Dr. Mohammed Alwosabi ECON 141- Ch.

Notes on Chapter 6
INFLATION

DEFINITION OF INFLATION
— Inflation is a process of continuous (persistent) increase in the
price level. Inflation results in a decrease of the value of money.
— In the definition of inflation we have to observe that:
o Inflation is an increase in the prices of all goods and services
not only of a particular good or service. An increase in the
price of one good is not inflation.
o Inflation is an ongoing process, not a one-time jump in the
price level.

INFLATION RATE:
— To measure the inflation rate, we calculate the annual percentage
change in the price level.
Pthis year - Plast year
Inflation Rate = × 100
Plast year

— We have learned that we measure the price level (P) of a country

using GDP Deflator or CPI.
GDP Deflator this year - GDP Deflator last year
Inflation Rate = × 100
GDP Deflator last year

OR
CPI this year - CPI last year
Inflation Rate = × 100
CPI last year

— These two equations show the connection between the inflation

rate and the price level. If the price level in the current year is

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Dr. Mohammed Alwosabi ECON 141- Ch.6

higher than that of the last year, the inflation rate will be positive
meaning higher inflation rate Ö the lower is the value of money.

CAUSES OF INFLATION
— The inflation can result from either
1. an increase in aggregate demand (demand-pull inflation), or
2. a decrease in aggregate supply (cost-push inflation)

Demand-Pull Inflation
— Demand-pull inflation as a result of the increase in spending is
faster than the increase in production of output.
— Demand-pull inflation starts as AD increases and AD curve shifts
rightward.
— An increase in aggregate demand is caused mainly by
1. the increase in quantity of money (Qm),
2. the increase in any of C, I, G, or X

The Process of Demand-Pull Inflation

— Suppose in the last year, the economy is at LR full employment
equilibrium point A, where LAS, AD0 and SAS0 intersect with each
other.
— At this point, RGDP = PGDP and P = P0.
— In the current year, an increase in Qm, C, I, G, or X leads to an
increase in AD ⇒ AD curve shifts rightward from AD0 to AD1 ⇒ the
new SR equilibrium is at point B,
— At B, RGDP is greater than PGDP, price level increases from P0 to
P1, ⇒ real wage rate has decreased and unemployment falls below
its natural rate (above FE) ⇒ there is a shortage of labor ⇒ money
wage rate starts to increase to attract more labor ⇒ SAS starts to

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decrease ⇒ SAS curve starts to shift leftward ⇒ P starts to

increase and RGDP starts to decrease until SAS curve shifted to
SAS1 where it intersects AD1 and LAS at point C
P
LAS SAS3

SAS2
P4 E

D
P3 SAS1

P2 C
AD3
P1 B

P0 A AD2

AD1

Y
Y0 Y1

— At point C, RGDP goes back to its potential LR and FE level (Y0)

and the price level increase further to P2.
— This process is only a one-time rise in P. For inflation to proceed,
AD must persistently increase.
— Since now the money wage is higher which means people can
spend more and as a result P is higher (P2), the only result is the
increase in Qm ⇒ increase in AD ⇒ AD curve will shift from AD1 to
AD2 ⇒ the process will continue ⇒ higher price level (inflation)
— This is an ongoing process of rising price level.

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Dr. Mohammed Alwosabi ECON 141- Ch.6

Cost-Push Inflation
— Cost-push inflation arises due to a decrease in supply as a result of
the rise in the per unit cost of production, mainly because of the
1. increase in wage rates
2. increase in the prices of key raw materials (e.g. oil price)
— Cost-push inflation starts as SAS increases and SAS curve shifts
leftward.
— At a given price level, the higher the cost of production, because of
an increase in the money wage rate or an increase in the prices of
raw material, the smaller is the amount that firms are willing to
produce ⇒ SAS decreases ⇒ SAS shifts leftward ⇒ an increase in
prices and unemployment and a decrease in RGDP ⇒ stagflation

The Process of Cost-Push Inflation

— Suppose price level was P0 and PGDP is Y0, where AD0, SAS0 and
LAS intersect at point A, LR FE equilibrium. If nominal wages or
prices of other factors of production  ⇒ production cost ⇒ firms
reduce production ⇒ SAS  ⇒ SAS curve shifts leftward to SAS2 to
point B
LAS
P
SAS3

SAS2
P4 E
SAS1
P3 D

P2 C
AD3
P1 B
A
P0 AD2

AD1

Y
Y1
Y0
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Dr. Mohammed Alwosabi ECON 141- Ch.6

