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Understanding Inflation Cycles: A Comprehensive Guide
Dive into the world of inflation cycles. Learn about demand-pull and cost-push inflation, forecasting techniques, and how these economic patterns impact our daily lives and financial decisions.

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Now Playing:Inflation cycles – Example 0a
Intros
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  1. Demand-Pull Inflation
    • Starting effect
    • Adjustment of Money Wage
    • Demand-Pull Inflation Process
  2. Cost-Push Inflation
    • Starting Effect
    • Response of Fed
    • Cost-Push Inflation Process
Inflation cycles
Jump to:NotesConceptFAQsPrerequisites
Notes

Demand-Pull Inflation

Demand-Pull Inflation: is when inflation happens due to an increase in aggregate demand.

Recall that aggregate demand can be increased by one of the following influences:
  1. Cut in interest rate
  2. Cut in taxes
  3. Increase in government expenditure
  4. Increase in exports
  5. Increase in investments

When any of these influences happens, it starts the effect of demand-pull inflation.

Starting Effect: Suppose we have a short and long-run aggregate supply and aggregate demand, and the aggregate demand increases by one of these influences. The aggregate demand shifts to the right.

Inflation Cycles

We see that the price level and real GDP increases, and unemployment rate < natural rate. We have an above full-employment equilibrium

Rise in Money Wage Rate: With higher price levels, workers want higher pay, causing a rise in the money wage rate. This shifts the aggregate supply to the left.

Inflation Cycles

We see that real GDP is back to potential GDP, and the price level has increased again.

Demand-Pull Inflation Process: is when the starting effect of demand-pull inflation and rise in money wage rate happens persistently (more than once).

Suppose the aggregate demand increases again.

Inflation Cycles

Real GDP is now greater than potential GDP. With higher price levels again, workers want to increase the money wage rate again, shifting aggregate supply to the left.

Inflation Cycles

Once again, real GDP = potential GDP, and the price level has risen again.

We know that if this cycle keeps repeating, then the result is an ongoing increase in the price level.

Cost-Push Inflation

Cost-Push Inflation: is when inflation happens due to an increase in costs, which decreases aggregate supply. The two main influences for costs to increase are

  1. An increase in the money wage rate

  2. An increase in the price of raw materials

When any of these influences happens, it starts if the effect of cost-push inflation.

Starting Effect: Suppose we have a short and long-run aggregate supply and aggregate demand, and the aggregate supply decreases by one of the influences. The aggregate supply shifts to the left.

Inflation Cycles

See that the price level has increased, but real GDP has decreased and unemployment rate > natural rate. This causes a recessionary gap. With real GDP < potential GDP, the Fed needs to respond.

Response of Fed: To restore full employment, the Fed must cut interests to increase aggregate demand. This causes the aggregate demand to shift to the right.

Inflation Cycles

We see that real GDP is back to potential GDP, and we are back to full employment. However, the price level has increased again.

Cost Push-Inflation Process: is when the starting effect of cost-push inflation and response of fed happens persistently (more than once)

Suppose the aggregate supply decreases again.

Inflation Cycles

Real GDP is less than potential GDP, causing a recessionary gap and unemployment rate > natural rate. Once again, Fed responds by cutting interests again to restore full employment. This shifts the aggregate demand to the right.

Inflation Cycles

If this cycle keeps repeating, then the result is an ongoing increase in the price level, which is a result of inflation.

Expected Inflation

If the inflation is to be expected, then demand-pull and cost-push inflation and its process does not occur.

With expected inflation, we will always have:

  1. Real GDP = Potential GDP

  2. Unemployment rate = Natural rate of Unemployment.

Why? Suppose we have a short and long-run aggregate supply and aggregate demand of today.

Inflation Cycles

We expect the Fed to cut interest to increase the aggregate demand next year. So, that means we should also expect an increase in the money wage rate. This means we expect a decrease in aggregate supply.

Inflation Cycles

Let’s say that we expect the same thing to happen the year after. Then we should expect the aggregate demand to increase and aggregate supply to decrease again.

Inflation Cycles

As a result, we have inflation, but we always maintain real GDP = potential GDP and full employment.

Forecasting Inflation

For inflation to be expected, inflation must be forecasted. This requires economists who have studied for many years in macroeconomics, and have worked for macroeconomic forecasting agencies, banks, etc.

Rational Expectation: is the best forecasting one can provide with all the relevant information given.

Rational expectation is the best forecast, but it is not always a correct forecast. In fact, it is often wrong. Therefore, sometimes inflation can be unexpected.

If inflation forecast is incorrect, then one of the following things can happen.

