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Chapter 30

Economics 102: Chapter 30

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University of British Columbia
ECON 102
Robert Gateman

Economics 102: Principles of Macroeconomics Chapter 30  Inflation: rise in the average level of all prices o Usually expressed as the annual percentage change in the CPI  Unexpected inflation can effect a firm's ability to predict wage and price increases o Lead to changes in the allocation of resources 30.1 Adding Inflation to the Model Why Wages Change:  As wages and other factor prices rise, unit costs increase and the AS curve shifts up o When wages and other factor prices fall, unit costs fall and the AS curve shifts down Wages and the Output Gap:  NAIRU (non-accelerating inflation rate of unemployment): when real GDP is equal to Y* o Also known as the natural rate of unemployment (U*) o Accounts for frictional and structural unemployment o Unemployment is less than NAIRU in an inflationary gap o Unemployment is more than NAIRU in a recessionary gap Wages and Expected Inflation:  If there is expected inflation workers negotiate a wage increase started at expected inflation o Firms expect to sell their outputs for the percentage of expected inflation  The behaviour of people expecting prices to rise will put upward pressure on money wages  Rational expectations: theory that people understand how the economy work and learn quickly from their mistakes so that even though random errors may be made, systematic and persistent errors are not Overall Effect on Wages:  Changes in money wages = Output-gap Effect + Expectational Effect  If wage increases are in line with inflation, real wages have not changed From Wages to Prices:  Output gaps and inflation expectations also determine what happens to the AS curve  If the net effect is to raise wages, the AS curve will shift up and the price level will rise (inflationary)  If the net effect is to reduce wages, the AS curve will shift down (deflationary)  Inflation caused by wage increases is two parts: output gap inflation and expected inflation o There are also shifts to the AS curve that are not wage related  Actual Inflation = Output Gap Inflation + Expected Inflation + Supply Shock Inflation Constant Inflation:  People with backward looking expectations about inflation will expect the actual level to continue o 2% two years ago, 2% last year, expected 2% increase this year, etc. Economics 102: Principles of Macroeconomics  In the absence of supply shocks, if expected inflation equals actual inflation, real GDP = Y*  If the AS curve is shifting up 2% from inflation expectations, the AD curve must also shift up that must in order to create the 2% equilibrium o AD curve is shifted by the growth of the money supply (BOC)  Validating: central bank increases the money supply at such a rate that the expectations of inflation end up being correct  Constant inflation: when the rate of monetary growth, the rate of wage increases, and the expected rate of inflation are all consistent with the actual inflation rate o Constant-inflation equilibrium, no output gap, and no changes in the interest rate 30.2 Shocks and Policy Responses  Often inflationary pressure is initially created by AD or AS shocks  Assume that the fluctuations of U do not actually change U* in the long-term o U* is determined by policy and institutional factors Demand Shocks:  Demand inflation: any right shift in the AD curve that creates an inflationary output gap o Caused by reduction in tax rates, increase in autonomous expenditure, investment, government, net exports or expansionary monetary policy o Caused by an increase/excess of demand in the market (for intermediate goods and labour)  The AD shift causes an increase in output and the price level o This is different than the validation process by the BOC No Monetary Validation:  AD shift creates excess demand, and pushes wages up, this shifts the AS curve upward o Rise in the price level shifts the AS curve up and back to an equilibrium (closed gap)  Only if the BOC holds the money supply constant o The inflationary gap is eliminated, but the new equilibrium is at a higher price level Monetary Validation:  As the AD shifts to create an inflationary gap the BOC could continue good economic times by validating the demand shock by decreasing the interest rate (increasing money supply) o The AS curve shifts up because of higher wages, AD curve shifts further because of interest rates o The price level rises and real GDP remains above Y*  Continued validation of a AD shock turn what would have been transitory inflation into sustained inflation fuelled by monetary expansion o BOC looks to continue high output and low unemployment in the good economic times Supply Shocks:  Supply inflation: any left shift in the AS curve that is not caused by excess demand in the market for factors of production Economics 102: Principles of Macroeconomics o Rise in the costs of material goods, rise in domestic wages (not caused by excess demand)  Negative supply shocks cause the price level to rise but the output level to drop o The BOC reacts and allows the money supply to increase (validates the AS shock)  If the BOC holds the money supply constant, the AS shock is not validated No Monetary Validation:  Upward shift in the AS curve causes the price level to rise, output is below Y* o Downward pressure on prices and money wages  As prices and wages begin to fall, factor prices also begin to fall o The AS curve will then shift down, which increases output and decreases the price level  AS curve will shift down until real GDP is equal to Y*, and the price level returns  If wages do not fall quickly, the adjustment process could be extended o Slow wage adjustment slows the recovery process when there is no validation Monetary Validation:  If the BOC responds to a negative supply shock by validating, there is a shift in the AD curve
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