The AS-AD model EC202A Macroeconomics

The AS-AD model EC202A Macroeconomics
Reading material that you may find useful: Abel, Bernanke and McNabb, Chapters 11 and 13 Abel, Bernanke, 5th ed, Chapters 10 and 12. Dornbusch, Fisher and Startz, Chapters 5-6 (9th ed)

Objective of the lecture
Unemployment and inflation are the most important macroeconomic problems for almost any country in the world. Politicians try to win consensus by promising low inflation and high growth. Moreover, unemployment and inflation are linked empirically by the Phillips curve, a fact that is missed by the IS-LM model, because of the assumption of fixed prices. Therefore, we need another framework.

While keeping some of the foundations built in the previous lectures, we will now take the analysis further by relaxing the assumption of fixed prices, and we will develop the AD-AS model, as a basic macroeconomic tool for determining output, employment and the price level.

Outline The labour market ; The aggregate supply curve and price adjustments ; The AS-AD model ; The Phillips curve ; The expectations-augmented Phillips curve .

The labour market The full employment level of output is the level of output that is produced in an economy when there is full employment, that is, labour demand is equal to labour supply: LS Given the production function and the current stock of capital K, the full employment level of output is a function of NF: YF = f(NF) Also: N = f-1 (Y) Real wages LD NF Labour, N

The labour market If the current level of output is persistently different from YF and the labour supply or demand haven’t changed, then there is disequilibrium in the labour market, which must be explained in some way (i.e. imperfect information, coordination problems, efficiency wages,…) We call the unemployment rate that exists when output is at full employment level YF the natural rate. The natural rate exceeds zero because of frictions in the labour market (i.e. shifting between jobs) and lags in matching demand with supply for labour. LS Real wages LD NF Labour, N

The Classical Flexible-Price model
The assumption that wages and prices are flexible was commonly made by classical economists Thus, this assumption is often called the classical assumption: it guarantees that all markets clear it guarantees full employment it guarantees that actual output is equal to potential output

The Classical Flexible-Price model
In the Classical Flexible-Price model: The Savings = Investment equilibrium determines the real interest rate: S = Y - C = I(r) The levels of potential output and real wages are determined in the labour market: LS(w) = MPN The aggregate price level is determined by the quantity theory of money: M ∙velocity = P ∙Y Target: Devise some applied problems (shocks, exogenous changes etc) and see how the model works, especially which market clears first Functioning of the labour market Notice that in the classical flexible-price model you can get a negative-sloped AD curve by means of the quantity theory of money.

The aggregate supply curve and price adjustments
We call the relationship between the aggregate level of output and the price level in the economy the Aggregate Supply Curve or AS: The short-run AS curve reflects an assumption that in the short-run the price level is fixed and firms are willing to supply any amount of output at that price level. Long run AS P Short run AS But in the long run prices adjust so that output is at full employment level YF. Y YF

The horizontal short-run AS curve is exactly equivalent to the assumption of fixed prices in the IS-LM-BP model, which served us well to answer a certain kind of questions. But if we want to analyse the link between unemployment and prices, this assumption becomes too simplistic. In practice, wages and prices are slow to adjust, therefore the aggregate supply is upward sloping in the short run. LRAS P SRAS Y YF

The theory of aggregate supply is one of the least settled areas in macroeconomics. There is a general consensus that prices adjust slowly to changes in output demanded, but there are a number of different theories used to explain this phenomenon. Here we review 3 theories (not mutually exclusive): Misperception, or imperfect information ; Coordination problems ; Efficiency wages.

Misperception, or imperfect information: Producers have imperfect information about the general price level. As a result, producers forecast the price level using their imperfect information. They don't know whether a price change is due to a change in the overall price level or a market-specific demand, but they have an expectation of the general price level. When a producer sees that the price of his own product has increased above the expected general price level, he assumes that the relative price of his product has increased, so he will increase production to earn more money.

