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Chapter 14
Inflation
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-1
Learning Objectives
• Derive and examine the so-called Phillips
curve.
• Discuss whether there is any apparent
trade-off between unemployment and
inflation.
• Examine the natural rate hypothesis and
use it to analyse Australia’s experiences
with stagflation.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-2
Learning Objectives (cont.)
• Explore the links between the Phillips
curve model and our model of
aggregate supply.
• Discuss demand-pull and cost-push
inflation in light of our understanding
of the Phillips curve.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-3
Phillips Curve:
Introduction
• Previous lectures assumed that the
economy could experience an inflationary
gap or a recessionary gap but not both!
• Realistically both can occur as shown in the
intermediate range of the AS curve
• Also we must now assume that AS can shift
leftward
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-4
Phillips Curve
• An inverse relationship suggestive of a
trade-off between inflation and the
unemployment rate
• Generalisation:
the greater the rate of growth of AD, the greater the
resulting inflation and GDP, and the lower the
unemployment level
– the slower the rate of growth of AD, the lower the
resulting inflation and GDP, and the higher the
unemployment level
–
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-5
Changes in AD, Real GDP and
the Price Level
ASLR
Price Level
AD0
AD1
AS
P2
AD3
P1
P0
0
Q0
Q1
Q2
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
Real GDP
14-6
Phillips Curve (cont.)
• Evidence:
–
Empirical work by economists in the 1950s and
1960s
• Explanations:
–
–
Labour market imbalances

bottlenecks

structural problems
Market power of unions and big business
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-7
The Phillips Curve Concept
Annual rate of inflation
(per cent)
7
6
as inflation declines...
5
unemployment increases
4
3
2
1
0
1
2
3
4
5
6
7
Unemployment rate (per cent)
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-8
Phillips Curve (cont.)
• Stabilisation policy dilemma:
–
Fiscal and monetary policies act on AD and not
on labour market imbalances and market power
• Two complications:
–
–
Reversibility problem
Shift of AS curve
• Not a reliable basis for economic
policy
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-9
Stagflation—A Shifting
Phillips Curve
Stagflation
• Simultaneous experience of both high
and increasing unemployment and
inflation
• Conflicts with the trade-offs embodied
in the Phillips Curve
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-10
Stability of the Phillips Curve
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-11
Causes of Stagflation
• Aggregate supply shocks such as
severe increases in fuel costs, and
devaluations of the Australian dollar
• Productivity decline
• Inflationary expectations and wages
–
expectations about the likely future path and
rate of increase of the general price level
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-12
Price Level
Aggregate Supply Shocks
AS3
ASLR
AS2
AS1
P3
P2
P1
AD1
0
Q3 Q2 Q1 QF
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
Real GDP
14-13
Natural Rate Hypothesis
• Suggests that there is a unique level of
unemployment around which observed
unemployment will fluctuate
• LR stability corresponds with natural or full-
employment rate of unemployment
• Two variants:
–
theory of adaptive expectations
–
rational expectations theory
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-14
Theory of Adaptive
Expectations
• People form their expectation of future
inflation based on previous and current
rates of inflation
• Series of short-run Phillips curves
–
short-run trade-offs between inflation and unemployment
• Long-run vertical Phillips curve
• Can be employed to explain disinflation
–
reductions in or elimination of the rate of inflation
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-15
Rational Expectations
Theory
• Increases in money wages lag behind
increases in the price level, giving rise
to temporary increases in profits and
employment
• Argues that government measures to
increase employment will only result
in accelerating rates of inflation
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-16
Short-Run Aggregate
Supply
• Short run: period in which input prices
(especially wages) remain fixed in the
presence of a change in the price level
• Constant input prices
–
lack of knowledge of existence of change
–
fixed-wage contracts
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-17
Long-Run Aggregate
Supply
• Long run: period in which input prices
including wages are fully flexible in
the presence of changes in the price
level
• Increasing input prices
–
Workers discover that prices have changed and
demand higher nominal wages to restore their
level of real wages
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-18
New Classical Policy
Implications
• Price-level surprises
–
may create short-run macroeconomic instability
–
however, long-run stability occurs at full-employment level
of output
• Long-run occurs either instantaneously or in
a very short period
• Government intervention is not endorsed
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-19
Short-Run & Long-Run AS
ASLR
AS1
B1
P2
Price Level
AS2
A2
AS3
A1
P1
P3
A3
0
Q3
C1
Q1
Q2
Real domestic
output
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-20
Modern Keynesian Policy
Implications
• Markets are not highly competitive
–
instantaneous adjustments do not occur
• Nominal wage adjustments are very
slow
• Stabilisation policies are required to
reduce the severe costs of
unemployment or inflation
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-21
Demand-Pull Inflation
• Occurs when an increase in AD pulls
up the price level
• Graphically: AD shifts rightward along
a stable AS curve
• Short-run: increased prices and real
output
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-22
Demand-Pull Inflation (cont.)
AS2
ASLR
Price Level
AS1
P3
e3
e2
P2
P1
e1
AD2
AD1
0
Q1 Q2
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
Real GDP
14-23
Demand-Pull Inflation (cont.)
• In the short run demand-pull inflation
will drive up the price level and
increase output
• In the long run, the increase in
aggregate demand has only moved
the economy along the vertical
aggregate supply curve ASLR
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-24
Cost-Push Inflation
• Occurs when an increase in the cost
of production at each price level shifts
the AS curve leftward, resulting in
increased prices
• Short run: increased prices and
decreased real output (and more
unemployment)
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-25
Price Level
Cost-Push Inflation (cont.)
ASLR
AS2
AS1
P3
e′2
P2
P1
e′3
An attempt to
increase AD
will only further
increase the
price level
e′1
AD2
AD1
0
Q2 Q1 Q3
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
Real GDP
14-26
Cost-Push Inflation and
Policy Dilemma
• Government intervention (AD):
If government intervenes to increase AD,
an inflationary spiral will result
• No government intervention (AD):
If government does not intervene to
increase AD, severe recession will result;
however, nominal wages will eventually
decline and restore AS to original position
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-27
Cost-Push Inflation: NonDemand Management Options
• Two categories of non-demand
management policies
–
Market policies
–
Wage–price (or incomes) policies
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-28
Next Chapter
Aggregate Supply and
the Labour Market
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
14-29