Chapter 14 - Inflation and Disinflation Flashcards
What is the formula for actual inflation?
Actual Inflation = Expected Inflation + Output-Gap Inflation + Supply-Shock Inflation
What is the sacrifice ratio formula?
Sacrifice Ratio = (% GDP lost) / (% reduction in inflation)
What causes the AS curve to shift upward?
Rising wages (from inflationary gaps or expectations) or supply shocks like higher material costs
What causes the AS curve to shift downward?
Falling wages (from recessionary gaps) or supply cost reductions
What happens when Y > Y*?
Excess demand → ↑ wages → AS shifts up → inflation increases
What happens when Y < Y*?
Excess supply → ↓ wages slowly → AS shifts down → inflation slows
What is the difference between anticipated and unanticipated inflation?
Anticipated = planned for, has minimal impact
Unanticipated = unexpected, causes wage/price mismatches, income redistribution, and inefficiency
How does expected inflation affect wages?
Higher expected inflation leads to higher nominal wage demands → shifts AS upward
What is the outcome of a constant inflation scenario?
Y = Y*, expected = actual inflation, AD and AS both shift upward at the same rate, inflation remains stable
What is monetary validation?
When the central bank increases the money supply to match inflation expectations → sustains inflation
What happens if the BoC validates a demand shock?
AD keeps shifting right → inflationary gap remains → sustained inflation
What happens if the BoC does NOT validate a demand shock?
AS shifts up → gap closes → price level rises → Y returns to Y*
What is the impact of a negative supply shock?
AS shifts left → ↑ price level, ↓ output → recessionary gap
Why does validating a supply shock risk long-term inflation?
It encourages higher wage/price expectations → wage-price spiral → persistent inflation
What is the Phillips Curve short-run tradeoff?
Lower unemployment ↔ higher wage/inflation rate (but only in the short run)
What does the long-run Phillips Curve look like?
Vertical at NAIRU — no tradeoff between inflation and unemployment in the long run
What are the 3 phases of disinflation?
- Remove monetary validation (tighten policy)
- Stagflation (wages still rising → recession)
- Recovery (AS shifts down or AD cautiously increases)
What makes disinflation less costly?
Forward-looking inflation expectations — people quickly adapt to the new low-inflation environment
What happens if disinflation expectations are backward-looking?
Slower adjustment → deeper and longer recession → higher sacrifice ratio
Is inflation always caused by monetary expansion?
Temporary inflation can be from shocks, but sustained inflation always requires ongoing monetary validation
When would you use the sacrifice ratio?
During disinflation, to estimate the economic cost (in lost GDP) of reducing inflation by a specific number of percentage points. Helps policymakers evaluate tradeoffs.
Why is the sacrifice ratio higher when inflation expectations are backward-looking?
Because people adjust slowly to new policies → inflation persists longer → deeper, longer recession required to bring inflation down.
How does the BoC use the sacrifice ratio when planning disinflation?
To weigh the short-term output losses against the long-term benefits of stable, low inflation.
What is the implication of a high sacrifice ratio?
Disinflation will likely cause larger GDP losses, requiring strong justification and careful policy planning.
