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Chapter 30

Chapter 30 Notes

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ECON 110
Ian James Cromb

Chapter 30 – Inflation and Disinflation  Inflation: a rise in the average level of all prices. Usually expressed as the annual percentage change in the Consumer Price Index 30.1 – Adding Inflation to the Model Why Wages Changes  Output gap and expectations of future inflation are causes for wages to change  The output gap influences wages… o Excess demand for labour that is associated with an inflationary gap (Y > Y*) puts upward pressure on money wages o Excess supply of labour associated with recessionary gap (Y < Y*) puts downward pressure on money wages o The Absence of either an inflationary or recessionary gap (Y = Y*) means that demand forces do not exert any pressure on money wages  When GDP = Y*, the unemployment rate is equal to NAIRU (non-accelerating inflation rate of unemployment) designated by U*  NAIRU is not zero because of frictional and structural unemployment (movement of people between jobs)  Inflationary Gap = (Y > Y*) = (U < U*)  Recessionary Gap = (Y < Y*) = (U > U*)  The expectation of inflation causes workers to negotiate increase in money wages from expected base rate to hold real wages constant (even if inflation wouldn’t have actually occurred)  Backward-looking expectations change slowly, some time must pass before a change in the actual rate of inflation provides enough past experience to cause expectations to adjust  Rational Expectations: 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  Forward-looking expectations adjust quickly to changes in events, since they are based on expected economic conditions and government policies  Expectations generally are formed using both techniques, as perfect forward-looking expectations require a greater understanding of the economy than we possess  Changes in Money Wages = Output-Gap Effect + Expectational Effect From Wages to Prices  Net effect of the forces acting on wages determines what happens to the AS curve  Forces pushing up wages (AS shifts up) are inflationary, forces pushing down wages (AS shifts down) are deflationary  Constant Inflation  If inflation and monetary policy have been constant for several years, the expected rate of inflation will tend to equal the actual rate of inflation  In the absence of supply shocks, if expected inflation equals actual inflation, real GDP must be equal to potential GDP  Constant inflation with Y = Y* occurs when the rate of monetary growth, the rate of wage increase, and the expected rate of inflation are all consistent with the actual inflation rate  There’s no output-gap effect operating on wages, wages rise at the expected rate of inflation, and expansion of the money supply validates those expectations 30.2 – Shocks and Policy Responses Demand Shocks  Demand Inflation: inflation arising from an inflationary output gap caused, in turn, by a positive AD shock  With no monetary validation, a positive AD shock creates an inflationary gap, which puts pressure on wages and factor prices to rise, shifting the AS curve upward in turn. This closes the inflationary gap, and equilibrium is sustained at a higher price level  With validation, a positive AD shock creates an inflationary gap, which still puts pressure on wages to rise, shifting the AS curve upwards. However, the AD curve continues to shift further to the right, offsetting the upward shift in the AS curve and leaving an inflationary gap.  Continued validation of a demand shock turns what would have been transitory inflation into sustained inflation fuelled by monetary expansion Supply Shocks  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  With no monetary validation, an upward shift in the AS curve causes price level to rise and pushes output below its potential level, opening a recessionary gap. Pressure mounts for wages and factor prices to fall, and AS will fall back down to its original position at the previous price  When wages and other factor prices fall slowly in the face of excess supply, recovery to potential output after a non- validated negative supply shock with take a long time, potentially causing problems (puts pressure on the bank to enact validation)  With monetary validation, an upward shift in the AS curve is followed by a rightward shift in the AD curve (from validation), which increases overall prices while returning Y to potential  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 to reduce factor prices  Wage-Price Spirals occur when, after validation and resulting sustained inflation, expectations of continued inflation will become stronger and stronger as years pass, so that even if validation is ended workers will continue to ask for raises in wages based around an expected inflation rate they’d come to know from history  To some economists, caution dictates that negative supply shocks should never be validated, in order to avoid a wage-price spiral. Other economists are willing to risk validation in order to avoid the significant, though transitory, recessions that otherwise accompany the supply shocks Accelerating Inflation  Acceleration Hypothesis: when real GDP is held above potential, the persistent inflationary gap will cause inflation to accelerate  Because of this, the Bank of Canada has adopted a formal, static inflation rate of 2%  There are several steps in the acceleration hypothesis… 1. If an inflationary output gap creates excess demand to push up wages by 2% per year, shifting up the AS curve by 2% per year. But after some time, people will come to expect inflation to continue. When expectations are for 2%, along with a demand pressure pushing up wages of 2%, the overall effect will be a 4% increase in wages. Eventually this 4% will come to be expected, and the output gap will continue to rise more rapidly 2. To continue to validate and hold the level of output above Y*, expansionary monetary policy must by implemented to allow the growth rate of money supply to rise. The AD curve must be shifted at an increasingly rapid pace to keep up with the quickly shifting AS curve 3. Rate of inflation must now be increase because of the rapid shifts of the AD and AS curves. The rise in actual inflation causes expected inflation rate to rise, which then causes the actual inflation rate to increase more. This results in a continually increasing rate of inflation.  At any level of unemployment less than the NAIRU, real GDP is above Y*, and the inflation rate tends to accelerate  As long as inflationary output gap persists, expectations of inflation will be rising, which will lead to increases in the actual rate of inflation, according to the acceleration hypothesis  Expectations-Augmented Philips Curve: the relationship between unemployment and the rate of increase of money wages that arises when the output-gap and expectations component of inflation are combined  EXTENSIONS IN THEORY 30-1 PAGE 740  Inflation as a Monetary Phenomenon  Causes of monetary inflation: 1. On the demand side, anything that shifts the AD curve to the right will cause the price level to rise (demand inflation) 2. On the supply side, anything that shifts the AS curve upward will cause the price level to rise (supply inflation) 3. Unless continual monetary validation occurs, the increases in the price level must eventually come to a halt  First two points say that a temporary burst of inflation don’t necessitate a monetary phenomenon (need not have monetary causes and need not be accompanied by monetary expansion). The third point tells us that sustained inflation must be a monetary phenomenon: if prices rise indefinitely, it must be accompanied by monetary policy  Consequences of monetary inflation: 1. In the short run, demand inflation tends to be accompanied by an increa
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