Definitions & Diagrams:
Definitions & Diagrams:
This commentary will explore the inflation and its causes in China, as well as evaluating it in terms of pros and cons. This article on inflation from BBC News on May 11, 2011 states that China’s inflation has slightly cooled due to the government’s efforts to ease inflation. This inflation that has been a concern for China comes about from the surge in economic growth, where the GDP and the living state of people increase, and the rise in prices.
Inflation is when the general prices of goods and services increase within an economy. There are essentially two types of inflation – demand pull inflation and cost push inflation. In theory, when the aggregate demand, the total demand for a good or service in a given time period, increases, and when the aggregate supply, the total amount of goods and services that an industry can produce at a given time period, decreases, there is inflation within the economy.
Figure 1 shows a cost-push inflation, where the aggregate supply decreases. Because this AS curve shifted to the left, the real GDP has decreased from Y1 to Y2, but the price levels have increased from P1 to P2. As the article explains that “rising food, fuel, and housing prices” has been problematic, this shows that there has been a cost push inflation.
Another type of inflation is the demand-pull inflation shown in Figure 2. As you can see, the aggregate demand increases. This causes inflation as well because both the real GDP and the price levels increase from Y1 to Y2 and from P1 to P2. In China, there has been an economic growth, and we can assume that this has resulted in an increase in demand.
To decrease inflation, there can be two things that can be done. Fiscal policy, which is the use of government expenditure and taxation to manage the economy, and monetary policy, which is the use of interest rates and money supply changes to manage the overall level of demand in the economy. The use of both policies will in theory help reduce inflation.
In China, only the monetary policy is used to reduce inflation. In the article, it explains how “the government’s previously loose monetary policy was the fundamental driver behind price rises”. As shown in Figure 3, the AD curve has shifted to the left, as monetary policies usually deals with the demand side, which results in a fall in inflation. This can be seen as food, fuel and housing prices have remained high; however, it has fallen 0.5% from 11.7% last month to 11.2%, and in addition China’s central bank “raised the cost of borrowing four times since October, and asked banks to hold more money instead of lending it out”. Such policies led to a fall in the annual inflation rate to 5.3%.
To evaluate China’s actions in attempting to reduce inflation, pros and cons are an aspect to look at. The government of China’s attempts to decrease inflation with monetary policies has helped the demand side to fall which is a good thing; however, it does not really describe actions that would deal with the supply side. Inflation does not only deal with the demand side, and so there is a necessity to also deal with the supply side. To do so, they will need to deal with fiscal policy. Although it explains in the article that “investment in fixed assets such as roads, buildings and factories also climbed”, that is not enough to help the supply-side. However, assuming that China does not want to deal with the supply-side as much because they do not want to provoke any more unemployment, their actions in reducing inflation is successful.
I think that this group presentation was overall a really good preparation for the exam that we will take in a few weeks, because these kind of real world examples with particular situations are the type of questions that will often show up on the exam. I was in charge of being the speaker, and during the rehearsals I was doing fine but when it came to the real presentation it self, I became somewhat nervous because the place we were in was the conference room and the situation was fairly formal. Particularly during the question section, when H.M. Jorgensen asked how we need to focus more on the business side and asked how exactly we will help him, our group struggled a little because we did not know that we had to focus on the business side before the people. However, I think that our group was able to answer all questions thoroughly and so overall I am very pleased with our outcome. From this project, I was able to understand macroeconomics better with the use of a real world situation.
There are several things that the government can do about fiscal policy that will increase aggregate demand (AD). AD, which is the total spending on goods and services at a given time at a certain price level consists of consumption, investment, government spending, and exports – imports. A period of time when you want to increase AD may be when there was deflation, where there were few demand on goods and services (eg. households buys fewer products). Or another scenario may be when there was a decrease in aggregate supply, which is the total amount of goods and services that all industries can produce at a certain price level. This fall in AS may have been caused by a natural disaster, or increase in wages that would need and increase in AD. Solutions to such scenarios are the fiscal policy, which are actions taken by the government that involve government spending and taxes to achieve the macroeconomic goals (price stability, external stability, growth, employment).
Figure 1 shows the increase shift in AD caused by changes in the fiscal policy. If the government increases government spending on goods and services such as school and hospitals, that would be one way of increasing AD. Another way is to decrease tax, specifically income tax. By decreasing income taxes, there would be more income for households to spend on, which will create and increase in AD.
So therefore, to increase the aggregate demand curve, there could be solutions made by changes in the fiscal policy that the government takes control of.
How can demand and supply side policies help people like W. Jorgensen?
W. Jorgensen is a businessman who is not very happy due to the decreasing demand of his company’s cars, and is worried about the cost of his labour force. To help someone like him, we can use demand and supply side policies.
For demand side policies, we can do something like “Cash for Clunkers”, where it encourages people to buy eco-friendly cars. By doing something like this, the government will be able to help businessmen such as W. Jorgensen by aiding them with money. The problem that this policy will encounter is that because we know that we cannot increase the government spending (as that will increase debt), we will have to think of a way to reallocate the spending ratios.
On the other hand, if we were to use supply side policies, we should decrease the payment of unemployed workers so that they will not rely so much on the benefits as a unemployed and will be encourage to be employed. Another solution may be to decrease the demand for oil so that the prices will drop.