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IB ECONOMICS HL

Internal Assessment Inflation

UPDATED ON - 27 APR 2020
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This Economics HL IA is an article that introduces the topic "Inflation" to the students by connecting it to an incident in Venezuela around 2006. It also brings us to an understanding of inflation is directly related to unemployment.

Venezuela Inflation to End 2006 at 16%, Above Target

 

This article deals with several macroeconomic concepts, notably inflation. Inflation is a constant rise in prices over a given time period. The article states that “Venezuelan inflation will accelerate” because of “surges in government spending” due to “record oil income” (Venezuela‟s oil is nationalized) and by President Chavez granting “tax reductions”. The diagram below shows how rises in government spending, which is part of aggregate demand (defined as the total demand for an economy‟s goods and services), will shift the AD curve out and to the right when near or at full employment (AD1 to AD2), resulting in an increase in output from Y1 to Y2 and in inflation from P1 to P2 since aggregate supply becomes vertical. Full employment is when everyone who wants work and is willing to work at the market wage is at work. The inflation mentioned in the article is an example of demand-pull inflation (when total demand for goods and services is greater than the supply at current prices).

 

 

When economist Enrique Alvarez explains that if local industries were running at full capacity then it would “worsen the inflationary front in Venezuela”, he is explaining that the consequences of the inflation will not be as severe, if the economy is below full employment. If the economy is at full employment, then as AD3 grows to AD4 there is no increase in output, but only prices. Prices still rise from P3 to P4 but national output remains the same, therefore there is arguably no positive effect from the inflation.

 

Increased government spending aside, the diagram shows how “faster economic growth” and the “inability of local manufacturers to cope with rising consumer demand” are pushing up the prices. This means an increase in consumption which shifts the AD curve to the right. When the author claims that President Chavez‟s plans to “grant tax reductions” will “spur inflation further”, one should be careful. If tax reductions generate an equal cut in government spending, increased consumer spending will depend on the marginal propensity to consume. If MPC is less then one (if marginal propensity to save is positive), aggregate demand will decrease. The MPC (MPS) is the ratio of the change in consumption (saving) to the change in disposable income.

 

In the article, central bank president Gaston Parra mentions that policymakers aim to use a “combination of measures in the monetary and real spheres” to “combat inflation”. Monetarists believe the link between money and aggregate demand is very strong, and if the economy is at or near full employment, like in Venezuela, growth in the money supply will lead to inflation. Measures mentioned include keeping the “currency fixed against the dollar” thereby indirectly „importing‟ low inflation and credibility from the USA. “Soaking up excess cash in the system” can be done by offering higher interest rates and increasing savings. This way the public will spend less, and the cost of borrowing for businesses increases (due to an increase in interest rates) and thus reduces investment (decrease in AD).

 

Clearly there is a lack of “policy coordination between the government and the central bank”, and as the article states - “that‟s where the failure to control inflation lies”. From the wording of the article, it seems evident that the central bank does have some autonomy, and its main objective is inflation targeting. Although one could guess that political pressures on the central bankers are strong, this attempt to give the central bank independence is commendable, mimicking the setup in the UK, EU, and the USA. Independence is primarily given to solve the problem of time-inconsistency.

 

The argument is that if a government promises to reduce inflation to levels below those compatible with the natural rate of unemployment (the rate when the economy is at full employment and the labor market clears), the rational public will not believe this, as the government will try to increase employment nearing re-elections and temporarily rising inflation. However, although the time-inconsistency is reduced through an independent central bank, another problem of policy coordination arises. Reading the article, it seems that the government and the central bank are playing a tug-of-war, one trying to curb inflation, while the other tries to increase employment.

 

The article demonstrates that an independent central bank will not be as effective at curtailing inflation as it should be if fiscal policy is counteracting monetary policy. Policy coordination is one of many aspects of which President Chavez should be reminded.

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