Question

On July 20, 1993. Alan Greenspan, chairman of the Board of Govemors of the Federal Reserve System, testified before a congressional committee. He said. The role of expectations in the inflation process is crucial. Even expectations not validated economic fundamentais can themselves add appreciably to wage and price pressures for a considerable period potentially derailing the economy from its growth path." (a) if workers are convinced that inflation is about to increase greatly, what effect will this have on their wage demands? Will their wage demands fuel further inflation! (b) If the managers of firms are convinced that inflation is about to increase greatly, what effect will this have on their pricing decisions? Will their pricing decisions fuel further inflation (C) How can ination derail the economy from its growth path? "A Green Story before the Committee on Banking Finance and Urban A of the US House of Representatives on y 20. 1992 This material is reorted in E M e lded Lead Economic Controvers of 1995 New York: WW Norton DELL

Answer 1

A).  If workers expect future inflation, they are more likely to bargain for higher wages to compensate for the increased cost of living.there maybe or maybe not an higher inflation in future but due to expectations of higher future inflation ,workers forces firms to pay higher wage which increase cost of firms and firms in return to maintain their same level of profit, increases their final good price ,which increase prices. So yes due to surety of higher future inflation, higher wage demand of workers fuels further inflation .If there happens to be a higher inflation in future due to some other reasons like demand shock or supply shock,but workers demand of higher wage will increase inflation further.

B).if firms are expecting inflation to rise (e.g. expecting the price of raw materials to increase) then they will be more likely to increase prices to protect their profit margins.if there would be a inflation in future in real due to other reasons but firms expectations of higher future inflation ,will cause more price increase,means it will work as fuel in fire.

C). There are many causes of inflation. And based on those causes its effect is different. A cost pull inflation is likely to derail from its growth path. As it happens in 1970s ,oil prices were very high in all over the world. oil is most important and usable input in production. Thus very high price of oil increased production cost.firms start demanding higher prices for same quantity. Thus there is decrease in aggregate supply at the same price level and AS curve shift upward which means at equilibrium a lower output and higher prices .

So 1970 stagflation in USA,UK ,where high employment with high inflation, decrease their growth rate till oil prices became normal again. Higher inflation lowerd output and thus, increased unemployment.

So cost push inflation , decrease growth and increase unemployment.there are other causes of inflation like demand push inflation,but below full employment it is a good thing for economy , incentive for firms to produce higher output.but even inflation from demand higher than 5% ,it will have a negitive effect on consumer confidence index,thus there will be a decrease in aggregate demand will further lower output.