Inflation is defined as a continuous increase
in the price index. It is not higher prices, but a rising price level.
Anticipated inflation: When inflation is
anticipated, individuals know what is coming, and how to deal with it.
For example, banks may raise interest rates to compensate for the anticipated inflation, workers may ask for
raises to maintain their real incomes, wealth holders will put their wealth into assets that will rise in value at
least at the same rate as the increase in the price index, etc.
Unanticipated inflation: When inflation
is unanticipated, individuals do not realize that they should protect
their real purchasing power against a rising price level until the price level has already risen and their real
purchasing power has already fallen. In this instance, there will be gainers and losers, in terms of purchasing
power, from the inflation.
Losers: Individuals on fixed incomes, retirees,
all creditors (who will have their loans paid back in dollars of
reduced purchasing power.)
Gainers: Individuals whose incomes rise faster
than inflation, debtors (who will pay their debts in dollars of
reduced purchasing power).
Costs of Unanticipated Inflation: an overview.
In general, unanticipated inflation causes a misallocation of resources.
Firms, unions, banks, will push prices and
wages up. Those who can do it best will cause a misallocation of
1. Suppose manufacturing workers get fast wage
increases, and public employees don't. Then, resources (labor)
will be reallocated due to the relative market power of the different workers.
2. Lenders will lose with respect to borrowers,
giving individuals an incentive to borrow. In relative terms,
borrowing becomes cheaper than paying in cash.
3. Individuals have an incentive to spend now
before the price level rises further. This will push prices up even
faster, and may cause the inflation rate to accelerate.
4. Uncertainty increases. Consumers and investors
are less certain about the future, as prices rise in an
unanticipated fashion. They may change their pattern of spending, and be less willing to undertake projects
that take a long time to payoff.
If inflation accelerates wildly, it may become a hyperinflation.
In this case, the rate of inflation is so high, money becomes virtually
worthless, and can no longer serve as a
medium of exchange.
GERMANY: After WWI, the German economy suffered
a serious hyperinflation. Using a wholesale price
index, base year 1913, we can see how prices rose in the early 1920's. [P = 100 in 1913]
DATE VALUE OF PRICE INDEX
Jan 1921 1400 or 14 x 102
Jan 1922 3700 or 37 x 102
July 1922 10100 or 10.1 x 103
Jan 1923 278500 or 2.785 x 105
July 1923 7480000 or 7.48 x 106
Aug 1923 94400000 or 9.44 x 107
Sept 1923 2390000000 or 2.39 x 109
Oct 1923 709600000000 or 7.096 x 1011
15 Nov 1923 75000000000000 or
7.5 x 1014
On 15 November 1923 the currency was converted to new denominations.
After WWII, Greece and Hungary had serious hyperinflations.
In 1948, the Federal Republic of Germany also had a serious hyperinflation.
Again, monetary conversion was
used to stop the process.
Old Currency New Currency
10 Reichsmarks = 1 Deutschmark
1/2 of old currency was converted.
1/2 was held in "blocked" bank accounts, and could not be withdrawn, so it could not be spent.
The money supply fell from 150 Billion RM to 12 Billion DM
No inflation can continue for long if the aggregate
demand curve does not increase to give it room. To stop an
inflation, we have two choices:
1. Lower Aggregate Demand (or stop it from
2. Increase Aggregate Supply (or stop it from falling).
All fiscal and monetary policies are demand
Supply side policies involve economic restructuring.
Types of Inflation:
1. Demand Pull: Aggregate Demand continuously rises faster than Aggregate Supply, and an inflation results.
In graph below, AD shifts from
AD0 to AD1. This leads to a movement
to the new short-run equilibrium, F. Since the real
wage at F is lower than at E, resource owners seek increases in money wages, rent and interest payments. This leads to a backward shift in AS0 to AS1. If there are no further increases in demand, the economy stops at G, with a higher price level and the same real GDP. At this point, there is not an inflation, just a higher price level.
