Equilibrium prices rise only if demands increase or supplies decrease. Inflation that originates on the demand side is referred to as "demand-pull inflation," while supply-side inflation is commonly termed "cost-push inflation."
You may have heard people complain, "If those #@*%! unions were less greedy and powerful, inflation and unemployment would be under control." Others blame all inflation on overly expansionary monetary policies. Still others cite government deficits as causing inflation: "Inflation would disappear if the federal budget ever balanced." Then there are those who blame business profiteering, wars or foreigners for our problems. What have been the basic sources of U.S. inflation in the last few decades? And why is unemployment so often so persistent? We will explore the expected equilibrium paths during both supply-side and demand-side inflation to begin to answer these intertwined questions. Then we can compare these results with recent history.
Growth of Aggregate Demand in an economy operating below capacity increases employment, output, income, and, perhaps, the price level. End of the Keynesian story. But suppose an economy is in a noninflationary equilibrium at full employment, such as that labeled point a in Figure 9: Full-employment GDP equals Qf, and the price level is P0. "Full employment" allows for frictional unemployment caused by flows of workers between jobs and in and out of the work force. Labor supplies reflect no expectations of inflation, which, along with other institutional characteristics (unemployment compensation rates, labor laws and so on) and aggregate productive capacity, yield the Aggregate Supply curve AS0.
Figures 9 Demand-Side Inflation: The Counterclockwise Path
Frictional employment, a normal by-product of economic activity, is reflected by the difference between Q1, which assumes that everyone who wants to work is employed, and Qf, which makes allowances for frictional unemployment. Frictional unemployment may artificially fall below normal levels (Q1 - Qf) if expansions of Aggregate Demand temporarily fool some frictional unemployed workers into taking jobs that pay low real wages (movement from a to b). In the long run, however, workers will adjust their wage demands to reflect higher prices and unemployment will rise back to normal levels (movement from b to c).
Now assume that Aggregate Demand rises from AD0 to AD1 because government spending grows, moving the economy toward a new short-run equilibrium at point b. Even an economy that started at full employment can expand if frictional unemployment falls and if business can be induced to employ the extra workers. If they can pass the costs of hiring these workers forward to consumers, firms will hire beyond the full employment point. The price level rises to P1 with this swollen Aggregate Demand.
Thus, if cyclical unemployment is negligible, expanding Aggregate Demand may temporarily reduce frictional unemployment, but this decline is artificial, so the ultimate effect of expansionary policy is to increase the price level, and the economy follows the counterclockwise path shown in this figure.
But what happens to real wages? Money wages do not rise as quickly as prices, so real wages (w/P) fall. This is shown in Figure 10. When workers eventually demand higher money wages to restore their purchasing power, the Aggregate Supply curve decreases toward AS1. Along the equilibrium path between points b and c, labor finds that although it earns higher money wages, these wages are partially eroded by continuing inflation. How long will this process continue? Labor repeatedly reacts to price hikes by demanding higher wages until equilibrium at point c is reached. At this point, real wages have regained their original values, the economy is back at full employment, and the aggregate price level equals P2---precisely labor's expectations about the price level.
Figure 10 Changes in Real Wages and Inflation
Rises in money wages lag price changes so that real wages typically fall when the rate of inflation rises. Conversely, when inflation declines, real wages tend to rise. Real wages in this figure include both wages and benefits.
Source: Economic Report of the President, 1994.
Price-level increases initiated when the Aggregate Demand curve expands (shifts to the right) are called demand-side (or demand-pull) inflation.
Prices continue to rise when labor's inflationary expectations adjust and so might be thought of as supply-side inflation, but this is simply the second phase of a demand-side cycle---the original inflationary impetus came from increased demand. The forces that set this inflationary spiral in motion shift the Aggregate Demand curve to the right. Notice that as labor reacts to the inflationary spiral, the economy's equilibrium path runs from point a to b to c, following a counterclockwise path.
We indicated earlier that a Keynesian inflationary gap such as that reflected by Q1 - Qf in Figure 9 creates inflationary pressure. In a sense, this is a "negative" GDP gap. Overfull employment can occur if frictional unemployment is artificially driven down by expansions of Aggregate Demand. Automatic pressures ultimately reduce output back to full employment levels. The economy illustrated in Figure 9 first moves from a to point b. When workers eventually realize that they have been fooled, the labor supply falls, returning the system to full employment at point c---but at a higher price level. Recall that (a) we initially assumed full employment, with allowances for normal frictional unemployment, and (b) if the economy is initially plagued by excess capacity, only the first phase of this cycle needs to occur---growing demand can yield much more output with only slightly higher prices.
