Download Inflation

Inflation
Learning Objectives
• To understand the difference between a demand
shock and a supply shock.
• To understand the difference between demand
inflation and supply inflation.
• To construct the short-run and long-run Phillips curve
as well as the expectations augmented Phillips curve.
• To examine the effects of demand and supply
changes on the rate of change in real GDP and the
inflation rate.
• To consider the impact of supply shocks on
unemployment.
Demand Shock
• A demand shock is a sustained acceleration or
deceleration in aggregate demand, measured
most directly as a sustained acceleration or
deceleration in the growth rate of nominal
GDP.
• Demand inflation is a sustained increase in
prices that is preceded by a permanent
acceleration of nominal GDP growth.
Supply Shock
• A supply shock is caused by a sharp change in
the price of an important commodity that
causes the inflation rate to rise or fall in the
absence of demand.
• Supply inflation is an increase in prices that
stems from an increase in business costs not
directly related to a prior acceleration of
nominal GDP growth.
Real GDP, the Inflation Rate, and the
Short-Run Phillips Curve
• Demand Pull Inflation
– A continuous increase in demand pulls the price
level up continuously.
• This type of inflation can be caused by large
government budget deficits and excessive rates of
growth of the money supply.
Aggregate Demand and the Phillips
Curve
P
LAS
SAS0
1.03
1.00
0
p
E1
100
3
0
-3
0
When AD0 shifts to AD1, the price
level moves to 1.03 at point E1.
E0
AD0
106
E1
E0
100
106
Top Graph:
The economy starts in long-run
equilibrium at point E0., where the
price level equals 1.00.
AD1
Bottom Graph:
The SP line is the short-run Phillips
curve and it shows the relationship
SP0(pe = 0)
between the inflation rate and real
GDP, when price change expectations
equal zero.
Y
Y
One Shot Increase in Aggregate
Demand and the Phillips Curve
P
LAS
SAS1
1.06
SAS0
D
1.03
1.00
0
p
E1
E0
100
0
AD1
Y
SP0(pe = 0)
3
0
-3
When AD0 shifts to AD1, the price
level moves to 1.03 at point E1.
AD1’
AD0
106
E1
E0
100
106
The economy starts in long-run
equilibrium at point E0 .
Y
At E1, there is upward pressure on
the wage rate, causing SAS to shift
up.
As SAS shifts, we move to a point like
D.
Continuous Increase in Aggregate
Demand and the Phillips Curve
P
LAS
SAS1
1.06
D
1.03
1.00
0
p
E’1
E1
E0
100
AD1’
AD0
106
0
AD1
Y
E1
106
To prevent output from declining, AD
must increase continuously.
The SP line shows that to maintain Y
above 100, AD must rise continuously
and create a continuous 3% inflation.
E0
100
When AD0 shifts to AD1, the price
level moves to 1.03 at point E1.
At E1, there is continuous upward
pressure on the wage rate, causing
SAS to shift up over time.
SP0(pe = 0)
3
0
-3
SAS0
The economy starts in long-run
equilibrium at point E0.
Y
The SP Curve
• Why is there continuous upward pressure for higher
wages in the model?
• The short-run Phillips curve (SP curve) is a schedule
relating real GDP to the inflation rate achievable
given a fixed expected rate of inflation.
• Consequently, the continuous upward pressure for
higher wages exists because contracts fail to
anticipate further inflation, and as a result fail to
specify in advance the wage increases needed to keep
up with inflation.
The Expectations Augmented Phillips
Curve
• The expectations augmented short-run Phillips
curve (SP curve) shifts its position whenever
there is a change in the expected rate of
inflation.
– Expectations of rising inflation shift the SP curve
up and to the left.
– Expectations of falling inflation shift the SP curve
down and to the right.
Expectations
• Forward-looking Expectations
– Attempt to predict the future behavior of an
economic variable, using an economic model that
specifies the interrelationship of that variable with
other variables
• Backward-looking Expectations
– Use only information on the past behavior of
economic variables.
Expectations Augmented Short-Run
Phillips Curve
p
LP(pe=p)
3
E2
0
E0
When people fully expect
3% inflation, the SP curve
SP1(pe=3) shifts up and to the left by 3%.
SP0(pe=0) Long-run equilibrium occurs at
point E2.
E1
-3
0
94 97 100 103 106 109
Y
The vertical LP line shows
all the possible positions of
long-run equilibrium, where
the actual and expected
inflation rates are equal (pe=p).
Policy Implication of the LP Curve
• The policy implication of the long-run Phillips
curve (LP curve) is that the best way to
stabilize the economy is to adopt policies to
keep real GDP equal to the natural rate of
GDP.
