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Chapter 28

Economics 1022 Chapter 28 notes

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Economics 1022A/B
Jeannie Gillmore

Chapter 28 Inflation Cycles  Inflation: A persistently rising price level o In the long run, occurs when the quantity of money grows faster than potential GDP o In the short run, occurs due to many factors (interaction between price level and real GDP)  Demand-pull inflation: Inflation that starts because aggregate demand increases o Kicked off by any factor that change aggregate demand  Decrease in (1) interest rate (2) tax rate.  Increase in (1) quantity of money (2) government expenditure (3) exports (4) investments stimulated by an increase in future profits. o Given a situation where real GDP equals potential GDP and price level is constant.  The Bank of Canada decides to decrease the interest rate, which causes the quantity of money to increase and the aggregate demand curve to shift right. Due to no change in potential GDP or the money wage rate, the aggregate supply curves remain.  Since the price level and real GDP are where the AD curve intersects the short-run AS curve, the price level rises and real GDP rises above potential GDP.  Unemployment falls below the natural rate, the economy is above full-employment equilibrium, and there is an inflationary gap. Due to the shortage of labour, the money wage rate rises and the short- run AS curve shifts left. The price level rises, and real GDP decreases.  As a result, the price level has increased, and real GDP has returned to equal potential GDP. o The above is a one-time rise in the price level, and for inflation to occur, AD must persistently increase. o AD only persistently increases when the quantity of money persistently increase. o Occurred in Canada during the 1960s–70s, which due to from increases in US and Canada expenditure.  Cost-push inflation: Inflation that is kicked off by an increase in cost o Caused by increase in the money wage rate, or increase in the money prices of raw material o Given a situation where real GDP equals potential GDP and price level is constant.  The world’s oil producers decide to price-fix and increase the relative price of oil, which causes the price level to increase and for short-run AS curve to shift left. Real GDP decreases, the economy is at below full employment equilibrium. The recessionary gap causes unemployment to rise above its natural rate.  An outcry of concern calls for action to restore full employment, and as such, AD curve shifts rightward and full employment is restored. But the price level rises even further.  As a result, price level has increased, and real GDP has returned to equal potential GDP. o The above is a one-time rise in the price level and for inflation to occur, the quantity of money must persistently increase, and something must cause a one-time supply shock. o The Bank of Canada has a dilemma in that, if it does not respond to the rise in prices, the economy remains below full employment, and if it does, another spike in oil price and price level is expected. o Stagflation: Combination of inflation and recession (occurred in 1970s in Canada)  Expected inflation: If inflation is expected, the fluctuations in real GDP are not accompanied by demand/cost pull inflation, and inflation proceeds as it does in the long-run. o In anticipation of increase in aggregate demand, money wage rate rises and short-run AS curve shifts left. o If aggregate demand turns out to be same as expected, the price level rises at an inflation rate that is expected. o Quantity theory of money does not explain fluctuations in inflation, as it assumes AD changes as expected.  Rational expectation: The best forecast of inflation possible, that uses all possible information o Not necessarily correct, if the information provided is lacking or wrong o When inflation forecast is correct, economy is at full employment. o If aggregate demand grows faster than expected, real GDP rises over potential GDP, and behaves like it does in a demand-pull inflation. o If aggregate demand grows more slowly than expected, real GDP falls under potential GDP, and behaves like it does in cost-pull inflation. Philips Curve  Philips curve: A curve that shows a relationship between inflation and unemployment o Shows clearly the changes in expected and actual inflation rates than AS-AD model o Shows short-term trade-offs between inflation and real economic activity (real GDP and unemployment)  Short-run Philips curve: o Shows the relations
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