The double-whammy of high unemployment and rapid inflation was once thought quite unlikely. Policymakers believed that low unemployment rates might spark rapid inflation, and vice versa, but faith in Keynesian policies to fine-tune Aggregate Demand to yield healthy growth and a reasonably stable price level was commonplace. A major reason neither conventional classical nor Keynesian theories offer much insight into why high rates of inflation and unemployment might occur simultaneously is that, from the 1940s into the 1970s, both schools of thought largely ignored shifts in Aggregate Supply.
Economists of a classical persuasion traditionally cited shifts in Aggregate Demand to explain inflation because the Aggregate Supply curve was assumed to be vertical and stable. Keynesian theory also viewed Aggregate Supply as stable, but treated it as horizontal during a recession. Thus, Keynesians focused on shocks to Aggregate Demand as disrupting output and employment. The resulting debate over whether shifts in Aggregate Demand ultimately yield price-level adjustments (the classical position) or adjustments to employment and the output level (the Keynesian position) caused economists to neglect shocks to Aggregate Supply.
The world economy was bombarded by supply shocks during the 1970s, however, creating problems that seemed enigmatic to most economists. High unemployment and inflation first occurred simultaneously in 1974--1975, giving rise to the term "stagflation"---a contraction of stagnation and inflation.
Stagflation entails simultaneous high unemployment and rapid inflation.
This malady proved persistent. Inflation and unemployment were both above historical norms for almost a decade. Attempts to reduce inflation from the double-digit range during 1979--1981 partially succeeded by 1982, but briefly drove civilian unemployment above 10 percent.
OPEC price hikes were the most notable supply shocks to the U.S. economy in the 1970s, but other types of shocks are clear possibilities. Suppose workers began viewing leisure more favorably and work less favorably, and that hard bargaining by unions became the norm in key industries. The effect of a major energy price increase is shown in Figure 11. Higher energy costs shift Aggregate Supply to the left. Suppose the original equilibrium is at point d. As Aggregate Supply shrinks from AS0 to AS1, equilibrium moves from point d to e. Firms will demand less labor because higher energy prices can only partially be passed on to consumers in the form of higher product prices. Unless something boosts Aggregate Demand, less real output is demanded at the new price level P1, and real output and employment fall to Q1. For incumbent politicians, this is the worst of all worlds: rising prices and unemployment, and declining real incomes and output.
Figure 11 Supply-Side Inflation: The Clockwise Path
Shocks to the supply side cause prices to rise while output and employment fall (movement from point d to e). If policymakers follow expansionary policies to counter unemployment, prices will rise further (from point e to f). If, on the other hand, they fight inflation by restricting Aggregate Demand, the price level will return to the P0 level, but output and employment will shrink dramatically (from point e to g).
As the economy moves to point e, politicians may worry about voters' reactions to a recession. Why this can be a concern is indicated in Focus 1. Policymakers may also perceive a duty to maintain full employment under the Employment Act of 1946 and the Humphrey-- Hawkins Full-Employment and Balanced Growth Act of 1978. Political pressure will mount to launch expansionary policies in response to any movement from point d to point e. If, on the other hand, policymakers view inflation as an evil that must be tamed and try to restore the price level to P0 by decreasing Aggregate Demand to AD2, the economy will move from point d to point g, further decreasing National Output and exacerbating unemployment.
Alternatives to achieving full employment by expanding Aggregate Demand would be policies to restore Aggregate Supply from AS1 to AS0. More output and employment would be generated at lower prices. The supply-side policies we listed in Figure 5 are aimed at increasing our productive capacity, a task not accomplished overnight, so the federal government has historically tended to be demand-management oriented. Nevertheless, the "supply-side" policies adopted in the early 1980s were avowedly a reaction against Keynesian policymaking, and were explicitly intended to expand Aggregate Supply.
Stimulating Aggregate Demand is a relatively quick and easy process; government cuts tax rates or boosts its spending or transfer payments, or the FED increases monetary growth. The government commonly counters shrinkage of Aggregate Supply by increasing Aggregate Demand, shown by a shift from AD0 to AD1 in Figure 11. With demand management, the economy will move along the equilibrium path described by the arrows from point e to f. Full employment is ultimately restored, but at a higher price level. Notice that the long-term equilibrium path for supply-side inflation is from point d to e to f, a clockwise pattern. (Remember that, in contrast, a demand-side inflationary cycle follows a counterclockwise pattern.)
Supply-side inflation is initiated when the Aggregate Supply curve shifts to the left and the price level rises as output falls.
A few qualifications are worth noting. First, shifts in the Aggregate Supply curve from AS0 to AS1 originate in a multitude of ways summarized previously under Figure 5. Second, the federal government need not increase government spending to shift the Aggregate Demand curve from AD0 to AD1. For example, monetary authorities might stimulate rapid monetary growth in attempts to push the economy out of a recession.