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Chapter 9
Inflation:
Its Causes
and Cures
Copyright © 2012 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%
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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.
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Figure 9-1 The Inflation Rate and the
Output Ratio, 1960–2010
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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.
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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%.
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Figure 9-2 Relationship of the Short-Run
Aggregate Supply (SAS) Curve to the Short-Run
Phillips (SP) Curve
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Figure 9-3 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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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.
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Table 9-1 Alternative Divisions of 6 Percent
Nominal GDP Growth Between Inflation and
Real GDP Growth
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Figure 9-4 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
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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.
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Figure 9-5 Effect on Inflation and Real GDP of
an Acceleration of Demand Growth from Zero
to 6 Percent
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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.
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Figure 9-6 Initial Effect on Inflation and Real
GDP of a Slowdown in Nominal GDP Growth
from 10 Percent to 4 Percent
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Figure 9-7 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
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International Perspective Did Disinflation in
Europe Differ from That in the United States?
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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.
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Figure 9-8 Four-Quarter Growth Rate of the
GDP Deflator and the Level of Nominal and
Real Oil Prices, 1970-2010
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Types of Supply Shocks
• Changes in business input costs (like Poil)
• Weather shocks that affect farm prices
• Import price shocks due to fluctuating ER’s
– If the value of the dollar falls, imported goods become
more expensive.
• Productivity growth shocks that change the
amount workers can produce
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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.
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Figure 9-9 The Effect on the Inflation Rate and the
Output Ratio of an Adverse Supply Shock That Shifts the
SP Curve Upward by 3 Percent
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The Role of Ιnflation During the Housing
Bubble and Subsequent Economic Collapse
Inflation and the Output Ratio Have No Systematic Relation
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Figure 9-10 Effect of Adverse Supply Shocks
in the 1970s and Beneficial Supply Shocks in
the 1990s
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Figure 9-11 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)
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Figure 9-11 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)
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Cures for Inflation
• Fundamental causes of inflation:
– Excessive nominal GDP growth
– Adverse supply shocks
• Government approaches to cure inflation
– Slow nominal GDP growth
– Create beneficial supply shocks
• Eliminate or weaken price- or cost-raising legislation
• Creative tax and/or subsidy policies
• Government should also recognize the presence of
beneficial supply shocks to prepare policies in case
of possible reversals
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Unemployment (U) and Inflation (p)
• Economists often say, “There is a trade-off between
unemployment and inflation.”
– There also is a direct relationship between the output ratio and
unemployment: (Y/YN)↑  U↓
– This relationship is known as Okun’s Law, which explicitly
states that there is a regular negative relationship between the
output ratio and the gap between actual unemployment and the
average rate of unemployment
– Okun’s Law is illustrated in Figure 9-12 (see next slide)
• Thus, the link between U and p is just the inverse of the
relationship between (Y/YN) and p discussed above
– Just as (Y/YN) cannot be above 100% without igniting inflation,
U cannot be below pushed below UN
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Figure 9-12 The U.S. Ratio of Actual to
Natural Real GDP (Y/YN) and the Unemployment
Rate, 1965–2010
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Figure 9-13 The Unemployment Rate
and the Inflation Rate, 1960–2010
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