Inflation As Expressions Of Pj Problems

Peter Oye Sagay

Inflation The two graphs of figure 1 illustrate two basic causes of inflation. Inflation is an increase in the general price level of goods and services. Inflation reduces the real value of money over time. Suppose a nation's annual rate of inflation is r%, then the value of its unit currency will be reduced to (1 - r/100) after one year. For example, if the nation is the US, and the annual rate of inflation is 4%, $1 will be worth 96c after one year.

Deflation is negative inflation. In other words, an inflation rate below 0%. It is characterized by a decrease in the general price level of goods and services and an increase in the real value of money. A deflationary spiral (a self-sustaining deflation) can be bad for an economy. It is characterized by low production, high unemployment and low wages.

Figure 1a is a graph of Demand-Pull Inflation while figure 1b is a graph of Cost-Push Inflation.

Demand-Pull Inflation
Rapid increase in aggregate demands for goods and services surpasses productive capacity. Businesses cannot significantly increase production in the short run, so supply, S remains constant. Aggregate demand D0 is increased to D1. Economy's point of equilibrium moves from A to B causing an increase in price level from p1 to p2. Such a rapid aggregate demand can occur if a central bank rapidly increases the money supply.

Cost-Push Inflation
Rapid decrease in aggregate supply of goods and services due to high production costs (e.g. rapid wage increases and high raw material costs). Aggregate supply decreases from S0 to S1. Economy's point of equilibrium moves from Y to Z causing an increase in price level from p3 to p4.

Economic variables impact an economy in complex manners. The Demand-Pull Inflation and Cost-Push Inflation models are simplified representations of such complexities. Nonetheless, inflation as expression of Pj problems is independent of the complexities because inflation is always an increase in the general price level and so it is always a change problem.

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