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Chapter 30 Inflation and Disinflation.

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1 Chapter 30 Inflation and Disinflation

2 In this chapter you will learn to
1. Describe the response of wages to change in both output gaps and inflation expectations. 2. Explain how a constant rate of inflation is incorporated into the basic macroeconomic model. 3. Describe the effects of aggregate demand and supply shocks on inflation and real GDP. 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.

3 Figure 30.1 U.S. CPI Inflation, 1965–2006

4 Adding Inflation to the Model
Why Wages Change Output Gaps Y > Y*  excess demand for labor (U<U*) Y < Y*  excess supply of labor (U>U*) Y = Y*  U=U* U* = non-accelerating inflation rate of unemployment 2. Expected Inflation - some workers/firms raise wages in advance of inflation

5 Overall Effect on Wages
Change in money wages + Expectational effect = Output-gap effect For example: Y>Y* excess labor demand 2% wage increases 3% due to expected wages total money wages = 2% + 3% = 5%

6 How do people form their expectations?
- forward-looking? - backward-looking? - a combination of both? APPLYING ECONOMIC CONCEPTS 30.1 How Do People Form Their Expectations?

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

8 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 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 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 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 Figure 30.5 A Supply Shock with and without Validation
Supply Shocks If wages fall only slowly (when Y<Y*), the return to Y* after a non-validated negative supply shock will be slow. Monetary validation of a negative AS shock causes the initial rise in P to be followed by a further rise.

13 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 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 Expectational Effects
The acceleration hypothesis: - as long as an inflationary gap persists, expectations of inflation will be rising  increases in the rate of inflation 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 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 Inflation as a Monetary Phenomenon
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.

18 Inflation as a Monetary Phenomenon
EXTENSIONS IN THEORY 30.1 The Phillips Curve and Accelerating Inflation

19 Inflation as a Monetary Phenomenon
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!

20 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 Figure 30.6 Eliminating a Sustained Inflation
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

22 Phase 2: Stagflation Stagflation caused by continued shifts in AS curve: - slow-to-adjust expectations wage momentum

23 Phase 3: Recovery Eventually, recovery takes output to Y*, and P is stabilized: Either wages fall, bringing the AS curve back to AS2 … …or the central bank increases the money supply sufficiently to shift the AD curve to AD2.

24 Figure 30.7 The Cost of Disinflation: the Sacrifice Ratio

25 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 The Death of Inflation? APPLYING ECONOMIC CONCEPTS The Death of Inflation?

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