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.
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 (COLAs) demand management policies
Contemporary Issues Stagflation
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
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Supply Shock Inflation
Typically the major cause of inflation is an excessively rapid growth of aggregate demand
of the demand for goods and services
a growth rate that outstrips the rate at which the economys productive capacity is
increasing. However in the 70s America faced with this new kind of inflation, one based on supply and not demand. This type of inflation, often called "cost-push" or supply shock inflation, is caused not by demand growing very rapidly, but by supply
growing very slowly
or even in some cases contracting
Supply shock inflation in the 70s was caused by worldwide crop failures followed by the Arab Oil Embargo. This caused US reserves of grain and oil to plummet. Prices on virtually everything shot upward. Inflation hit 10.8% and the nation reeled from its two supply-shocks.
These kind of supply shocks first caused food and energy prices to soar. Beyond that, these agricultural and energy products
and especially the energy products
are inputs to other productive processes, so other manufacturers have to use these things to produce other goods, and therefore, because they were suffering cost increases, the prices of these other manufactured goods went up.
This economic combination created something new: supply shock inflation
and recession. People called it stagflation.
Comment and Analysis by Richard Gill
Using supply and demand curves Gill demonstrates the how shift in the curve are affected by inflation and stagnation. What was happening was a shift of focus from the demand
side of the economy to the supply side. We can think of "stagnation" as occurring whenever the economy moves toward lower GNP.
A Focus on Inflation
For most of 1973, employment remained relatively high, and it was natural forgovernment leaders and economists to think that the problem of inflation was due to excessive demand. The Fed or policy-makers in general
or economists for that matter
didnt understand well how the oil price shock affected the economy.
So the Federal Reserve, under the leadership of Chairman Arthur Burns, sought to fight inflation by restricting the money supply. In late 1973, the Fed raised the interest rates charged to member banks to cool the economy by moderating the expansion of credit and disciplining inflationary psychology.
And the Feds actions didnt halt the inflationary spiral, even with another raise in the interest rates.
An economic summit conference was convened by the administration. The majority of economists present spoke out about the deepening recession and wanted to stimulate the sagging economy. Despite the signs of worsening stagflation, despite the message from the economic summit, neither President Ford nor Burns, could bring themselves to alter the policy of fighting inflation. Their policies relied on the old formulas, a tight ceiling on federal spending, and a tax surcharge. Finally, soaring unemployment figures convinced the administration that a policy change was due. President Ford bowed to the inevitable. Ford began to shift our emphasis from inflation to recession and offered a tax relief package.
Comment and Anaysis by Richard Gill Well, the reason the government was running into difficulty fighting problems with the economy at this time was that they were trying to deal with the problem too exclusively from the demand side.
Is Inflation Dead?
Over the years the Federal Reserve came to assume that the economy could not experience prolonged growth above two and a half percent a year without causing inflation. And yet in the 1990s, growth was double that. Unemployment was at a thirty-year low, and all without waking the sleeping giant of inflation.
A major factor in keeping inflation at bay was the revolution in information technology. The digitization of all information created new companies and new industries. The technology revolution contributed to an increase in productivity, creating a new economy.
Another factor was the globalization of business in preventing inflation. The introduction of market forces, freer trade, and widespread deregulation, meant that international
trade and investment played a much larger role in our economy than before.
There was a lot of emphasis on expenditure restraint, and that was particularly strong during the 1990s.
Still economists believe inflation has been a recurrent characteristic of modern capitalism and we need to be wary not to be complacent during long periods of stability.
Comment and Analysis by Nariman Behravesh
Behravesh asserts that any claim that inflation is dead must be backed up by the assumption that productivity growth will remain strong.
Unfortunately as the experience the 1970s showed us, there is no guarantee that productivity growth will continue to be robust. Thus the Fed has to remain vigilant against the possibility that inflation will be resurrected once again.