To generate inflation, AD must continue to shift out to the right to permit the price level to keep rising, as seen below:
If AD1 moves out to AD2, then the next short-run equilibrium will be at point H. Then, as before, AS will shift back,
this time from AS1 to AS2 , as resource owners again seek to restor the reat wage. This will move the economy to J, unless AD continues to shift out to the right.
The main lesson here is that the demand-pull inflation cannot continue unless Aggregate Demand continues to increase. Otherwise, the economy would eventually return to a long-run equilibrium along the LAS curve, at a higher price level but at the potential real GDP level, as resource owners seek to restore the real wage. But, if AD keeps shifting out, then resource owners are continually raising their money wage,rent and interest demands to compensate for the rising price level. The dynamic ratcheting effect keeps the price level rising continuously.
The only policy tool that can actually sustain increases in demand for long periods without disrupting the rest of the economy or polity is Monetary Policy. As Milton Friedman says, "Inflation is always and everywhere a monetary phenomenon."
2. Cost Push: Costs of production rise without
an increase in aggregate demand. This is the supply shock case
we saw earlier.
Typically, Cost-Push inflation
begins when there is an increase in the price of some critical resource
used in production. The most-cited modern example is the dramatic
increase in oil prices due to the formation of the OPEC cartel in the early
The increase is the price of some basic productive resource causes the costs of production to rise across the economy. This is illustrated by the backward shift in aggregate supply seen in the diagram below, as AS0 moves to AS1. The short-run equilibrium will move to F from E.
What happens next depends on the reaction of the policy makers to the stagflation that has been created, i.e., higher prices with a rising unemployment rate. Worse, at point F, the real wage has fallen as compared to E. Therefore, resource owners will seek to raise their wage demands to compensate for the reduction in their real wage.
It must be remembered that the backward movement of AS0 to AS1implies that the potential real GDP level
in the economy has been reduced. Therefore, as seen in the graph below, the long-run equilibrium will now be found at a lower level of real GDP than before, as illustrated by the new LAS' curve below. The higher costs illustrated by the initial shift in AS0 to AS1 mean that the economy is restructured to some extent. The money wage has not risen as much as P, so the real wage has declined. But, the equilibrium real wage itself is lower than it was at point E, because of the economy's restructuring to deal with the new higher resource prices.
As we also see below, the
policy makers have decided to fight the unemployment created by the supply
shock, and let the price level rise. Therefore, AD0 shifts
to AD1, which would leads us to a short-run equilibrium at G.
But, this is no longer a long-run equilibrium. Long-run equilibria
now occur along LAS1. Therefore, the movement to G will generate
further backward movements in AS as resource owners seek to restore their
real purchasing power.
We see below that policy makers can maintain the original real GDP level only if they are willing to keep shifting AD out to the right, trying to out-run the backward movements in AS as resource owners seek higher money payments to compensate for their lost purchasing power. Inflation occurs because of this continued shifting of AD out to the right. If AD is held steady, or reduced, the inflation can end. The costs of doing this, measured as high and long-lasting unemployment rates, rise the longer the inflation is accommodated.
As seen above, the economy has moved from E to F to G to H to J, in a zigzag pattern. This will continue, ratcheting inflation upward as real GDP bounces up and down, as long as AD is manipulated to maintain real GDP at its original level.
Again, as we saw with demand-pull inflation, policy decisions to increase AD allow the inflation to continue.
Supply side policies can be followed to move AS to the right, and mitigate the increases in the price level, but such policies are hard to implement and take a great deal of time to work. This is so because supply-side policies require a restructuring of the economy, generating new groups of winners and losers. The political consequences of the formation of these new groups can limit the range of policy responses considerably.
In recent years, federal government policies have been muted to allow restructuring to go on rather quickly, even in the face of rather high unemployment rates in the early 90's, until about 1995. Monetary policy has been steady, keeping interest rates stable and rather low in the past 2 or 3 years, to permit investment to expand. As had been hoped, growth has begun to accelerate again, generating demand for new workers and keeping unemployment low. How long this can continue is an open question.