– Restrictive policies are required when AD>LRAS
– Expansionary polices are required when
AD<LRAS.
Nominal GDP Growth and Inflation
• Definitions:
– Nominal GDP equals the price level times real
GDP.
• X = PY
– The growth rate of nominal GDP equals the sum of
the growth rates of the price level and real GDP
•x = p + y
where
• x = Growth rate of nominal GDP
• p = Growth rate of the price level
• y = Growth rate of real GDP
3 Propositions
1. When inflation is greater than the growth of
nominal GDP, real GDP growth must fall.
2. When inflation equals the growth of nominal
GDP, real GDP growth equals zero
3. When inflation is less than the growth of
nominal GDP, real GDP growth is positive.
Nominal GDP Growth and Inflation
Level of Variable
Growth Rate of Variable Between
Periods 0 and 1
Period
X
Y
P
x
y
p
Alternative A
p = 9%
0
1
100
106
100
97
1.00
1.09
6
-3
9
Alternative B
p = 6%
0
1
100
106
100
100
1.00
1.06
6
0
6
Alternative C
p = 3%
0
1
100
106
100
103
1.00
1.03
6
3
3
Equilibrium in the Long-Run
•
Long run equilibrium is defined by the
following three conditions:
1. The economy is on the SP curve.
2. x = p, which implies that y = 0.
•
x = p + y
so if x = p, (x – p) = 0 and y = 0.
3. pe = p, price expectations are accurate.
Long-Run Equilibrium
P
LAS
SAS0
1.00
E0
AD0
0
p
100
SP0(pe = 0)
3
0
-3
0
Y
E0
100
Y
Top Graph:
The economy starts in long-run
equilibrium at point E0., where the
price level equals 1.00.
Bottom Graph:
At the point E0, the economy is on
the SP curve, pe = p = 0, and x = p.
Acceleration in Nominal GDP: Effects
p
6
LP
(pe
0
=p)
E3
A permanent 6% acceleration in nominal
GDP growth moves the economy in the
first period to point F.
F
2
0
Initially, the economy is at E0, with actual
SP0(pe=0) and expected inflation of 0%.
E0
D
104
94 97 100 103 106
In the short-run if the expected rate of
inflation fails to respond to faster actual
inflation, the economy moves to point E3.
Y
112
The economy never moves to point D.
Acceleration in Nominal GDP:
Point E0
p
6
LP (pe =p)
0
One of the equilibrium conditions no longer
holds.
F
2
0
The permanent acceleration of GDP growth
means that the economy cannot stay at point
e
SP0(p =0) E0.
E3
E0
The 6% value of x exceeds the 0% initial value
of p, so GDP must grow.
D
104
94 97 100 103 106
Y
112
With no price increases, firms respond to
rising spending by producing more goods and
services.
The growth rate of real GDP becomes positive
when nominal GDP growth exceeds the
inflation rate.
Acceleration in Nominal GDP: Point D
p
6
LP (pe =p)
0
One of the equilibrium conditions no
longer holds.
F
2
0
SP0(pe=0)
E3
E0
The permanent acceleration of GDP
growth also means that the economy
cannot go to point D.
D
104
94 97 100 103 106
Y
112
Point D does not lie on the SP curve,
so it cannot represent a combination
of output and inflation that is
consistent with profit maximizing
business behavior and zero expected
inflation.
Acceleration in Nominal GDP: Point F
p
6
LP (pe =p)
0
At point F, the inflation rate is 2%,
while real GDP has grown by 4%; ie.,
y = x – p = 4% = 6% - 2%.
F
2
0
SP0(pe=0)
E3
E0
The permanent acceleration of GDP
growth means that in the short-run
the economy will go to point F.
D
104
94 97 100 103 106
Y
112
A 6% acceleration in the rate of
growth of nominal GDP causes the
economy to slide up the SP curve,
dividing the growth in nominal GDP
between real GDP growth and
inflation.
Acceleration in Nominal GDP:
Point E3
p
6
LP (pe =p)
E3
0
At point F, x does not equal p and pe does
not equal p.
F
2
0
The permanent acceleration of GDP
growth means that in the economy cannot
e
SP0(p =0) stay at point F.
E0
If x is greater than p, y must grow,
moving the economy to the right of point
F.
D
104
94 97 100 103 106
Y
112
Real GDP must keep growing until
inflation rises by enough so that x= p =6.
The economy must move to point E3.
Acceleration in Nominal GDP:
Point E4
p
6
LP (pe =p)
0
E3
E4
At point E3, x = p, but pe still does not
equal p.
F
2
0
The permanent acceleration of GDP
growth means that in the long-run the
e
SP0(p =0) economy cannot stay at point E .
