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