Misperception, or imperfect information: In other words, producers misinterpret changes in the general price level as changes in relative prices. This leads to a short-run aggregate supply curve that isn’t vertical. If P > PE, producers are fooled into thinking that the relative prices of their own goods have risen, and they increase their output. LRAS P SRAS PE If P < PE, producers believe that the relative prices of their goods have fallen, and they reduce their output. Y YF

Coordination problems : Different firms within an economy cannot coordinate price or wage changes in response to policy changes. If any one firm increases its price but no one else does, then the single firm that raised its price will loose business. LRAS If Y > YF, producers may react in 2 ways: changing prices so as to restore full employment in the labour market (at output level YF) ; Or, decide to accommodate demand. P SRAS Y YF

Coordination problems : Unsure about the behaviour of competitors, individual firms change their prices or wages only reluctantly, preferring to accommodate demand rather than changing prices. Therefore, if demand increases prices do not rise enough to bring the economy back to YF. This leads again to a short-run aggregate supply curve that isn’t vertical. LRAS P SRAS Y YF

Efficiency wages: Employers pay above market-clearing wages to motivate their workers to work harder, and are reluctant to change wages because of the perceived cost (efficiency loss) involved. On the other hand, firms are inclined to pay higher wages also because they can pass this cost onto consumers, in the form of higher prices. This happens because each firm enjoys some degree of monopoly power in her own market.

Efficiency wages: In addition, there are long-term relations between firms and workers, that is, wages are usually set in nominal terms and wage contracts are renegotiated only periodically. As prices change over time, real wages fluctuate over the length of the wage contract.

Efficiency wages: As a result of the existence of efficiency wages, at any point in time real wages need not be at the level needed to clear the labour market, therefore actual output need not be equal to YF. It is important to realize that these various explanations are not mutually exclusive and all point in the same direction: in the short run the AS-curve is upward sloping, while in the long run it is vertical. LRAS The process of adjusting wages and prices continues until the economy eventually gets back to full employment, and the level of output will go back to YF, but during this process output adjusts only slowly to the changes. P SRAS YF Y

The AS-AD model The aggregate demand curve AD shows the relationship between the quantity of goods demanded and the price level when the goods market and the money market are in equilibrium. So the AD curve represents the price levels and output levels at which the IS and LM curves intersect. LM (P=P2) r LM (P=P1) IS Y P P2 P1 AD Y

The AS-AD model The AD curve slopes downward because a higher price level is associated with lower real money supply, shifting the LM curve up, raising r, and decreasing Y. Any factor that causes the intersection of the IS and LM curves to shift causes the AD curve to shift. For example, an increase in government expenditure shifts the IS to the right, so it shifts the AD curve to the right as well. LM r IS2 IS1 Y P AD2 AD1 Y

Equilibrium in the AD-AS model:
The AS-AD model Equilibrium in the AD-AS model: Short-run equilibrium: AD intersects SRAS Long-run equilibrium: AD intersects LRAS LRAS P If the economy isn’t in general equilibrium, economic forces work to restore equilibrium both in AD-AS diagram and IS-LM diagram. SRAS AD YF Y

The Phillips curve Many people think there is a trade-off between inflation and unemployment. The idea is that, to reduce unemployment, the economy must tolerate high inflation, or alternatively that, to reduce unemployment, more inflation must be accepted. The idea originated in 1958 when A.W. Phillips showed a negative relationship between unemployment and nominal wage growth in Britain. Statistical studies also found a similar negative relationship for other countries and time periods. Since then, economists have looked at the relationship between unemployment and inflation.

The Phillips curve The Phillips curve shows an empirical inverse relationship between the unemployment rate and increases in the nominal wage rate. This relationship can be expanded into a relationship between inflation and unemployment, which implies that the Phillips curve and the AS-curve can be viewed as two alternative ways to study price adjustments

The Phillips curve Example: The Phillips curve and the U.S. economy during the 1960s

= – h(u – u) Phillips curve
The Phillips curve In the 1950s and 1960s the prevailing view was that the economy had a negative relationship between the two variables. This suggested that policymakers could choose the combination of unemployment and inflation they most desired: = – h(u – u) Phillips curve However, in the following decades the negative relationship failed to hold. The 1970s were a particularly bad period, with both high inflation and high unemployment, inconsistent with the Phillips curve.

The Phillips curve Example: Inflation and unemployment in the United States, 1970–2002

Why did it seem to vanish after 1970 ?
The Phillips curve This experience raised at least 3 important questions: Why was the original Phillips curve frequently observed historically (Britain before 1958 and the US and Europe in the 1960s) ? Why did it seem to vanish after 1970 ? Does the Phillips curve actually provide a menu of unemployment and inflation rates from which politicians can choose? economic theory provided an answer to these questions, even before the actual breakdown of the Phillips curve!

