1.Draw the initial effect of Demand-Pull inflation.Show the effect on real GDP and Price Level.(Be sure to label everything)

2.Draw the initial impact of Cost-Push inflation.Show the effect on real GDP and Price Level.(Be sure to label everything)

1.What will initially happen to price level and real GDP with

a.Demand-Pull Inflation?

b.Cost-Push Inflation

2.What does the Phillips curve show the relationship between?

3.a. What will happen to the short-run Phillips curve with an increase in the expected inflation rate?

b. What will happen to the long-run Phillips curve with an increase in the expected inflation rate?

4.If the natural unemployment rate decreases, what will happen to

a.The Long-Run Phillips curve?

b.The Short-Run Phillips curve?

\fW H AT I S E C O N O M I C S ? 105 105 1 2 THE BUSINESS CYCLE, INFLATION, AND DEFLATION* U.S. Inflation, Unemployment, and Business Cycle I. Inflation Cycles Inflation is a process in which the price level is rising and money is losing value. Inflation is not a rise in one priceit is a broad increase in the price level. Inflation also is not a onetime jump in the price level. It is an ongoing process. Demand-Pull Inflation An inflation that results from an initial increase in aggregate demand is called demand-pull inflation. Any factor that increases aggregate demand can start demand-pull inflation: Quantity of money increase Interest rate decrease Government expenditure increase Tax rate decrease Transfer payment increase Investment increase Foreign income increase In the short run, an increase in aggregate demand raises the price level and increases real GDP. Real GDP exceeds potential GDP and so in the tight labor market the money wage rate rises. The rise in the money wage rate decreases short-run aggregate supply. In the figure, the SAS curve shifts from SAS0 to SAS1. Real GDP returns to potential GDP. Inflation occurs only if aggregate demand continues to increase. And aggregate demand continues to increase only if the quantity of money persistently increases. Cost-Push Inflation An inflation that results from an initial increase in costs is called cost-push inflation. The two main sources of increases in costs are: an increase in money wage rates or an increase in the money prices of raw materials. The cost hike decreases short-run aggregate supply, o which raises the price level and o decreases real GDP. The combination of a rise in the price level and a fall in real GDP is called stagflation. One possible response to the decrease in real GDP is for the Fed to use monetary policy to increase aggregate demand. o If the Fed increases aggregate demand, real GDP increases and the price level rises still higher. o In the figure, this Fed policy shifts the aggregate demand curve from AD0 to AD1 and the price level rises to 120. Inflation occurs only if, in response to the higher price level, the force that initially decreased aggregate supply recurs so that aggregate supply continues to decrease and, at the same time, the Fed continues to increase aggregate demand. 476 W H AT I S E C O N O M I C S ? 477 Deflation An economy experiences deflation when it has persistently falling price level. The inflation rate is negative. What Causes Deflation? A one-time fall in the price level is NOT deflation. Deflation is a persistent and ongoing falling price level. A One-Time fall in the Price Level could be caused by a decrease in aggregate demand (e.g. less demand for exports or investment) or an increase in short-run aggregate supply (e.g. capital increase or technology increase). Consequences of Deflation Unanticipated deflation Redistributes income and wealth (workers now have more real income because purchasing power increases) Lowers real GDP and employment (firms cut back on unprofitable projects) Diverts resources from production Low nominal interest rates How can Deflation be Ended Grow the quantity of money faster 477 II. Inflation and Unemployment: The Phillips Curve A Phillips curve shows the relationship between inflation and unemployment. There are two time frames for a Phillips curve: the short run and the long run. The Short-Run Phillips Curve The short-run Phillips curve (SRPC) shows the relationship between the inflation rate and the unemployment rate o holding constant the expected inflation rate and the natural unemployment rate. o Inflation and unemployment have a negative relationship in the short run, so moving along a short-run Phillips curve, a higher inflation rate (holding constant the expected inflation rate) leads to lower unemployment rate. The Long-Run Phillips Curve The long-run Phillips curve (LRPC) shows the relationship between the inflation rate and the unemployment rate when the actual inflation rate equals the expected inflation rate. As illustrated in the figure, the long-run Phillips curve is vertical at the natural unemployment rate. In the graph, the natural unemployment rate is 6% (where the LRPC intersects the x-axis). The short-run Phillips curve intersects the long-run Phillips at the expected inflation rate. In the figure the expected inflation rate is equal to 4 percent. Shifts of the Phillips Curves A change in the expected inflation rate shifts the SRPC vertically upward or downward by the amount of the change but has no effect on the LRPC. A change in the natural unemployment rate shifts both the SRPC and the LRPC. An increase in the natural rate shifts the SRPC and LRPC rightward by the amount of the increase; a decrease shifts the curves leftward by the amount of the decrease. 478