Question

Vincent Hartnett, Jr., president of Penske Logistics, is confused. Federal Reserve officials have been expressing concerns about a perceived threat of "deflation." In Hartnett's view, cost-push sources of inflationary pressures abound. Hartnett has watched his firm's health care costs jump, including a 9 percent increase within the past year. Fuel costs continue to escalate, and market wages required to retain workers have risen. In response to these cost increases, his firm and others throughout the nation are producing fewer goods and services at any given price level. The implication, at least as far as Hartnett can discern, is that inflation is likely to increase, and he continues to see a steady upward creep in the annual U.S. inflation rate in monthly government reports.

The fact that Fed officials keep fretting about a potential decline in the price level has made Hartnett concerned that the Fed may unexpectedly increase the quantity of money in circulation to try to raise aggregate demand. Such an action, Hartnett worries, would essentially produce an aggregate demand shock that would lead to a higher rate of inflation.

1. How would "cost-push pressures" that Hartnett perceives raise the price level?

2. Why would an unexpected increase in the quantity of money generate inflation?

Answer 1

1. Cost push pressures raise the price level because increase in input costs of production reduce profit margins of producers, who respond by cutting down production levels. This shifts the market supply curve to the left, leading to an increase in market prices and thus Inflation.

2. An unexpected increase in the price level would mean people would have unexpected more income in their hands. This will increase their purchasing power, thereby increasing their aggregate demand for goods and services. This shifts the AD curve to the right, leading to an increase in market price and thus Inflation.