Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Robert J. Gordon, Macroeconomics, 10 th edition, 2006, Addison-Wesley Chapter 8: Inflation: its Causes and Cures

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Explaining the inflation rate  The AD SAS model implies that nay event that causes a single upward shift in the economy’s AD curve will cause a single upward jump in the price level.  Sustained inflation requires a continuous increase in AD. Inflation or deflation can be caused either by shifts in AD (demand shocks) or in AS (supply shocks).  The volatility history of the inflation rate  Look at figure 8-1. The output ratio is the ratio of actual real GDP to natural real GDP.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 8-1 The Inflation Rate and the Output Ratio, 1960–2004

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  How is inflation related to the output ratio.  there is no unique relationship between inflation and output ratio, but it is assumed that inflation remains constant when the output ratio is 100, and accelerates when the output ratio is above 100 and decelerates when output ratio is below 100.  Demand shocks and supply shocks.  When a positive demand shock (sustained acceleration or deceleration in AD; measured as the growth rate of nominal GDP), inflation increases and the output ratio rises temporarily and a negative demand shock can cause inflation to decelerate.  An adverse supply shock (cause by a sharp change in the price of an important commodity that causes inflation to rise or fall) can boost inflation while causing output ratio to decline. Look at figure 8-1 again.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Real GDP, the inflation rate and the short run Phillips curve  A continuous increase in demand pulls the price level up continuously (demand pull inflation). This can be caused by large government deficit and excessive growth of MS.  Effects of an increase in AD  Shifts AD upward and the economy initially moves to E1. P increases to 103. This puts pressures on nominal wages to rise and SAS shifts up causing P to rise to 106. Look at figure 8-2.  How continuous inflation occurs.  What happens to the output ratio and the price level as a result of the upward shift from SAS0 to SAS1 there are two possibilities.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 8-2 Relationship of the Short-Run Aggregate Supply (SAS) Curve to the Short-Run Phillips (SP) Curve Long run eq.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  A one shot increase in AD.  AD remains at AD1, the economy shifts to D. To prevent the output ratio from declining the AD must shift upward by exactly the same shift of the SAS (from AD1 to AD1’) since price level 1.06 is ahead of the wage rate 1.03, there will be upward pressures on the nominal wage rate.  A continuous increase in AD.  To keep the output ratio from declining the AD must increase continuously and the economy will move straight upward along the black arrows. The maintenance of a high output ratio requires a continuous increase in AD and in the price level.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The SP curve  Look at the bottom frame of 8-2, the SP curve shows that to maintain the output ratio above 100, AD must be raised continuously to create a continuous inflation. Along the SP curve, the economy is not in a long run equilibrium because the price level is constantly racing ahead of the nominal wage rage.  There will be continuous pressures for higher wages. As labor contracts fail to anticipate further inflation, and as a result they fail to specify in advance the wage increases needed to keep up with inflation. These wage contracts have an expected inflation of zero, Shown as the SP0 curve in the frame  The SP curve is the short run Phillips curve, it slops upward indicating a +ve relationship between real GDP and inflation, additional reasons for this relationship are the sensitivity of raw material prices to higher AD and the tendency of firms to boost prices when AD is high.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The position of the SP curve is fixed by the rate of inflation expected at the time current wage contracts were negotiated. that is why it is called expectations augmented Phillips curve.  The adjustments of expectations.  So far we assume that expectations are constant i.e., people never learn to anticipate inflation when negotiating contracts.  Changing inflation expectations shift the SP curve  If negotiators anticipate inflation in advance, the SP curve shifts upward. Look at figure 8-3. now an output ratio above 100 cannot be achieved along SP1, unless actual inflation exceeds 3%, in which case the actual inflation would exceed the expected inflation.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 8-3 Effect on the Short-Run Phillips Curve of an Increase in the Expected Inflation Rate (p e ) from Zero to 3 Percent No inflation is expected Only this point is qualified LAS

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The economy in long run is in equilibrium (no pressures to change) E 1 does not quality, there are pressures to adjust erroneous expectations (p e =0)  The LP correct expectations line.  The LP shows all possible points where expected inflation rate turns out to be correct. To the right of the LP line, inflation turns to be higher than expected, and the expected inflation rate will be raised. To the left of the LP line inflation turns to be lower than expected and inflation will be reduced.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Nominal GDP growth and inflation  The SP curve is a single relationship between inflation rate and output ratio. Starting with the levels of prices (P) nominal GDP (X) and real GDP (Y). X = PY  In this chapter we are interested in the growth rates of these variables x, p, and y, such that; x = p + y  The growth rate of nominal GDP equals inflation plus growth rate of real GDP. Look at table 8-1.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Table 8-1 Alternative Divisions of 6 Percent Nominal GDP Growth Between Inflation and Real GDP Growth

