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Chapter 9
Inflation: Its Causes and Cures

Chapter Outline
9-1 Introduction
a. Explaining the Inflation Rate: The Central Target of Monetary Policy
b. The Volatile History of the Inflation Rate
c. How Is Inflation Related to the Output Ratio?
d. Demand Shocks and Supply Shocks
9-2 Real GDP, the Inflation Rate, and the Short-Run Phillips Curve
a. Effects of an Increase in Aggregate Demand
b. How Continuous Inflation Occurs
c. The SP Curve
9-3 The Adjustment of Expectations
a. Changing Inflation Expectations Shift the SP Curve
b. The LP “Correct Expectations” Line
Box: Learning About Diagrams: The Short-Run (SP) and Long-Run (LP) Phillips Curves
9-4 Nominal GDP Growth and Inflation
9-5 Effects of an Acceleration in Nominal GDP Growth
9-6 Expectations and the Inflation Cycle
a. Forward-Looking, Backward-Looking, and Adaptive Expectations
b. Adjustment Loops
9-7 Recession as a Cure for Inflation
a. How to Achieve Disinflation
b. The “Cold Turkey” Remedy for Inflation
c. The Process of Adjustment to the New Long-Run Equilibrium
d. The Output Cost of Disinflation
IP Box: Did Disinflation in Europe Differ from that in the United States?
Box: Global Economic Crisis Focus: Policymakers Face the Perils of Deflation
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Chapter 9
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Inflation: Its Causes and Cures
9-8 The Importance of Supply Shocks
a. Types of Supply Shocks
b. Adverse and Beneficial Supply Shocks
c. Supply Shocks, the “Twin Peaks,” and the “Valleys”
9-9 The Response of Inflation and the Output Ratio to a Supply Shock
a. Supply Shocks and the Short-Run Phillips (SP) Curve
b. Policy Responses to Supply Shocks
c. What Happens in Subsequent Periods
Box: Understanding the Global Economic Crisis: The Role of Inflation During the Housing
Bubble and Subsequent Economic Collapse
d. Why Beneficial Supply Shocks Help Us Understand the 1990s
e. Preview: A Graphical Summary of the Role of Supply Shocks
9-10
Inflation and Output Fluctuations: Recapitulation of Causes and Cures
a. A Summary of Inflation and Output Responses
b. Cures for Inflation
9-11
How Is the Unemployment Rate Related to the Inflation Rate?
a. Changes in the Unemployment Rate Are the Mirror Image of Changes in Real GDP
b. The Unemployment Rate, the Output Ratio, and Okun’s Law
c. Interpreting the Postwar History of Unemployment and Inflation
d. Implications of the Unemployment–Inflation Trade-off
Summary
Appendix: The Elementary Algebra of the SP-DG Model
a. Equation for the SP Curve
b. Equation for the DG Line
c. Combining the SP and DG Equations
d. Example When x€ Rises from Zero to 6 Percent
e. Learning to Shift the SP Curve and DG Line
f. Shifting the SP Curve
g. Shifting the DG Line
h. Tracing the Economy’s Adjustment with Shifts in SP and DG
i. The Consequences of a Supply Shock
j. The Behavior of the Unemployment Rate

Chapter Overview
This is a very important chapter for this book as it explains one of the three basic concepts
(inflation) of macroeconomics as mentioned in Chapter 1. To explain the causes of inflation and to
formulate a cure for this problem Gordon extends the static model of price and output
determination as discussed in Chapter 8. This Chapter 9 develops a more general analysis of
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Chapter Overview
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inflation and output and their dynamic behavior over time. The text develops this model in two
steps. First, it derives the short-run Phillips (SP) curve by introducing inflation and inflationary
expectations into the traditional AD-SAS model of Chapter 8. Second, the text develops the
relationship between nominal GDP growth, real GDP growth, and the inflation rate based on
expectation formation. Gordon completes the analysis by combining these relationships together.
Thus, this model determines short-run inflation, long-run inflation, and the path by which the
economy arrives at long-run equilibrium. Next, the chapter discusses the different choices
policymakers can make to alter this dynamic adjustment to long-run equilibrium. The chapter then
extends the model by analyzing the impact of supply shocks (rather than demand shocks) on
inflation. The author explains different types of supply shocks and how inflation formation can be
affected, with the help of the Philips curve analysis. This chapter also discusses the possibility of
positive supply shocks which may cause the inflation rate to decline. The chapter then incorporates
alternative Fed policy responses to mitigate the adverse effect of supply shocks. The chapter also
explains how the unemployment rate is related to inflation rate in the end of the chapter.