The expectations-augmented Phillips curve
During the second half of the 1960s, Friedman and Phelps questioned the logic of the Phillips curve. They argued that there should not be a stable negative relationship between inflation and unemployment. Instead, a negative relationship should exist between unanticipated inflation (the difference between actual and expected inflation) and cyclical unemployment (the difference between actual and natural unemployment rates).

How does this work in the AD-AS model? First case: anticipated increase in money supply LRAS P AD shifts up and SRAS shifts up, with no misperceptions because the increase in the money supply is fully anticipated ; Result: P rises, Y unchanged ; Inflation rises with no change in unemployment . SRAS2 SRAS1 AD2 AD1 YF Y

Second case: unanticipated increase in money supply LRAS P Money supply rises unexpectedly, so AD1 shifts to AD2 ; Result: Y rises as misperception occur ; Long run: misperception goes away as producers cannot be fooled indefinitely . P rises, Y declines to full-employment level. SRAS2 SRAS1 AD2 AD1 YF Y

Thus, when the public correctly predicts aggregate demand growth and inflation, unanticipated inflation is zero, actual employment equals the natural rate, and cyclical unemployment is zero. If aggregate demand goes up unexpectedly, the economy faces a period of positive unanticipated inflation and negative cyclical unemployment. – e : unanticipated inflation (u – u) : cyclical unemployment h : a positive number The relationship between unanticipated inflation and cyclical unemployment implied by this analysis is:  – e = – h(u – u)

The preceding equation expresses the idea that unanticipated inflation will be positive (negative) when cyclical unemployment is negative (positive). We can re-write it as: = e – h(u – u) Expectations-augmented Phillips curve

The Phillips curve and the aggregate supply
EC202A Macroeconomics The Phillips curve and the aggregate supply Reading material that you may find useful: Abel, Bernanke and McNabb, Chapter 13. Abel, Bernanke, 5th ed, Chapter 12 Dornbusch, Fisher and Startz, Chapter 6 (9th ed).

The Phillips curve is one of the most controversial relationships in macroeconomics, whose existence has been questioned several times. Does the original Phillips curve relationship apply to all historical cases?

The Original Phillips Curve for the United Kingdom

Inflation and unemployment in the UK 1978-2000
To see the actual data on inflation and unemployment, right click on the picture above, then select “Chart object”, then select “Open”.

In this lecture we will see how economic theory can explain these apparently illogical patterns in the data. We will focus on the role of expectations and credibility.

Outline: The Phillips curve and the aggregate supply;
Shifts in the AS curve ; Macroeconomic policy ; Credibility ; The shifting Phillips curve in practice Supply shocks .

The original Phillips curve showed an empirical inverse relationship between the unemployment rate and increases in the nominal wage rate. This relationship can be expanded into a relationship between inflation and unemployment, which implies that the Phillips curve and the AS-curve can be viewed as two alternative ways to study price adjustments.

Write the simple Phillips curve as: gW = – h ∙(u – u) Where: gW : change in the nominal wage rate u : actual unemployment rate u : natural unemployment rate (u – u) : cyclical unemployment h : responsiveness of wages to unemployment when u = u , gW = 0

When u = u , the labour market is in equilibrium. Thus, the estimated Phillips curve provides a measure of the natural rate of unemployment in a country. For example, by looking at the previous graph, we can see that the natural rate for Britain in the period was about 5%. However, the simple Phillips curve fell apart in the 1960s. Friedman and Phelps showed that this happened because the original Phillips curve lacked an important element: inflation expectations.

When workers and firms bargain over wages, they are concerned with the real value of wages, so they take into account expected inflation. For example, a wage increase of 3% with expected inflation of 0 is quite a different thing from the same wage increase with e = 10%. Now we need 2 more steps to go from the Phillips curve to the AS curve. Thus, according to Friedman and Phelps: gW – e = – h ∙(u – u)

Step 1: Specify the relationship between wage growth and prices Assumption: firms set prices according to a mark-up rule P = (1+m) ∙ W Where: m = mark-up ; P = price ; W = wage . As a result: gW = 

Step 2: Specify the relationship between unemployment and output According to Okun’s law: (Y – YF )/ YF = – ω ∙ (u – u) Where: Y = output ; YF = full-employment or potential output ; ω ≈ 2.5

gW – e = – h ∙(u – u) gW =  (Y – YF )/ YF = – ω ∙ (u – u) – e = h/ω ∙ (Y – YF )/ YF  = (Pt – Pt-1 )/ Pt-1 e = (PEt – Pt-1 )/ Pt-1 (Pt – Pt-1 )/ Pt-1 – (PEt – Pt-1 )/ Pt-1 = = h/ω ∙ (Y – YF )/ YF

