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Chapter 28

Economics 1022A/B Chapter Notes - Chapter 28: Real Wages, Potential Output, Aggregate Demand

3 pages19 viewsFall 2013

Department
Economics
Course Code
Economics 1022A/B
Professor
Jeannie Gillmore
Chapter
28

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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 1960s70s, 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 worlds 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)
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