TOPIC 7: INFLATION &

UNEMPLOYMENT
(PART 1)
1
Case & Fair (Ch. 20, 26 & 27)
CHAPTER OUTLINE

Causes of Inflation
Demand-pull inflation
Cost-push/ supply-side inflation
Expectation of future prices
The growth of Money
CAUSES OF INFLATION
 Inflation – an increase in the overall price level.

 Sustained inflation – occurs when the price level

continues to rise over some fairly long period of
time.

 Stagflation – occurs when output is falling at the

same time that prices are rising.

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CAUSES OF INFLATION (CONT.)
1. Demand- pull inflation – inflation that is
initiated by an increase in AD.
Price level, P

4
Output level, Y
 Causes of Inflation (cont.)
2. Cost- push/supply- side inflation –
inflation that is caused by an increase in
costs.
Price level, P

5
Output level, Y
Causes of Inflation (cont.)
 Cost shocks are bad news for policy
makers.
 The only way they can counter is having
the price level increase even more than it
would without the policy action.
 When there is a cost shock, AS curve shifts
to the left, lower Y & increase P.

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Causes of Inflation (cont.)
 Expansionary monetary/ fiscal policy
could be changed enough to have the AD
curve shifts to the right.
 The policy would increase Y, but P would
increase further.
 Contractionary monetary/ fiscal policy
could be changed enough to have the AD
curve shifts to the left.
 The policy would decrease P, but Y would
decrease further.
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Causes of Inflation (cont.)
Cost- shock inflation: Expansionary fiscal/
monetary policy
Price level, P

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Output level, Y
Causes of Inflation (cont.)
Cost- shock inflation: Contractionary fiscal/
monetary policy
Price level, P

Output level, Y
Causes of Inflation (cont.)
3. Expectations of future prices
 When firms are making price/output decision,
their expectations may affect their current
decisions.

 Suppose inflation has been running about 10%

per year. Firms may expect competitors increase
price about 10%. So, they are likely to do so.

 This response is how expectations can get “built

10
into system”.
Causes of Inflation (cont.)
 Expectations can lead to an inertia that makes it
difficult to stop an inflationary spiral.
 If people form their expectations based on
previous pricing behaviour, firms may continue
increasing prices & wages also continue to
increase.
 As a result, AS curve shifts to the left.

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Causes of Inflation (cont.)
3. Expectations of future prices
Price level, P

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Output level, Y
Causes of Inflation (cont.)
4. The growth of money
 Ms may also play a role in creating a sustained
inflation.

 An increase in G with Ms constant shifts AD

curve to the right.

 This leads to an increase in r and I crowds out.

 If CB tries to keep the r unchanged by

increasing Ms, AD curve will shift farther &13
farther to the right.
Causes of Inflation (cont.)
 If CB tries to keep the r constant when the
economy is operating on the steep part of AS
curve, this could lead to a hyperinflation.

 Hyperinflation – a period of very rapid increases

in the price level.

 Thus, CB must accommodates with monetary

policy for a sustained inflation.
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 Quantity theory of money explains that P ∆
proportionately to the ∆ of Ms.
Causes of Inflation (cont.)
 The growth of money
Price level, P

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Output level, Y
 TOPIC 7: INFLATION &
UNEMPLOYMENT
(PART 2)
16
Case & Fair (Ch. 20, 26 & 27)
CHAPTER OUTLINE

The short run relationship between the

unemployment rate & inflation
Phillips curve
Expectation & the Phillips Curve
Long run Phillips Curve
SR RELATIONSHIP BETWEEN U & Π
 An increase in Y leads to an increase in N, a
lower u.
 An increase in Y corresponds to a decrease
in U, thus, Y & U are negatively related.
 When Y increase, P increase too.
 Inflation rate, π – the % ∆ in the P.
 Y up, P up, π up, u down.
 There is a negative relationship between u
and π.
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PHILLIPS CURVE
 Phillips curve – a graph showing the relationship
between the inflation rate & the unemployment
rate.

 Short run Phillips curve – the tradeoff between π

& u holding constant

 The expected inflation rate

 The natural unemployment rate
 Long run Phillips curve – the relationship
between π & u when the actual π equals the πe. 19
PHILLIPS CURVE (CONT.)
 SRPC is downward sloping.
Inflation rate, π

Unemployment 20
rate, u
 EXPECTATIONS AND THE
SHORT-RUN PHILLIPS CURVE
Inthe long run, expected inflation adjusts to
changes in actual inflation.

The CB’s ability to create unexpected inflation

exists only in the short run.
 Once people anticipate inflation, the only way to get
unemployment below the natural rate is for actual
inflation to be above the anticipated rate.
 AD/ AS Analysis & Phillips
Curve (cont.)
• Assume that govt. implement fiscal policy & ∆ in
AD is anticipated by people.
Price level, P Inflation rate, π

Unemploy-
Output level, ment rate, u
Y
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 AD/ AS Analysis & Phillips
Curve (cont.)
• Assume that ∆ in AD is greater than people’s
anticipation.
Price level, P Inflation rate, π

Unemploy-
Output level, ment rate, u
Y 23
 AD/ AS Analysis & Phillips
Curve (cont.)
• Assume that ∆ in AD is smaller than people’s
anticipation.
Inflation rate, π
Price level, P

Output level, Unemploy-

Y ment rate, u
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 Long Run Phillips Curve
• If the AS curve is vertical in LR, Phillips curve
also vertical.
Price level, P Inflation rate, π

Unemploy-
Output level, ment rate, u
Y
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LONG RUN PHILLIPS CURVE
(CONT.)
 In the LR, when inflation is anticipated,
real GDP is equals to natural rate of output
(Yn); unemployment is at its natural rate
(un).
 Natural rate of unemployment – the
unemployment that occurs as a normal
part of the functioning of the economy.

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∆S IN SRPC & LRPC
 When the πe ∆, SRPC will shifts but not the LRPC.
 πe lower, SRPC shifts leftward by an amount equal
to the fall in the πe.

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u
∆S IN SRPC & LRPC (CONT.)
 When the un ∆, both SRPC & LRPC will shift.
 un increases, SRPC & LRPC shifts rightward by an
amount equal to the increase in the un.
π

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u