Therefore, the AS curve : Pt – PEt= Pt-1 ∙ h/ω ∙ (Y – YF )/ YF Pt = PEt + Pt-1 ∙ h/ω ∙ (Y – YF )/ YF Simplification: Pt-1 = 1 a = (h/ω) / YF Pt = PEt + a ∙ (Y – YF ) Short-run AS curve

Pt = PEt + a ∙ (Y – YF ) Pt SRAS PE The slope of the SRAS depends on a, its position depends on PEt . Y YF 3 cases are possible: If a = 0, then the SRAS is horizontal. If a = infinity, then the SRAS is vertical. If a > 0, then the SRAS is upward-sloping.

But if the SRAS were horizontal, prices would be fixed, which is unrealistic. Pt SRAS YF Y Pt SRAS But if the SRAS were vertical, then Y = YF always. This can be true only if, whenever Y ≠ YF, firms increase their prices until Y = YF again. YF Y

We know that, whenever Y ≠ YF, u ≠ u , so the labour market is not in equilibrium. Firms maximise profits only when Y = YF and u = u . W LS LD LF L If demand for output is higher than YF, firms can quell the demand by increasing prices. If demand for output is lower than YF, firms can increase their sales by decreasing prices.

But we know that prices are slow to adjust to changes in demand conditions (see previous lecture), and Y can be away from YF. Therefore the SRAS is upward-sloping, and a > 0 is the only possible case. Prices increase with the level of output because increased output implies decrease in unemployment, and therefore increased labour costs (Phillips curve: when unemployment is low wages increase). Pt SRAS YF Y

Pt = PEt + a ∙ (Y – YF ) Shifts in the AS curve
SRAS’ Pt LRAS SRAS SRAS’’ Pt = PEt + a ∙ (Y – YF ) Y YF The SRAS shifts with inflation expectations. If inflation expectations increase , then next period the SRAS curve will shift up to SRAS’. If inflation expectations decrease , then next period the SRAS curve will shift down to SRAS’’.

SRAS’ Pt LRAS SRAS SRAS’’ Pt = PEt + a ∙ (Y – YF ) Y YF The SRAS shifts over time. If output this period is above YF , then the SRAS curve will shift up to SRAS’. If output this period is below YF , then the SRAS curve will shift down to SRAS’’.

LRAS LRAS’ Pt SRAS SRAS’ Pt = PEt + a ∙ (Y – YF ) Y YF YF ‘ Both the SRAS and the LRAS shift with changes in the natural rate of unemployment and full employment/potential output. If YF increases , then both the SRAS and the LRAS curves will shift to the right.

Macroeconomic policy Case 1: anticipated increase in money supply P YF
LRAS P AD shifts up and SRAS shifts up, with no misperceptions because the increase in the money supply is fully anticipated ; Result: P rises, Y unchanged ; Inflation rises with no change in unemployment . SRAS2 SRAS1 AD2 AD1 YF Y

Case 2: unanticipated increase in money supply
Macroeconomic policy Case 2: unanticipated increase in money supply LRAS P Money supply rises unexpectedly, so AD1 shifts to AD2 ; Result: Y rises as misperception occur ; Long run: misperception goes away as producers cannot be fooled indefinitely . P rises, Y declines to full-employment level. SRAS2 SRAS1 AD2 AD1 YF Y

How rapid is the adjustment?
Credibility How rapid is the adjustment? The speed of adjustment depends on the degree of flexibility of prices ; Notice that the shift from SRAS1 to SRAS2 can be avoided if the central bank implements a reduction in money supply, so that the economy goes back to YF with no increase in prices. LRAS P SRAS2 SRAS1 AD2 AD1 YF Y

Credibility The belief that the central bank is going to take resolute action to lessen inflation would prevent the shift from SRAS1 to SRAS2 because inflation expectations would not change. However, this happens only if the central bank is credible. If the central bank is irresolute, expectations won’t change and inflation can be brought down only after a recession. This would tend to suggest that making central banks independent and adopting statements of principle regarding governmental or bank action in relation to inflation are important.

