ECON 1010 Chapter Notes - Chapter 28: Aggregate Supply, Aggregate Demand, Potential Output

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24 Jul 2016
Chapter 28-The Business Cycle, Inflation, and Deflation
Inflation Cycles:
Inflation is a monetary phenomenon in the long run that occurs if the quantity of money grows faster than
potential GDP.
Demand-pull inflation and cost-push inflation are two factors that can start inflation in the short run.
Begins because aggregate demand increases.
Demand-pull inflation can be started by any of the factors of aggregate demand (tax cuts, increase in exports,
cut in the interest rate etc.).
The only way aggregate demand can persistently increase is if the quantity of money persistently increases.
In that case: The aggregate demand curve keeps shifting rightward, puts a continual upward pressure on
the price level, money wage rate rises, and decreases short run aggregate supply.
Begins with an increase in costs.
Cost-push inflation can be started by:
1. An increase in the money wage rate.
2. An increase in the price of raw materials.
*At any given price level, the higher the cost of production, and the smaller the amount firms are willing to produce. If
the money wage rate rises, or if the prices of raw materials rise, firms decrease their supply of goods and services. As a
result, aggregate supply decreases, shifting the short run aggregate supply curve leftward.
Producers increase the prices of raw materials to restore relative prices and the short run aggregate supply
curve then shifts leftward. The price level rises, and real GDP decreases. Unemployment increases above its
natural rate.
The combination of a rising price level and decreasing real GDP is called stagflation.
If inflation is expected, the fluctuations in real GDP that accompany demand-pull and cost-push inflations do not
Instead, inflation proceeds as it does in the long run, with real GDP = potential GDP, and unemployment at its
natural rate.
To anticipate inflation, people must forecast it.
The best forecast available is the one that is based on all the relevant information called rational expectation.
It is simply the best forecast that can be made with the information available.
When the inflation forecast is correct, the economy operates at full employment.
If aggregate demand grows faster than expected, real GDP increases to above potential GDP resulting in
the economy behaving in demand-pull inflation.
If aggregate demand grows slower than expected, real GDP decreases to below potential GDP and the
inflation rate slows.
An economy experiences deflation when it has a persistently falling price level (negative inflation rate).
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