Chapter 14 - Inflation and disinflation

Question 1

Why do wages change? (3 reasons)

Answer 1

1 - Excess demand for labor (when Y>Y) puts upwards pressure on Nominal wages.
2 - Excess supply for labor (When Y<Y) puts downward pressure on nominal wages (but its slow to adjust)
3 - Absence of gaps (Y=Y*) implies no pressure on wages.

Question 2

What happens to the unemployment rate and wages when Real GDP is equal to Potential GDP? (When Y=Y*, no gap)

Answer 2

The unemployment rate is equal to NAIRU (Non Accelerating Inflation Rate of Unemployment)

Question 3

What happens to the unemployment rate and wages when Real GDP is greater or smaller than Potential GDP? (Gaps when Y>Y* , Y<Y*)

Answer 3

1 - When Y>Y, unemployment will be less than NAIRU (U<U) and wages rise
2 - When Y<Y, unemployment rate will exceed the NAIRU (U>U) and wages fall

Question 4

Which two macro forces determine what happens to the AS (Aggregate supply) curve?

Answer 4

1 - Output gaps
2 - Inflation EXPECTATIONS

(Not actual inflation rate)

Question 5

How do we calculate actual inflation?

Answer 5

Actual inflation = Output gap inflation + Expected inflation + Supply shock inflation

Question 6

What is an example of supply shock inflation? (other than wages)

Answer 6

A change in prices of materials used as inputs in production.

Question 7

Can expected inflation be equal to the actual rate of inflation?

Part 2. What happens if there is no supply shocks?

Answer 7

Yes, if inflation doesn’t change for several years (constant), and monetary policy also doesn’t change for several years. Then the expected will tend to equal the actual.

In the absence of supply shocks, if expected equals actual then real GDP must equal potential GDP (Y=Y*)

Question 8

Under which conditions does constant inflation occur with Y=Y*?

Answer 8

Occurs when the rate of monetary expansion, rate of wage increase and 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 expectations, central banks build it into their policy decisions, and the economy can operate with real GDP equal to potential output. (happyland?)

Question 9

What would happen if the bank acted to maintain output above Y*?

Answer 9

What happens is predicted by the acceleration hypothesis, which states that when real GDP is held above potential output, that persistent inflationary gap will cause inflation to accelerate.

Question 10

What 3 factors cause inflation?

Answer 10

1- Anything that shifts the AD curve to the right. aka Demand inflation (because price will increase)
2 - Anything that shifts the AS curve to the left/upward. aka Supply inflation (because price will increase)

Question 11

What are the consequences of inflation in the short run?

Answer 11

1 - Demand inflation tends to be accompanied by an increase in real GDP, pushing it above its potential level.
2 - Supply inflation tends to be accompanied by a decrease in real GDP below its potential level.

Question 12

Assuming no monetary validation, what happens when there is a positive demand shock or negative supply shock?

Answer 12

Without monetary validation, positive demand shocks cause inflationary output gaps and temporary burst of inflation.
Without monetary validation, negative supply shocks cause recessionary output gaps and temporary burst of inflation.

The gaps are eventually removed and GDP returns to its potential level but a different price.

Question 13

T/F
Disinflation means a fall in price/negative inflation rate.

Answer 13

False. Disinflation is a reduction in the rate of inflation, still positive inflation rate.