP 16, 00C 13, 000. Real GDP - Page 2

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1 Unemployment, Inflation, and Interest Rates As real GDP (Y) (spending by consumers (C) + businesses (J) + the government ( G) + foreigners ( X) ( net exports: exportsimports) changes over time, so do other economic variables, such as unemployment, inflation, and interest rates. These economic variables give us a better understanding of the human story behind the changes in real GDP and why real GDP changes over time. Page 1

2 Inflation Just as real GDP and unemployment have fluctuated over time, so has inflation. The inflation rate is the percentage increase in the average price (P) level of all goods and services from one year to the next. Often the expected rate of inflation impacts consumer decisions. If prices are expected to go up, some will buy earlier rather than later, and vice versa. The inflation rate is included in nominal GDP. Inflation occurs when nominal GDP grows quicker than real GDP; when price levels increase. <> ina versus Real U.S. GDP B - l ions ofdo crs 17, (X)Q 16, 00C 15, , , Page 2 o na GDP Real GDP , , , , , , ,

3 Inflation (cont.) Stagflation is persistent high inflation combined with high unemployment and stagnant demand for goods in a country's economy. Demand-pull inflation occurs when inflation is caused by an excess of aggregate demand (AD) vs. supply, (AS), like after natural disasters occur. Finally, a sticky price is a price for goods or services that does not respond immediately to changing economic conditions. Sticky price situations can occur when busin,ess leaders make production decisions that do not create equilibrium in the market. It can also occur because of the cost and time to communicate the price change in society, like price tags or advertising. Because of this, sticky prices have been used to explain the shape of the short-run aggregate supply (SRAS) curve because the quantity of goods supplied (Qs) does depend on the price level. Page 3

4 Inflation (cont.) Increases in aggregate demand (AD) causes the inflation rate to increase and vice versa. This occurs because of the demand which then leads to price increases over time. Higher inflation rates make your money worthless. After WW I, Germany's money was worthless because their inflation skyrocketed. Prices for goods went up tremendously. The same happened to the South during th American Civil War. A rapid increase in a country's money supply creates hyperinflation, which explains why governments just can't print more money. C,ost-push inflation is inflation caused by an increase in prices of inputs like labor, raw material, etc. The increased price of the factors of production, like labor and materials, leads to a decreased aggregate supply (AS) of the goods being made, and we know that when supply (S) decreases prices (P) increase, which causes inflation. Page 4

5 Inflation (cont.) A low and stable inflation rate has not been a feature of the U.S. There are some useful facts to know about inflation. First, inflation is closely correlated with the ups and downs in real GDP (Y) and employment: inflation increased prior to every recession of the last 40 years. Think of a bike going down hill and picking up speed, just like an economy does as it improves. Prices become inflated because firms know people have more money and will pay more in the short-run (SR). PER E~"T Page 5 197S ;- 10!) :,>ouo

6 Inflation (cont.) Second, there are long-term trends with inflation. Disinflation occurs when the inflation rate is slowing down. When inflation is falling and average price (P) level falls, economists call it deflation, something that sounds good but is very bad. Third, there is no reason to expect the inflation rate to be zero. The inflation rate has averaged around 2% or 3% since the 1990's, and that is the rate goal of most economies. The lower and more stable inflation is in a country, the greater the chance for economic growth, because high inflation puts more goods and services out of reach for some who make less !) Page 6

7 The Interest Rate and Inflation The figure below represents the monetary policy rule graphically. The nominal interest rate must rise by more than the inflation rate if the real interest rate is to rise when inflation rises. 11\'TEHE.ST HA g ( Pt-;llC I :" ) J ominal in t r " ~t r at H a l in t r' t rat l 4 6 ~ ' I XFI...\ T I o, H \' r E ( PEHC ~'T) Page 7

8 The Interest Rate and Inflation (cont.) Most central banks have a target inflation rate (about 2%)(the inflation rate that the central bank tries to maintain on average over the long run). Sometimes the inflation rate will rise and sometimes fall below the target inflation rate. By reacting to these movements in inflation, according to a monetary policy rule, that is, by increasing the nominal interest rate when the economy is expanding and inflation rises and cutting the nominal interest rate when the economy is contracting and inflation falls, the central bank can cause the actual inflation rate ( the real interest rate) to move back toward the target inflation rate over time by adjusting the spending of consumer consumption (C), business investment (J), and and net exports ( X) (exports-imports). Remember, government purchases ( G) are not impacted by interest rates. Page 8

9 Inflation-Questions t.tl...: c_., :i:: -> " 0.. :.i: SRAS, AD 2 0 REAL OUTPUT 32. Th e graph above sho,v aggregate den1and AD ). short-run aggregate supply (S RAS and curves for an economy. B ased on tne graph, cost-push inflation is caused by a moven1.ent from (A) SRAS 1 to SRAS 2 (B) SRAS 2 to SRAS 1 (C) AD 1 to AD 2 ( D ) AD 2 to AD1 Page 9

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11 Inflation-Questions 8. ~ lu h of the follo,ving,vould gen rate o t-pu h inflation? A An in re< e in the pri of labor B) A de r a e in the pri e of en rgy (C) An in rec e in hou ehold con 11nption D) A deer a e in gov rn111ent pending E) An in rea e in the tnone)' upply 2. Inflation o cur,vhen tj1eie a ll tained in rea e in,, 1 lii h of th follo,ving? Real gro dotne tic prod\1 t The average pr i e lev 1 Th price of any con11nodity Labor produ tivity The unen1ployn1ent rate Page 11

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13 Inflation-Questions 51. Which of the following i a cau e of hyperinflation? Page 13 (A Rapid growth of real gro dome tic product (B Rapid growth of the money upply (C Unanticipated decrea e in aggregate demand (D Unanticipated increa e in aggregate upply (E Unanticipated ri e in real intere t rate 7. Hyperinflation i typically cau ed by (A high tax rate that di courage work effort B continuou expan ion of the money upply to finance go emment budget deficit C trade urplu es that are cau ed by trong protectioni t policie D bad harve ts that lead to wide pread hortage E a large decline in corporate profi that lead to a decrea e in production

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