The introductory section defines inflation as a continuous increase in the price level rather than a
single increase. Inflation is measured by the (percentage) rate of change of the GDP deflator, and
Section 8-1 explains with numerical example how sustaining inflation may erode the purchasing
power of the economic agents and its adverse effect on the economy. Gordon explains that a central
objective of the Fed is to restrain inflation, which it does by instituting restrictive policies that work
to raise interest rates. In Figure 9-1, Gordon presents an historical graph of the inflation rate and the
output ratio, which is the ratio of actual real GDP to natural real GDP. From the graph, it is not
possible to capture any stable relation between these two variables, but there are periods when
inflation and the output ratio rise and fall together. Gordon explains that when a positive demand
shock occurs, inflation increases and the output ratio rises temporarily. At other times, inflation and
the output ratio may move in opposite directions.
To understand the causes of inflation in the context of a dynamic model, we should analyze the
effect of continuous and sustained changes in aggregate demand on the rate of change of prices—
the inflation rate. This analysis is explained graphically in Figure 9-2, where the AD-SAS model is
used to show how, beginning with Y = YN and both actual and expected inflation equal to zero,
continuous growth in aggregate demand generates a permanent increase in inflation. From this, the
SP (short-run Phillips) curve is derived and its location is shown to depend on the amount of
inflation expected at the time current wage contracts and agreements were made. This figure should
be given careful coverage in your lecture. In this context, a brief review of the model of Chapter 8
will be useful to remind students that the position of the SAS curve depends on the nominal wage
rate and the demand for labor. After an increase in aggregate demand, increases in the nominal
wage shift the SAS curve until the actual real wage is again equal to its equilibrium level of real
wage, and short-run aggregate supply is equal to both long-run aggregate supply and aggregate
demand. To sustain an output level above the natural level requires a continuous, rather than a oneshot, increase in aggregate demand. The simultaneous shifts in AD and SAS which maintain the
above-natural level of GDP result in a continuous increase in the price level, or inflation. This is
why the SP curve slopes upward in Figure 9-2 (when expected rate of inflation is assumed zero).
Explain that even though nominal wages are constantly being adjusted at the beginning of each
period, employers and employees are assuming a constant price level and adjusting each current
period’s wage to the previous period’s price level. This is represented by SP0(pe = 0) in Figure 9-2.
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Under this assumption, then, workers fail to anticipate inflation when the economy is operating at
an output ratio greater than 100 percent.
The important distinction between shifts in SP and movements along SP is covered in Section 9-3.
There are two explanations of why SP shifts upward in response to an increase in the expected
inflation rate. As inflationary expectations are incorporated into nominal wage contracts, (1) a
greater rate of inflation resulting from a larger continuous increase in aggregate demand is
necessary to sustain any given level of the output ratio and (2) the same level of inflation resulting
from the same continuous expansion of aggregate demand sustains a lower level of the output ratio,
and this lower level of output will be 100 percent of the natural level of output when inflationary
expectations are totally accurate (a movement from E0 to E2 in Figure 9-3). The model assumes
that, in the long-run, inflationary expectations are accurate. Therefore, the economy will eventually
adjust to the vertical line at the 100 percent value of the output ratio or the “long-run Phillips curve
(LP).”
Section 9-4 develops the identity linking real GDP growth to nominal GDP growth and the rate of
inflation. Observe that SP gives the combinations of the output ratio and inflation consistent with
equilibrium in the AD-SAS model. It cannot by itself find an equilibrium rate of inflation and output
ratio; thus, another relation between the two variables is needed. It follows from the definition of
nominal GDP (X = PY) that the growth rate of nominal GDP must be divided between the growth
rate of prices (inflation) and the growth rate of real GDP (i.e., x = p + y). You may want to verify
this by presenting the calculus derivation in Footnote 5 of Chapter 9. Given this, the model’s shortrun equilibrium must be a combination of the output ratio and inflation consistent with both SP and
x = p + y.
Section 9-5 analyzes the effect of an increase in nominal GDP growth on the short-run equilibrium
of this economy. Stress that since an increase in nominal GDP growth must be divided between a
rise in inflation and real GDP growth, the short-run equilibrium position must move up along the
given SP. This is clearly illustrated by the numerical example associated with Figure 9-4. The text
next explains the adjustment to long-run equilibrium. After the change in the rate of growth of
nominal GDP, the economy is no longer in long-run equilibrium (where y = 0, p = x, and the
economy is on LP). Inflationary expectations adjust, and subsequent SP shifts continue to produce
short-run equilibriums until the economy reaches long-run equilibrium. Be sure students understand
that the factors causing the acceleration in nominal GDP growth are exactly those factors causing
the acceleration in aggregate demand shifts. The Appendix to Chapter 9 introduces the concept of
DG line (nominal GDP growth line or demand growth line). This appendix contains the complete
algebraic and graphical SP-DG model. You may wish to teach this appendix simultaneously with
this chapter and supplement the text by drawing in DG lines in your lectures. The appendix covers
the mechanics of shifting the SP and DG lines.
