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Notes on Chapter 6
INFLATION
DEFINITION OF INFLATION
Inflation is a process of continuous (persistent) increase in the
price level. Inflation results in a decrease of the value of money.
In the definition of inflation we have to observe that:
o Inflation is an increase in the prices of all goods and services
not only of a particular good or service. An increase in the
price of one good is not inflation.
o Inflation is an ongoing process, not a one-time jump in the
price level.
INFLATION RATE:
To measure the inflation rate, we calculate the annual percentage
change in the price level.
Pthis year - Plast year
Inflation Rate = × 100
Plast year
OR
CPI this year - CPI last year
Inflation Rate = × 100
CPI last year
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Dr. Mohammed Alwosabi ECON 141- Ch.6
higher than that of the last year, the inflation rate will be positive
meaning higher inflation rate Ö the lower is the value of money.
CAUSES OF INFLATION
The inflation can result from either
1. an increase in aggregate demand (demand-pull inflation), or
2. a decrease in aggregate supply (cost-push inflation)
Demand-Pull Inflation
Demand-pull inflation as a result of the increase in spending is
faster than the increase in production of output.
Demand-pull inflation starts as AD increases and AD curve shifts
rightward.
An increase in aggregate demand is caused mainly by
1. the increase in quantity of money (Qm),
2. the increase in any of C, I, G, or X
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Dr. Mohammed Alwosabi ECON 141- Ch.6
SAS2
P4 E
D
P3 SAS1
P2 C
AD3
P1 B
P0 A AD2
AD1
Y
Y0 Y1
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Dr. Mohammed Alwosabi ECON 141- Ch.6
Cost-Push Inflation
Cost-push inflation arises due to a decrease in supply as a result of
the rise in the per unit cost of production, mainly because of the
1. increase in wage rates
2. increase in the prices of key raw materials (e.g. oil price)
Cost-push inflation starts as SAS increases and SAS curve shifts
leftward.
At a given price level, the higher the cost of production, because of
an increase in the money wage rate or an increase in the prices of
raw material, the smaller is the amount that firms are willing to
produce ⇒ SAS decreases ⇒ SAS shifts leftward ⇒ an increase in
prices and unemployment and a decrease in RGDP ⇒ stagflation
SAS2
P4 E
SAS1
P3 D
P2 C
AD3
P1 B
A
P0 AD2
AD1
Y
Y1
Y0
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Dr. Mohammed Alwosabi ECON 141- Ch.6
EFFECTS OF INFLATION
Inflation may be anticipated (expected) or unanticipated
(unexpected)
A moderate anticipated (expected) has a small cost, but a rapid
anticipated inflation is costly because it decreases potential GDP
and slow growth.
Unanticipated (unexpected) inflation has two main consequences in
the labor market. It redistributes income and results in the
departure from full employment
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Dr. Mohammed Alwosabi ECON 141- Ch.6