3
E0
As labor negotiations react to the higher
6% rate of inflation, wage demands will
rise, causing the SP curve to shift up and
to the left.
D
104
94 97 100 103 106
Y
112
The SP curve will stop shifting only when
the economy reaches point E4, where all
equilibrium conditions are met.
Acceleration in Nominal GDP:
Summary
SP1(pe=6)
p
6
LP
(pe
=p)
SP0(pe=0)
E4
0
A permanent 6% acceleration in nominal
GDP growth moves the economy in the
first period to point F.
F
2
0
E3
If the expected rate of inflation fails to
respond to faster actual inflation, the
economy eventually moves to point E3.
E0
104
94 97 100 103 106
Initially, the economy is at E0, with actual
and expected inflation of 0%.
Y
112
As expectations adjust, the economy moves
to point E4.
Adjustment Loop
LP (pe =p)
p
SP0(pe=0)
9
5
3
E4
7
E3
4
6
6
Initially, the economy is at E0, with actual
and expected inflation of 0%.
8
3
2 H
But, if expectations adjust fully to the last
period’s actual inflation, the economy moves
along the red path to E4.
1
F
0
0
E0
Y
94 97 100 103 106
When expectations do not adjust and the
nominal growth of GDP increases by 6%,
the economy moves along the black path to E3.
112
For example, if inflation increases by 2%
as the economy moves from E0 to F, the SP
curve shifts to the left by 2% in the next period,
so the economy moves to point H.
Adjustment Loops: Path
Characteristics
• An acceleration of demand growth raises the
inflation rate and real GDP in the short run.
• In the long run, if expectations adjust to the actual
behavior of inflation, the inflation rate rises by
exactly the same amount as nominal GDP, and any
increase in real GDP along the way is only
temporary.
• Following a permanent increase in nominal GDP
growth, inflation always experiences a temporary
period when it overshoots the new growth rate of
nominal GDP.
Overshooting
•
Overshooting occurs because the economy
arrives at its long-run inflation rate in period 3
before expected inflation has caught up with
actual inflation.
–
The subsequent points that lie above 6% reflect the
combined influence on inflation of:
1. The continued upward demand pressure that raises
actual inflation above expected inflation whenever the
economy is to the right of the LP line.
2. The upward adjustment of expectations.
Disinflation
•
•
•
Disinflation is a marked deceleration in the
inflation rate.
Recessions cause a decrease in aggregate
demand and result in disinflation.
The “cold turkey” remedy for inflation
operates by implementing a sudden and
permanent slowdown in nominal GDP growth.
Deceleration in Nominal GDP: Effects
p
LP
(pe
=p)
13
10
8
4
0
Initially, the economy is at E5, with actual
and expected inflation of 10%.
SP2(pe=10)
E5
A permanent 6% deceleration in nominal
GDP growth moves the economy in the
first period to point K.
E6
At point K, the inflation rate has fallen by
2% and real GDP has fallen by 4%.
SP3(pe=4)
K
Y
94 96 100 103
106 109
As expectations adjust and the SP curve
shifts down and right, the economy moves
to point E6.
Adjustment Loop
Initially, the economy is at E4, with actual
and expected inflation of 10%.
LP (pe =p)
p
E4 1980
A permanent 6% deceleration in nominal
GDP growth causes a recession and
disinflation.
1990
The red line between E4 and 1981 traces
the same path as between E5 and K in the
previous slide.
12
10
8
6
1981
1982
4
1983
2
0
E5
1985
1984
94 96 98 100
1986
Y
102 104 106
For the remaining years, the economy
follows the red path.
The Output Cost of Disinflation
• The cost of disinflation is a slump in output.
• The alternative is to live with inflation and no
growth in GDP.
• The sacrifice ratio is the cumulative loss of
output incurred during a disinflation divided by
the permanent reduction in the inflation rate.
• The sacrifice ratio illustrates the trade-off
between permanently reducing inflation and
learning to live with it.
Real World Sacrifice Ratio
• The real world the cumulative loss of output is
measured by the ratio of actual GDP to full
employment GDP.
• The cumulative loss of output during 1980-85
was 26.4%. During that period, inflation fell
from 9% to 3%. The sacrifice ratio was 4.4.
• The recession of the early 1990s reduced
inflation by 1.7% while the cumulative loss of
output was 4.7. The sacrifice ratio was 2.8
Supply Disturbances
• Supply inflation is an increase in prices that
stems from an increase in business costs not
directly related to a price acceleration of
nominal GDP growth.
• During the 1970s, changes in nominal GDP
growth did not explain changes in the inflation
rate very well.
– The US inflation rate exhibited volatile
accelerations and decelerations that were not
preceded by changes in nominal GDP growth.
Types of Supply Shocks
• Supply shocks can be adverse or beneficial.