Section 9-6 addresses the issue of how inflationary expectations are formed. It is important to
emphasize the contrast between forward-looking and backward-looking expectations. Forwardlooking expectations assume individuals form expectations by combining all relevant current and
past information with some theory about the phenomena of interest. Backward-looking, or adaptive,
expectations, assume individuals form expectations on the basis of past information only. Point out
that forward-looking, or rational, expectations imply that the economy immediately adjusts to longrun equilibrium following an anticipated increase in nominal GDP growth (Point E0 to Point E4 in
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Figure 9-5). The text argues that backward-looking expectations are more consistent with the
infrequency of wage rate changes observed for most workers and the presence of long-term wage
contracts and agreements. These slow the adjustment of wage rates when the economy is off its
LAS curve. The text therefore employs backward-looking expectations for its inflation analysis.
“Adaptive expectations” are the type of backward-looking expectations the text uses. Adaptive
expectations may be represented by the equation, pe = p1 + j(p–1 – p1). This equation is not
explicitly presented in the text, however; instead, Gordon works solely with the case in which j = 1,
that is, pe = p–1. Students must understand how changing inflationary expectations, along with a
steady growth rate of nominal GDP, can generate an inflation cycle. Carefully explain why the
adjustment path of inflation initially overshoots the new growth rate of nominal GDP. Do so by
explaining the effect of adaptive expectations on SP.
Section 9-7 analyzes the ways inflation could be cured. One of the ways is called “cold turkey”
approach. The “cold-turkey” disinflation policy is characterized by a sudden sharp reduction of
nominal GDP growth. It is illustrated in Figures 9-6 and 9-7. Stress that the speed with which the
economy adjusts to long-run equilibrium depends on three fundamental factors: the amount by
which nominal GDP growth is reduced, the speed at which inflationary expectations adjust, and the
slope of SP. Point out that adjustment time will be longer and the recession more severe if SP is
flatter and the adjustment of inflationary expectations is slower. Be sure students understand the
“output costs” of disinflation and the “sacrifice ratio.” Gordon compares the output costs of
reducing inflation from 10 percent to 4 percent with a policy of “living with inflation” and doing
nothing to reduce it. Living with inflation means the “output costs” and “sacrifice ratio” are both
zero. The “output costs” of disinflation and the “sacrifice ratio” raise significant policy questions
about the importance of inflation reduction and the comparison of the costs and benefits of
disinflation. In the Box: Global Economic Crisis Focus: Policymakers Face the Perils of
Disinflation, these issues are explained further.
Section 9-8 begins the analysis of supply shocks and inflation. Note that up to this point in the
chapter, inflation has originated from the acceleration in nominal GDP growth or aggregate
demand. Fluctuations in nominal GDP growth and aggregate demand explain the inflation behavior
of the 1960s and the 1980s. They do not, however, explain the great volatility of the unemployment
and inflation rates that destabilized the U.S. economy during most of the 1970s or the low inflation
during the latter half of the 1990s. Figure 9-8 relates nominal and real oil prices and nominal GDP
growth to the post-1970 inflation rate. The main idea here is that both demand and supply shocks
contributed to the fluctuations of the inflation rate observed in the period covered. These shocks are
oil price shocks, farm price shocks, import price shocks and productivity growth shocks.
Section 9-9 begins by explaining how supply shocks affect the SP curve. This is illustrated in
Figure 9-9. Stress that because an adverse supply shock increases the rate of inflation at every level
of the output ratio (Y/YN), it will shift SP upward. Explicitly note that the dynamic SP model has
two distinct factors that shift SP: (1) changes in inflationary expectations, introduced earlier in the
chapter and (2) supply shocks. The direct effects of a supply shock are its effects on the output ratio
and inflation. The indirect effects depend on how policymakers respond to the supply shock by
altering the level of nominal GDP growth. The three alternative responses of
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aggregate demand are accommodating, neutral, and extinguishing policies. Show each of these
policy responses. Show how the output ratio and inflation change along SP as nominal GDP growth
is altered following a supply shock. Remind students that movements along SP resulting from
changes in nominal GDP growth must satisfy the growth equation x = p + y. The other important
point to stress is that SP will remain at its new position (Figure 9-9) only if the supply shock is
permanent and only if the expected rate of inflation remains fixed at its pre-supply shock level.
