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Chapter 30

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ECON 110
Ian James Cromb

Chapter 30: Inflation and Disinflation Adding Inflation to the Model  Recall: Inflation is a rise in the average level of all prices – usually expressed as the annual percentage change in the CPI  In this ch. we modify the model to explain how sustained and constant inflation can exist o Must understand the role of inflation expectations (later on) Why Wages Change Wages and the Output Gap  When real GDP = Y*, the unemployment rate is said to = the NAIRU (non-accelerating inflation rate of unemployment) or natural rate of unemployment (U*) o When Y > Y*, unemployment < U*; when Y < Y*, unemployment > U*  When Y>Y* (or UU*), recessionary gap w. excess supply of labour decrease wages Wages and Expected Inflation  If inflation is expected to increase by X%, employees will want a wage increase of at least X% so as to keep their real wages constant (can buy the same amount of things) o As long as people expect prices to rise, their behaviour will put upward pressure on money wages Overall Effect on Wages  Money Wages = Output gap effect + Expectation effect From Wages to Prices  The net effect of the above two forces determine what happens to the AS curve o If wages rise, then the AS curve will shift up  causing price level to rise o If wages fall, then the AS curve will shift down  causing price level to fall  Actual Inflation = Output gap inflation + expected inflation + supply shock inflation Constant Inflation  If inflation is currently 2% per year & has been for several years, called constant inflation o People w. backward looking expectations will expect it to remain the same o People with forward looking expectations know if BoC leaves it, rate will be same  For the economy as a whole, the expected rate of inflation is the actual rate of inflation  In the absence of supply shocks, if expected inflation = actual inflation, real GDP = Y*  Constant inflation requires both the expectations of inflation (shifts AS) and the continuing expansion of the money supply (shifts AD)  Key point: No output gap effect on wages because wages rise at expected rate of inflation  Interest rates are being kept stable by two equal but offsetting forces Shocks and Policy Responses Demand Shocks  Demand inflation is inflation arising from an inflationary output gap caused, in turn, by a positive AD shock  Assumptions: Y* is constant, there is no ongoing inflation o Implies a starting point in stable LR eql’m w. constant real GDP and price level  If there is a rightward shift in AD, price level and output increases No Monetary Validation  Inflationary gap opens, puts pressure on wages to rise shifting AS curve up  As long as BoC holds money supply constant, the rise in the price level moves the economy upward and to the left along the new AD  reducing the inflationary gap o Eventually gap is eliminated and eql’m established at higher but stable price level Monetary Validation  If an inflationary gap opens and the BoC chooses to sustain these “good economic times” would validate the demand shock by reducing its policy interest rate allow MS to increase o The result would be sustained inflation (not constant inflation) Supply Shocks  Supply inflation is inflation arising from a negative AS shock that is not the result of excess demand in the domestic markets for factors of production No Monetary Validation  Same process: Recessionary gap opens, downward pressure on wages, gap closes  Whenever wages and factor prices fall only slowly in the face of excess supply, the recovery to Y* after a non-validated negative supply shock may take a long time Monetary Validation  Monetary validation of a negative supply shock causes the initial rise in the price level to be followed by a further rise  leads to higher price level than in previous situation Is Monetary Validation of Supply Shocks Desirable?  Possible cost associated with a monetary validation – extends period of inflation o Might lead workers to expect more inflation so AS curve will continue to go up o If BoC continues its policies the AD curve will also shift up = wage-price spiral  The spiral can only be stopped if the BoC stops validating the expected inflation initially caused by the supply shock  some economists say never validate, others say yes Accelerating Inflation  Acceleration hypothesis is the hypothesis that when real GDP is held a
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