Macroeconomic indicators workbook answers

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Demand-pull inflation

Cost-push inflation

16 Demand-pull inflation occurs when there is an increase in the level of aggregate demand in the economy. Aggregate demand consists of five components, which are stated in the following equation:

AD = consumption + investment + government spending + (exports – imports)

When there is an increase in one of the components — consumption, investment, government spending or exports — the level of economic activity in the economy will increase and real national output will increase. This will be represented on a diagram as AD shifting to the right. However, as aggregate demand increases there will be greater pressure on resources, and firms supplying goods and services may face the problem of excess demand, especially if production capacity is limited. This will result in businesses increasing prices and/or employing more overtime workers less efficiently to satisfy demand. The higher prices will feed into the inflation indices CPI and RPI as the price level increases at the same time as GDP growth occurs (providing there is spare capacity in the economy).

Demand-pull inflation has been caused mainly by the growth in consumption spending, caused by rising levels of disposable income, which in turn stems from a combination of increased employment, tax cuts, lower interest rates, easy credit and increased household confidence.

17 Cost-push inflation occurs when the costs of production increase, causing the short-run aggregate supply curve to shift to the left.

The major causes of cost-push inflation are rising prices of raw materials, oil, gas and food, or a sudden increase in wage rates. Increased business costs imposed on firms squeeze profit margins and force firms to push up their prices, which then causes cost-push inflation.

The cost-push inflation experienced in the UK since 2009 has two main sources. First, the devaluation of sterling on the currency markets has made imported goods and services into the UK more expensive. Second, the global increases just noted in the prices of food, energy and commodities have been causing a cost-push inflation in the UK.

18 The Fisher equation is:

money supply (stock of money)  velocity of circulation of money =

price level  total transactions in the economy

or MV = PT

In the Fisher equation, for a particular time period, say a year, the stock of money in the economy (or money supply) shown by the symbol (M) multiplied by the velocity of circulation of money (the number of times money changes hands) or (V) equals the price level (P) multiplied by the total number of transactions (T). A transaction occurs when a good or service is bought. T measures all the purchases of goods and services in the economy.

To convert the equation of exchange (MV = PT) — which is true by definition — into a theory of inflation, it is necessary to make three assumptions. The first two are:

  • The velocity of circulation or speed at which money is spent and total transactions (which are determined by the level of real national output in the economy) are fixed, or at least stable.

  • In the quantity theory, money is a medium of exchange (or means of payment), but not a store of value. This means that people quickly spend any money they receive.

Suppose the government allows the money supply to expand faster than the rate at which real national output increases. As a result, households and firms possess money balances (or stocks of money) that are greater than those they wish to hold. According to the quantity theory, these excess money balances will quickly be spent. This brings us to the third assumption in the quantity theory: changes in the money supply are assumed to bring about changes in the price level (rather than vice versa).

19 Macroeconomic policy trade-offs are possible along the short-run Phillips curve but are not sustainable in the long run. In the short run a government can choose between targeting the level of unemployment or the rate of inflation. In the short run, expansionary fiscal policy can spur the economy and create jobs at the cost of a higher rate of inflation.

However, the capacity of the economy is fixed in the short run. The economy’s long-run Phillips curve is a vertical line, whose position is fixed by the economy’s short-run productive capacity. It is impossible to trade off along this line in the long run between the two policy targets of reducing unemployment and reducing inflation.

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