Chapter 29

Question 1

why wages change? (3 things)

Answer 1

1. The excess demand for labour that is associated with an inflationary gap (Y > Y*) puts upward pressure on nominal wages.
2. The excess supply of labour associated with a recessionary gap (Y < Y*) puts downward pressure on nominal wages, though the adjustment may be quite slow.
3. The absence of either an inflationary or a recessionary gap (Y = Y*) implies that demand forces are not exerting any pressure on nominal wages.

Question 2

what does NAIRU stand for

Answer 2

non-accelerating inflation rate of unemployment.

Question 3

When real GDP is equal to Y*, the unemployment rate is equal to the _______

Answer 3

NAIRU

Question 4

nominal wage rates react to various pressures of _______

Answer 4

demand

These demand pressures can be stated either in terms of the relationship between actual and potential GDP or in terms of the relationship between the actual unemployment rate and the NAIRU

Question 5

overall effect on wages formula

Answer 5

Change in Money Wages =
Output-gap Effect
+ Expectational Effect

Question 6

what determines what happens to the AS curve?

Answer 6

The net effect of the two macro forces acting on wages—output gaps and inflation expectations

Actual Inflation =
Output-gap Inflation
+ Expected Inflation +
Supply Shock Inflation

Question 7

describe constant inflation

Answer 7

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 consistent with the actual inflation rate.

If inflation has been constant for several years and there is no indication of an impending change in monetary policy:
-> expected inflation will equal actual inflation

If expected inflation equals actual inflation:
-> Y must equal Y* èno output gap

Question 8

constant inflation with no supply shocks

Answer 8

Wage costs are rising because of expectations of inflation, and these expectations are being validated by the central bank’s policy. Real GDP remains at Y*

Question 9

demand inflation

Answer 9

inflation arising from an inflationary output gap caused, in turn, by a positive AD shock.

A demand shock that
is not validated produces temporary inflation.

Question 10

what does monetary validation of a positive demand shock do?

Answer 10

causes the AD curve to shift further to the right, offsetting the upward shift in the AS curve.

Continued validation of a demand shock turns what would have been transitory inflation into sustained inflation fueled by monetary expansion.

Question 11

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

Answer 11

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

Question 12

def. supply inflation

Answer 12

inflation arising from a negative AS shock that is not the result of excess demand in the domestic markets for factors of production

Question 13

what happens with supply shocks with no monetary validation

Answer 13

the reduction in wages and other factor prices make the AS curve shift slowly back down to AS0.

Question 14

what happens with supply shocks with monetary validation

Answer 14

With monetary validation, the AD curve shifts from AD0 to AD1.

The result 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

Monetary validation of a negative AS shock causes the initial rise in P to be followed by a further rise.

Question 15

potential danger of monetary validation of a supply shock

Answer 15

wage-price spiral could be created

Question 16

what are the 3 main causes of inflation?

Answer 16

1. Anything that shifts the AD curve to the right will cause the price level to rise (demand inflation).
2. Anything that shifts the AS curve upward will cause the price level to rise (supply inflation).
3. 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.

**Sustained inflation must be a monetary phenomenon.

Question 17

main conclusions about inflation: without monetary validation, demand

Answer 17

1. 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.

Question 18

main conclusions about inflation: without monetary validation, supply

Answer 18

2. 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.

Question 19

main conclusions about inflation: monetary validation

Answer 19

3. Only with continuing monetary validation can inflation initiated by either supply or demand shocks continue indefinitely.

Sustained inflation is everywhere and always caused by sustained monetary expansion.

Question 20

things to know about disinflation

Answer 20

Reducing inflation is often costly
• lost output and unemployment
Expectations can cause inflation to persist even after its original causes have been removed.
Crucial factor:
• how quickly inflation expectations are revised

Question 21

What are the 3 phases of eliminating a sustained inflation

Answer 21

1. Removing Monetary validation
2. Stagflation
3. Recovery

Question 22

describe the process of eliminating a sustained inflation: phase 1

Answer 22

Phase 1: Removing Monetary Validation

Begin with a reduction in the rate of monetary expansion.

Starting at E1, suppose the central bank stops increasing the money supply.

The AD curve stops shifting
• but inflation expectations keep AS curve shifting

Question 23

describe the process of eliminating a sustained inflation: phase 2

Answer 23

stagflation caused by continued shifts in AS curve:
• slow-to-adjust expectations
• wage momentum

Question 24

describe the process of eliminating a sustained inflation: phase 3 recovery

Answer 24

Eventually, recovery takes output to Y*, and P is stabilized:
•Either wages fall, bringing the AS3 curve back to AS2.
•Or the central bank increases the money supply sufficiently
to shift the AD curve to AD2.

Question 25

cost of disinflation: sacrifice ratio

Answer 25

The sacrifice ratio is the cumulative loss in real GDP, expressed as a percentage of potential output, divided by the percentage-point reduction in the rate of inflation