The model above is a Keynesian model; this shows short term changes in price level. For demand pull inflation to be illustrated in the long run it must be modelled using the classical model. In the classical model LRAS is a vertical line which also represents potential GDP. The theory is the same in that there is a shift in the aggregate demand curve resulting in a new real GDP and higher price level. In this model an inflationary gap can be derived. An inflationary gap is the surplus of GDP as a result of real GDP being greater than potential. The graph below shows how an inflationary gap is found.
This shift in aggregate demand is then met with a shift in aggregate supply. The inflationary gap mean that unemployment is below its natural rate, meaning there is a shortage of labour. If there is a shortage of labour money wage rate increases resulting in the aggregate supply curve shifting to the left. This causes price level to rise again and output to return to potential GDP level. These shifts are shown in the graph below.
This process shows a one off rise in price levels, for inflation to occur the rise in price level must increase persistently and not in one off jumps. Hence for demand pull inflation to occur aggregate demand must persistently increase, this only happens when the quantity of money supplied persistently increasing. The same sequence of shifts described in the model above occur however they happen continuously, this is called the demand pull inflation spiral.
This theory suggests that this type of inflation is triggered by an initial aggregate demand shock; however without the persistent increase in the quantity of money the inflation would only be short lived.
Another type of inflation is cost push inflation. Cost push inflation is the result of a sudden increase in costs. The main sources of cost increases are: increase in money wage rate and increase in money prices of raw materials (such as crude oil). An increase in costs affects the aggregate supply curve. The higher the cost of production, the smaller quantity firms are willing to produce, therefore aggregate supply decreases and the short run aggregate supply curve shifts to the left. This is illustrated in the graph below.
A recessionary gap occurs; this is the opposite of an inflationary gap. It means that real GDP is below potential GDP and the economy is below its full employment equilibrium (unemployment above natural rate). This supply shock on its own does not cause inflation. For inflation to occur aggregate demand must now respond. If aggregate demand does not change then the recessionary gap will eventually forces the money wage rate and prices down, shifting the aggregate supply curve rightward restoring the full employment equilibrium. However if like in demand pull inflation, there is a persistent increase in the quantity of money, cost push process is converted into ongoing inflation. Aggregate demand increases when the quantity of money is increased by the Bank of England. If the rate of unemployment is high the Bank of England will be under pressure to take action to return unemployment to its natural rate, therefore aggregate demand is increased by increasing the quantity of money, and as a result the natural rate of employment is restored, potential GDP is restored and prices increase again as in the diagram below.
For inflation to occur a cost push spiral must be created. Therefore there must be another increase in costs. This second increase in costs now repeats the above process resulting in price level continuously increasing – inflation.
Cost push inflation spiral:
Cost push is therefore a result of a supply “shock”, and if the increase in aggregate demand is persistent due to a persistent increase in quantity of money then inflation will occur. Therefore for both cost push and demand pull inflation persistent money growth is required for inflation to occur and not be “short lived”.
This affect of money growth is what led to the Monetarist inflation theory, the quantity theory of money. “The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level. The basis of the quantity theory of money is a concept known as the velocity of exchange and an equation called the equation of exchange.” (Matthews, 2008). The velocity of circulation is “The speed with which money whizzes around the economy, or, put another way, the number of times it changes hands. Technically, it is measured as GNP divided by the money supply.” (www.economist.com) The velocity of exchange equation is MV=PY, when M=quantity of money, V=velocity of exchange, P=price level and Y=real GDP. In this theory some assumptions must be made, V is regarded as a constant, and Y is predictable (average growth rate of 2.5% in U.K). If these assumptions are made then it can be deduced that money supply directly affects price level. It can be seen more clearly if the equation is rearranged to give P=(V/Y) x M, therefore a change in M brings about a proportionate change in P due to (V/Y) being independent of M.
The equation of exchange can also be expressed as an equation of exchange in growth rates, which will allow us to bring inflation rate into the equation. The equation we now have is:
Inflation rate = Money growth rate + Rate of velocity exchange – Real GDP growth rate
Another assumption can be made at this point. In the long run rate of velocity rate of exchange is equal to zero (approx.) This assumption gives us:
Inflation rate = Money growth rate – Real GDP growth rate
This theory therefore supports the idea that without money growth inflation would be short lived. Keynesian economists argue against this theory, they ask what if V is not constant? This is a good question because if the is a small percentage change in M and P and a significant change in V then the theory does not work. They believe the assumptions made make the equation flawed. However there is evidence when comparing inflation and money growth rate over time that there is a clear pattern, fluctuations in both rates are in line with each other, this suggests that they are definitely linked however maybe not as simply as the quantity theory of money.
Hyperinflation is an obvious example of how money growth can cause inflation however. Hyperinflation is generally considered to be when inflation is greater than 1000%. Hyperinflation is a result of a massive increase in the supply of money, not supported by corresponding growth in output. The increase in quantity of money causes a very big increase in price levels – high inflation, and also results in a loss in confidence in money.
In conclusion, from the inflation theories discussed it is obvious that demand and supply shock can cause inflation, however for these rises in price level to be long term there must be a persistent increase in the quantity of money. The argument between Keynesian and Monetarist economists today is whether the short term effects from economic pressures last long enough to be important and a significant factor in long term inflation.
Bibliography
(n.d.). Retrieved from www.economist.com: http://www.economist.com/research/economics/alphabetic.cfm?letter=V#velocityofcirculation
Powell, Parkin and Matthews. (2008). Economics seventh edition.
Diagrams
2-7. Powell, Parkin and Matthews. (2008). Economics seventh edition.
