Hi, Professor Navarro here. Welcome back to the power of macroeconomics. In this lesson, we're going to discuss in more detail, two of the most important parameters in macroeconomics, Inflation and interest rates. In fact, we talked about inflation and interest rates a lot already in this course. But in this lesson, we need to dig a little deeper and get into some of the finer grained details. You'll soon see this finer grained approach, should help you significantly sharpen and hone your business strategy and management skills. So let's begin with the discussion of inflation and its two main variants, demand pull and cost push. Inflation has often been described as the clueless tax, because it eats away at our savings and at our paychecks. For example, if the rate of inflation exceeds the rate of growth in our paycheck, that means our real income or purchasing power is actually declining even though our wages are going up. This figure illustrates these two main types of inflation, demand pull versus cost push within an aggregate supply, aggregate demand framework. You could see in the left hand figure which illustrates demand pull inflation, how an outward shift in the aggregate demand curve, an AD to AD prime results in an increase in the level of real gross domestic product from Q to Q prime as well as an increase in the price level from P to P prime. By contrast, you can see on the right side an example of cost push inflation. In this case, the aggregate supply curve shifts inward due to a rise in production costs that may come from any number of supply side shocks. For example, a spike in energy prices due to conflict in the Persian Gulf or a spike in food prices due to a worldwide drought. You could see in this case, that the negative supply side shock causes the price level to increase from P to P double prime. However, in addition to this inflation, we get a recessionary shock as well as real GDP downshifts from Q to Q double prime. This is the classic case of stagflation: Simultaneous inflation and slow growth or recession. Knowing the difference between and being able to recognize demand pull versus cost push inflation, can be very important from a business strategy perspective. For example, suppose you run a manufacturing plant that is heavily dependent on energy input to produce your products. Suppose further, that your economic forecasting team is projecting a significant rise in energy prices over the next several years. How might you strategically adapt these potential cost push pressures? Take a minute now, jot down some ideas before moving on. At the highest level of strategy, you may want to revise your economic growth forecasts downward, as higher energy prices are likely to mean a slower rate of GDP growth and a slower rate of growth in demand for your products. So, you may want to reduce your planned level of capital investment in new factories. However, this is even more interesting if you are forecasting a sustained higher level of energy prices. Your company may now find it more economical and prudent to invest in more energy efficient technologies in the production process, in anticipation of this energy shock. Now, what if instead of cost push inflation, you are forecasting and your forecasting team indicates an era of demand pull inflation marked by intense wage pressures. How might you as the chief executive officer strategically respond in this case? Again, please jot down some ideas before moving on. Well here, you might consider substituting more machinery for labor in your production process. Think robotics here. In the broader key concept note here, is how rising labor costs can sometimes lead to the elimination of jobs through capital substitution. A happy day for workers but, a harsh economic reality of the marketplace. Now let's turn to this critical question: Which kind of inflation, demand pool or cost push, do you think might be easier to address using the Keynesian tools of fiscal and monetary policy? Please think about this carefully and jot down some ideas before moving on. It is a very critical question. So which kind of inflation, demand pull or cost push, do you think might be easier to address using the Keynesian tools of fiscal and monetary policy? The answer is clearly demand pull inflation. In the case of demand pull inflation, contractionary fiscal or monetary policy may be used to reduce aggregate demand. However, with cost push or supply side inflation, we are confronted with this Keynesian dilemma. Any attempt to fight cost push inflation, would deepen a recession and any attempt to fight recession, will only exacerbate inflation. This means that, Keynesian discretionary policy tools can only be used to solve half of the stagflation problem at any one time rendering Keynesian fiscal and monetary policy ineffective in the face of stagflation. To better understand the failure of Keynesian activism in a world of stagflation, we have to delve more deeply in our next module into modern inflation theory and the mystery of the Phillips curve.