  1. Aggregate demand grows faster than expected, then real GDP > potential GDP. This cause a demand-pull inflation.

  2. Aggregate demand grows slower than expected, then real GDP < potential GDP. This slows down the inflation rate.

If the inflation forecast is correct, then real GDP = potential GDP, and we are at full employment.
Concept

Introduction to Inflation Cycles

Welcome to our comprehensive guide on inflation cycles, a crucial concept in economics. Our introduction video provides a solid foundation for understanding this complex topic. Inflation cycles are recurring patterns of price level changes in an economy over time. This article delves into the various aspects of inflation, including demand-pull inflation, cost-push inflation, expected inflation, and the art of forecasting inflation. Demand-pull inflation occurs when aggregate demand outpaces supply, while cost-push inflation results from increased production costs. Expected inflation reflects anticipated future price increases, influencing economic decisions. Forecasting inflation is essential for policymakers and businesses to make informed decisions. By exploring these key components, you'll gain a deeper understanding of how inflation impacts economies and personal finances. Whether you're a student, professional, or simply curious about economic trends, this guide will equip you with valuable insights into the dynamic world of inflation cycles.

FAQs

  1. What is the difference between demand-pull and cost-push inflation?

    Demand-pull inflation occurs when aggregate demand exceeds the economy's productive capacity, leading to higher prices as "too much money chases too few goods." Cost-push inflation, on the other hand, results from increased production costs, such as higher wages or raw material prices, which businesses pass on to consumers through higher prices.

  2. How does expected inflation affect the economy?

    Expected inflation influences economic decisions without causing significant disruptions. When accurately anticipated, both aggregate demand and supply curves shift simultaneously, maintaining the same level of real output at a higher price level. This helps preserve economic equilibrium and prevents unexpected changes in purchasing power.

  3. Why is forecasting inflation important?

    Forecasting inflation is crucial for economic planning and policy-making. It helps businesses, governments, and individuals make informed decisions about investments, wage negotiations, and economic policies. Accurate forecasts enable proactive measures to maintain economic stability and growth.

  4. What happens when inflation forecasts are incorrect?

    Incorrect inflation forecasts can lead to economic imbalances. If aggregate demand grows faster than expected, it can create an inflationary gap with higher prices. If it grows slower, a recessionary gap may occur, potentially leading to economic contraction and increased unemployment. These scenarios often require adjustments in monetary and fiscal policies.

  5. How does the Federal Reserve respond to inflation?

    The Federal Reserve adjusts monetary policy based on inflation trends. For demand-pull inflation or inflationary gaps, it may raise interest rates to cool down the economy. In cases of cost-push inflation or recessionary gaps, it might lower interest rates to stimulate economic activity. The Fed's goal is to maintain price stability and support maximum sustainable employment.

Prerequisites

Understanding inflation cycles is a crucial aspect of economics and financial literacy. While there are no specific prerequisite topics provided for this subject, it's important to recognize that a solid foundation in basic economic principles can greatly enhance your comprehension of inflation cycles. Concepts such as supply and demand, monetary policy, and economic indicators are inherently connected to the study of inflation cycles.

Inflation cycles are complex phenomena that affect economies worldwide, influencing everything from consumer purchasing power to investment decisions. To fully grasp the intricacies of these cycles, it's beneficial to have a basic understanding of how economies function. This includes knowledge of factors that drive economic growth, the role of central banks, and the impact of government policies on inflation rates.

While not explicitly listed as prerequisites, topics such as macroeconomics, fiscal policy, and monetary theory provide valuable context for understanding inflation cycles. Familiarity with these areas can help you analyze the various forces at play during different phases of an inflation cycle, including periods of rising prices, stagnation, and potential deflation.

Additionally, an awareness of historical economic events and their impact on inflation can offer valuable insights. Studying past inflationary periods, such as the stagflation of the 1970s or hyperinflation events in various countries, can provide a practical understanding of how inflation cycles develop and affect economies over time.

It's also worth noting that mathematical and statistical skills can be beneficial when studying inflation cycles. The ability to interpret economic data, understand graphs and charts, and perform basic calculations will enhance your ability to analyze inflation trends and make informed predictions about future economic conditions.

While specific prerequisites may not be mandatory, a well-rounded knowledge of economic principles will undoubtedly enrich your understanding of inflation cycles. As you delve into this topic, consider exploring related areas such as interest rates, exchange rates, and global economic interdependence. These subjects are closely intertwined with inflation cycles and can provide a more comprehensive view of how economies function in the face of changing inflationary pressures.

In conclusion, although there are no explicit prerequisite topics listed for studying inflation cycles, a strong foundation in basic economic concepts will significantly enhance your ability to grasp this important subject. By approaching the topic with a broad understanding of economic principles and a willingness to explore related areas, you'll be well-equipped to analyze and interpret the complex dynamics of inflation cycles in both domestic and global contexts.