CH14 - Inflation and disinflation Flashcards
What are the macroeconomic forces that cause the general level of nominal wages to change? (2)
- Output gap
- Expectations of future inflation
What type of pressure on wages does an inflationary gap put?
Upward pressure
(Y > Y*)
What is NAIRU? (U*)
Non-accelerating inflation rate of unemployment
At equilibrium, (GDP = Y*), what is said about the unemployment rate?
It’s NAIRU
Why is the NAIRU not 0?
Because even when Y = Y*, there is some amount of frictional and structural unemployment
What is the relationship between GDP and unemlployment
Negative
If GDP is less than Y, unemployment rate will be more than U
What pressure does the expectation of some specific inflation rate do?
Pressure for nominal wages to rise by that specific rate
As long as people expect prices to rise, their behavior will put _______ pressure on nominal wages.
upward
(even when there is no real inflation)
What is the total effect on wages equation?
Output-gap effect + Expectational effect
Changes in wages and other factor prices lead to what?
Shifts the in AS curve
What are deflationary forces?
The combined effect of the output-gap and expectational effect is to reduce wages, therefore shifting down the AS
What is the actual inflation equation?
Output-gap inflation + Expected inflation + Supply-shock inflation
What is constant inflation?
When inflation stays at the same rate for several years
What happens if inflation and monetary policy are unchanged for several years?
expected rate of inflation = actual rate of inflation
What happens if there are no supply shocks and expected inflation = actual inflation?
real GDP = potential GDP
What does a constant inflation require from the AD and AS curve?
To both shift upward equally
With constant inflation, why is the demand curve shifting up?
Because the central bank increases the money supply
With constant inflation, why is the supply curve shifting up?
Because of the wage increase
What is validating the expectations?
When a central bank increases the money supply at a rate that the expectations of inflation end up being correct
What is the assumption regarding AS and AD shocks in the analysis of the macro model?
They do not influence the level of potential output Y*
What is demand inflation?
Inflation arising from an inflationary output gap caused, in turn, by a positive AD shock
What are the 2 assumptions about the study of demand inflation?
- Y* is constant
- Initially no inflation
What happens when a demand shock is not validated?
it creates inflation temporarily
(the upward pressure on wages will cause the AS curve to return the equilibrium at Y*)
What does the monetary validation of a positive demand shock cause for the AD curve?
It causes it to shift further to the right, offsetting the upward(leftward) shift in the AS curve
What does continued validation of demand shocks do?
Is turns transitory inflation into sustained inflation fuelled by monetary expansion
What is supply inflation?
Negative supply shock not caused by excess demand in the markets for factors of production
e.g. of a supply shock: rise in the cost of raw material
What does the bank do to validate the negative supply shock
it allows the money supply to increase
Following a negative supply shock, what is the major concern if there is no monetary validation?
The speed at which wages adjust so AS return to the initial equilibrium (when GDP = Y*)
Why would the Bank of Canada want to validate negative supply shocks?
To speed up the process of return to equilibrium
What happens when the bank validates a negative supply shock? (2)
There is a large increase in the price level and almost no recession
What is the cost of monetary validation?
Extending the period of inflation
(people will expect inflation to continue even after reaching equilibrium, so AS will continue to shift upwards)
Many economist argue that negative supply shocks ______ be validated and that any associated recessionary gap should simply be ___________
should not
accepted
What is the wage-price spiral?
The longer the Bank waits before stoping the validation of the shocks, the more firmly held will be the expectations that it will continue to do the validation
What is the acceleration hypothesis?
When real GDP is held above potential, the persistant inflationary gap causes the inflation to accelerate because the expectations of inflation will be rising
What are the 3 causes of inflation?
- Anything shifting the AD curve to the right and increasing the price level
- Anything shifting the AS curve to the left and increasing the price level
- Increases in the price level caused by AD and AS shocks will eventually come to a halt unless they are continually validated by monetary policy
What is the condition for sustained inflation?
It must be accompanied by a monetary policy that allows the money supply to continually increase
What are the 3 consequences of inflation?
1- depends on AD shock
2- depends on AS shock
3- long term
- Demand inflation is accompanied with increase in real GDP above its potential (short-run)
- Supply inflation is accompanied with a decrease in real GDP below its potential (short-run)
- When all costs and prices are adjusted fully and real GDP = Y*, the only effect of AD or AS shocks is a change in the price level
What are the 3 conclusions about inflation?
- Without monetary validation, positive demand shocks cause inflationary output gaps and temporary burst of inflation. Rising factor prices shift AS curve up, returning GDP to Y* with an increase in the price level.
- Without monetary validation, negative demand shocks cause recessionary output gaps and temporary burst of inflation. Falling factor prices shifts the AS curve down to restore GDP at Y* and the price level to its initial level
- Only with continuing monetary validation can inflation initiated by either types of shock continue indefinitely.
Sustained inflation is ________ and ______ caused by sustained monetary expansion.
always
everywhere
What is disinflation?
A reduction in the rate of inflation
What are the 3 steps of disinflation?
- Monetary validation is stopped
- Stagflation
- Recovery
What is the “cold-turkey” approach?
When interest rates are increased so much that the growth rate of the money supply is reduced to 0. The upward AD shift is halted abruptly
How can the Bank of Canada remove monetary validation?
By tightening monetary policy by increasing the interest rate (it reduces the growth rate of the money supply)
What is stagflation?
The combination of rising prices (inflation) and reduction in output
Once monetary validation is removed, what happens (2nd step of disinflation)
People are backward-looking, thus, inflation remains high and the AS curve continues to shift upwards
If most people are forward-looking, expected inflation will fall relatively quickly and the AS curve’s upward shift will soon come to an end
What are the 2 ways to return to potential output after disinflation? (3rd step)
- Recessionary gap may reduce factor prices, thus shifting AS downward, reducing price but increasing real GDP
- Expansionary monetary policy can shift AD upward, increasing both GDP and price level
What is the cost of disinflation?
The loss of output that is generated in the process
What is the sacrifice ratio?
The cumulative loss in real GDP, expressed as a percentage of potential output, divided by the percentage-point reduction in the rate of inflation
If GDP loses 80M out of 800M, and disinflation reduced by 4 percentage points, what is the sacrifice ratio?
What does it mean?
10/4 = 2.5
It costs 2.5% of real GDP for each percentage point of inflation that is reduced
Sustained inflation is best viewed as ______
a monetary phenomenon
Which types of unemployment are part of NAIRU?
Structural and frictionnal
