INFLATION - DATA HANDLING SKILLS
2003 2004 2005 2006* Rate of inflation in China (%)
1.2 3.9 4.1 4.2
(i) Describe the trend of prices in China from 2003 to 2006.[2]
Question 1:
Overall, prices in China have increased [1] at an increasing rate. [1]
(ii) Describe the change in inflation rate in China from 2003 to 2006. [1]
Inflation rate in China from 2003 to 2006 has increased by 250%.[1]
or
Inflation rate in China in 2006 is 3.5 times that of 2003. [1]
Try this question on your own!
Question 2:
(i) Describe the trend of Consumer Price Index from 2002 to 2007. [1]
(ii) Describe the trend in price changes from 2002 to 2007. [1]
2014 JC2 H1/H2 Economics
INFLATION (1)
< CAUSES>
Ms Lim Lyn Na
MJC Econs Dept
Macro Problems and Causes
Recommended Reading: Sloman, 8th ed, p.446-456..
MJC lecture notes, H2 Unit 10A, H1 Unit 8A
ObjectiveS Of tOday’S Lecture
• Explain the sources of each type of inflation.
At the end of this lecture, can you answer this question?
Analyze the recent sources of inflation in Singapore. [10m]
• Define ‘Inflation’.
• Rank the significance of domestic and
international influences on inflation in SG.
•Using AD/AS analysis, explain and evaluate the 2
types of inflation (Demand Pull, Cost Push).
WHAT IS INFLATION?
Inflation is defined as a period of sustained and
inordinate increase in the general price level.
excessive for a reasonable period of time
rise in average price of ALL goods
CPIprevious year
x100%
(CPIcurrent year – CPIprevious year) Inflation rate (%) =
CPI measures the changes in cost of a basket of goods and services consumed by a typical household in an economy over a period of time.
H2 (10A) / H1 (8A) : p.2
CAUSES OF INFLATION
Demand Pull Inflation
Cost Push Inflation
√
A situation where AD is persistently higher than AS,
close to or at full employment generating sustained increase in GPL
2 IMPORTANT Conditions for DEMAND-PULL INFLATION
AD 2
E2
AD 3
E3
Yf Real output
GPL
AS
0
P3
P4
P2
AD 1
E1
P1
Y1
AD 4
E4
p.2 Demand Pull Inflation
AD is persistently increasing •when the economy is near or at full employment. •to create situation of excess demand at every general price level
H2 (10A) / H1 (8A) : p.2
DD-PULL INFLATION
A rise in any autonomous component
of AD will cause AD to increase sustained increases in AD
near or at Yf DD pull inflation
• Quantity Theory of Money
MV = PY where
M: money supply
V: velocity of circulating money
P: GPL
Y: real national output
Assuming V and Y are constant, increase in money supply lead to proportionate increase in GPL.
STEP 1: EXPLAIN THE FIRST
TRIGGER
• Assume that the SG economy is
operating near full employment ,
Initial eqm is at E1
Analysis on Demand Pull Inflation H2 (10A) / H1 (8A) : p.2-3
AD 3
E3 AD 4
E4
Real output
GPL
AS1
0
P4
P3
AD 2
E2
P2
Y1 Y2 Y3
AD 1
E1 P1
Fig 1: DD-pull inflation
• Consider global economic growth
↑real Y in many countries
↑purchasing power of
foreigners
↑ DD for X
(assume normal goods)
↑X
AD1 to AD2
STEP 2: Explain ADJUSTMENT
PROCESS.
At P1, AD2> AS shortage
Firms experience a ↓in inventories
↑production to meet increased
AD hire more FOP i.e. workers
Analysis on Demand Pull Inflation H2 (10A) / H1 (8A) : p.3
AD 3
E3 AD 4
E4
Real output
GPL
AS1
0
P4
P3
AD 2
E2
P2
Y1 Y2 Y3
AD 1
E1 P1
Fig 1: DD-pull inflation
• As less resources are available due
to ↑ competition for FOP firms
need to offer higher factor prices to
hire more fop ↑GPL as profit-max
firms produce more output
• New eqm @ E2 where total
spending = total output
P1 rises to P2, Y1 increases to Yf
Analysis on Demand Pull Inflation
STEP 3: COMPLETING THE ANALYSIS (Inflationary Process)
However, as AD continues to increase,
•Eg. Greater consumer confidence from to households ↑Cd AD2 rises to AD3 & then to AD4 …
AD 3
E3 AD 4
E4
Real output
GPL
AS1
0
P4
P3
AD 2
E2
P2
Y1 Y2 Y3
AD 1
E1 P1
Fig 1: DD-pull inflation
Note that
(1) Below Yf: As GPL rises from P1 to P3, real output increases (Actual growth occurs), N rises.
