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Chapter 28 Notes.docx

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Department
Economics
Course
Economics 1022A/B
Professor
Jeannie Gillmore
Semester
Summer

Description
Chapter 28 Notes Demand-Pull Inflation  an inflation that starts because aggregate demand increases is called demand-pull inflation o can be initiated by any factors that change aggregate demand:  fall in the interest rate  increase in the quantity of money  an increase in government expenditure  tax cut  increase in exports  increase in investment stimulated by an increase in expected future profits  initial effect o suppose the Bank of Canada cuts the interest rate o the quantity of money increases and the aggregate demand shifts rightward o the price level and real GDP are determined by the point where the aggregate demand curve intersects the SAS  the price level rises, and real GDP increases above potential, leading to an inflationary gap  money wage rate response o with unemployment below its natural rate, there is a shortage of labour, which causes the money wage rate to rise  SAS decreases and shifts leftward  price level rises further and real GDP decreases  this continues until real GDP is back at potential  GDP is back at original level, but at a higher price level  demand-pull inflation process o for inflation to proceed, aggregate demand persistently increases  caused by persistent increases in the quantity of money o suppose that every day, the BoC buys bonds in an open market operation  when the BoC buys bonds, it creates monetary base and an expanding monetary base increases the quantity of money  if the quantity of money keeps growing, aggregate demand keeps increasing  aggregate demand keeps increasing  the persistent increase in aggregate demand puts continual upward pressure on the price level  demand-pull inflation occurred in Canada during the late 1960s and early 1970s o resulted from increases in aggregate demand due to:  large increase in US government expenditure and the quantity of money in the US  increased world aggregate demand  increase in Canadian government expenditure and quantity of money Cost-Push Inflation  inflation that is kicked off by an increase in costs is called cost-push inflation, which sources from: o an increase in the money wage rate o an increase in the money prices of raw materials  at a given price level, the higher the cost of production, the smaller is the amount that firms are willing to produce o aggregate supply decreases and the short-run aggregate supply curve shifts leftward  initial effect of a decrease in aggregate supply o in the current year, the world’s oil producers form a price-fixing organization that strengthens their market power and increases the relative price of oil o if the price of oil goes up, SAS decreases and shifts leftward  the price level rises, and there is a recessionary gap o on its own, a supply shock cannot cause inflation  for on going inflation to occur the quantity of money must persistently increase  aggregate demand response o when real GDP decreases, unemployment rises above its natural rate  public outcry of concern and a call for action to restore full employment o the BoC cuts the interest rate and increases the quantity of money, causing aggregate demand to increase  shifts rightward, restoring full employment, but at a higher price level  cost-push inflation process o the oil producers now see the prices of everything they buy increasing, so they increase the price of oil again o if the BoC responds again, there will be another increase in the price level when full employment is restored o the combination of a rising price level and decreasing real GDP is called stagflation  with this process, the BoC has a dilemma  if it responds, price level increases, if it doesn’t, we are below full employment  a cost-push inflation occurred in Canada during the 190s o OPEC continually increases the price of oil , leading to high inflation o in 1980, Canada did not respond to the oil price hike  recession occurred, but inflation eventually fell Expected Inflation  if inflation is expected, fluctuations by demand-pull or cost-push do not occur o inflation proceeds as it does in the long run, with real GDP equal to potential GDP at full employment  suppose that aggregate demand is expected to increase o in anticipation of this increase, the money wage rate rises and the short-run aggregate supply curve shifts leftward o if aggregate demand turns out to be the same as expected, the economy will experience an inflation rate equal to that expected  if this inflation is ongoing, aggregate demand increases in the following year and etc.  this account of the inflation process and its short run effects show why the quantity theory of money doesn’t fully explain the fluctuations in inflation Forecasting inflation  the best forecast of expected inflation is called a rational expectation o not necessarily correct  simply the best forecast with the information available Inflation and the Business Cycle  when the inflation forecast is correct, the economy operates at full employment o if aggregate demand grows faster than expected, real GDP rises above potential GDP and the economy behaves like it does in a demand-pull inflation o if aggregate demand grows more slowly than expected, real GDP falls below potential GDP and the inflation rate slows Short-Run Phillips Curve  the SRPC shows the relationship between inflation and unemployment, holding both the expected inflation rate and the natural unemployment rate constant  if inflation rises above its expected rate, unemployment falls below its natural rate o this joint movement in the inflation rate and the unemployment rate is illustrated as a movement up along the SRPC  if inflation falls below its expected rate, unemployment rises above its natural rate o there is then a movement down along the SRPC  the SRPC is like the short run aggregate supply curve o a movement up along the SAS curve that brings a higher price level and an increase in real GDP is equivalent to a movement up along the SRPC that brings an increase in inflation and a decrease in the unemployment rate o a movement along the SAS curve that brings a lower price level and a decrease in real GDP is equivalent to a movement down along the SRPC that brings a decrease in inflation and an increase in the unemployment rate Long-Run Phillips Curve  the LRPC shows the relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate o the LRPC is vertical at the natural unemployment rate o tells us that any expected inflation rate is possible at the natural unemployment rate  the SRPC intersects the LRPC at the expected inflation rate o a change in the expected inflation rate shifts the SRPC but not the LRPC  an increase/decrease in the expected inflation rate corresponds to a movement down/up the LRPC  a change in the natural unemployment rate shifts both the long run and short run Phillips curves  example: o if the natural unemployment rate increases from 6 to 9 percent, the LRPC shifts rightward, and if expected inflation is constant, the SRPC shifts rightward as well  because the expected inflation rate is constant, the SRPC intersects the LRPC at the same inflation rate  overall, changes in both the expected inflation rate and t
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