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Demand-Pull Versus Cost-Push Inflation and the Keynesian Dilemma

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The Power of Macroeconomics: Economic Principles in the Real World

University of California, Irvine

4.6 (1,449 ratings) | 160K Students Enrolled

In this course, you will learn all of the major principles of macroeconomics normally taught in a quarter or semester course to college undergraduates or MBA students. Perhaps more importantly, you will also learn how to apply these principles to a wide variety of situations in both your personal and professional lives. In this way, the Power of Macroeconomics will help you prosper in an increasingly competitive and globalized environment. This course is also available in Portuguese. To join the fully translated Portuguese version, visit this page: https://www.coursera.org/learn/macroeconomia-pt/

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PS

Aug 06, 2018

This was an instructive course with lots of examples of the US economy and with a great explanation and tests, nevertheless sometimes I lacked some examples from the other parts of the world.

NT

Sep 07, 2015

The course is so well-organized that helps me to accomplish a systematic understanding about the field. Beyond that, thanks to the Professor, I now feel more keen on learning about this.

From the lesson

Unemployment, Inflation, and Stagflation

Some Basic Unemployment Concepts 4:26

Unemployment Defined and Measured 4:03

Okun's Law 3:48

Demand-Pull Versus Cost-Push Inflation and the Keynesian Dilemma6:22

Taught By

Dr. Peter Navarro
Professor

[MUSIC]

Now let's turn to the topics of inflation and stagflation.

Inflation has often been described as the cruelest tax because

it eats away at our savings and at our paychecks.

For example, if the rate of inflation exceeds

the rate of growth in our paycheck, that

means our real income or purchasing power is

declining, even though our wages are going up.

But not everyone loses from inflation.

For example, as we learned in lecture one, inflation that

is unanticipated can benefit borrowers at the expense of lenders.

As a practical matter, there are two very different types of

inflation economists have to worry

about, demand-pull inflation and cost-push inflation.

The essence of demand-pull inflation is, too much money chasing too few goods.

And that's

exactly what happened when the US tried to finance both guns and butter.

Both the Vietnam War and the Great Society.

Do you remember from lecture one how to use the aggregate supply, aggregate demand

framework to depict demand-pull inflation? Take a few minutes to draw it.

Does your figure look like this?

Increased government expenditures on both guns and butter

drive aggregate demand from AD to AD prime.

And equilibrium output increases from E to E prime

as real GDP expands. However, when real output

rises far above potential output the price level moves up sharply as well.

From P to P prime.

In 1972, President Richard Nixon imposed price and wage controls and

gained the nation a brief respite from the Johnson era inflation.

However, once the controls were lifted in 1973, inflation

jumped back up to double digits, helped in large

part by a different kind of inflation then emerging,

an inflation known as cost-push or supply side inflation.

Cost-push or supply side inflation occurs when external shocks such as rapid

increases in raw material prices or wage increases drive up production costs.

In the early 1970s, such supply shocks included crop failures, a

worldwide drought, and a quadrupling of the world price of crude oil.

Again, do you remember from lecture

one how to use the aggregate

supply-aggregate demand framework to depict cost-push inflation?

The cost-push situation in the 1970s is illustrated in this figure.

Sharply higher oil, commodity, and labor

costs increased the cost of doing business.

The higher costs shift the AS curve up from AS to

AS prime and the equilibrium shifts from E to E prime.

Output declines from Q to Q prime, while prices rise.

This leads to stagflation, the double whammy

of both lower output and higher prices.

Prior to the 1970s economists didn't believe you could even

have both high inflation and high unemployment at the same time.

If one went up, the other had to go down.

But the 1970s proved economists wrong on this point, and likewise exposed

Keynesian economics as being incapable of solving the new stagflation problem.

The Keynesian Dilemma was simply this, using expansionary policies to reduce

unemployment simply created more inflation while using contractionary policies

to curb inflation only deepened the recession.

That meant that the traditional Keynesian tools could solve

only half of the stagflation problem at any one time.

And only by making the other half worse.

This dilemma was well illustrated by the ill fated initial Keynesian responses

to the emerging stagflation crisis. During 1973 and

1974, inflation was labeled public enemy number one by policy

makers even though there were clear signs of an accompanying recession.

During both of these years, the

Federal Reserve under Chairman Arthur Burns ordered

sharp increases in the discount rate as a form of contractionary monetary policy.

In addition, in

1974, President Gerald Ford responded to the crisis with a Whip

Inflation Now campaign that included Keynesian calls for contractionary

fiscal policy in the form of fiscal restraint and a tax surcharge.

The result of these discretionary policies was to drive the economy

deeper into recession even as oil price shocks in particular helped drive

the inflation rate ever higher.

Then, in 1975, alarmed by the

deepening recession, the nation's policymakers switched their

Keynesian strategy as they replaced inflation with

recession as their number one policy worry.

As Congress passed a $23 billion Keynesian tax cut to fight

recession, the Federal Reserve switched to an expansionary Keynesian monetary policy.

Result was a disaster.

It drives home the seemingly unreconcilable

dilemma that stagflation poses for traditional Keynesianism.

High inflation remained, even as the economy failed to recover from recession.

It was this inability of the Keynesian economics to cope with stagflation that

set the stage first for professor Milton

Friedman's monetarist challenge to what had become

the Keynesian orthodoxy and then later for the emergence of supply-side economics.

To better understand the failure of Keynesian

activism in a world of stagflation, we have

to delve more deeply now into modern inflation

theory and the mysteries of the Phillips Curve.

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