The Right Way to Beat Chinese Inflation

High inflation is threatening social stability in China, soaring from 3.3 percent in March 2007 to 8.3

percent in March 2008. China's accelerating inflation reflects a similar climb in its GDP growth rate, from

11 percent in 2006 to 11.5 percent in 2007. The proximate cause of price growth since mid-2007 is the

appearance of production bottlenecks as domestic demand exceeds supply in an increasing number of

sectors, such as power generation, transportation, and intermediategoods industries. The prolonged

rapid increase in Chinese aggregate demand has been fueled by an investment boom, as well as a

growing trade surplus.

Source: Brookings Institution, July 2, 2008

a) Is China experiencing demand-pull or cost-push inflation? Explain.

b) Draw a graph to illustrate the initial rise in the price level and the money wage rate response to

a one-time rise in the price level.

c) Draw a graph to illustrate and explain how China might experience an inflation spiral.