• Adverse supply shocks make inflation worse
and cause real GDP to fall.
– A rise in the price of an important resource.
– Weather changes that disrupt agriculture.
• Beneficial supply shocks reduce inflation and
cause real GDP to rise.
– A fall in the price of an important resource.
– Lower real price of imports.
Supply Shocks and the SP Curve
• Adverse supply shocks shift the SP curve up
and left.
– At every level of output, inflation is higher or at
every inflation rate output is lower.
• Beneficial supply shocks shift the SP curve
down and right.
– At every level of output, inflation is lower or at
every inflation rate output is higher.
Adverse Supply Shock and the SP
Curve
p
LP (pe =p)
The economy begins at point
E4 with an output ratio of
SP2(pe=6) 100% and actual and
expected inflation of 6%.
SP3(pe=6)
12
9
6
The supply shock shifts the
SP curve up and to the left.
E4
The impact of the supply
shock depends on the policy
response.
3
0
0
88 91 94 97 98 100 103 106
Y/YN
Adverse Supply Shock and the SP
Curve The impact of the supply
shock depends on the policy
SP3(pe=6) response.
p
12
N
9
8
SP2(pe=6) An accommodating policy
moves the economy from
point E4 to point N.
L
M
E4
A neutral policy moves the
economy from point E4 to
point L.
6
3
0
0
88 91 94 96 97 100 103 106
Y/YN
An extinguishing policy
moves the economy from
point E4 to point M.
Policies
• A neutral policy maintains nominal GDP
growth to allow a decline in the output ratio
equal to the increase of the inflation rate.
• An accommodating policy raises nominal GDP
growth to maintain the original output ratio.
• An extinguishing policy reduces nominal GDP
growth to maintain the original inflation rate.
The Impact of Supply Shocks in
Subsequent Periods
• If the supply shock occurs in only one period,
the SP curve shifts back to its original position
when the shock is reversed.
• This happens, however, only if inflation
expectations are not changed by the supply
shock.
• Is this plausible?
The Impact of Supply Shocks in
Subsequent Periods
• The response of the expected inflation rate to
the supply shock depends on:
– whether people view the supply shock as
permanent or temporary and on
– whether labor contracts incorporate cost-of-living
agreements that automatically boost wages by a
percentage that is related to the inflation rate.
The Impact of Supply Shocks in
Subsequent Periods
• COLAs
– COLAs automatically incorporate the one-period
increase of inflation into faster growth of nominal
wages in the next period.
– This means that it is not possible to return to the
point E4 because the expected rate of inflation will
shift up above the original 6%, causing the SP curve
to shift up.
COLAs and Monetary Policy
• COLAs imply that a permanent supply shock
will permanently raise the inflation rate unless
an extinguishing policy response to the initial
impact of the supply shock prevents any
increase of inflation and the rate of change in
nominal wage rates.
• Therefore, COLAs present a policy dilemma for
the makers of monetary policy.
Social Costs of Inflation and Monetary
Policy
• The Fed faces a trade-off between inflation
and lost output.
– If the Fed imposes an extinguishing policy, the
loss in output could be severe as GDP falls.
– However, if the Fed pursues an accommodating
or neutral policy the social costs of permanently
higher inflation might be relatively small.
Beneficial Supply Shocks
•
Beneficial supply shocks shift the SP curve
downward and to the right.
–
This means that policy makers may choose
between lower inflation, a higher output ratio or
both.
•
Gordon (p253) attributes the excellent economy of the
late 1990s on the deceleration of inflation which he
argues was not due to “brilliant” monetary policy, but
rather to four beneficial supply shocks.
Beneficial Supply Shocks
•
Four Beneficial Supply Shocks of the 1990s.
1.
2.
3.
4.
Lower real price of energy
Lower real price of imports
Faster decline in the real prices of computers
Slower inflation in medical care
Beneficial Supply Shocks and
Unemployment
•
The beneficial supply shocks of the 1990s
also help to explain the decline in the natural
rate of unemployment.
–
As GDP rises, unemployment falls.
•
•
•
During the 1990s the natural rate of unemployment
fell.
From 1995 and until 2001, the unemployment rate
was below the natural rate of unemployment.
During this period, the rate of inflation decelerated up
through mid-1999.
Explanations of the Decline in the
Natural Rate of Unemployment
•
Demographic Changes
–
The fraction of teenagers and young adults fell in
the 1980s and 1990s.
•
–
Higher rates of imprisonment of young males.
•
–
These groups typically have higher rates of
unemployment.
In 1998, 2.3% of young males were imprisoned, up
from 1.15% in 1985.
Temporary help agencies and the Internet
•
These agencies help firms fill vacancies faster.