Long- and Short-run ISSUES

Part the Second: Inflation

“Up, Up, and Away!”

• Inflation is the increase in the overall price level.

• Note that we are dealing with the price level of all goods

and services in the economy and not individual goods.

• Thus, it measures the simultaneous and sustained

increase in prices in the economy.

• Deflation is the decrease in the overall price level.

• Hyperinflation refers to situations of rapid and extreme

rises in the price level over short periods of time.

Prices have a tendency to rise over time.

Causes of Inflation

Inflation can be demand-driven, supply-driven, or both.

Demand-driven (“demand-pull”) inflation occurs when there

is an increase in the aggregate demand for goods and

services in the economy.

• Example: if the national income of an economy

increases, there should be a commensurate increase in

the demand for goods and services.

Supply-driven (“cost-push”) inflation occurs when the costs

of production of goods and services rise, leading to a

decrease in aggregate supply.

• Examples: oil price hikes or crop failures.

Why do prices rise?

Measuring Inflation

• The GDP Deflator

• Because it is the ratio of nominal to real GDP, a rising

GDP deflator means that nominal GDP is rising.

• The Consumer Price Index (CPI)

• A fixed-weight index based on a “basket of goods”

typically purchased by the average consumer.

• The Producer Price Indices (PPI)

• Indices of the prices that producers received for

products at each stage of the production process.

Indicators and Indices.

More on the CPI

• Pick a base year.

• Select a “market basket”.

• Compute:

Computing the consumer price index.

where: Value of Basket in Current Year = PCY x QBY

Value of Basket in Base Year = PBY x QBY

CPI =

Value of Basket in Current Year

Value of Basket in Base Year

x 100

Other IndicesA peek into the Economist’s Big Mac Index.

An Aside on Interest Rates

• Inflation matters because it directly affects people’s

standard of living.

• It also important to businesses because it affects the

interest rate.

• In economic terms, the interest rate is the opportunity

cost of investment.

• The Fisher equation shows how inflation affects the

interest rate:

More on the costs of inflation.

i = r + π e

Nominal Interest Rate Real Interest Rate Expected Inflation

“Sticky Prices”

• Inasmuch as prices tend to rise in the long-run, economists

have observed that prices often exhibit “stickyness” in the

short-term.

• Sticky prices refer to the phenomenon whereby prices

do not adjust quickly enough to keep equilbrium

between quantity demanded and quantity supplied.

• Part of this can perhaps be explained by “menu costs”.

• Menu costs are those costs firms must pay in order to

change the stated price of their goods they sell.

Some insights from macroeconomic theory on the desirability of inflation.

Suppose that firms set prices at P0.

An unanticipated deflation occurs in the economy, making the efficient price P1.

Firms can pay a menu cost Z to change their prices from P0 to P1.

D

P

Q

MC

0P

0Q

1P

1Q

P

Q

D

1P

MC

0PA

C

B

By holding prices fixed, firms lose potential profit in the amount of [C – A].

If prices are held fixed, consumers lose potential consumer surplus in the amount of [A + B].

As such, the total social loss is [C + B].

*If [C + B] > Z > [C – A], firms will not pay the menu cost even if society will be better off if they do.

The unanticipated deflation unambiguously decreases social welfare.

0Q 1Q

P

Q

D

1P

MC

0PD

F

E

By holding prices fixed, firms gain profit in the amount of [F – D].

If prices are held fixed, consumers gain consumer surplus in the amount of [D + E].

As such, the total social gain is [F + E].

*If – Z < [F – D] firms will not pay the menu cost and hold prices fixed.

The unanticipated inflation has increased social welfare.

0Q1Q

Either-Or?The relationship between inflation and unemployment.

The trade-off between inflation and unemployment is depicted by the Phillips Curve.

Short-Run Phillips Curve Long-Run Phillips Curve

Infl

ati

on

Infl

ati

on

Unemployment Unemployment