Demand Shocks and Accelerating Inflation

INFLATIONARY DEMAND SHOCKS AND INFLATION

-An increase in consumption, investment, government expenditures, and net exports causes an increase in aggregate expenditure, a rightward shift in aggregate demand, and an increase in the equilibrium price level.

IF THE GOVERNMENT DOES NOT VALIDATE INFLATION CAUSED BY AN ISOLATED DEMAND SHOCK

Aggregate demand will shift to the right as a result of this demand shock. Y is now greater than Y*, and thus we have an inflationary gap. however, wages adjust: excess demand for labour increases wages, which in turn increases firm costs. As a result, short run aggregate supply shifts to the left, and output returns to its original level, but at a higher price level. This is one-shot inflation. The price level is now at a higher equilibrium level, but since the demand shock is isolated, inflation will not be sustained.

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Inflation and Supply Shocks

FROM WAGE CHANGES TO PRICE CHANGES

-If a change in money wages is positive (wages increase), short run aggregate supply will decrease (it shifts to the left due to increased costs). This causes prices to rise, and the overall effect is inflationary

-If an change in money wages is negative (wages decrease), short run aggregate supply will increase (it shifts to the right due to lowered costs). This causes prices to fall, and the overall effect is deflationary.

Wages up --> Costs up ---> SRAS shifts left --> Equilibrium price level rises

Okay... so so far, we've talked about two causes of inflation: gap effects and worker expectations. There is, however, a third cause of inflationary pressures: AN EXOGENOUS SUPPLY SHOCK (for an example, a change in the price of raw materials, such as oil, can increase the general price level, which is why vegetables can start to cost more when the price of oil goes up).

SOOO

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The Gap Effect, and the Expectation Effect

THE WONDERFUL WORLD OF INFLATION:

People talk about inflation a LOT, so its probably a good idea know what it is. If you've survived macroeconomics without knowing what inflation is up until this point, congratulations, you live a seriously charmed life.

For the rest of us, lets reiterate:

Inflation is any rise in the general price level (P)

Inflation can be temporary/transitory (the price level increases to a new equilibrium price level, where it stays put for a while) or it can be sustained/persistant (the price level rises continuously over time)

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The Transmission Mechanism

So... what happens when the money supply changes? How does this affect things? That's what we're going to figure out today!

Remember the marginal efficiency of investment function?

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The Demand & Supply for Money

The Liquidity Preference Function: This shows people's preference to hold money (cash balances) rather than bonds (interest bearing assets)
-People have a choice between holding their wealth in one of two ways: bonds or money
-Money pays no returns, and bonds do pay a return
-The opportunity cost of holding money is the interest rate one earns on a bond
-People only want to hold money when it provides benefits which at least equal the cost of forgoing bond interest

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Bonds!

TODAY: WE ARE GOING TO LEARNING ABOUT THE MONEY MARKET: This basically let's us understand how the money supply determines the interest rate

BONDS: What are bonds...

Well... Wealth is accumulated purchasing power, and wealth can be held in assets, or "things which you own" -This includes both money and "interest bearing assets"

Any household's financial portfolio includes a combination of money and interest bearing assets- choosing a different investment plan is just a matter of deciding how much of your wealth you wish to hold as money, and how much of it you wish to hold as an asset

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MONEY MONEY MONEY

Money Money Money!

THE NATURE OF MONEY

-Classical economists arbitrarily divided economies into the real sector, and the monetary sector.

-The REAL SECTOR describes the allocation of resources to produce different goods

-Resource allocation (use of factors) is dependent on relative prices

-Relative prices affect output (so if wood is cheaper than brick, an economy will produce more wood houses than brick houses

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