Case Application: Talk about Inflation. The United States experienced unpreceden

Question

Case Application: Talk about Inflation. The United States experienced unprecedented levels of inflation-unprecedented since price controls were lifted at the end of World War II-in the late 1970s and the beginning of the 1980s. Prices rose at a rate of 13.3% in 1979 and 12.4% in 1980. This rate of inflation was very disturbing to the public and to policy makers in Washington, but compared to inflation rates in some other countries, the U.S. inflation rate was quite tame. Latin American, African, and Eastern European countries have had the highest inflation rates in recent years. Russia had an annual rate of 245% in January 1992, and Poland reached a peak rate of 640% in 1989. However, even the advanced economy of Israel reached an inflation rate of 370% in 1983-84. A tankful of gasoline in Israel cost an amount of shekels that would have paid for the car 5 years earlier. Such extreme inflation rates are the consequence of large government budget deficits and increases in the money supply. When the government is spending more than it collects in tax revenues, the extra money spent by the government is chasing the same resources as the money in the taxpayers' pockets. Hence, the prices of resources and finished products are bid up. When the government finances its deficit spending by putting more money into circulation, it compounds the inflation. Economic Reasoning If dinner in a Tel-Aviv restaurant cost 10 shekels at the end of 1983, what would a restaurant patron have to pay for the same meal at the end of 1984? What types of inflation are described in this application? Why do you think inflation was so much greater in some other countries than in the United States?

Explanation / Answer

1. Formula for calculating price after inflation

Pt = Pt-1 (1+i)

=10*(1+3.74) (374% inflation)

Pt = 47.4 shekels i.e. the price of a Dinner at Tel-Aviv restaurant costed 10 shekels in 1983 and the same costs 47.4 shekels in 1984.

2. In this context the inflation was mainly demand-pull instead of cost-push. Because of high government spending, people were having more money to spend but for the same amount of production and resources. Hence, there was high demand but not a substantial output growth which resulted in demand-pull inflation.

3. US was cautious in government spending unlike other countries which had no limit on their spendings. This has resulted in high inflation in other countries when compared to US.

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