— At point B, price level increases to P1 and RGDP decreases to Y1

and therefore unemployment increases above its natural rate
(below FE) ⇒ the combination of a rise in P and a fall in RGDP
(and a rise in unemployment) is called stagflation.
— As a response to the increase in P and a decrease in RGDP,
government increases Qm ⇒ AD increases ⇒ AD curve starts to
shift rightward until it reaches AD1 at point C, where AD1 intersects
with SAS1 and LAS.
— At point C, the economy is at higher price level (P2) and RGDP
goes back to PGDP (Y0) at full employment
— With the new higher price, money wage rate and prices of other
productive resources start to increase again which leads to
increase in the cost of production ⇒ SAS curve will shift leftward
from SAS1 to SAS2 ⇒ stagflation ⇒ the process will be repeated ⇒
higher price level (inflation)
— This is an ongoing process of rising price level.
— Note that a one-time increase in the price of one resource without
any following change in AD produces stagflation but not inflation.

EFFECTS OF INFLATION
— Inflation may be anticipated (expected) or unanticipated
(unexpected)
— A moderate anticipated (expected) has a small cost, but a rapid
anticipated inflation is costly because it decreases potential GDP
and slow growth.
— Unanticipated (unexpected) inflation has two main consequences in
the labor market. It redistributes income and results in the
departure from full employment

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1. Higher than anticipated inflation (unexpectedly high) ⇒ lowers

the real wage rate ⇒ employers gain at the expense of workers
⇒ increases the quantity of labor demanded, makes jobs easier
to find, and lowers the unemployment rate.
2. Lower than anticipated inflation (unexpectedly low) ⇒ raises the
real wage rate ⇒ workers gain at the expense of employers ⇒
decreases the quantity of labor demanded, and increases the
unemployment rate.
3. If workers and employers base their wages on an inflation
forecast that turns out to be correct, neither workers nor
employers gain or lose from the inflation.
— Unanticipated inflation has two main consequences in the market
for financial capital: it redistributes income and results in too much
or too little lending and borrowing.
1. When the inflation rate is higher than anticipated (unexpectedly
high) ⇒ the real interest rate is lower than anticipated ⇒
borrowers gain but lenders lose ⇒ borrowers want to have
borrowed more and lenders want to have loaned less.
2. When the inflation rate is lower than anticipated (unexpectedly
low) ⇒ the real interest rate is higher than anticipated ⇒ lenders
gain but borrowers lose ⇒ borrowers want to have borrowed
less and lenders want to have loaned more
— We can conclude from the above that Inflation that is higher than
expected, transfers resources from workers to employers and from
lenders to borrowers. The opposite is true
— Other costs of inflation:
1. Unexpected inflation makes goods produced in the country
more expensive relative to goods produced abroad resulting in a
decrease in exports and an increase in imports.

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2. People who hold a lot of money loose from unexpected inflation

because money value becomes less overtime.
3. Those who own “real” assets such as land, stocks, etc. gain
from inflation because the value of these assets goes up with
inflation.

INFLATION AND UNEMPLOYMENT: THE PHILLIPS CURVE

— Phillips curve shows the inverse relationship between inflation rate
(IR) and unemployment rate (UR).
IR
— There are two time frames for Phillips curves
B
ƒ The short-run Phillips curve
ƒ The long-run Phillips curve
EIR A
— Our focus here is only on the SR
Phillips curve. C
SRPC
— The SR Phillips curve (SRPC) slopes
0 UR
downward to show the tradeoff between NRU

inflation rate and unemployment rate holding constant both the

expected inflation rate (EIR) and the natural rate of unemployment
(NRU).
— If inflation rises above its expected rate, Unemployment falls below
its natural rate. This is represented by the movement from point A
to point B along SRPC.
— If inflation rate falls below its expected rate, unemployment rises
above its natural rate. This is represented by the movement from
point A to point C along SRPC.
— Movements downward along the short-run Phillips curve result from
unanticipated decreases in aggregate demand.
— An increase in the expected inflation rate or natural rate of
unemployment shifts the short-run Phillips curve rightward.

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— The SR Phillips curve (SRPC) is like SAS curve. A movement

along SAS curve that brings a higher price level and an increase in
RGDP is equivalent to a movement along SRPC that brings an
increase in the inflation rate and a decrease in the unemployment
rate
— Similarly, a movement along SAS curve that brings a lower price
level and a decrease in RGDP is equivalent to a movement along
SRPC that brings a decrease in the inflation rate and an increase in
the unemployment rate