Macroeconomics: different types of inflation and methods to stabilize inflation

Types of inflation:

Demand pull inflation: caused by a rightward shift in the aggregate demand. The increased in consumption among consumers for a limited amount of goods forces prices to rise.

When the economy is below full employment, an increase in AD does not drastically change the price level, since the economy is not fully using its resources (workers and machines) and can therefore easily increase production.

When the economy is at full employment, an increase in AD causes a large increase in inflation, it becomes relatively more costly to increase production.

Methods for reducing demand pull inflation:

Contractionary fiscal policies: raising taxes or reducing the government spending, will put downward pressure on the aggregate demand, and thereby reduces its rightward shift.

Contractionary monetary policies: Usually, the central bank is the entity that deals with inflation. It does so by increasing the federal funds rate through open market transaction, which decreases the supply of money in the system.

Cost-push inflation: caused by an increase in the cost of production, a shift in the short run aggregate supply to the left.

This can be caused by an increase in the price of raw materials, or in energy and transportation cost. Higher business taxes can also have this effect.

Methods for reducing cost-push inflation:

Contractionary demand side policies: will reduce inflation by shifting the AD to the left, however, it will also increase the unemployment level and increase the level of economic contraction. Might need a larger fiscal and monetary stimulus in the future.

Expansionary supply side policies: corrects both the unemployment and inflation levels. Here are a few examples: reducing business taxes, minimum wage, subsidies for energy or transportation.

Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 203-208.

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