Download Inflation: Its Causes and Cures Inflation • Introduction

Inflation
• Introduction
– Examine
Inflation:
Its Causes and Cures
• the fundamental causes of inflation
• the responsiveness of inflation to shifts in AD & AS
– Inflation requires
• a continuous increase in AD, or
• a continuous contraction in AS
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Figure 8-1 Relationship of the Short-Run Aggregate Supply Curve (SAS) to the Short-Run
Phillips Curve (SP)
Inflation
• Real GDP, the Inflation Rate, and the
Short-Run Phillips Curve
– Introduction
• A continuous increase in AD pulls the price level up
continuously
– Demand pull inflation
» Figure 8-1
» Key assumption: nominal wages do not adjust
instantaneously
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Inflation
Inflation
• Real GDP, the Inflation Rate, and the
Short-Run Phillips Curve (continued)
• Real GDP, the Inflation Rate, and the
Short-Run Phillips Curve (continued)
– Effects of an Increase in Aggregate Demand
– How Continuous Inflation Occurs
» Figure 8-1
• A One-Shot Increase in Aggregate Demand
» Figure 8-1 (top)
• A Continuous Increase in Aggregate Demand
» Figure 8-1 (bottom)
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Inflation
Inflation
• Real GDP, the Inflation Rate, and the
Short-Run Phillips Curve (SP) (continued)
• The Adjustment of Expectations
– Changing Inflation Expectations Shift the SP
Curve
– The SP Curve
» Figure 8-2
» Figure 8-1 (bottom)
• Once the SP shifts upward with higher p(e), Y
cannot exceed Y(n) unless p accelerated
• Long-run equilibrium exists only when there is no
pressure for change
• For Y > Y(n) the economy is not in long-term
equilibrium because p > nominal wages
• Nominal wages keep rising because workers have
failed to correctly anticipate future inflation
– p(e) = 0
• Position of SP curve depends on expected p
– Expectations-augmented Phillips curve
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Figure 8-2 Effect on the Short-run Phillips Curve of an Increase in the Expected Inflation
Rate (pe) from Zero to 3 Percent
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Inflation
• The Adjustment of Expectations (con’t)
– The LP “Correct Expectations” Line
• The LP line shows all possible points where p(e) = p
– Long-run Phillips line
– “correct expectations” line
• To the right of the LP line,
p > p(e), p(e) will rise
• To the left of the LP line,
p < p(e), p(e) will fall
• Y cannot be permanently raised beyond Y(n)
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Inflation
Inflation
• Nominal GDP Growth and Inflation
• Effects of an Acceleration in Nominal GDP
Growth
Nominal GDP (X) =
Price Level (P) times Real GDP (Y)
or
X=P*Y
» Figure 8-3
– Begin at (long-term) equilibrium
• on the SP curve
• x = p or y = 0
• p(e) = p
In growth rate terms
x=p+y
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Figure 8-3 The Adjustment Path of Inflation and Real GDP to an Acceleration of Nominal
GDP Growth from Zero to 6 Percent When Expectations Fails to Adjust
Inflation
• Effects of an Acceleration in Nominal GDP
Growth (continued)
– Adjustment process
• Nominal GDP grows
– real GDP grows because x > p
– create disequilibrium because off the SP curve
• Inflation accelerates
– move back to the SP curve
– y < x and p > 0
– Short-term equilibrium established
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Inflation
Inflation
• Effects of an Acceleration in Nominal GDP
Growth (continued)
• Expectations and the Inflation Cycle
– The Continuing Adjustment
– Forward-Looking, Backward-Looking, and
Adaptive Expectations
• How far Y can be increased depends on how fast
p(e) responds to higher p
• Because not in long-term equilibrium
– x > p and p(e) < p
• Because x > p, y > 0
• Forward-Looking Expectations
– economy must continue to grow until x = p
– Based on forecasts of economic variables
• Because p(e) < p
– p(e) must rise, shifting SP curve up
• Process continues until long-term equilibrium is reestablished
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Inflation
Inflation
• Expectations and the Inflation Cycle (con’t)
• The Adjustment of Expectations
(continued)
– Forward-Looking, Backward-Looking, and
Adaptive Expectations (continued)
– Adjustment Loops
• Backward-Looking Expectations
• How the economy actually responds to higher
demand growth will depend on the speed of the
adjustment of expectations
– Based on the past behavior of economic variables
– Rationality of:
» Forecasts are difficult and often incorrect
» The adjustment process is often gradual
– Adaptive expectations
» Expectations are adjusted to the difference between
what was expected to happen and what actually
happened
» Figure 8-4
• Characteristics of the inflation process
– An acceleration in demand raise p and Y in the short-run
– If p(e) adjusts to p then x = p and rise in Y is temporary
– During adjustment p > x
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Figure 8-4 Effect on Inflation and Real GDP of an Acceleration of Demand Growth from
Zero to 6 Percent
Inflation
• Recession as a Cure for Inflation
– How to Achieve Disinflation
– The “Cold Turkey” Remedy for Inflation
» Figure 8-5
• Sudden reduction in demand growth
– Divided between inflation and real output
– Leads to a recession
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Figure 8-5 Initial Effect on Inflation and Real GDP of a Slowdown in Nominal GDP Growth
from 10 Percent to 4 Percent
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Inflation
• Recession as a Cure for Inflation (con’t)
– The Adjustment Process to the New Long-Run
Equilibrium
• Introduction
– Long-run equilibrium exists when
» p=x
» p(e) = p
» “Missouri” effect and the adjustment process
