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Chapter 28

ECON 1010 Chapter Notes - Chapter 28: Phillips Curve, Real Business-Cycle Theory, Potential Output

8 pages42 viewsWinter 2014

Department
Economics
Course Code
ECON 1010
Professor
Jean Adams
Chapter
28

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CHAPTER 28: Canadian Inflation, Unemployment, and Business Cycle
ECON 1010
Week 7
Inflation cycles
oIn the long run, inflation is a monetary phenomenon
oInflation occurs if money grows faster than potential GDP
oIn the short run, many factors can start an inflation and real GDP and the price
level interact
There are two sources of inflation:
oDemand-pull inflation
Inflation that starts because aggregate demand increases is called demand-
pull inflation
Can be triggered by anything that changes aggregate (interest rate,
increase in quantity of money, increase in G etc.)
Initial Effect of Increase in Aggregate Demand:
Price level rises
Real GDP increases above potential GDP (if previous equilibrium
was at potential GDP)
Unemployment falls below natural rate
An above full-employment economy creates an inflationary gap
A rise in the money wage rate occurs
oShortage of labour occurs, money wage create begins to
rise
oAs this happens, price level rises further, and real GDP
begins to decrease
oShort-run aggregate supply decreases; price level rises
further and real GDP begins to decreases
Demand-pull inflation process:
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Aggregate demand must persistently increase (since otherwise it
would be evened out by the decrease in supply and would not
count as inflation)
For AD to persistently increase, quantity of money must
persistently increase
The ongoing rising price level is what creates inflation
oCost-push inflation
Kicked off by an increase in costs caused by:
Increase in money wage rate
oIf money wage rate rises, firms decrease supply of goods
and services because of higher production costs
Increase in money prices of raw materials (mostly oil)
oSame as above
At a given price-level, the higher the cost of production, the smaller the
number of firms willing to produce
Initial Effect of a Decrease in Aggregate Supply:
Oil producers come together to raise oil prices
SAS curve shifts to the left
Price level rises
Real GDP decreases
Economy, previously at full-employment equilibrium, is now at
below-employment equilibrium
Aggregate demand response: Bank of Canada, worried about
decreased GDP, increases quantity of money, thus increasing
aggregate demand and restoring full employment but further
raising price level
Prices rise for oil producers, who raise their prices once again
If the effect described above occurs repeatedly (due to an increase in the
amount of money by the Bank of Canada), inflation occurs
The combination of a rising price level and decreasing real GDP is called
stagflation
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Bank of Canada dilemma: Raise money quantity  Inflation decided by oil
producers, Not raise money quantity  Employment at below full
Expected Inflation:
oFluctuation in real GDP doesn’t occur if inflation is expected, but instead real
GDP stays equal to potential GDP and inflation proceeds as it would in the long-
run
oWhen AD is expected to increase:
Potential, real GDP do not change, therefore LAS does not change
Money wage rate rises in anticipation; SAS curve shifts leftward
If money wage rate growth = inflation, then SAS moves to a point where
short term equilibrium will be at the same amount of real GDP
Price level rises by an expected amount
oMoney theory predicts an expected inflation at full-employment
Forecasting Inflation:
oTo anticipate inflation, people must forecast it.
oEconomists work with all available information to create a rational expectation;
best forecast possible
Inflation and the Business Cycle:
oWhen the inflation forecast is correct, the economy operates at full employment
oIf AD grows faster than expected, real GDP rises above potential GDP, with the
economy behaving in a demand-pull inflation (expansion)
oIf AD grows slower than expected, real GDP falls below potential GDP and the
inflation rate slows
Inflation and Unemployment: The Phillips Curve
oThe Phillips curve focuses on the short-run tradeoff and relationship between
inflation and unemployment
oHelps to study changes in both expected and actual inflation rates
oShort-Run Phillips Curve:
Sows the relationship between inflation and unemployment with expected
inflation rate and natural unemployment rate held constant (y,x)
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