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Lecture

ECON 105 Chapter 30: Inflation and Disinflation

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Department
Economics
Course
ECON 105
Professor
Tony Xiang
Semester
Fall

Description
Chapter 30: Inflation and Disinflation In this chapter you will learn... 1. …that wages tend to change in response to both output gaps and inflation expectations. 2. …how a constant rate of inflation is incorporated into the basic macroeconomic model. 3. …how aggregate demand and supply shocks affect inflation and real GDP. 4. …what happens when the Bank of Canada validates demand and supply shocks. 5. …the three phases of a disinflation. 6. …how the cost of disinflation is measured by the sacrifice ratio. 30.1 Adding Inflation to the Model Why Wages Change Output Gaps. Y > Y*  excess demand for labour Y < Y*  excess supply of labour Expected Inflation. - some workers/firms raise wages in advance of inflation Change in Money Wages = Output-gap Effect + Expectational Effect How do people form their expectations? - forward-looking? - backward-looking? APPLYING ECONOMIC CONCEPTS 30-1 - a combination of both? How Do People Form Their Expectations? From Wages to Prices - Overall effect on nominal wages determines how the AS curve shifts  impact on price level - Actual Inflation = Output-gap + Expected + Supply Inflation Inflation Shock Inflation - The last term captures any shifts in the AS curve caused by things other than wage changes. (eg., change in raw material prices) Constant Inflation - If inflation has been constant for several years and there is no indication of an impending change in monetary policy:  expected inflation will equal actual inflation - If expected inflation equals actual inflation: o  Y must equal Y*  no output gap - But if there is no output gap, what is causing the inflation? - Constant inflation with Y=Y* occurs when the rate of money growth, the rate of wage increase, and expected inflation are all consistent with the actual inflation rate. Constant and sustained inflation: - Wage costs are rising because of expectations of inflation - Expectations are being validated by the central bank (money growth)  Expected inflation = Actual inflation  No output gap (Y=Y*) * Note: - no change in real wages, interest rates, real variables 30.2 Shocks and Policy Responses Demand Shocks - Demand inflation results from a rightward shift in the AD curve. - A demand shock that is not validated produces only temporary inflation. - With monetary validation: - the AD curve shifts further to the right - keeping open the inflationary gap - 0Continued validation turns a transitory inflation into sustained inflation. Supply Shocks - Inflation caused by AS shifts unrelated to excess demand is called supply inflation. - If wages fall only slowly (when Y
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