» Figure 8-6
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Figure 8-6 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
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Inflation
• Recession as a Cure for Inflation (con’t)
– The Adjustment Process to the New Long-Run
Equilibrium (continued)
• The Downward Spiraling Loop
– Mirror image of Figure 8-4
– Economy overshoots long-rum equilibrium
• A Fatter Loop
– Shape of the loop and length of the adjustment process
depend on the shape of the SP curve
» Flatter SP curve implies flatter, deeper, and slower
adjustment process
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Inflation
Inflation
• Recession as a Cure for Inflation (con’t)
• CASE STUDY: Why Inflation Declined in
the 1980s and 1990s
– The Output Cost of Disinflation
• The Sacrifice Ratio
– 1981-82: A Classic Disinflation
– The cumulative output lost to achieve a permanent
reduction in inflation
– Cumulative output lost / inflation improvement
• Introduction of tight monetary policy
• Sharp deceleration in nominal GDP growth
» Figure 8-7
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Figure 8-7
The Inflation Rate and the Output Ratio, 1980–1996
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Inflation
• CASE STUDY: Why Inflation Declined in
the 1980s and 1990s (continued)
– Disinflation and the Revival of Inflation During
the 1982-90 Expansion
• Introduction of fiscal expansion
• Re-acceleration in nominal GDP growth
• Oil prices fell sharply in 1986
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Figure 8-8 The Inflation Rate, The Actual Unemployment Rate, and the Natural Rate of
Unemployment, 1980–97
Inflation
• CASE STUDY: Why Inflation Declined in
the 1980s and 1990s (continued)
– Comparing the Actual and Natural Rates of
Unemployment
» Figure 8-8
– Steady Inflation During 1994-1996
• Natural rate of unemployment declined
– Declining Inflation During 1997-1998
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Inflation
Inflation
• CASE STUDY: Why Inflation Declined in
the 1980s and 1990s (continued)
• The Importance of Supply Disturbance
– Introduction
• Demand inflation
• Supply inflation
– Why Did the Natural Rate of Unemployment
Decline in the mid-1990s?
» Figure 8-9
• Falling price of computers
• Disinflation for medical care services
• Weaker bargaining position for labor
• Global competition
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Figure 8-9 Four-Quarter Growth Rates of the GDP Deflator and Nominal GDP and the
Level of Nominal and Real Oil Prices, 1970–96
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Inflation
• The Importance of Supply Disturbance
(continued)
– Types of Supply Shocks
• Supply inflation stems from sharp changes in
business costs that are not related to prior changes in
nominal GDP growth
• Temporary versus permanent
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Inflation
Inflation
• The Importance of Supply Disturbance
(continued)
• The Response of Inflation and Real GDP to
a Supply Shock
– Types of Supply Shocks (continued)
– Effects of Supply Shocks on the Price level and
on the Rate of Inflation
• Adverse shocks shift the SP curve backward
– Rising raw material prices
– Regulation and/or less competitive pressures
• Temporary Supply Shocks
– Do inflationary expectations change?
• Beneficial shocks shift the SP curve outward
– Falling raw material prices
– Deregulation and/or increased competitive pressures
– Rapid technological innovation and implementation
• Permanent Supply Shock
– Do inflationary expectations change?
• Supply shocks and policy decisions
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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
Inflation
• The Response of Inflation and Real GDP to
a Supply Shock (continued)
– Supply Shocks and the Short-Run Phillips
Curve (SP)
• Supply Shocks Shift the SP Schedule
» Figure 8-10
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Inflation
Inflation
• The Response of Inflation and Real GDP to
a Supply Shock (continued)
• The Response of Inflation and Real GDP to
a Supply Shock (continued)
– Policy Responses to Adverse Supply Shocks
– What Happens in Subsequent Periods
• Economy’s response depends on the response of
nominal GDP growth which in turn depends on
government policy actions
• Introduction
– SP curve shifts up in the initial period
– What happens next depends on p(e)
» No change in p(e)
» A rise in p(e)
† Viewed as permanent or temporary
† The effect of cost-of-living adjustments (COLAs)
– Neutral Policy Response
» Maintain nominal GDP growth
– Accommodating Policy Response
» Maintain output ratio
– Extinguishing Policy Response
» Maintain inflation rate
• The Policy Dilemma
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Inflation
Inflation
• The Response of Inflation and Real GDP to
a Supply Shock (continued)
• Inflation and Output Fluctuations:
Recapitulation of Causes and Cure
– Effects of Favorable Supply Shocks
– A Summary of Inflation and Output Responses
» Figure 8-11
• Shift the SP curve outward
• The policy options
• Case A: Demand Shifts Alone
• Case B: Supply Shifts Alone
• Case C: Demand and Supply Shifts in the Same
Vertical Direction
• Case D: Demand and Supply Shifts in Opposite
Directions
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Figure 8-11 Responses of the Inflation Rate (p) and the Output Ratio (Y/YN) to Shifts in
Nominal GDP Growth and in SP
Inflation
• Inflation and Output Fluctuations:
Recapitulation of Causes and Cure
– Cures for Inflation
• Policies to slow nominal GDP growth
• Policies to create beneficial supply shocks
• Luck
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