Chapter 14 Flashcards
What happens to wages when there is excess demand for labour that is associated with an inflationary gap (Y>Y*)?
There is upwards pressure on nominal wages meaning that they increase
What happens to wages when there is excess supply of labour that is associated with a recessionary gap (Y<Y*)?
It puts downward pressure on nominal wages through, meaning that wages decrease
What happens to wages when there is the absence of either an inflationary or a recessionary gap (Y=Y*)?
This means that demand forces are not exerting any pressure on nominal wages meaning that they do not change
When real GDP is equal to Y*, what is the unemployment rate equal to?
It is equal to NAIRU
What does NAIRU stand for?
It stands for the non-accelerating inflation rate of unemployment
When real GDP exceeds potential GDP (Y>Y*), the unemployment rate will be less than what?
It will be less than NAIRU (U<U*). This is because there is an inflationary gap characterized by excess demand for labour, and nominal wages tend to rise
When real GDP is less than potential GDP (Y<Y*), the unemployment rate will exceed what?
It will exceed NAIRU (U>U*). This is because there is a recessionary gap characterized by excess supply of labour, and nominal wages tend to fall
What does the expectation of some specific inflation rate create?
It creates pressure for nominal wages to rise by that rate
What determines what happens to the AS curve?
The net effect of two macro forces acting on wages - output gaps and inflation expectations
What is the best example of a non-wage supply shock?
It is a change in the prices of materials used as inputs in production
If inflation and monetary policy have been unchanged for several years, what does the expected rate of inflation tend to be equal to?
The actual rate of inflation
In the absence of supply shocks, if expected inflation equals actual inflation, then real GDP must equal to what?
Potential GDP
When does the constant inflation with Y=Y* occur?
When the rate of monetary expansion, the rate of wages increase, and the expected rate of inflation are all consistent with the actual inflation rate
When inflation is low and relatively stable, firms and consumers build it into their ___, central banks build it into their ___, and the economy can operate with real GDP equal to ___
Expectations
Policy decisions
Potential output
Why are wage costs rising?
Because of expectations of inflation
What are the expectations of inflation being validated by?
They are being validated by the central bank’s policy. Real GDP remains at Y*
Demand inflation is arising from an inflationary output gap caused by what kind of shock?
A positive AD shock
What does a demand shock that is not validated produce?
It produces temporary inflation
What happens when a positive demand shock accepts monetary validation?
It causes the AD curve to shift further to the right, offsetting the upward shift in the AS curve
What does continued validation of a demand shock do?
It turns what would have been a transitory inflation into sustained inflation fuelled by monetary expansion.
Where does the AD curve shift when there is a positive AD shock?
To the left
Where does the AS curve shift when there is a positive AD shock?
It shifts to the left
What is supply inflation?
It is inflation that arises from a negative AS shock that is not the result of excess demand in the domestic markets for factors of production
With not monetary validation, the reduction in wages and other factor prices makes the AS curve shift slowly back to ___
Its original position, which is to the left (as it originally shifts to the right)
With monetary validation during a supply shock, the AD curve shifts to the ___
left
What is the result of a supply shock?
It is a higher price level but a much faster return to potential output than would occur if the recessionary gap were relied on to reduce wages and other factor prices
What would happen if the Bank acted to maintain output above Y*?
The acceleration hypothesis is demonstrated as it states that when real GDP is held above potential, the persistent inflationary gap will cause inflation to accelerate
What are the 3 causes of inflation?
- Anything that shifts the AD curve to the right will cause the price level to rise (demand inflation).
- Anything that shifts the AS curve upward will cause the price level to rise (supply inflation).
- 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 kind of phenomenon is sustained inflation?
It is a monetary phenomenon
What are the consequences of inflation?
- In the short run, demand inflation tends to be
accompanied by an increase in real GDP above its
potential level. - In the short run, supply inflation tends to be
accompanied by a decrease in real GDP below its
potential level. - When all costs and prices are adjusted fully and
real GDP has returned to its potential level, the only long-run effect of AD or AS shocks is a change in the price level.
What are the conclusions of inflation?
- Without monetary validation, positive demand shocks cause inflationary output gaps and a temporary burst of inflation.
The gaps are removed as rising factor prices push the AS curve upward, returning real GDP to its potential level but at a higher price level. - Without monetary validation, negative supply shocks cause recessionary output gaps and a temporary burst of inflation.
The gaps are eventually removed when factor prices fall sufficiently to restore real GDP to its potential and the price level to its initial level. - Only with continuing monetary validation can inflation initiated by either supply or demand shocks continue indefinitely.
Sustained inflation is always and everywhere caused by sustained monetary expansion.
What is disinflation?
It is a reduction in the rate of inflation
When does the central bank adopt a tight monetary policy which halts the growth of the money supply?
When the curves reach AS1 and AD1
When is the AD curve stabilized?
When it is at AD1
Why do wages continue to rise and the AS curve shifts leftward to AS2?
Because of the output gap and inflation expectations
What leads to stagflation?
Expectations and wage momentum with falling outpur and continuing inflation
What are the 2 possible scenarios that lead to the recovery that takes output Y* and stabilizes the price level?
Wages fall and the AS curve returns to AS2 or the central bank increases the money supply sufficiently to shift AD to AD2
What is the sacrifice ratio?
It is the cumulative loss in real GDP as experessed by a percentage of potential output divided by the percentage-point reduction in the rate of inflation
