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Demand-Pull Versus Cost-Push Inflation and the Keynesian Dilemma
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From the course by University of California, Irvine
The Power of Macroeconomics: Economic Principles in the Real World
1257 ratings
University of California, Irvine
1257 ratings
From the lesson
Unemployment, Inflation, and Stagflation
Meet the Instructors
Dr. Peter NavarroProfessor
Paul Merage School of Business
[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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