(2) At Yf: As GPL rises from P3 to P4, real output remains constant @ Y3=Yf .
H2 (10A) / H1 (8A) : p.3
•With a persistent increase in AD
→ creates a situation of sustained excess demand in the economy
→ sustained increase in GPL
Demand pull inflation.
Analysis on Demand Pull Inflation
EVALUATION: Factors affecting the extent of rise in GPL
EG: The state of the economy
If the economy is operating near Yf (i.e.
upward sloping portion of AS)
firms face larger rise in cost of
production as they compete for highly
limited resources to produce more
output larger ↑ GPL
1. The extent of rise in AD
2. The state of the economy
3. Other factor(s) that may affect
AD or AS
AD 3
E3
AD 4
E4
Real output
GPL
AS1
0
P4
P3
AD 2
E2
P2
Y1 Y2 Y3
AD 1
E1 P1
Fig 1: DD-pull inflation
H2 (10A) / H1 (8A) : p.3
RANKING: Is DD-pull inflation more likely to be caused by internal/domestic or external/ international influences
in SG?
DD-PULL INFLATION
Internal: Cd, domestic I, G External: FDI, X
Recall: AD=Cd + I + G + X
State ONE Criterion clearly:
• Characteristics of SG economy • Intensity of source of inflation
Small domestic DD
DD-pull inflation in SG is more likely to be caused by international
influences (i.e.FDI & X) rather than domestic factors.
Highly open to trade & capital
flows Large External DD + Cd + domestic I + G constitute a
smaller proportion of AD FDI + X constitute a larger
proportion of AD
Alternative
way of
RANKING?
Most vs
Least
Significant
Cause
Rise in FDI & X are likely to increase AD more significantly
CAUSES OF INFLATION
Demand Pull Inflation
Cost Push Inflation
COST PUSH INFLATION
A situation where there is a
sustained increase in the unit cost of production,
independent of changes in AD
sustained increase in the General Price Level (GPL).
Wage Push
Profit Push in indirect tax
rate
Structural
rigidities Imported
Inflation
H2 (10A) / H1 (8A) : p.4
SOURCES OF COST PUSH INFLATION
WAGE PUSH INFLATION
Wage Push Inflation
trade unions with strong bargaining power persistently ask for
increases in wages that exceed increases in productivity
Increases in unit COP for many firms
Many individual SS curves shift to the left as profit-maximising
firms reduce production at every price level
leftward shifts in AS
Increases in GPL
EV: In SG, wage push inflation is not likely to be a significant cause of inflation.
• Government measures that moderate wage increases to ensure that they
do not exceed productivity gains.
• The National Wage Council (NWC), a tripartite body comprising the
government, employers & unions, formulates guidelines for wage
adjustments in line with SG’s long-term economic performance.
H2 (10A) / H1 (8A) : p. 5-6
SOURCES OF COST PUSH INFLATION
IMPORTED INFLATION
1. Imported inflation
Persistently higher prices of
imported raw materials
(eg. oil, metals) &
intermediate products
April 4 2011 (Bloomberg) -- Oil
futures rose to the highest
level(above $108) in more
than 30 months as Libyan
rebels fought loyalists at an oil
port, adding to concern that
protracted conflict in the
Middle East and North Africa
will curtail supply….
H2 (10A) / H1 (8A) : p.6
Increases in unit COP for
many firms
Many individual SS curves
shift to the left as profit-
maximising firms reduce
production at every price level
leftward shifts in AS
Increases in GPL
DD/SS factors that account for rise in Price of oil?
AD/AS analysis: Cost Push Inflation
• Assume ↑Price of imported raw
materials
• in unit COP AS curve to shift
to the left from AS1 to AS2
AD1
E1
Yf
GPL
P1
0
P2
Y2
E2
AS2
E3
AS3 P3
Y3
AS1
Real
output Y
Step 1 : Explain the first trigger
H2 (10A) / H1 (8A) : p.4-5
• At P1, a shortage YfY3 is created
Firms produce output along AS2 in
response to a fall in inventories
bids up prices of FOP profit max
firms will only produce more at
higher prices upward pressure on
GPL
• As GPL rises, total spending falls until a
new eqm is reached at E2 where total
spending = total output.
