INFLATION, UNEMPLOYMENT, DEFICITS, and DEBT

Chapter Summary
1. Any event which increases the cost of supplying aggregate output shifts
the aggregate supply curve to the left, causing increases in the price level
and decreases in output. Inflationary pressures stemming from costs (cost-
push inflation) are most often associated with increases in the costs of labor
and raw materials.
2.Demand-pull inflation occurs when outputs is unable to meet increases in
aggregate spending. Inflationary pressures can develop prior to full-
employment output when increases occur in aggregate demand and the
aggregate supply curve is positively sloped. Inflationary pressures from
increasing aggregate demand are greater when the unemployment rate
falls below its natural rate.
3.The Phillips curve shows an inverse relationship between the rate of
inflation and the rate of unemployment. The unemployment rate can be
pushed below the natural rate in the short run by increasing the rate of
inflation. The unemployment rate will not permanently remain below the
natural rate over time, however, because of eventual rightward shifts of the
Phillips curve.
4. A federal deficit exists, when government outlays exceed revenues. The
U.S. federal budget has been in deficit almost every year since World War II.
The U.S. structural deficit -- the deficit that exists when output is at its full-
employment level -- rose during the 1980s because federal outlays
increased at a faster rate than did federal revenues.
5.The public debt is the amount owed by the federal government. The U.S
public debt increased dramatically during the 1980s as a result of increasing
federal deficits. The nominal public debt per capita increased from
$1,799.67 in 1970 to $15,103.34 in 1993.
Important Terms
Cost-push inflation: inflation caused by increases in the cost of producing
output rather than by increased in aggregate demand.

Cyclical deficit: the federal deficit that arises when output is below its full-
employment level.

Demand-pull inflation: inflation that occurs because of increases in

aggregate demand.

Phillips curve: a curve depicting an inverse relationship between the rate of

inflation and the rate of unemployment.

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Public debt: the amount owed by the federal government; that is, the sum of
interest-bearing debt obligations issued by the federal government.

Stagflation: a situation in which there is increasing inflation and

unemployment simultaneously.

Structural deficit: the federal deficit that exists when output is at its full-
employment level.

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Shoe-leather Costs: Earlier in this chapter, we explained that nominal
interest rates usually rise in line with inflation in order to preserve the real rate
of interest. But we have also seen that it is the nominal interest rate that is the
opportunity cost of holding money. Hence when inflation is higher, people hold
less money balances. In Section 28-2 we examined the flight from money
during the German hyperinflation as an extreme example of this relation
between inflation and the demand for real balances.

We began our study of money in Chapter 23 by showing that society uses

money to economize on the time and effort involved in undertaking
transactions. When high nominal interest rates induce people to economize on
holding real money balances, society must use a greater quantity of resources
in undertaking transactions and therefore has less resources available for
production and consumption of goods and services. We call this the shoe-
leather cost of higher inflation.

With higher inflation and nominal interest rates, people will hold less of their
wealth in cash and more of it in interest-bearing assets such as bank accounts.
Instead of withdrawing £50 at a time from an interest-bearing bank account
and visiting the bank only once a month, people will withdraw £10 a time but
visit the bank 5 times a month. For a given level of transactions, this enables
people to hold less of their wealth in non-interest-bearing cash, but it makes
people wear out their shoe-leather in walking to the bank more frequently.
Shoe-leather costs stand for all the extra time and effort people put into
transacting when they try to get by with lower real balances.

Menu Costs: When prices are rising, price labels have to be changed. For
example, menus have to be reprinted to show the higher price of meals. The
menu costs of inflation refer to the physical resources required to reprint price
tags when prices are rising (or falling). The faster the rate of price change, the
more frequently menus have to be reprinted if real prices are to remain
constant.

Among the menu costs of inflation we should probably include the effort of
doing mental arithmetic. When the inflation rate is zero it is easy to walk into a
shop and see that a pound of steak costs the same as it did 3 months ago. But
when inflation is 25% /year, it takes a bit more effort to compare the price of
steak today with that of 3 months ago so as to see what has happened to the
real or relative price of steak. Although people without inflation illusion try to
think in real terms, the mental arithmetic required involves real time and effort.

How significant are menu costs? In supermarkets it may be relatively easy to

change price tags. But the cost of changing parking meters, pay telephones,
and slot machines are more substantial. In fact, in countries where inflation

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rates are high, pay telephones usually take tokents whose price can be easily
changed without having to physically alter the machines.

Even when inflation is perfectly anticipated and the economy has fully adjusted
to inflation, it is impossible to avoid shoe-leather costs and menu costs.
Although these costs become very significant when the inflation rate reaches
hyperinflation levels, they suggest that the social cost of living with 20%
inflation for ever might not be too large. However, this applies to the case in
which society is best able to adjust to inflation. As we now see, the costs of
inflation will be larger in other situations.

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