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Chapter 28

ECON 1010 - Class Notes - Chapter 28.docx

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ECON 1010
Jean Adams

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CHAPTER 28: Canadian Inflation, Unemployment, and Business Cycle ECON 1010 Week 7 • Inflation cycles o In the long run, inflation is a monetary phenomenon o Inflation occurs if money grows faster than potential GDP o In the short run, many factors can start an inflation and real GDP and the price level interact • There are two sources of inflation: o Demand-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 inAggregate 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 • Arise in the money wage rate occurs o Shortage of labour occurs, money wage create begins to rise o As this happens, price level rises further, and real GDP begins to decrease o Short-run aggregate supply decreases; price level rises further and real GDP begins to decreases  Demand-pull inflation process: • Aggregate demand must persistently increase (since otherwise it would be evened out by the decrease in supply and would not count as inflation) • ForAD to persistently increase, quantity of money must persistently increase • The ongoing rising price level is what creates inflation o Cost-push inflation  Kicked off by an increase in costs caused by: • Increase in money wage rate o If 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) o Same 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 inAggregate 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  Bank of Canada dilemma: Raise money quantity  Inflation decided by oil producers, Not raise money quantity  Employment at below full • Expected Inflation: o Fluctuation 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 o WhenAD 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 o Money theory predicts an expected inflation at full-employment • Forecasting Inflation: o To anticipate inflation, people must forecast it. o Economists work with all available information to create a rational expectation; best forecast possible • Inflation and the Business Cycle: o When the inflation forecast is correct, the economy operates at full employment o If AD grows faster than expected, real GDP rises above potential GDP, with the economy behaving in a demand-pull inflation (expansion) o If AD grows slower than expected, real GDP falls below potential GDP and the inflation rate slows • Inflation and Unemployment: The Phillips Curve o The Phillips curve focuses on the short-run tradeoff and relationship between inflation and unemployment o Helps to study changes in both expected and actual inflation rates o Short-Run Phillips Curve:  Sows the relationship between inflation and unemployment with expected inflation rate and natural unemployment rate held constant (y,x)  Equivalent to the SAS curve in that it brings a higher price level and an increase in real GDP while Phillips curve brings a higher inflation rate and a lower unemployment rate, and vice versa o Long-run Phillips Curve:  Shows the relationship between inflation and the unemployment when the actual inflation rate equals the expected inflation rate  Long-run phillips curve is vertical at the natural unemployment rate  Any expected inflation rate is possible at the natural unemployment rate  SRPC intersects LRPC at the expected inflation rate  If the inflation rate falls, there is a movement down along the LRPC, while the SRPC shifts down o Change in the Natural Unemployment Rate:  SRPC moves to the right/above  LRPC moves to the right  Expected inflation rate generally has a greater effect • The Business Cycle o Mainstream business cycle theory  Potential GDP grow at a steady rate while aggregate demand grows at a fluctuating rate
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