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Chapter 30

ECO 100 Chapter 30- Inflation and Disinflation.docx

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Department
Economics
Course Code
ECO100Y5
Professor
Kalina Staub

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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 Change • Wages and the Output Gap  The excess demand for labour that is associated with an inflationary gap (Y>Y*) puts upward pressure on nominal wages o Unemployment rate will be less than NAIRU; non-accelerating inflation of unemployment , denoted by U* (U < U*) o Excess demand for labour, and wages are assumed to rise  The excess supply of labour associated with a recessionary gap (YU*) o Excess supply of labour, and wages are assumed to fall  The absence of either an inflationary or recessionary gap (Y=Y*) implies that demand forces are not exerting any pressure on nominal wages o Unemployment rate is equal to NAIRU • Wages and Expected Inflation  The expectation of some specific inflation rate creates pressure for nominal wages to rise by that rate  Nominal wages can be rising even if no inflationary gap is present ; as long as people expect prices to rise, their behaviour will put upward pressure on nominal wages  Rational Expectations- The 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 • Overall Effect on Wages  Change in nominal wages = Output gap effect + Expectational effect o Nominal wages rise by %, the net effect of a % increase caused by expected inflation and a % increase caused by the excess demand for labour hen Y > Y* o Nominal wages rise by %, the net effect of a % increase caused by expected inflation and a % decrease caused by the excess supply for labour when Y < Y* From Wages to Prices • The net effect of the two macro forces acting on wages- output gaps and inflation expectations- determines what happens to the AS curve o If the net effect of the output gap effect and the expectational effect is to raise wages, then the AS curve will shift up; increase price level (inflationary) o If the net effect of the output gap effect and the expectaional effect is to reduce wages, the AS curve will shift down; decrease wages (deflationary) • Actual Inflation= Output gap inflation + Expected inflation Supply shock inflation 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 o Wage costs are rising because of expectations of inflation and these expectations are being validated by the central bank • In constant inflation, there is no output gap effect operating on wages; either there is no output gap at all or whatever gap exists is not large enough to create wage adjustments; nominal wages rise exactly at the expected rate of inflation • Constant inflation equilibrium interest rates are being kept by two equal but offsetting forces: 1. Central bank is increased the money supply, which pushes interest rates down 2. Rising prices are increase demand for money and pushing interest rates up 30.2 Shocks and Policy Responses • AD and AS shocks do not influence the level of potential output, Y* Demand Shocks • Demand Inflation- Inflation rising from an inflationary output gap caused, in turn, by a positive AD shock; rightward shift in the AD curve (could be caused by increase in autonomous expenditure or expansionary monetary policy) • Demand inflation sometimes occurs at the end of a strong upswing, as rising output causes excess demand to develop simultaneously in the markets for labour, intermediate goods, and final output • Two assumptions: 1. Y* is constant and 2. Initially there is no ongoing inflation • No Monetary Validation  A demand shock that is not validated produces temporary inflation, but the economy’s adjustment process eventually restores potential GDP and stable prices  Inflationary gap  excess demand= upward pressure on wages  stable price level • Monetary Validation  Con
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