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Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 30 Inflation and Disinflation.

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1 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 30 Inflation and Disinflation

2 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Describe the response of wages to change in both output gaps and inflation expectations. 3. Describe the effects of aggregate demand and supply shocks on inflation and real GDP. 2. Explain how a constant rate of inflation is incorporated into the basic macroeconomic model. 4. Explain what happens when the Federal Reserve validates demand and supply shocks. 5. Describe the three phases of a disinflation. 6. Explain how the cost of disinflation is measured by the sacrifice ratio. In this chapter you will learn to

3 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 30.1 U.S. CPI Inflation, 1965–2006

4 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Why Wages Change 1.Output Gaps -Y > Y*  excess demand for labor (U

5 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Change in money wages = Output-gap effect + Expectational effect Overall Effect on Wages For example: Y>Y*  excess labor demand  2% wage increases 3% due to expected wages total money wages = 2% + 3% = 5%

6 Copyright © 2008 Pearson Addison-Wesley. All rights reserved forward-looking? - backward-looking? - a combination of both? APPLYING ECONOMIC CONCEPTS 30.1 How Do People Form Their Expectations? How do people form their expectations?

7 Copyright © 2008 Pearson Addison-Wesley. All rights reserved From Wages to Prices Overall effect on nominal wages determines how the AS curve shifts  impact on price level Actual inflation = Output-gap inflation Expected inflation Supply- shock inflation ++ The last term captures any shifts in the AS curve caused by things other than wage changes.

8 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Constant Inflation 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*  no output gap But if there is no output gap, what is causing the inflation?

9 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 30.2 Constant Inflation without Supply Shocks Constant inflation with Y=Y* occurs when the rate of monetary growth, the rate of wage increase, and expected inflation are all consistent with the actual inflation rate.

10 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 30.3 A Demand Shock without Validation Demand Shocks Demand inflation results from a rightward shift in the AD curve. A demand shock that is not validated produces only temporary inflation.

11 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 30.4 A Demand Shock with Validation With monetary validation: -the AD curve shifts further to the right - keeping open the inflationary gap Continued validation turns a transitory inflation into sustained inflation.

12 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 30.5 A Supply Shock with and without Validation If wages fall only slowly (when Y

13 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Is Monetary Validation of Supply Shocks Desirable? One potential danger of validation: - a wage-price spiral could be created Once started, a wage–price spiral can be halted only if the Fed stops validating the supply shocks that are causing the inflation. But the longer it waits to do so, the more firmly held will be the expectations that it will continue its policy of validating the shocks.

14 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Accelerating Inflation Question: What happens to inflation if the central bank tries to maintain an inflationary gap through continued monetary validation? Answer: Inflation will accelerate.

15 Copyright © 2008 Pearson Addison-Wesley. All rights reserved The acceleration hypothesis: - as long as an inflationary gap persists, expectations of inflation will be rising  increases in the rate of inflation Expectational Effects Implications of rising expected inflation: To hold real GDP constant, expansionary monetary policy is needed to shift the AD curve at an increasingly rapid pace to offset the increasingly rapid shifts in the AS curve.

16 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Inflation as a Monetary Phenomenon The causes of inflation: 1. Anything that increases AD will cause P to rise. 2. Anything that increases factor prices will decrease AS and cause P to rise. 3. Unless continual monetary expansion occurs, such increases in P must eventually come to a halt.

17 Copyright © 2008 Pearson Addison-Wesley. All rights reserved The consequences of inflation: 1. In the short run, demand inflation tends to be accompanied by an increase in output above Y*. 2. In the short run, supply inflation tends to be accompanied by a decrease in output below Y*. 3. When costs and prices have fully adjusted, shifts in either AD or AS affect P but leave output unchanged. Inflation as a Monetary Phenomenon

18 Copyright © 2008 Pearson Addison-Wesley. All rights reserved EXTENSIONS IN THEORY 30.1 The Phillips Curve and Accelerating Inflation Inflation as a Monetary Phenomenon

19 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Conclusions about inflation: 1. Without monetary validation, positive AD shocks cause temporary inflation, and output returns to Y*. 2. Without monetary validation, negative AS shocks cause temporary inflation, and output returns to Y*. 3. Inflation initiated by either AD or AS shocks can only be sustained with continuing monetary validation.  Sustained inflation is always a monetary phenomenon! Inflation as a Monetary Phenomenon

20 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Reducing Inflation The Process of Disinflation 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

21 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Begin with a reduction in the rate of monetary expansion. Starting at E 1, suppose the central bank stops increasing the money supply. Phase 1: Removing Monetary Validation The AD curve stops shifting - but inflation expectations keep AS curve shifting Figure 30.6 Eliminating a Sustained Inflation

22 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Stagflation caused by continued shifts in AS curve: - slow-to-adjust expectations -wage momentum Phase 2: Stagflation

23 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Eventually, recovery takes output to Y*, and P is stabilized: Either wages fall, bringing the AS curve back to AS 2 … …or the central bank increases the money supply sufficiently to shift the AD curve to AD 2. Phase 3: Recovery

24 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 30.7 The Cost of Disinflation: the Sacrifice Ratio

25 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Conclusion Throughout the history of economics, inflation has been recognized as a harmful phenomenon. The high inflation rates that the United States experienced in the 1970s and early 1980s were also experienced in many other developed countries. Some commentators have argued that inflation is now “dead.” One of the reasons is the process of globalization that has exerted greater competitive forces to keep inflationary pressures at bay.

26 Copyright © 2008 Pearson Addison-Wesley. All rights reserved APPLYING ECONOMIC CONCEPTS 30.2 The Death of Inflation? The Death of Inflation?


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