Question

Q 2 - “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” Ronald Reagan (1911-2004)

a. There are two types of inflation. How are these different types of inflation reflected in the aggregate demand and aggregate supply (AD-AS) model? Use diagrams to illustrate your answer.

b. Governments may adopt fiscal policy to control one of these types of inflation. What type of fiscal policy can be adopted? Explain how this fiscal policy works. How would the ‘ratchet effect’ affect the effectiveness of this fiscal policy?

c. On a separate diagram, clearly illustrate your answer in (b).

Answer 1

a) The two types of inflation are:

1. Demand – Pull Inflation: This type of inflation is a result of increase in aggregate demand from the four major sectors of the economy i.e. Household, Business Firms, Government and the foreign sector. At any given price level, the aggregate demand from all these sectors exceeds the aggregate output being produced which creates a shortage and drives up the overall price-level leading to Inflation. Demand pull inflation is generally observed in case of an expanding/growing economy. Factors that caused aggregate demand to increase are as follows:

o Lower interest rates make it cheaper for consumers and business firms to borrow and spend that raises the aggregate demand.

o Lower income tax increases the consumer’s disposable income and with more capacity to spend it raises the aggregate demand

o Lower corporate tax increases retained profits for businesses and induces them to invest more that raises the aggregate demand

o Increased Government spending on public welfare projects creates greater employment opportunities which raises aggregate income and spending and thus increases aggregate demand

o Weaker currency due to lower interest rates increases the supply for exports (X) and reduces the demand for imports (M) and with an overall increase in net-exports (NX) aggregate demand rises.

Refer to figure (a) below: The X-axis represents real GDP and Y-axis represents price level. Let us assume that initially the economy is at short-run equilibrium point A where aggregate demand curve AD1 and aggregate supply curve intersects. The equilibrium price level is P1 and equilibrium real GDP is Y1, which is less than the full employment level YF. An increase in aggregate demand due to any of the above mentioned factors caused the aggregate demand curve shifts rightwards from AD1 and AD2. The equilibrium moves to point B, where price level rises from P1 to P2 leading to inflation and the real-GDP rises to Y1 to Y2 making the economy move near to the full employment levels.

2) Cost-Push Inflation: This type of inflation is a result of a decrease in aggregate supply due to an increase in the cost of production for the majority of firms in the economy. When firms are suffering from higher cost of production they pass on these increased costs to producers in the form of higher prices that leads to inflation. Factors that cause a decrease in the short-run aggregate supply are as follows:

o Increase in raw material prices

o Increase in wage rate

o Increase in the business taxes such as Value added taxes or GST

o Increase in the price of imported raw materials due to a weaker exchange rate.

Refer to figure (b) below: The X-axis represents real GDP and Y-axis represents price level. Let us assume that initially the economy is at short-run equilibrium point A where aggregate demand curve AD and short-run aggregate supply curve SRAS 1 intersects. The equilibrium price level is P1 and equilibrium real GDP is Y1. An increase in the cost of production due to any of the factors mentioned above, induces the producers reduce production levels. This production cut reduces the aggregate supply and shifts the short-run aggregate supply curve leftwards from SRAS1 to SRAS2. With this shift the equilibrium to point B, where real GDP falls from Y1 to Y2 and price level increases from P1 to P2 leading to inflation.

b) The government may adopt a Contractionary fiscal policy – involving a tax increase or reduced government spending – to deal with demand-pull inflation. This policy is implemented to reduce aggregate spending which causes a fall in the aggregate demand leading to lower price levels and lower aggregate output.

When a Contractionary fiscal policy is applied, the price level falls but not immediately because the firms and its management are hesitant to lower the wage rate as it may hurt the workers and reduce their confidence. A lower morale would lead to lower productivity and efficiency. Thus, as per the Ratchet effect businesses are slow to respond to the fiscal policy implemented to deal with inflationary pressures and this delay reduces the effectiveness of the policy. This results into a greater drop in the production levels as compared to the optimal levels.

c) Refer to figure (c) below: The X-axis represents real GDP and Y-axis represents price level. Let us assume that initially the economy is at short-run equilibrium point A where aggregate demand curve AD1 and short-run aggregate supply curve SRAS intersects. The equilibrium price level is P1 and equilibrium real GDP is Y1.

The optimal level of output i.e. the full potential level of output is YF and in the goal of the government is to get the economy to the potential equilibrium level at point B where all the curves i.e. aggregate demand curve, short-run aggregate supply curve and the long-run aggregate supply curve should intersect. In order to bring down the price level from P1 to P2 the government could implement a Contractionary fiscal policy that would reduce aggregate demand from AD1 to AD2, but the Ratchet effect would prevent the price level to fall immediately in the short-run and remain at P1 itself. The real GDP would fall to a greater level i.e. YR which is less than the full employment level (YR < YF <Y1). The ratchet effect may deter the price level to fall to P2, but it may surely allow the inflation rate to slow down.