The shifting Phillips curve in practice
Why did the Phillips curve disappear after 1970? (1) Both the expected inflation rate and the natural rate of unemployment varied considerably more in the 1970s than they did in the 1960s ; (2) Especially important were the oil price shocks of 1973–1974 and 1979–1980 ; (3) Also, the composition of the labour force changed in the 1970s, raising the natural rate of unemployment ;

The shifting Phillips curve in practice
(continued): (4) Monetary policy was expansionary in the 1970s, leading to high and volatile inflation. Because inflation was volatile, expected inflation was volatile too, hence the Phillips curve shifted a lot ; (5) Plotting unanticipated inflation against cyclical unemployment shows a fairly stable relationship since 1970.

Supply shocks What are the effects of a supply shock, such as an oil price increase? a permanent supply shock will affect potential output YF and thus the equilibrium level of unemployment u. a temporary supply shocks will leave these measures unaffected, but will shift the short run Phillips curve and the short run aggregate supply schedule. The AS curve shifts up because all costs – therefore prices – will be higher at any level of output, due to the oil price increase.

Temporary supply shock: short run effects
The SRAS0 curve shifts up to SRAS1 The equilibrium of the economy moves from E0 to E1 An adverse supply shock is doubly unfortunate: it causes a simultaneous increase in inflation and unemployment. LRAS P SRAS1 SRAS0 E1 E0 AD1 YF Y

Temporary supply shock: long run effects
Supply shocks Temporary supply shock: long run effects The unemployment at E1 forces wages and thus the price level down. The adjustment back to the original equilibrium is slow because prices are slow to adjust At E0 the economy is back at full employment, but real wages have fallen LRAS P SRAS2 SRAS1 E1 E0 AD1 YF Y

Supply shocks Policy makers can accommodate supply shocks by expansionary demand-side policies, but this will accelerate inflation. On the other hand, they can offset the price increase by implementing restrictive demand-side policies, but this will cause output to fall further. A favourable supply shock shifts the upward-sloping AS-curve to the right, leading to lower prices combined with increased output. Some economists believe that this is what the US experienced in the late 1990s (technological improvements made in the computer industry).

Unemployment and inflation
EC202A Macroeconomics Unemployment and inflation Reading material that you may find useful: Abel, Bernanke and McNabb, Chapter 13. Abel, Bernanke, 5th ed, Chapter 12 Dornbusch, Fisher and Startz, Chapter 7 (9th ed). Begg, Fischer and Dornbusch, Chapter 27 (7th ed).

Unemployment and inflation are widely perceived to be the most important economic problems in industrialised nations. However, compare, for example, Poland in 1990 (unemployment rate 6.3%), with the UK in 1991 (unemployment rate 7.7%). Was it better to live in Poland in 1990 or in the UK in 1991?

Poland: rigid labour market, reforms were still under way, unemployment rate = 11.8% the following year. UK: important to distinguish between frictional and structural unemployment. Fast flows through unemployment pool may allow better matching of skills to jobs in a changing world. The example shows that we need to: Study the classification of unemployment. Understand the costs of inflation and unemployment.

Outline: Analysing unemployment ; The costs of unemployment ;
Factors affecting unemployment ; Policies to reduce the natural rate of unemployment ; The costs of inflation.

Analysing unemployment
Definitions: labour force participation rate unemployment rate Unemployment is a stock concept, measured at a point in time (“static view”). However, there is high turnover in the labour market, with constant flows into and out of the unemployment pool (“dynamic view”).

Unemployment rate: the percentage of the labour force without a job but registered as being willing and available for work Labour force: those people holding a job or registered as being willing and available for work Participation rate: the percentage of the population of working age declaring themselves to be in the labour force. Example: the discouraged worker effect “conceals” unemployment.

LABOUR FORCE Working New hires Recalls Unemployed Job-losers Lay-offs Quits Taking a job Retiring Temporarily leaving Discouraged workers Re-entrants New entrants Non-participants

Types of unemployment: Frictional = the irreducible minimum level of unemployment in a dynamic society (time to search for jobs, the ‘almost unemployable’) ; Structural = unemployment arising from a mismatch of skills and job opportunities when the pattern of demand and production changes (time to acquire human capital) ;

We call the unemployment rate that exists when the labour market clears equilibrium unemployment or the natural rate. LS Wages WF LD LF Labour, L Natural rate of unemployment = frictional + structural unemployment

Types of unemployment: From low demand (“Keynesian unemployment”) = when output is below the full employment level YF ; From high wages (“classical unemployment”) = when wages are above WF ;

The costs of unemployment
There are 2 principal costs of unemployment: Loss in output from idle resources ; Personal or psychological cost to workers and their families . However, the burden of unemployment is not equally distributed across society, since its costs are borne mainly by the poor and disadvantaged.

