economy is “running on all cylinders,” or at productive capacity. The price level begins increasing, telling us that the
economy is growing. In range 3, total spending is still increasing; however, the economy has virtually all of its resources
employed. This means that as demand increases, it causes the price level to increase. Firms cannot respond to an increase
in demand by increasing output, so they raise prices.
Cost-Push Inflation
Cost-push inflationoccurs on the supply side of goods and services. This type of inflation is seen when producers’
per-unit production costs rise. As goods become more expensive to produce, suppliers raise their prices in efforts to
retain revenue. Raising prices freeze profits and decreases the supply of goods and services in the economy. A major
source of cost-push inflation is supply shocks. Supply shocksare abrupt increases in the costs of production, such as
raw materials and power inputs.
Who Does Inflation Hurt?
Unanticipated inflation hurts fixed-income recipients, savers, and creditors. Fixed incomeis income that remains the
same over a long period of time. As inflation rates increase, the value or the purchasing power of the dollar drops. The
most common example of people on a fixed income are the elderly. They receive pensions or other incomes that are
fixed over a sustained period of time. Landlords with fixed leases are also hurt by inflation because their income may
not be adjusted for a fixed period of time.
Unanticipated inflation hurts savers because accounts that don’t offer interest payments equivalent or higher than infla-
tion rates end up eating away a saver’s purchasing power. If Nicole puts her money in a savings account that yields a
2 percent interest rate each year and the rate of inflation for this year is at 3 percent, Nicole ends up losing 1 percent
of her purchasing power because of inflation. The old saying “Money can’t buy today what it bought yesterday” is true
because of inflation.
Finally, unanticipated inflation hurts creditors and lenders. Suppose Bulldog Bank lends Mr. Valencia $1000 to be repaid
in two years. If during those two years the rate of inflation doubles, the $1000 that Mr. Valencia repays will have only half
the purchasing power of the amount he originally borrowed. As prices rise, the value of the dollar falls.
Who Benefits from Inflation?
Two groups actually benefit from inflation. The first group consists of people on a flexible income who receive a cost-
of-living adjustment (COLA) from their employers. The other group consists of debtors. In our earlier example, Mr.
Valencia benefited from taking out a $1000 loan because inflation minimizes the purchasing power of the money owed.
With inflation, it is easier for debtors to pay back the money they owe.
Review of Key Points
Here’s an overview of the important points we just covered:
■ Market economies have three areas of money flow. Government, firms, and households all exchange the factors
of production for a monetary flow.
■ A product market is one in which firms give households goods and services and, in exchange, households provide
a monetary flow to the firms.
■ A factor market is one in which firms purchase the factors of production from households.
■ Economic growth, efficiency, and full employment are the goals of a market economy.
■ Gross Domestic Product (GDP) is the value of total output in an economy. It can be measured with the income
approach (adding up all incomes) or with the expenditures approach (adding up all expenditures in C, I, G, X).
Only final goods and services count when you’re calculating GDP.Part II: Macroeconomics