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Chapter 8 Inflation: Its Causes and Cures Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Definition: Inflation • Inflation is a sustained upward movement in the aggregate price level that is shared by most products. – The price level is notated P – Inflation is notated p = %∆P • The Core Inflation Rate is the inflation rate for all products and services other than food and energy. – The Federal Reserve target core inflation rate is about 2%. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-2 The Output Ratio and Inflation • The Output Ratio is the ratio of actual real GDP to natural real GDP (i.e. Y/YN ). – If Y/YN = 100%, p is constant – If Y/YN > 100%, p is accelerating – If Y/YN < 100%, p is decelerating • What affects the output ratio? – A Demand Shock is a sustained acceleration or deceleration in AD, measured most directly as a sustained acceleration or deceleration in the growth of nominal GDP. – A Supply Shock is caused by a sharp change in the price of an important commodity (e.g. oil) that causes the inflation rate to rise or fall in the absence of demand shocks. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-3 Figure 8-1 The Inflation Rate and the Output Ratio, 1960–2007 Sources: Bureau of Economic Analysis NIPA Tables and research by Robert J. Gordon. Details in Appendix C-4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-4 Temporary vs. Continuous Inflation • A one-shot increase in AD will cause only temporary inflation as the output ratio rises above 100% and pushes up wages causing the SAS curve to shift back. • A continuous increase in AD can potentially cause continued inflation as wages rise (shifting back the SAS curve) together with continued shifts to the right of the AD curve. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-5 The Phillips Curve • The Short-Run Phillips (SP) Curve is the schedule relating the inflation rate and real GDP given a fixed expected rate of inflation. – The Expected Rate of Inflation (pe) is the rate of inflation that is expected to occur in the future. – The SP Curve is also known as the Expectations-Augmented Phillips Curve because it shifts its position whenever there is a change in the expected rate of inflation. • The Long-Run Phillips (LP) Curve gives the output ratio when inflation is accurately anticipated (i.e. pe = p). – Since prices and wages are perfectly flexible in the long-run, the LP curve is a vertical line at Y/YN = 100%. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-6 Figure 8-2 Relationship of the Short-Run Aggregate Supply (SAS) Curve to the ShortRun Phillips (SP) Curve Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-7 Figure 8-3 Effect on the Short-Run Phillips Curve of an Increase in the Expected Inflation Rate (pe) from Zero to 3 Percent Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-8 Nominal GDP Growth and Inflation • Recall: Nominal GDP (X) is related to the price level (P) and real GDP (Y) as follows: X = PY (Note: Lower case letters represent the growth rates of the same variables) • When is the economy at a long-run equilibrium? – It must be operating on the SP curve. – Inflation must equal the growth rate of nominal GDP: x = p real GDP growth = 0 (Or if y > 0 x = p + y) – The economy must be on the LP line with pe = p. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-9 Table 8-1 Alternative Divisions of 6 Percent Nominal GDP Growth Between Inflation and Real GDP Growth Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-10 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-11 Figure 8-5 Effect on Inflation and Real GDP of an Acceleration of Demand Growth from Zero to 6 Percent Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-12 Different Types of Expectations • The speed of adjustment of inflation expectations affects how long Y can be pushed beyond YN. • 3 Types of Expectations – Forward-looking Expectations attempt to predict the future behavior of an economic variable using economic models. – Backward-looking Expectations use only information on the past behavior of economic variables. – Adaptive Expectations base expectations for next period’s values on an average of actual values during previous periods. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-13 The Cure for Inflation: Recession • Theoretically, if an increase in nominal GDP causes inflation, then a recession should do the opposite. – Disinflation is a marked deceleration in the inflation rate. • How can disinflation be achieved? – The “Cold Turkey” approach to disinflation operates by implementing a sudden and permanent slowdown in nominal GDP growth. • The cost of disinflation is measured by the Sacrifice Ratio, which is the cumulative loss of output incurred during a disinflation divided by the permanent reduction in the inflation rate. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-14 Figure 8-6 Initial Effect on Inflation and Real GDP of a Slowdown in Nominal GDP Growth from 10 Percent to 4 Percent Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-15 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-16 International Perspective: Did Disinflation in Europe Differ from That in the United States? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-17 Figure 8-8 Four-Quarter Growth Rate of the GDP Deflator and the Level of Nominal and Real Oil Prices, 1970–2007 Sources: Top frame: Bureau of Economic Analysis NIPA Tables. Details in Appendix C-4. Bottom frame: Energy Information Administration Monthly Energy Review. Details in Appendix C-4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-18 Demand vs. Supply Inflation • Demand Inflation is a sustained increase in prices that is preceded by a permanent acceleration of nominal GDP growth. • Supply Inflation is an increase in prices that stems from an increase in business costs not directly related to prior acceleration of nominal GDP growth. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-19 Types of Supply Shocks • Changes in business input costs (like Poil) • Weather shocks that affect farm prices • Import price shocks due to fluctuating exchange rates – If the value of the dollar falls, imported goods become more expensive. • Productivity growth shocks that change the amount workers can produce Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-20 Figure 8-9 The Effect on the Inflation Rate and the Output Ratio of an Adverse Supply Shock That Shifts the SP Curve Upward by 3 Percent Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-21 Policy Responses to Supply Shocks • Following a supply shock, there are three possible policy responses: – A Neutral Policy maintains nominal GDP growth so as to allow a decline in the output ratio equal to the increase in the inflation rate. – An Accommodating Policy raises nominal GDP growth so as to maintain the original output ratio. – An Extinguishing Policy reduces nominal GDP growth so as to maintain the original inflation rate. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-22 Figure 8-10 Effect of Adverse Supply Shock in the 1970s and Beneficial Supply Shocks in the 1990s Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-23 Figure 8-11 Responses of the Inflation Rate (p) and the Output Ratio (Y/YN) to Shifts in Nominal GDP Growth and in the SP Curve (1 of 2) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-24 Figure 8-11 Responses of the Inflation Rate (p) and the Output Ratio (Y/YN) to Shifts in Nominal GDP Growth and in the SP Curve (2 of 2) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-25 Figure 8-12 The U.S. Ratio of Actual to Natural Real GDP (Y/YN) and the Unemployment Rate, 1965–2007 Sources: Appendix Table A-1. Bureau of Labor Statistics, Bureau of Economic Analysis, and research by Robert J. Gordon. Details in Appendix C-4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-26 Figure 8-13 The Unemployment Rate and the Inflation Rate, 1960–2007 Source: Bureau of Labor Statistics and Bureau of Economic Analysis NIPA Tables. Details in Appendix C-4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-27 Figure 8-14 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-28 Figure 8-15 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-29 Chapter Equations Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-30 Chapter Equations X PY x p y y x p Copyright © 2009 Pearson Addison-Wesley. All rights reserved. (8.1) (8.2) (8.3) 8-31 Appendix Equations General Linear Form Numerical Example p p e gY z p p e 0.5Y General Linear Form Numerical Example p jp1 (1 j ) pe1 p e pe1 General Linear Form Numerical Example p p e gY z p p e 0.5Y (1) (2) (3) x p y (4) x yN p y yN (5) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-32 Appendix Equations x p Y Y 1 (6) Y Y 1 x p (7) p jp1 (1 j ) pe1 g (Y 1 x p ) z (8) General Linear Form Numerical Example 1 2 e p jp1 1 j p1 g Y 1 x z p p1 0.5 Y 1 x 1 g 3 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. (9) 8-33 Appendix Equations 1 e p p1 g Y 1 x z 1 g General Linear Form Numerical Example U U N hY U U N 0.5Y General Linear Form Numerical Example U U 1 h y y N U U 1 0.5 y y N Copyright © 2009 Pearson Addison-Wesley. All rights reserved. (10) (11) (12) 8-34
