Inflation

Demand Pull

Demand Pull inflation occurs when the demand for goods exceeds the full employment supply.

In terms of our models: C + I + G > YFE

Such a condition can occur in wartime when the government vastly increases the demand for war material when the economy is at YFE. Such was the case in the late 60s when Johnson want to maintain his great society programs and fight the Viet Nahm war at the same time.

The only way war material firms could expand production is to lure workers away from firms producing civilian goods because there were no qualified unemployed workers. To do this they had to offer them higher wages so the wage costs increased in all industries. Manufacturers passed their increased costs through to customers and inflation was on its way.

Cost Push

Cost push inflation occurs when the cost of a basic raw material increases and this cost increase permeates throughout the economy. Energy costs rose because of OPEC and this started inflation on its way.

Quantity Theory of Money


This is the oldest economic theory and dates back to the 16th century. Observes created the quantity theory of money in response to the influx of gold from the new world to the old world by the Spanish as: PY = VM
where P is the price index (1.0 in base year), Y is the real gross domestic product, V is the velocity of money (number of times it goes round the circular flow diagram a year), and M is the supply of money.

V has been increasing with technology and varies with the interest rate, but in a short time period is approximately constant. Thus we have one control variable M (controlled by the FED) to explain two variables P and Y. IT CAN NOT BE DONE. If you make a small change in the money supply it could result in a myriad of possible changes in P and Y and exactly what might happen can not be determined.

The only time the quantity theory of money is useful for prediction is when DM >> Max DY < 10% over an extended period of time--hyperinflation. Under such conditions most of the increase in M will result in an increase in P. If DM is 200% over three years, then DP will also be about 200%.

ADJUSTING TO INFLATION


Economic actors adjust to inflation. For example, in the 70s with OPEC creating cost push inflation, labor unions insisted on COLA, cost of living adjustments, in their labor contracts. With COLA, labor’s wages are automatically adjusted to inflation so that they maintain constant purchasing power.

Manufacturers also adjust to inflation in the manner in which they adjust prices. Before the inflation of the 70s auto manufacturers adjusted prices once a year. With inflation to avoid sticker shock they adjust prices many times during the year in small increments.

All economists agree that economic actors adjust the strategies with respect to their expectations of inflation. Where economists disagree is how well economic agents are able to forecast inflation. A very strong assumption is “rational expectations” that says economic actors are able to forecast expected inflation. A weaker assumption is adaptive expectations that assumes economic actors adapt towards rational expectations. For example, in the 70s manufacturers started raising their prices in response to the changes in the money supply reported in the Wall Street Journal. True believers in neoclassical macroeconomics believe in rational expectations. I believe there is more evidence towards adaptive expectations.