Overview
Purpose:
To discuss how rising inflation and rising unemployment can occur simultaneously when ther is a supply shock; and how demand management policis can fight cost-push inflation only by causing extremely high unemployment.
Objectives:
1. Inflation can come about because of increases in aggregate demand pressures. This demand-pull inflation can result from expansionary fiscal and montary policies pushing the economy up to its capacity limits.
2. Inflation can also be caused by sudden changes in aggregate supply (such as oil embargoes and crop failures). Rapid inflation in necessary goods can cause people to cut back on postponable expenditures such as durable goods. Cost-push inflation can be a major factor behind stagflation.
3. There is general agreement that, in the short run, there is a tradeoff between the rate of inflation and the amount of slack in the economy (the unemployment rate). However, the tradeoff is much worse when there are supply shocks and when wages are indexed to inflation.
4. In the early stages of demand-pull inflation, demand management policies may be able to reduce inflation without causing unemployment to rise to high levels. But in order to fight inflation that is entrenched or inflation that is due to supply shocks, the government would have to reduce aggregate demand significantly, causing a high level of unemployment.
| Key Economic Concepts stagflation Phillips curve (long-run and short-run) demand pull inflation natural rate of unemployment cost-push inflation expectations wage determination supply shocks indexing (COLA’s) demand management policies. |
| Contemporary Issues During the boom years of the 1990s, the U.S. had strong growth with very little inflation – the opposite of stagflation. How much of this was due to growth in aggregate demand versus growth in aggregate supply? In other words, was aggregate supply growing faster than aggregate demand? During this period, the Fed accommodated the stronger growth by keeping interest rates relatively low. Was this the right policy or should the Fed have raised interest rates in order to pre-empt a rise in inflation? |
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