Also point out the policy dilemma faced by the Fed when full COLAs immediately adjust the
expected inflation rate. Then even a temporary supply shock can lead to permanent inflation if it is
not extinguished through a possibly severe loss of output.
Section 9-10 presents a good summary of the interplay between nominal GDP growth and supply
shocks and their effects on the inflation rate and the output ratio. You can cover this by discussing
Figure 9-11 in your lecture.
Section 9-12 discusses the relationship between the unemployment rate and the inflation rate.
Gordon explains that the relationship between the unemployment rate and the inflation rate is the
opposite of the relationship between the output ratio and the inflation rate. This is because the
unemployment rate is inversely related to the output ratio through Okun’s Law. The inverse
relationship is illustrated in Figure 9-12 between the ratio of actual to natural real GDP and the
unemployment rate for the United States for the period 1965–2010. Gordon has also examined the
history of unemployment and inflation for the United States since 1960 in Figure 9-13. He
concludes that the unemployment–inflation tradeoff suggests that the unemployment rate cannot be
maintained below the natural rate of unemployment for any substantial length of time. A permanent
reduction of the unemployment rate requires a reduction in the natural rate itself.

Changes in the Twelfth Edition
The structure of this chapter has remained almost the same as it was in the 11th edition. The only
significant changes are (1) the deletion of the section of the case study “Why Did Inflation Creep
Up After 2003?” and (2) addition of a new box: Global Economic Crisis Focus: Policymakers Face
the Perils of Disinflation in Section 9-4, (3) addition of another box about Understanding the
Global Economic Crisis in Section 9-9 and (4) all the Figures in the chapter have been updated
with newer data up to the year 2010.
In Section 9-4, Gordon has made some changes for the Equations 9.1 and 9.2 by treating them as
identity instead of equations.
In Section 9-8, the explanation about the topic “Supply Shocks, the Twin Peaks, and the Valleys”
has been extended to include the discussion about the impact of oil price on inflation rate.
Similarly, in Section 9-9 discussion about “Supply Shocks and the Short Run Phillips Curve (SP)
has been enriched with the new discussion about Understanding the Global Economic Crisis: The
Role of Inflation During the Housing Bubble and Subsequent Economic Collapse. In the same
section, Gordon has also elaborated the discussion about the topic “The Policy Dilemma.”
©2012 Pearson Education, Inc. Publishing as Addison Wesley
Answers to Questions in Textbook
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In Section 9-10, discussion for the topic “Cure for Inflation” has been elaborated further with
additional explanation about Fed’s policy after the year 2000. In Section 9-11, the explanation
about Figure 9-12, a graph of the unemployment rate against the output ratio, has been modified
slightly.

Answers to Questions in Textbook
1. The output ratio and the rate of inflation both rose from 1964–66, from 1976–78, from 1987–89, and
from 2003–05. They both declined from 1982–83, in 2002, and from 2007–09. The output ratio fell
and the inflation rate rose from 1973–75 and again from 1979–81. The output ratio rose and the
inflation rate fell in 1984–86 and again from 1996–97.
2. Both the SAS curve and the SP curve are supply curves; that is, they relate a price variable to the
amount of output that producers are willing to produce. The SAS curve shows the relationship of the
price level to output. The SP curve shows the relationship between the change in the price level (the
inflation rate) and the level of output.
3. a. An increase in money supply growth increases the rate of nominal GDP growth. This causes the
economy to experience some combination of higher real GDP and higher inflation, moving it up
along a given SP curve.
b. An increase in the expected inflation rate causes the SP curve to shift upward.
c. A decrease in production costs associated with technological improvement causes a downward shift
of the SP curve.
d. A decrease in nominal GDP growth has the opposite effect of (a). The economy experiences some
combination of lower real GDP and lower inflation, moving it down along a given SP curve.
4. When the equilibrium real wage is constant and output is at the natural rate, the nominal wage will be
increasing at the same rate as the inflation rate. If output is greater than the natural rate and actual
inflation exceeds expected inflation, then the actual real wage would be falling. In this case, we would
expect workers to try to increase the rate of growth of nominal wages.
5. The three conditions are: (1) the economy is on the SP curve; (2) x = p (so that y = 0); and (3)
expectations are accurate ( pe = p). The economy cannot be off SP because SP gives the amount of
output firms will produce at various inflation rates. If x is greater than (less than) p, then real GDP
increases (decreases) and thus cannot be at the natural level of output. If expectations are not accurate,
the economy can be in short-run equilibrium, but workers will adjust their expectations (and wage
demands) in the coming period.
