Inflation. Image Source: Flickr

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1 Inflation Image Source: Flickr Inflation is a primary concern for economists, voters, and policy makers alike. It is the major factor that affects unemployment and consumer s ability to buy or sell their products. Its rate also affects the government s ability to buy or sell bonds and run effective monetary policy. The key definition of inflation is the general increase in the prices of goods and services in a given economy. The prices that are calculated into the inflation rate are usually those that are related to key elements of the economy in a grouping known as the market basket. This basket of goods is usually common consumer goods such as milk and bread, as well as services such as the internet. When inflation is taken into consideration while calculating the value of a nation s GDP, this GDP is referred to as the nation s real GDP or its value after inflation devalues its currency. Despite its effects on the economy and the nation s GDP, there is no consensus on the positives and negatives of an inflation rate. 77

2 Types of Inflation There are two main types of inflation that are dictated by different factors in the economy. These two main types are either caused by the government s fiscal policy or consumer behavior. They both may be controlled by direct government intervention. These types are as follows. 1. Cost-Push This is a complicated type that is not typically demonstrable in the economy at large. The most common situation that is cited as an example of cost-push inflation is the 1970 s oil crisis. The increased cost of petroleum during the crisis increased the prices of goods related to petroleum, which pushed up the prices of these products. As demonstrated in the example, cost-push is attributed to the increase of the costs of goods and services that do not have substitutes. Oil is the good in this example, and it is required for the production of goods such as plastics and rubber. There are no cost effective replacements for producing these goods. The rising price of oil therefore affects the prices of goods related to oil. 2. Demand-Pull This is the most common type and the key factor in dictating monetary policy. In this case, there is price inflation when GDP is rising at the same time that unemployment is falling. As demonstrated by the Phillips Curve, when unemployment falls inflation will rise because they have a negative relationship. Another way this may be explained is that there is too much money in the economy and not enough production. As a result, demand continues to increase and prices will rise to meet demand. 78

3 Cost-push inflation will not normally appear in the AP macroeconomics exam except maybe as a multiple choice question. However, demand-pull will almost always appear in the free response questions, especially as a result of government intervention and monetary policy. Because of this we will focus more on how demand-pull inflation works. Fiscal and Monetary Policy The primary goal of expansionary and contractionary monetary and fiscal policies is to raise or lower the unemployment and inflation rates. Doing so will increase or decrease production. While there are many aspects of these policies, the most common way to do so is by increasing or decreasing the money supply and affecting demand. When the government is enacting expansionary policies, it is actively pumping money into the economy. This is done in three ways. The first way is by increasing spending. As the government increases spending it is putting more money and investment into the economy. This investment money is directed towards consumers who eventually spend it on other goods. This turns into further consumption and further demand. The rising demand will increase inflation. Secondly, the government can enact public works. When it creates public works it will hire more workers to take on projects. As a result, the unemployment rate will fall and inflation will rise. Finally, the government s central banks (i.e. the Federal Reserve) can buy bonds in order to increase the money supply. When the central bank sells bonds to banks it acts as an IOU with interest where eventually the bank can sell the bond back to the central bank for money with a profit in interest. The central bank can start buying bonds back to increase the money supply as a result, which increases inflation. The bank can also directly mint more money to increase inflation, but this can be uncontrollable. 79

4 Improper governmental handling of the economy can lead to what is known as hyperinflation. When the government enacts an expansionary policy to decrease unemployment, inflation will rise. The government expects that the changes in both rates will be within a certain limit. However, if the government makes a misstep in its policies, the inflation rate can rise too much and cause hyperinflation, where the price levels rise exponentially. Finally, in macroeconomics, the inflation rate in one country can influence its ability to buy and sell goods on the global market. When the inflation rate increases in the United States, for example, its goods are more expensive which makes them less desirable. As a result, exports decrease. Conversely, a falling inflation rate decreases the price of goods relative to foreign goods and exports increase. Inflation and AP Macro The inflation rate has a key role in AP econ and therefore should be a major part of your AP macroeconomics review. It is especially important within the realm of the free response questions, as demonstrated by the 2014 AP Free Response Questions. Let s demonstrate how inflation may have a role in your AP. The foremost example of inflation s role on the AP exam is by way of demonstrating how it affects the economic relations between two countries. In the 2014 FRQ, you must demonstrate how a change in the inflation rate will affect the economy of the two countries in various ways. In order to answer this question, you will have to have a grasp of the AS-AD curve as well as the Phillips curve. As a general rule, as inflation increases, demand decreases. This means that as inflation increases in the United States, demand for its goods decreases. Therefore, South Korea will be less likely to buy its goods. This will generate a deficit in the United States current account balance due to it exporting less than it imports. 80

5 The price of one currency versus another will be key in measuring relative inflation. In order to visualize this, you will most likely have to draw a graph that shows the relationship between the two currencies and the overall shift in their value. As part of the effects of inflation rates on the economy, you will also most likely have to demonstrate the effects of the Federal Reserve s monetary policy on the inflation rate. The Federal Reserve mostly effects inflation by way of increasing or decreasing interest rates or the money supply. You will have to explain why these actions increase or decrease the inflation rate, or explain the inflationary effects as part of the answer. Inflation Relative to Other AP Macro Concepts The most important thing to consider is how inflation relates to all other aspects of the economy. The economy is a complex machine that contains many different factors and influences. The inflation rate is just one part of this machine. A change in one part can cause a change that ripples throughout the economy, which is why fiscal and monetary policies are so difficult to manage. This is most obvious in the first question of the aforementioned free response questions. Within this FRQ, you have to demonstrate how the government will influence the economy during cyclical and natural unemployment. If you remember, as previously mentioned, the inflation rate is conversely related to the unemployment rate. As part of the answer you have to mention how the change in unemployment affects the inflation rate. Other considerations to keep in mind are the effects of inflation on the real gross domestic product. It is important to keep in mind that the real GDP is when inflation has been taken into account for economic production. Therefore, all actions under this measure of production are subject to inflationary changes. The real GDP will fall as inflation rises and vice versa. 81

6 Conclusion The inflation rate is an extremely important factor to take into consideration while calculating economic performance. The main way of calculating inflation is through the Consumer Price Index (CPI). The CPI takes a common basket of goods that should be universal among consumers. It calculates the difference in prices between two years to get the inflation in that country. Inflation is influenced mainly by government policy and consumer demand. When the government wants to increase or decrease unemployment, it will respectively decrease or increase inflation. At the same time, an increase in demand by consumers due to them having more money will cause inflation to grow. Measuring inflation influences all other aspects of the economy, both domestically and globally. For this reason it is a key part of Macroeconomics. You should take inflation into account when you are planning your AP macroeconomics review. It is more than likely to appear on the exam, especially in the FRQ section. 82