14.1 Adding Inflation to the Model

Question 1

How have we treated inflation in previous chapters?

Answer 1

In other words, any inflation we have so far seen in our model was temporary—it existed only while the economy was adjusting toward its long-run equilibrium in which .

In this chapter we modify our model to explain how constant inflation can exist. After all, even though Canadian inflation is very low by recent historical standards, over the past two decades it has been sustained and relatively stable at an average rate of 2 percent.

Question 2

What is key to understanding sustained inflation?

Answer 2

inflation expectations are key to understanding sustained inflation. When combined with excess demand or excess supply, as reflected by the economy’s output gap, such expectations give us a more complete explanation of why costs and prices change.

Question 3

What are the macroeconomic forces that cause the general level of nominal wages to change?

Answer 3

• Output gap
• Expectations of future inflation.

Question 4

In Chapter 9, we encountered three propositions about how changes in nominal wages are influenced by the output gap…

Answer 4

Question 5

What is NAIRU and what does it stand for?

Answer 5

When real GDP is equal to , the unemployment rate is said to be equal to the NAIRU, which stands for the non-accelerating inflation rate of unemployment and is designated by U*

Question 6

What is the realationship between real GDP, unemployment and the NAIRU?

Answer 6

Question 7

What is the relationship between nominal wages and excess demand or supply?

Answer 7

Question 8

How does expected inflation influence nagotiations and bargaining between employers and employees?

Answer 8

Suppose both employers and employees expect 2 percent inflation next year. Workers will tend to start negotiations from a base of a 2 percent increase in nominal wages, which would hold their real wages constant.

Firms will also be inclined to begin bargaining from a base of a 2 percent increase in nominal wages because they expect that the prices at which they sell their products will rise by 2 percent.

Question 9

What does the expectation of some specific inflation rate create?

Answer 9

The expectation of some specific inflation rate creates pressure for nominal wages to rise by that rate.

Question 10

How do firms, workers, and consumers form their expectations about future inflation?

Answer 10

Expectations combine backward-looking and forward-looking elements.

Many people will look backward, for example, and come to expect low inflation in the future largely as a result of experiencing many past years of low inflation.

At the same time, most people are prepared to look forward and adjust their expectations in response to clear and credible announcements about future policy.

Question 11

What is the key point concerning rising nominal wages and inflation?

Answer 11

The key point for our current discussion is that 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.

Question 12

What are changes in nominal wages a combination of?

Answer 12

What happens to wages is the combined effect of the two forces.

Question 13

When nominal wages increase by the amount expected by both labour and managemant, what happens to real wages?

Answer 13

First, suppose both labour and management expect 2 percent inflation next year and are therefore willing to allow nominal wages to increase by 2 percent. Doing so would leave real wages unchanged.

Question 14

During a period of a significant inflationay gap with an associated labour shortage, what would a potential combined effect on nominal wages be?

Answer 14

Suppose also there is a significant inflationary gap with an associated labour shortage and that the excess demand for labour causes wages to rise by an additional 1 percentage point.

The final outcome is that nominal wages rise by 3 percent, the combined effect of a 2 percent increase caused by expected inflation and a 1 percent increase caused by the excess demand for labour when Y > Y*

Question 15

What is an example of when a recessionary gap could dampen an increase in nominal wages?

Answer 15

Assume again that expected inflation is 2 percent, but this time there is a large recessionary gap.

The associated high unemployment represents an excess supply of labour that exerts downward pressure on wages. The output-gap effect now works to dampen wage increases, say, to the extent of one percentage point.

Nominal wages therefore rise only by 1 percent, the combined effect of a 2 percent increase caused by expected inflation and a 1 percent decrease caused by the excess supply of labour when .

Question 16

What determines what happens to the AS curve?

Answer 16

The combined effect of the two macro forces acting on wages—output gaps and inflation expectations—determines what happens to the AS curve.

Question 17

What happens when the combined effect of the output-gap effect and the expectational effect raise wages?

Answer 17

If the combined effect of the output-gap effect and the expectational effect is to raise wages, then the AS curve will shift up. This shift will cause the price level to rise—that is, the forces pushing up wages will be inflationary.

Question 18

What happens when the combined effect of the output-gap effect and the expectational effect reduce wages?

Answer 18

If the combined effect of the output-gap effect and the expectational effect is to reduce wages, the AS curve will shift down—the forces reducing wages will be deflationary.

Question 19

What two compnenet parts can we decompose inflation caused by wage increases into?

Answer 19

ince anything that leads to higher nominal wages will shift the AS curve up and lead to higher prices, we can decompose inflation caused by wage increases into two component parts: output-gap inflation and expected inflation.

Question 20

Why must we ad a third componenet into wage changes? What is it called?

Answer 20

Supply - Shock inflation

However, since the AS curve can also shift for reasons unrelated to changes in wages, we must add a third element. Specifically, we must consider the effect of non-wage supply shocks on the AS curve and thus on the price level.

Question 21

What are the three componenets of actual inflation?

Answer 21

Question 22

Which component of actualy inflation is most difficult for the BoC to manage?

Answer 22

Question 23

What is constant inflation?

Answer 23

Suppose the inflation rate is 2 percent per year and has been 2 percent for several years. This is what we mean by a constant inflation.

Question 24

If inflation and monetary policy have been inchanged for several years, what is the expected rate of inflation?

Answer 24

If inflation and monetary policy have been unchanged for several years, the expected rate of inflation will tend to equal the actual rate of inflation.

Question 25

If there are no supply shocks and epected inflation equals actual inflation, what is real GDP equal to?

Answer 25

If there are no supply shocks and expected inflation equals actual inflation, real GDP must be equal to potential GDP.

Question 26

In order for there to be constant inflation, the AD and AS curve must both be shifting at the same time. Whie the AS curve shifts in response to expected inflation, what makes the AD cruve shift with it?

Answer 26

The AS curve is shifting up only because of the wage increases driven by the expectation of inflation. What is causing the AD curve to shift up in lockstep? This is where the central bank and monetary policy enter the story. The AD curve is shifting up because the central bank is expanding the money supply.

Question 27

In the AD/As model, with no supply shocks, when does constant inflation occur?

Answer 27

In the AD/AS model with no supply shocks, constant inflation occurs when Y = Y*.

Question 28

What circumstances must be fulfilled in order for constant inflation to occur?

Answer 28

Constant inflation with Y = Y* occurs when the rate of monetary expansion, the rate of wage increase, and the expected rate of inflation are all equal to the actual inflation rate.

Question 29

What are the two opposing forces that attempt to keep constant -inflation equilibrium?

Answer 29

Note that in this constant-inflation equilibrium, interest rates are being kept stable by two equal but offsetting forces.

The central bank is increasing the money supply, which tends to push interest rates down.

But at the same time, rising prices are increasing the demand for money and pushing interest rates up.

In equilibrium, the monetary policy is just expansionary enough to accommodate the growing money demand, thus leaving interest rates unchanged.

Question 30

What happens if the BoC underestimates the NAIRU?

Answer 30

Question 31

What would happen if the NAIRU was higher then the actual unemployment rate?

Answer 31

Question 32

During an inflationary gap, where does the long-run price level occur?

Answer 32

The long-run price level occurs at the intersection of the AD curve and the potential GDP.