Inflation in economics can be defined as a sustained increase in the general price levels of the economy. Inflation can be caused either by a surge in the aggregate demand of the economy also known as demand-pull-inflation or by a shortage in aggregate supply also known as cost-push-inflation
Don’t worry, let’s understand the topic inflation in economics with the help of a diagram
Demand-Pull-Inflation
Demand-pull-inflation is caused when the economy is growing at a faster rate
leading to a surge in demand for goods and services. This type of inflation is
generally more helpful for the economy compared to cost-push inflation.
Triggers of
Demand-Pull-Inflation
It occurs when Aggregate demand for goods and services rises
more than proportionately compared to the long run production capacity of the
firms shown by Long-Run-Aggregate Supply
curve. Firms respond to this surge in demand by raising the prices of the
goods and services produced.
It provides incentives to firms for expanding their
production capacity and as a result they undertake capex to boost output growth
which in turn leads to an increase in demand for labor.
Therefore, demand-pull-inflation leads to a decline in unemployment rate and also boosts total or actual output of the economy.
E0 is the initial level of equilibrium in the economy where
AD1 (Aggregate Demand) curve 1 intersects with LRAS
(Long-Run-Aggregate-Supply). The equilibrium level of output is Q0 and the
general level of price is P0. Now, assume that Aggregate Demand increases for
any particular reason like increase in investor sentiments, bullish economic
output, etc.
The increase in aggregate demand shifts AD1 curve to AD2 and
the new equilibrium takes place at E1 where AD2 intersects with LRAS. We see
that both economic output rises with increase in the equilibrium price level P1.
The increase in price level from P0 to P1 is known as demand-pull-inflation
Cost-push-inflation
Cost-push-inflation starts with an increase in the cost of production, which may
be expected or unexpected. For example, the cost of raw materials or inventory
used in production might increase, leading to higher costs. It is much harsher
as it indicates an economic slowdown combined with decline in actual output or
GDP level of the economy.
This condition is often termed as stagflation. It means an
increase in the level of prices i.e. inflation along with decline in output
level known as stagnation
Stagflation is term that
describes a "perfect storm" of economic bad news: high unemployment,
slow economic growth and high inflation. The term was born out of the prolonged
economic slump of the 1970s, when the United States experienced spiking
inflation in the face of a shrinking economy, something economists had
previously thought to be impossible.
From the above figure we can see that initial level of
equilibrium is E0 where AD1 intersects with LRAS1. Due to increase in cost of
production or due to a monopoly power, the firms decline their level of
production in the economy and as a result the LRAS1 curve shifts to LRAS2 and
due to unchanged aggregate demand the new equilibrium takes place at E1.
We can clearly see that the price level of the economy increases
and at the same time output or GDP decreases. This situation is known as stagflation.
Example: OPEC enjoys a monopoly power in controlling crude
oil prices. As a result, in order to increase crude prices, OPEC sometimes cut
crude oil production which results in a supply shock and leads to increase in
the price of crude. This is an example of stagflation
Stay tuned for our upcoming advanced
modules on inflation where we will discuss the following topics
- Inflation rate and unemployment by using Philips curve
- Inflation and interest rate risk
- Portfolio hedging risk using futures and options trading
- Gold hedging to protect you against inflation
Disclaimer: Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. It is for educational purposes only.
0 Comments