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ECO102H1 (155)

ECO100 - MAR 13

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University of Toronto St. George
James Pesando

Inflation ● Inflation: The rate at which the price level is rising ● Measures of Inflation ○ CPI: Inflation of a domestically consumed basket of good ■ how many dollar it costs to buy year over year ■ depended on what people are consuming ○ GDP deflator: inflation of domestically produced goods ■ nominal value of goods produced in Canada ● => Inflation as a percentage ● Dependent upon the price level, the price level rises after: ○ 1) Short run - expansionary fiscal policy ■ AE changes ■ changes AD - shifts to the right, price level rises ■ increases G, decreases T ● AD to right, increase in price ○ 2) Short run - expansionary monetary policy ■ increase AD by expanding money supply, decreases the interest rate ● Changes the way we spend ○ 3) Long run - when unemployment rate < NAIRU ■ self correction of the economy when there is any inflationary gap ■ overemployment ○ When AD shifts to the right, upward pressure on wages, AS shifts to the left ○ Inflationary output gap: price level is going to rise ○ Overworked: upward pressure on wages: cause AS to contract The Inflation Fallacy ● The fallacy: Inflation robs people of the purchasing power of their income ● Reality: If the price level doubles (inflation = 100%), then income in total must also double. ● GDP: measured by income or expenditure ○ Inflation: Expenditure = income ■ Mary pays john 20 to mow her lawn ● Mary’s expenditure = John’s income = 20 ■ After 100% inflation, Mary will pay John $40 to mow her lawn ● Mary’s expenditure = John’s income = $40 ● The problem: When price level doubles, income will double on average ○ some income will go up by more, some less ○ some incomes will double, and others will not ○ Redistribution of wealth as assigned by inflation ○ inflation creates “winners” and “losers” Winners and Losers ● Winners and losers due to inflation is directly related to whether or not the inflation is anticipated ○ anticipate the right amount ● Anticipated inflation: The inflation rate expected by individual and firms ○ policy outcome ○ when you are at potential, there is constant inflation at an expected rate ■ around 2% ● Unanticipated inflation: The difference between actual inflation and the anticipated rate of inflation ○ Example: ■ Anticipated inflation: 2% ■ Actual: 5% ■ Unanticipated: 3% ○ Its unanticipated inflation that redistributes income and creates winners and losers ● Should be concerned with rate of return ● Wage: purchasing power ○ real wage increase A Wage Negotiation ● Workers and firms are concerned with the real level of wages ○ not nominal ● Suppose: ○ Anticipated inflation is 3% ○ Planned real wage increase is 2% ■ VMP has gone up ○ So: Nominal wage increase will be 5% ● Case 1: Actual inflation = 5% ○ Actual inflation > Anticipated inflation ○ The real wage increase = nominal wage increase - inflation ○ The real wage increase = 0 ○ Workers expected a 2% increase in purchasing power, but got nil ○ Firms expected a 2% increase in real labour cost, but no charge ■ no actual change to input/output
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