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Effects of an acceleration in nominal GDP growth  How do x affect real GDP Y and inflation p. Look at figure 8-4, if p = p e = 0 and if nominal GDP growth is zero, y must also be zero. y = x – p 0 = 0 – 0  The continuing adjustment  The economy can’t stay at point F (out of long run equilibrium). It violates 2 of the 3 requirements of long term equilibrium (x=p, and that expectations are accurate).  The long run equilibrium meets three conditions; 1: growth of natural GDP = zero, 2: x=p, 3: inflation expectations are accurate (p e =p)

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 8-4 The Adjustment Path of Inflation and the Output Ratio to an Acceleration of Nominal GDP Growth from Zero to 6 Percent When Expectations Fail to Adjust

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Expectations and the Inflation cycle  Forward-looking expectations  Predicting the future behavior of an economic variable using a model of the interrelation of that variable with other variables. Contract negotiators will use a 6% inflation if accelerated inflation in the long run is 6%. This would move the economy from point E 0 to E 4 in figure (8-4).  The rationality of backward-looking expectations.  This simply adjusts expectations to what has already happened in the past. There are two important reasons why rational agents for expectations by looking backward:

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University 1. There may be no reason to believe that an acceleration in nominal GDP will be permanent. 2. Even if the acceleration of nominal GDP is permanent existing contracts and agreements (formal or informal) may prevent actual inflation from adjusting immediately, as changes in wages and prices will adjust gradually to acceleration of nominal GDP. The most popular form of backward-looking expectations is “adaptive expectations”.  Adjustment loops.  Look at figure 8-5, the orange path exhibits several characteristics of the inflation process: 1. Acceleration of demand growth raises inflation and output ratio in the short run

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 8-5 Effect on Inflation and Real GDP of an Acceleration of Demand Growth from Zero to 6 Percent

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University 2. In the long run inflation rate (p) rises by exactly the same amount as (x) 3. Following a permanent increase in nominal growth (x), inflation (p) always experience a temporary period when it overshoots the new growth rate of nominal GDP.  Recession as a cure for inflation  To eliminate inflation, we have to set in reverse the process of inflation (disinflation: deceleration of inflation).  The Cold Turkey remedy for inflation  Look at figure 8-6. Cold turkey operates by implementing a sudden and permanent slowdown in nominal GDP.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 8-6 Initial Effect on Inflation and Real GDP of a Slowdown in Nominal GDP Growth from 10 Percent to 4 Percent

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The process of adjustment to the new long run equilibrium  The process of adjustment comes to end when inflation equals the new growth rate of GDP, and expected inflation has declined to its long run equilibrium value.  The downward spiraling loop  Look at figure 8-7.  The output cost of disinflation  The cold turkey (figure 8-7) leads to a sudden drop in nominal GDP. Thus the cost of disinflation is a slump in output.  A conventional method of the cost of disinflation is the sacrifice ratio; the cumulative loss of output incurred during a disinflation divided by the permanent reduction in inflation rate.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 8-7 Adjustment Path of Inflation and Real GDP to a Policy That Cuts Nominal GDP Growth from 10 Percent in 1980 to 4 Percent in 1981 and Thereafter

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The importance of supply shocks

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University International Perspective Did Disinflation in Europe Differ from That in the United States?

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University

Figure 8-8 The Inflation Rate and the Output Ratio, 1980–95

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University

Figure 8-9 Four-Quarter Growth Rate of the GDP Deflator and the Level of Nominal and Real Oil Prices, 1970–2004

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University

Figure 8-10 The Effect on the Inflation Rate and the Output Ratio of an Adverse Supply Shock That Shifts the SP Curve Upward by 3 Percent

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University

Figure 8-11 Effect of Adverse Supply Shocks in the 1970s and Beneficial Supply Shocks in the 1990s

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University

Figure 8-12 Responses of the Inflation Rate (p) and the Output Ratio (Y/Y N ) to Shifts in Nominal GDP Growth and in the SP Curve (1 of 2)

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University

Figure 8-12 Responses of the Inflation Rate (p) and the Output Ratio (Y/Y N ) to Shifts in Nominal GDP Growth and in the SP Curve (2 of 2)

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University

Figure 8-12 Responses of the Inflation Rate (p) and the Output Ratio (Y/Y N ) to Shifts in Nominal GDP Growth and in the SP Curve

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University

Figure 8-13 The U.S. Ratio of Actual to Natural Real GDP (Y/Y N ) and the Unemployment Rate, 1965–2004

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 8-14 The Unemployment Rate and the Inflation Rate, 1960–2004

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University

Figure 8-15

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University

Figure 8-16

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University