ECON 102 6
Inflationrefers to a sustained increase in general price , which results toa decline in the purchasing power of money. Demand pull inflation mayoccur when the aggregate demand grows at an unsustainable rate. Thefollowing diagram shows demand pull inflation
Y1 Y2 Yp
Realnational output (Y)
Costpush inflation occurs the moment firms tend to respond to increasingcosts through increasing prices in order to protect their profits.The diagram below shows cost push inflation
Averageprice level LRAS
Y2Y1 Yp Real national output (Y)
Differentcosts of inflation include paying high for commodities, may result tounemployment, can cause frustrations in investments, and may lead tothe closure of businesses. The central bank has a role in controllinginflation. The central bank controls inflation through maintainingthe public’s expectation of inflation being equal to its targetedinflation and through varying the rates of funds in a manner thatcauses the real interest track the natural rate (Mankiw,2009). Through maintaining expected inflation at its inflationtarget, inflation and money grow in line with the targeted inflation.
Thequantity theory of money (QTM) claims that aggregate price (P) andtotal money supply (M) are related by the equation P = VM/Y where Yis the real output and V is the velocity of money.
Fromthe QTM, P = VM/Y therefore, an increase in money supply (M) willresult in an increase in the aggregate prices since the numeratorwill increase with the increase in money supply. Thus, in case moneysupply increases, while real output remains unchanged, the aggregateprices will increase.
Thereal value of money refers to the nominal amount of money divided bythe price level in the economy. The real value of money determinesthe amount of commodities that the money can purchase. Thus, incase the nominal value of money is fixed, but the price levelincreases, then one can only purchase fewer commodities with themoney. This is an indication that the real value of money declineswith an increase in the price level.
Thereare four types of unemployment, which include seasonal, cyclical,structural, and frictional. Seasonal unemployment is a kind ofunemployment that results, when there is a limited need forperforming a certain type of work during given time of the year(Mankiw,2009). Frictional unemployment is a kind of unemployment that resultsfrom employees seeking job opportunities that best fits them.Structural unemployment entails a form of unemployment that resultsdue to changes in the demand patterns or as a result of technologyobsolescence, leading to retraining of employees and vast investmentsin new capital equipments. Conversely, cyclical unemployment is as aresult of the changing business cycles.
Theinflation rates and unemployment rates have an inverse relationship.This implies that when unemployment decreases, the inflationincreases (McEachern,2012). This relationship can be indicated through the short-runPhillips curve shown below
SRPC Unemployment rate (%)
Naturalrate of unemployment = U/L
=0.05 / (0.05 + 0.15)
Mankiw,N. G. (2009). Principlesof economics.Mason, OH: South-Western Cengage Learning.
McEachern,W. A. (2012). Economics:A contemporary introduction.Mason, OH: South-Western Cengage Learning.