• P1 rises to P2, Yf falls to Y2
STEP 2: Explain ADJ Process.
• To maintain real income level,
workers are likely to demand
higher wages as product prices
rise
if wages rise faster than
increases in productivity
↑ unit COP again
further leftward shift in AS
from AS2 to AS3
further GPL from P2 to P3
rises in GPL are sustained
COST PUSH INFLATION
AD/AS analysis: Cost Push Inflation
AD1
E1
Yf
GPL
P1
0
P2
Y2
E2
AS2
E3
AS3 P3
Y3
AS1
Real
output Y
• Note: Real output & employment falls as ↑GPL.
Step 2 COMPLETING THE ANALYSIS
(Inflationary Process)
EV: The impact on the economy
depends on the extent of rise in AS.
Higher imported inflation would lead
to a greater fall in AS greater rise in
GPL, greater fall in real output.
H2 (10A) / H1 (8A) : p.4-5
Imported inflation What else could have led to higher prices of imported goods?
Note: Depreciated domestic currency affects imported inflation in 3 ways.
EG. Depreciation of domestic currency
↑Pm in domestic currency
More domestic currency is needed to pay for the same value of imported goods
1. ↑ Price of imported
raw materials +
intermediate goods
↑ unit COP
↑ prices of final G+S
produced locally
2. ↑ price of imported
final consumption
goods
3. Higher imported
prices less
competitive
pressure on
domestic
producers to keep
their prices low
H2 (10A) / H1 (8A) : p.7
EV: Depreciation of a currency not only leads to cost-push inflation via
higher prices of imported raw materials and intermediate goods. In addition,
imported final goods are also more expensive, which may provide domestic
producers an incentive to increase the price of their goods.
RANKING: Is Cost-push inflation more likely to be caused by internal/domestic or external/ international influences in SG?
COST-PUSH INFLATION
Cost-push inflation in SG is likely to be due to external influences
(i.e. imported inflation) rather than domestic influences.
Lacks natural resources
State ONE Criterion clearly:
•Characteristics of SG economy •Intensity of source of inflation
Heavily reliant on imported raw
materials & goods
Highly open to trade
Highly vulnerable to rise in prices of
imported raw materials & goods
+
CONSIDER : Is inflation more likely to be caused by internal/domestic or external/ international influences in SG?
CASE OF WAGE-PRICE SPIRAL
•Inflation can be caused by the interaction of both
demand-pull and cost-push factors.
•Even when an inflationary process starts as either
demand-pull or cost-push, it is often difficult to
separate out the effects of both.
EXAMPLE
•An initial cost-push inflation fall in real Y, rise in
unN
• Government may expand AD to offset rises in unN
•Trade union may bargain for higher wages that
exceed productivity, thus driving up unit COP.
AD1
E1
Yf
GPL
P0
0
P1
Y1
E2 AS2
E3 P2
AS1
E4 P3
AS3
ANALYSIS ON WAGE-PRICE SPIRAL
AD2
• The economy is initially in eqm
E1 at price level P0 and output
Yf.
• ↑unit COP (independent of
increases in AD) i.e. due to
supply oil shocks shift the AS
curve from AS1 to AS2 GPL
increases from P0 to P1, real
output falls from Y1 to Y2, fall in
employment.
• ↑G to reduce unemployment
increase AD to AD1 to AD2
causes GPL to increase further
from P1 to P2.
Y2 Real Y
AD1
E1
Yf
GPL
P0
0
P1
Y1
E2 AS2
E3 P2
AS1
E4 P3
AS3
ANALYSIS ON WAGE-PRICE SPIRAL
AD2
Y2 Real Y
trade unions demand for
higher wages for workers
to maintain real income
level wages rise faster
than increases in
productivity ↑unit COP
such that causes AS to
shift from AS2 to AS3
this leads to an wage-price
spiral where cost and
demand factors continue to
interact in an interlocking
process (NOT strictly DD-
pull or Cost-push inflation)
OVERVIEW OF INFLATION
Cost of Unanticipated Inflation
Internal Effects
External effects
COST-PUSH
Imported Inflation
Structural rigidities
Wage Push
Profit Push
Increase in indirect tax
COSTS OF HIGH INFLATION
Cost of Anticipated Inflation
Shoe leather costs
Menu costs
DD-PULL
Keynesian
Monetarist
Types & Sources Consequences
BENEFITS OF LOW INFLATION
Healthy BOP
Strengthen exchange rate
Aid in Pursuit of high &
sustained Economic Growth