Economic Impacts of Inflation and Aggregate Demand
What is Inflation?
Inflation is the continuing and widespread growth of prices for goods and services in an economy, measured and monitored through a price index. Prices to be taken include wholesale prices (IP), consumer prices (IPC), and the cost of living.
Types and Effects of Inflation
There are two primary types of price scenarios: repressed inflation (where prices are not allowed to rise) and hyperinflation (where price growth becomes exorbitant). The overall effects of inflation generate several negative outcomes:
- Uncertainty
- Reduced efficiency of the productive system
- Unemployment
- Maldistribution of income and wealth
Primary Inflation Types
Demand Inflation: The origin of this type is found in excess demand. According to the Quantity Theory of Money, any increase in the amount of money will translate into the growth of prices. Regarding the demand for real income, the growth of demand can be met by the factors of production; however, when prices go up, the bid cannot be attended.
Cost-Push Inflation: This implies a higher autonomous cost not matched by productivity growth. This includes:
- Wage-price spiral
- Administrative inflation
- Sectoral inflation: This is due to structural causes, such as bottlenecks and imbalances in the productive structure.
Economists also distinguish between anticipated inflation, unanticipated inflation, accommodating inflation, and rational expectations.
Prices and Aggregate Demand
We consider price as an endogenous variable and study how prices affect aggregate demand. Although the money supply remains constant, a rise in prices results in a reduction in real balances, which is equivalent to a monetary contraction and hence leads to a rise in interest rates. A price decrease has the opposite effect.
The effect of prices on interest rates depends on the sensitivity of the demand for money to these changes. A rise in prices raises interest rates and reduces investment. That reduction affects the aggregate demand function based on the value of the multiplier effect.
The Demand Curve and Market Equilibrium
The Demand curve shows the combinations of aggregate price levels and production in which real and monetary markets are in equilibrium. The aggregate demand curve is downward sloping; it shifts to the right or left when you increase or decrease any of its components, especially as a result of fiscal or monetary demand policies.