Monetary policy is one of the most difficult topics in economics. But also, I believe, a topic of absolutely crucial importance for our prosperity.
Aggregate Demand, Aggregate Supply, and Inflation
(Part H)
by
Charles Lamson
 |
Causes of Inflation
Inflation versus Sustained Inflation: A Reminder Inflation, as you know, is an increase in the overall price level. Anything that shifts the AD curve to the right or the AS curve to the left causes inflation, but it is often useful to distinguish between a one-time increase in the price level (a one-time inflation) and an inflation that is sustained. A sustained inflation occurs when the overall price level continues to rise over some fairly long period of time. When we speak of a sustained inflation rate of 3 percent, for example, we generally mean that the price level has been rising at a rate of 3 percent per year over a number of years. It is generally accepted that there are many possible causes of a one-time increase in the price level. (We discuss the main causes next.) For the price level to continue to increase period after period, most economists believe it must be "accommodated" by an expanded money supply. This leads to the assertion that sustained inflation, whatever the initial cause of the increase in the price level, is essentially a monetary phenomenon. Demand-Pull Inflation   FIGURE 11        Cost-Push, or Supply Side, Inflation Inflation can also be caused by an increase in costs, referred to as cost-push, or supply-side inflation. Several times in the last four decades oil prices in world markets increased sharply. Because oil is used in virtually every line of business, costs increased.      Cost shocks are bad news for policymakers. the only way they can counter the output loss brought about by a cost shock is by having the price level increase even more than it would without the policy action. This situation is Illustrated in Figure 14.   Expectations and Inflation When firms are making their price/output decisions, their expectations of future prices may affect their current decisions. If a firm expects that its competitors will raise their prices, in anticipation it may raise its own price. Consider a firm that manufactures toasters. The toaster maker must decide what price to charge small stores for its toaster. If it overestimates price and charges much more then other toaster manufacturers are charging, it will lose many customers. If it underestimates price and charges much less than other toaster makers are charging, it will gain customers but add a considerable loss in revenue per sale. The firm's optimum price---the price that maximizes the firm's profits---is presumably not too far from the average of its competitors' prices. If it does not know its competitors' projected prices before it sets its own price, as is often the case, it must base its price on what it expects its competitors' prices to be. Suppose inflation has been running at about 10 percent per year. Our firm probably expects its competitors will raise their prices about 10 percent this year, so it is likely to raise the price of its own toaster by about 10 percent. This is how expectations can get "built into the system." If every firm expects every other firm to raise prices by 10 percent, every firm will raise prices by about 10 percent. Every firm ends up with the price increase it expected.  The fact that expectations can affect the price level is vexing. Expectations can lead to an inertia that makes it difficult to stop an inflationary spiral. If prices have been rising, and if people's expectations are adaptive---that is, if they form their expectations on the basis of past pricing behavior---then firms may continue raising prices even if demand is slowing or contracting. In terms of the AS/AD diagram, an increase in inflationary expectations that causes firms to increase their prices shifts the AS curve to the left. Remember that the AS curve represents the price/output responses of firms. If firms increase their prices because of a change in inflationary expectations, the result is a leftward shift of the AS curve. Money and Inflation   Remember what happens when the price level increases. The price level causes the demand for money to increase. With an unchanged money supply and an increase in the quantity of money demanded, the interest rate will rise, and the result will be a decrease in planned investment (I) spending. The new equilibrium corresponds to higher G, lower I, a higher interest rate, and a higher price level.  Now let us take our example one step further. Suppose that the Fed is sympathetic to expansionary fiscal policy (the increase in G we just discussed) and decides to expand the supply of money to keep the interest rate constant. As the higher price level pushes up the demand for money, the Fed expands the supply of money with the goal of keeping the interest rate unchanged, eliminating the crowding-out effect (phenomenon that occurs when increased government involvement in a sector of the market economy substantially affects the remainder of the market, either on the supply or demand side of the market) of a higher interest rate.  What would happen if the Fed tried to keep the interest rate constant when the economy is operating on the steep part of the AS curve? The situation could lead to a hyperinflation, a period of very rapid increases in the price level. If no more output can be coaxed out of the economy and its planned investment is not allowed to fall (because the investment rate is kept unchanged), then it is not possible to increase G. As the Fed keeps pumping more and more money into the economy to keep the interest rate unchanged, the price level will keep rising. Sustained Inflation as a Purely Monetary Phenomenon Virtually all economists agree that an increase in the price level can be caused by anything that causes the AD curve to shift to the right or the AS curve to shift to the left. These include expansionary fiscal policy actions, monetary expansion, cost shocks, changes in expectations, and so forth. It is also generally agreed that for a sustained inflation to occur, the Fed must accommodate it. In this sense, a sustained inflation can be thought of as a purely monetary phenomenon.  This argument, first put forth by monetarists (coming in a future post), has gained wide acceptance. It is easy to show, as we just did, how expanding the money supply can continuously shift the AD curve. It is not as easy to come up with other reasons for continued shifts of the AD curve if the money supply is constant. One possibility is for the government to increase spending continuously without increasing taxes, but this process cannot continue forever. To finance spending without taxes, the government must borrow. Without any expansion of the money supply, the interest rate will rise dramatically because of the increase in the supply of government bonds. Now, the public must be willing to buy the government bonds that are being issued to finance the spending increases. At some point, the public may be unwilling to buy any more bonds even though the interest rate is very high. At this point, the government is no longer able to increase non-tax-financed spending without the Fed's cooperation. If this is true, then sustained inflation cannot exist without the Fed's cooperation. *CASE AND FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 550-553* end |
No comments:
Post a Comment