CHAPTER 30 – INFLATION AND DISINFLATION
- That wages tend to change in response to both output gaps and inflation expectations
- How a constant rate of inflation is incorporated into the basic macroeconomic model
- How AD and AS shocks affect inflation and real GDP
- What happens when the Bank of Canada validated demand and supply shocks
- Three phases of a disinflation
- How the cost of disinflation is measured by the sacrifice ratio
Inflation: a rise in the average level of all prices. Usually expressed as the annual percentage change in
Peaked in 1974 (12%) and 1981 (13%). Current : around 2%.
Anticipated vs unanticipated.
If firms and workers have difficulty predicting what inflation will be, they have problems determining
how wages and prices should be set. Unexpected changes in real wages and relative prices as inflation is
different than expected. Lead to different allocation of resources.
30.1 ADDING INFLATION TO THE MODEL
In our macroeconomic model so far – inflation was only temporary. Economy’s adjustment process
always pushed economy back toward Y*with stable price level.
Why Wages Change
Increases in wages led to increases in unit costs – maintained assumption that productivity/technology
Thus, as wages and factor prices rise, unit costs increase and the AS curve shifts up.
What causes wages to change?
1. Output gap
2. Expectations of future inflation
Wages and the Output Gap
Three propositions on how money wages influenced by output gap:
1. Excess demand for labour with inflationary gap – upward pressure on money wages
2. Excess supply of labour associated with recessionary gap – downward pressure on money wages
3. Y = Y* - no pressure on money wages
At Y = Y* - NAIRU – non-accelerating inflation rate of unemployment. Also known as natural rate of
Not zero – includes frictional and structural unemployment.
Inflationary gap – unemployment rate less than NAIRU – excess demand for labour – wages rise
Recessionary gap – unemployment rate will exceed NAIRU – excess supply of labour – wages fall
Wages and Expected Inflation
If 3% inflation is expected, workers will start negotiations from base of 3% increase in money wages.
Firms will start by conceding 3% because they expect the prices of their profits to go up by that much.
The expectations of some specific inflation rate creates pressure for money wages to rise by that rate.
Money wages can rise even without inflationary gap. As long as they expect prices to rise, their
behaviour will put upward pressure on money wages. Every year since WW2, nominal wages have increased because price level has been expected to
How do people form their expectations?
- Backward looking – look at past to predict future.
o Expect past to be repeated.
o If inflation was 5% last year, expect it to be 5% the next year. Naïve.
o Less naïve – revise expectations in light of the mistakes in estimating in the past.
Thought it was 5% but ended up being 3% - will revise estimate for next year down.
o Backward-looking expectations tend to change slowly because some time must pass
before a change in the actual rate of inflation provides enough past experience to cause
expectations to adjust.
- Forward-looking – look to current conditions to estimate future
o Some look to macroeconomic policy – predict outcomes of policies being followed
o Rational expectations: the theory that people understand how the economy works and
learn quickly from their mistakes so that even though random errors may be made,
systematic and persistent errors are not. Makes best possible use of information to
o Forward-looking expectations can adjust quickly to changes in events. Instead of beings
based on past inflation rates, expected inflation is based on expected economic
conditions and government policies.
Just backward is pretty naïve, but assumption of ‘fully rational’ expectations requires workers to have
more understanding of economy than they likely have. Probably combination.
Overall effect on wages
Change in money wages = output-gap effect + expectational effect
What happens to wages is net effect.
Ex: labour and management expect 3% inflation and allow money wages to increase by 3%. Real wages
unchanged. Inflationary gap and associated labour shortage – causes wages to rise by additional 2%.
Wages thus rise by 5% - 3% increase expected inflation and 2% increase by excess demand labour.
From Wages to Prices
The net effect of the two forces acting on wages – output gaps and inflation expectations – determines
what happens to the AS curve.
Net effect – raise wages – price level will rise – inflationary forces pushing wages up.
Net effect – reduce wages – AS will shift down – deflationary wages reducing wages.
Anything that leads to higher wages shifts AS up and leads to higher prices.
Two component parts inflation caused by wage increases: output-gap inflation and expected inflation.
Also – non-wage supply shock son the AS curve and thus price level. Ex: prices raw materials.
Actual inflation = output-gap inflation + expected inflation + supply-shock inflation
Even if Y = Y* and no inflation is expected, a supply shock can increase price level.
Constant – has been 2% for several years Those with backward looking expectations about inflation will expect actual level to continue. Those
with forward looking expectations will also expect it to continue in absence of changes in monetary
If inflation and monetary policy have been constant for several years, the expected rate of inflation will
tend to equal the rate of inflation.
In the absence of supply shocks, if expected inflation equals actual inflation, real GDP must be equal to
Both workers and employers expect 2 percent inflation.
