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Chapter 10 Inflation and Aggregate Supply Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–1 Chapter 10: Inflation and Aggregate Supply • Inflation, spending, and output: aggregate demand curve • Inflation and aggregate supply • Aggregate demand: aggregate supply diagram • Sources of inflation • Controlling inflation Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–2 Aggregate Demand (AD) • AD is another word for PAE • AD relates demand to the rate of inflation (p) rather than to GDP as in previous chapters • Distinguish price level from its rate of change • A rise in p reduces AD Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–3 Why Does AD Slope Down? • When p exceeds the RBA target, the RBA will react by raising interest rates to reduce AD • Inflation and wealth • Inflation and income distribution • Inflation and uncertainty • Inflation and international competitiveness Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–4 The AD Curve 10–5 Shifts in AD • Exogenous changes in components of PAE • Exogenous changes in the RBA policy reaction function reflected in a higher or lower nominal and real interest rate at any given rate of inflation Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–6 Shifts in AD (cont.) 10–7 Shifts in AD (cont.) 10–8 What Influences Inflation Rate? • • • • Expectations of the inflation rate The size of the output gap between Y and Y* Shocks to the cost of inputs Shocks to Y*: affect the size of the output gap Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–9 Inflation Expectations • Influence the rate of wage increase that workers ask for and employers agree to, and thus the current rate of inflation • Expectations are likewise influenced by current inflation rates • This makes inflation ‘inertial’ • Inertia is reinforced by labour contracts which guarantee real wages, so wages follow prices and prices then follow wages Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–10 Inflation Inertia 10–11 The Size of the Output Gap • Y = Y*: inflation rate constant • Y > Y*: inflation rate rises • Y < Y*: inflation rate falls Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–12 Shocks to the Cost of Inputs • Oil price shocks • Successful attempts to raise money wages faster than rises in labour productivity, causing labour costs per unit of output, and prices, to rise Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–13 Shocks to Y* • Fall in labour force due to retirement of ‘baby boomers’ • Rise in labour force due to immigration of skilled workers • Change in industrial relations which make it more/less attractive for employers to hire workers • Changes in taxes/pensions/unemployment benefits which make it more/less attractive to seek work • Productivity-enhancing technology • Rise in energy prices and capital obsolescence Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–14 Short-Run Aggregate Supply • SRAS depicts the current rate of inflation, determined by inflationary expectations • Like GDP, these expectations are constant in the SR • So SRAS is horizontal Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–15 Long-Run Aggregate Supply • LRAS is determined by Y* • Does not depend on p • LRAS is vertical Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–16 Aggregate Demand and Supply 10–17 Recessionary Gap • Y < Y*: cyclical unemployment so unemployment is above the natural rate • Workers ask for wage increases less than the current inflation rate to reduce real wages and keep/get jobs • The inflation rate falls • Shift along AD as the inflation rate falls • Y increases • This continues until Y = Y* Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–18 Recessionary Gap 10–19 Inflationary Gap • Y > Y*: unemployment below the natural rate • Excess demand for labour: workers ask for, and are granted, wage increases in excess of the inflation rate • The inflation rate rises • AD falls as the inflation rate rises • Y falls • This continues until Y = Y* Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–20 Inflationary Gap 10–21 Does the Economy Self-Correct? • Yes, in the long run • But how long is the ‘long run’? • How long it takes to get out of a recessionary gap without stimulus from the RBA depends on the flexibility of real wages (money wages growing slower than prices) • This depends on the strength of unions and the attitude of wage-fixing authorities • When Keynes was writing, there was zero inflation, so a fall in real wages required an absolute fall in money wages, which was strongly resisted • In Keynes’ time, ‘long run’ was ‘too long’ to wait Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–22 Self-Correcting Inflationary Gaps • This is achieved by a rise in the inflation rate • In the view of the RBA, inflationary gaps should not be allowed to develop, because inflation is so harmful and difficult to eradicate once it has fed into expectations • So the RBA is not willing to rely on this selfcorrecting mechanism Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–23 Causes of High Inflation • Excessive spending • Shocks to the cost of inputs (oil and labour) combined with wage indexation • Rapid depreciation of the currency, which raises the domestic cost of imported raw materials, combined with wage indexation Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–24 Policy Dilemma for RBA • Suppose inflation shock lifts SRAS: two options 1. Do nothing: leads to a recession/unemployment, and eventually a fall in the inflation rate, as wages rise more slowly than prices 2. Increase AD: avoids recession but stabilises the rate of inflation at the higher rate, which may be unacceptably high • In the 1970s the RBA and other central banks chose the first option, to force workers to accept a fall in real wages following a wage ‘breakout’ and rise in oil prices Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–25 Policy Dilemma 10–26 Reducing Inflation Expectations • Two options 1. As in 1989, RBA imposes a recession, so wage growth falls below price growth and the actual rate of inflation falls. Costly in terms of unemployment and lost output 2. RBA announces a lower inflation target • If credible, expectations follow the lower target, and workers and employers negotiate new wage agreements which reflect the new target Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–27 Reducing Inflation Expectations (cont.) • The economy smoothly transits to lower inflation • Illustrates the value of RBA credibility • RBA maintains credibility by continually publicising its inflation targets, achieving them, and operating at ‘arms length’ from government/politicians Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–28 Painful Inflation Reduction 10–29 Zero Inflation? • Zero inflation is neither easy nor desirable • To have zero inflation (a constant average price level) significant areas of the economy (manufacturing) must experience actual price falls (deflation) • This is because service prices (health care and education etc.) must rise relative to goods prices • Deflation creates bankruptcy for business in debt • With zero inflation, the only way to reduce real wages to cure unemployment would be to cut money wages, which is strongly resisted with strikes/riots (refer back to slide 22) Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 10–30