Society throws away output by failing to put people at work. 1. Loss in output from idle resources: How to measure it? Workers lose income Society pays for unemployment benefits and loses tax revenue Okun’s Law

Okun’s Law : (Y – YF )/ YF = – ω ∙ (u – u) Where: Y = output ; YF = full-employment or potential output ; (u – u) : cyclical unemployment ; ω ≈ 2.5 Thus Okun’s Law allows us to measure the cost to society (in terms of lost production) of a given rate of unemployment.

The natural rate of unemployment in the UK, To see the actual data on inflation and unemployment, right click on the picture above, then select “Chart object”, then select “Open”. UK GDP in 1995: 720 billions (pounds), approx.

We cannot directly observe the natural rate of unemployment, we can only rely on estimates of YF 2. Personal or psychological cost: They depend on the average unemployment duration. The duration of unemployment is the average length of time a person remains unemployed.

However, there are some factors offsetting the costs of unemployment: Unemployment leads to increased job search and acquiring new skills, which may lead to increased productivity and increased future output; Unemployed workers have increased leisure time, though most wouldn’t feel that the increased leisure compensated them for being unemployed.

Factors affecting unemployment
The problems associated with determining the natural rate are a major issue of controversy. Actual and natural unemployment rates in the US However, the natural rate is understood to depend on many factors which vary through time.

Factors affecting the natural rate of unemployment: Demographic make-up of the labour force; Availability and duration of unemployment benefits; Efficiency of the labour market in matching workers and jobs, labour market regulation; Labour productivity;

(continued) : Structural change, the variability of the demand for labour across employers ; Hysteresis (= long periods of high unemployment may actually contribute to a higher natural unemployment rate); Organization of the labour force & unions.

Hysteresis: There are two possible explanations. The first is that workers who are unemployed may become accustomed to not being in the work force (though they may take on odd jobs while receiving unemployment benefits) or may get discouraged. The second is that workers with a history of long and/or frequent unemployment may convey the (often unwarranted) signal that they do not have the motivation or skills required to ensure stable employment.

Policies to reduce the natural rate of unemployment
Government support for job training and worker relocation. Firms may be reluctant to train workers because they might leave to go to other firms. Tax breaks or subsidies would encourage training; Increased labour market flexibility. Regulations (like minimum wages, working conditions, fringe benefits, etc.) increase the costs of hiring workers. Reducing regulations whose benefits are less than the costs would help reduce unemployment;

Policies to reduce the natural rate of unemployment
Unemployment benefits reduction. Unemployment insurance increases the time workers spend looking for work and increases the incentives for firms to lay off workers. ; Using expansionary monetary and fiscal policies in order to reduce the natural rate of unemployment: useful only in the case of hysteresis, otherwise there are inflationary consequences. Critics suggest that there is little evidence of hysteresis

The costs of inflation The costs of inflation depend primarily on whether inflation is anticipated or not. 1. Perfectly anticipated inflation No effects if all prices and wages keep up with inflation Wages, taxes, and interest rates can be indexed Only shoe-leather costs & menu costs . Shoe-leather costs: people spend resources to economize on currency holdings, Menu costs (the cost of periodically changing prices ).

The costs of inflation 2. Unanticipated inflation
Realized real returns differ from expected real returns Result: transfer of wealth From lenders to borrowers when   e From borrowers to lenders when  < e Moreover, taxpayers may loose from the "bracket creep"

The costs of inflation Numerical example: i = 6%, e = 4%, so expected r = 2%. If  = 6%, actual r = 0%. If  = 2%, actual r = 4%. If actual inflation is higher than expected, debtors profit while creditors lose. Homeowners who have fixed-rate mortgages can gain substantially from long-term unanticipated inflation, while people on fixed incomes from pension plans may be significantly hurt.

The costs of inflation In most cases inflation is not perfectly anticipated and a redistribution of income and wealth results. Indexation is problematic: wage indexation prevents real wage flexibility. People want to avoid risk of unanticipated inflation. As a result, they spend resources to forecast inflation. Inflation causes loss of “trust” in the government, prices provide valuable signal. These costs are a real danger for the economy in a pathological case: hyperinflation.

The AS-AD model EC202A Macroeconomics

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