1. Inflation and Government Policy

2. Causes of Inflation Demand-Pull Inflation demand-pull inflation Inflation that is initiated by an increase in aggregate demand. If the economy is operating on the steep portion of the AS curve at the time of the increase in aggregate demand, most of the effect will be an increase in the price level instead of an increase in output. If the economy is operating on the flat portion of the AS curve, most of the effect will be an increase in output instead of an increase in the price level.

3. Causes of Inflation Cost-Push, or Supply-Side, Inflation cost-push, or supply-side, inflation Inflation caused by an increase in costs Cost-Push, or Supply-Side, Inflation An increase in costs shifts the AS curve to the left. By assuming the government does not react to this shift, the AD curve does not shift, the price level rises, and output falls. stagflation Occurs when output is falling at the same time that prices are rising.

4. Causes of Inflation Cost-Push, or Supply-Side, Inflation Cost Shocks Are Bad News for Policy Makers A cost shock with no change in monetary or fiscal policy would shift the aggregate supply curve from AS0 to AS1, lower output from Y0 to Y1, and raise the price level from P0 to P1. Monetary or fiscal policy could be changed enough to have the AD curve shift from AD0 to AD1. This policy would raise aggregate output Y again, but it would raise the price level further, to P2.

5. Causes of Inflation 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, it may raise its own price. The firm’s profit-maximizing optimum price is presumably not too far from the average of its competitors’ prices. 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, firms may continue raising prices even if demand is slowing or contracting. Given the importance of expectations in inflation, central banks aim to keep them low.

6. Causes of Inflation Money and Inflation Sustained Inflation from an Initial Increase in G and Fed Accommodation An increase in G with the money supply constant shifts the AD curve from AD0 to AD1. Although not shown in the figure, this leads to an increase in the interest rate and crowding out of planned investment. If the Fed tries to keep the interest rate unchanged by increasing the money supply, the AD curve will shift farther and farther to the right. The result is a sustained inflation, perhaps even hyperinflation.

7. Causes of Inflation 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. It is also generally agreed that for a sustained inflation to occur, the Bank of England must accommodate it. In this sense, a sustained inflation can be thought of as a purely monetary phenomenon.

8. The Behaviour of the Central Bank Bank Of England Behaviour

9. The Behaviour of the Central Bank Targeting the Interest Rate The actual variable of interest to the Bank of England is not the money supply, but the interest rate. In practice, it is the interest rate that directly affects economic activity, for example, by affecting firms’ decisions about investing. Targeting the interest rate thus gives the interest rate via the Monetary Policy Committee (MPC) decisions gives more control over the key variable that matters to the economy. Since 1997, the MPC has independent control of interest rates.

10. The Behaviour of the Bank of England The Bank’s Response to the State of the Economy The Bank’s Response to Low Output/Low Inflation During periods of low output/low inflation, the economy is on the relatively flat portion of the AS curve. In this case, the Bank is likely to lower the interest rate (and thus expand the money supply). This will shift the AD curve to the right, from AD0 to AD1, and lead to an increase in output with very little increase in the price level.

11. The Behaviour of the Bank The Bank’s Response to the State of the Economy The Bank’s Response to High Output/High Inflation During periods of high output/high inflation, the economy is on the relatively steep portion of the AS curve. In this case, the Bank is likely to increase the interest rate (and thus contract the money supply). This will shift the AD curve to the left, from AD0 to AD1, and lead to a decrease in the price level with very little decrease in output

12. The Behaviour of the Bank of England Interest Rates Near Zero The Bank lowered the short-term interest rate to near zero beginning in 2008 IV. Since interest rates cannot go below zero, the ability of the Bank to stimulate the economy when interest rates are zero is severely limited. Its main way of stimulating the economy is to lower interest rates, which stimulates plant and equipment investment as well as consumption of durable goods and housing investment. This option is not available when interest rates are near zero. In this case, stimulus must come primarily from fiscal policy.

13. The Behaviour of the Bank of England Inflation Targeting inflation targeting When a monetary authority chooses its interest rate values with the aim of keeping the inflation rate within some specified band over some specified horizon. The Bank of England has an inflation target of 2%. By using the aggregate supply and aggregate demand curves, we can determine the equilibrium price level in the economy and understand some causes of inflation. We have still said little about employment, unemployment, and the functioning of the labour market in the macroeconomy.

14. Key Terms • aggregate supply • aggregate supply (AS) curve • cost-push, or supply-side, inflation • cost shock, or supply shock • demand-pull inflation • equilibrium price level • inflation targeting • potential output, or potential GDP • stagflation