800 "
© 2014 Pearson Canada Inc."- Why a cost-push inflation is a monetary phenomenon? Use the appropriate graph to support
your answer.
Answer: Students must use a graph similar to the one below. Initially the economy is on point 1
with an aggregate output equal to the normal rate output. Supposing that workers succeed in
seeking higher wages as they want to increase their real wages. The effect of such an increase
will be similar to a negative supply shock and will shift the short-term aggregate supply curve to
the left so that the economy slides to point 1'. If we have an activist government with a high
employment target point 1' is associated with increased unemployment and lower output, so the
government will implement policies to raise the aggregate demand and shift the aggregate
demand curve to AD 2 so that we will return to the natural rate level of output at point 2 with a
higher price level. Workers may be encouraged to seek even higher wages due to the increased
price level and if they succeed and the government continues to accommodate this the economy
will move from point 2 to 2', 3, 3', and 4 on the graph. But the continuous shift of the demand
curve to the right cannot be sustained by fiscal policy as government spending and tax cuts have
limits. This policy can only be sustained to create inflation only with an increasing money
supply. Thus, a cost-push inflation is a monetary phenomenon because it cannot occur without
the monetary authorities pursuing an accommodating policy of a higher rate of money growth.
Diff: 3 Type: SA Page Ref: 615
Skill: Recall
Objective List: 26.3 Explain Milton Friedman's famous proposition that "inflation is always and
everywhere a monetary phenomenon"