Output and Inflation
Aggregate demand determines the actual output of goods and services produced. Given a fixed potential output for any short-term period, aggregate demand will thus determine the unemployment rate. In the simple model used above, when aggregate demand exceeds potential output, an inflationary gap exists and the price level rises. However, in the real world, inflation occurs at or below full employment.
The inflation rate for a given time period is the per year change in price level: INFT = (PT+1-PT)/PT. The price level represents the overall price of all goods and services taken together. The most commonly cited measure of the average price level is the Consumer Price Index (CPI). This provides an index of typical consumer products purchased by average households. However, it does not take into account the roughly one-third of total output represented by investment expenditure. The price level index which includes all goods and services in the economy is called the GDP deflator.
Most firms set their prices based on the anticipated costs of production and the anticipated demand for the goods and services produced. These expectations are based on past performance, economic indicators, and the thought processes of managers. The most recent level of aggregate demand is one of the key factors determining these expectations. The higher aggregate demand, the higher the firm’s own recent demand is likely to have been, and the higher its expectations of future demand. In addition, the higher the aggregate demand, the higher the firm’s expectations about the cost of labor, materials and other factor inputs. As a result, the higher recent aggregate demand has been, the higher a firm is likely to set its prices. If all firms operate in this fashion, then the rate of increase of the price level will be directly and positively related to the level of aggregate demand.
In any short run period, therefore, aggregate demand will influence both the unemployment rate and the inflation rate. As a result, there will be an implied relationship between unemployment and inflation. For each possible level of aggregate demand, there will be corresponding rate of unemployment and of inflation. The graph of unemployment against inflation for a varying level of aggregate demand in the short run is called a Phillps Curve:
In the real world, the constraint that Y cannot exceed Q is somewhat relaxed, because of the way we have defined full employment. Facing demand exceeding Q, some fatories and workers can work overtime and the average frictional and structural rates of unemployment will fall because there are so many unfilled vacancies. Thus the economy in the short run can ‘squeeze’ some extra production out of its resources. However, the cost of this economic ‘boom’ is that factor prices will rise and consequently the price level will rise at a rate higher than normal. This is represented by the increasing slope of the Phillips Curve as unemployment goes above UF.
One might expect inflation at full employment to be zero, because at over-full employment, scarcity of factors of production will lead to rising demand and thus rising prices; at under-full employment, abundance of factors of production will lead to reduced demand and thus reduced prices; and at exact full employment, demand and supply will be in equilibrium, resulting in stable prices. Empirically, however, the position of the Phillips Curve has been such that some positive rate of inflation occurs at the full emploment rate of unemployment. This is caled the inflationary bias.
No comments:
Post a Comment