So wages are raised by 2%. And AS curve shifts up by that amount.
But in order for expected to be the actual rate of inflation, AD must also shift up at a 2% rate – caused
by growth in the money supply.
So no output-gap inflation and actual and expected inflation are equal.
Constant inflation with Y = Y* occurs when the rate of monetary growth, the rate of wage increase, and
the expected inflation are all consistent with the actual inflation rate.
No output-gap effect operating on wages. Wages rise at expected rate of inflation and expansions of
money supply validate those expectations.
Interest rates are being kept stable by offsetting forces
- Central bank is increasing the money supply, which tends to push interest rates down
- Rising prices are increasing demand for money and pushing interest rates up
Equilibrium – interest rates left unchanged.
Is Deflation a problem?
Fear of it stems from belief that deflation causes a decline in economic activity.
How? Prices are falling – firms and consumers delay spending because they know prices will be lower in
future. Leads to leftward shift in AD curve and decline in rGDP.
- Deflation during Great Depression likely result rather than cause of economic events. Major
decline in AD, caused leftward shift, reducing both rGDP and price level.
- If deflation is only 1-2%, unlikely people would really delay purchases.
30.2 SHOCKS AND POLICY RESPONSES
Constant rate of inflation is special case – rising price level not caused by inflationary gap.
Many cases, inflationary pressure is initially created by an aggregate demand or supply shock.
Assumption: level of potential output independent of the path of real GDP. Shocks that led to shifts in
AD or AS curves were assumed to have no influence on the level of potential output, Y*.
In terms of NAIRU – path of actual unemployment rate does not affect the value of U*.
Implication – following AD or AS shocks, economy’s adjustment process returns real GDP and
unemployment to Y* and U*.
Demand inflation: inflation arising from an inflationary output gap caused, in turn, by a positive AD
shock. Shift in AD due to things like reduction in tax rates, increase in autonomous expenditure like I, G, NX, or
by expansionary monetary policy.
Major demand shock inflations after WW1 and WW2 – large increases G without offsetting increase in
taxes. Y > Y*.
- Y* is constant
- No ongoing inflation
Starting point – stable-long-run equilibrium with constant real GDP and price level
Disturbed by rightward shift in the AD curve. Causes price level and output to rise.
No Monetary Validation
Initial rise in AD – output above potential and inflationary gap opens up.
Pressure of excess demand causes wages to rise, shifting AS curve upward.
As long as money supply is held constant, rise in price level moves economy upward and to the left,
reducing inflationary gap.
Equilibrium established at Y* with higher price level.
Initial period of inflation followed by further inflation until long-run equilibrium is reached.
After demand shock created inflationary gap, Bank of Canada validates demand shock by reducing its
policy interest rate and allowing the money supply to increase.
- Spurred by inflationary gap, increase in wages causes AS to shift upward
- Expansionary monetary policy – AD shifts further to the right
Price level rises, but real GDP remains above Y*.
Continued validation of a demand shock turns what would have been transitory inflation into sustained
inflation fuelled by monetary expansion.
Bank chooses to sustain ‘good economic times’ characterized by high output and low unemployment.
Result – sustained inflation.
Supply inflation: inflation arising from a negative AS shock that is not the result of excess demand in the
domestic markets for factors of production
Ex: rise in costs of imported raw materials, rise in domestic wages not due to excess demand
Initial effects – price level rises while output falls.
No Monetary Validation
Upward shift in AS causes price level to rise and pushes output below Y*, opening up a recessionary gap.
Pressure for money wages and other factor prices to fall. Unit costs fall. So AS shifts down, increasing
output while reducing price level. Returns to Y*. price level back to initial value.
Concern – speed of adjustment.
Whenever wages and other factor prices fall only slowly in the face of excess supply, the recovery to
potential output after a non-validated negative supply shock may take a long time.
Monetary validation (lowering interest rates and allowing money supply to increase) shifts the AD curve
to the right and closes the output gap.
Price level rises further, rather than falling back to its original value. Monetary validation of a negative supply shock causes the initial rise in the price level to be followed by a
further rise, resulting in a higher price level than would occur if the recessionary gap were relied on the
reduce factor prices.
Supply-shock inflation – OPEC oil-price shock. Bank of Canada validated it with large increases in money
supply. Large increase in price level but no recession.
Is Monetary Validation of Supply Shocks Desirable?
Validate negative supply shock – prevent what could otherwise be a protracted recession. Sounds like
good policy. But cost – extend period of inflation. Can lead firms/workers to expect further inflation. AS
would continue to shift upward and Bank’s validation would keep AD shifting upward – wage-price
Can be halted only if Bank stops validating inflation. Longer it waits – expectations will be more firmly
May cause wages to rise after validation