6. Point D in Figure 9-4 is not on the SP curve, which shows how much output firms are willing to
produce at different rates of inflation. Given the 6 percent increase in nominal GDP growth, the 6
percent increase in real GDP (from 100 to 106) with zero inflation, represented by a move from Point
E0 to Point D, is a mathematically possible outcome, but it is not consistent with firms’ profitmaximization. Firms would be willing to increase output to 106 only if the inflation rate were 3
percent, but that is not possible given nominal GDP growth of just 6 percent. The 6 percent nominal
GDP growth must be divided between real GDP growth and inflation along the SP curve as it is at
Point F.
7. Forward-looking expectations attempt to predict the implications of economic disturbances (and policy
changes) in advance. The backward-looking approach adjusts to what has already happened. It is likely
that workers and firms will use the backward-looking approach. The existence of long-term wage and
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price agreements would prevent actual inflation from responding immediately to policy changes. Thus,
they know that changes in wages and prices will adjust gradually to policy changes.
8. This represents forward-looking expectations, because workers and firms use the predictions of the
long-run LP model to form their expectations of the behavior of inflation. With pe = x, the SP line
immediately shifts upward or downward by the full amount of the change in nominal GDP growth.
Thus, there is no effect on real GDP (y = 0). The economy moves along its LP line, and the adjustment
loops pictured in Figures 9-5 and 9-7 are no longer relevant. If workers and firms adjust their
expectations in this way, the output cost of disinflation is zero.
9. a. If workers and business firms believe that the Fed will take actions to prevent a demand shock from
causing any permanent change in the rate of inflation, then their expectations are that any changes
in inflation rates are only temporary. Therefore, any change in the output ratio that raises or lowers
the inflation rate does not result in a change in the expected rate of inflation. Given that the
expected rate of inflation does not change, there is no shift in the short-run Phillips curve.
b. For workers and business firms to continue to hold these expectations, the Fed must take actions to
reduce the growth of nominal GDP to its original level when there is a positive demand shock, and
to increase the growth of nominal GDP to its original level when there is a negative demand shock.
If the Fed fails to do so, then the demand shock could result in a permanent change in the inflation
rate, which would cause workers and business firms to abandon their original expectations.
10. What happens to the rate of inflation depends on how fast actual real GDP rises. If actual real GDP
rises by more than 3 percent, the growth rate of natural real GDP, then the output ratio rises. The
increase in the output ratio results in a rise in the inflation rate, given the expected rate of inflation. On
the other hand, if actual real GDP increases by less than 3 percent, then the output ratio falls, resulting
in a decline in the rate of inflation, given the expected rate of inflation.
11. The four types of supply shocks are oil shocks, farm price shocks, import price shocks, and
productivity growth shocks.
An oil price shock is when a change in the price of oil results in a rise or fall in the inflation rate, given
the growth rate of nominal GDP. Oil price shocks were adverse during the 1970s, the early 1980s,
1990, 1999–2000, and from 2003 to 2008, and beneficial from 1981–86, 1996–98, and again from
2009–10.
Farm price shocks are when changes in the prices of agricultural commodities lead to a rise or fall in
the inflation rate, given the growth rate of nominal GDP. Farm price shocks were adverse from 1972 to
1974 and just recently in 2005–08 as the use of ethanol as a gasoline additive drove up the price
of corn.
Import price shocks are when changes in the prices of imported goods lead to a rise or fall in the
inflation rate, given the growth rate of nominal GDP. Import price shocks were adverse during the
1970s, from 1985 to 1987, and from 2002–08. Import price shocks were beneficial from 1980 through
1985 and again from 1995 to 2002.
Productivity growth shocks occur when changes in the growth rate of productivity cause a rise or fall
in the inflation rate, given the growth rate of nominal GDP. Productivity growth shocks were adverse
from 1965 to 1980 and mildly adverse from 2004–08. Productivity growth shocks were moderately
beneficial in the early 1980s, strongly beneficial from 1995 through 2004, and highly beneficial in
2009 and early 2010.
12. The three policies have different rates of nominal GDP growth. A neutral policy would keep the
growth of nominal GDP constant. An accommodating policy requires an acceleration of nominal GDP
growth, but an extinguishing policy requires cutting nominal GDP growth.
©2012 Pearson Education, Inc. Publishing as Addison Wesley
Answers to Questions in Textbook
Policy
Inflation
Y/Y N
Accommodating
Extinguishing
Neutral
Increases
Remains the Same
Increases
Remains the same
Decreases
Decreases
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13. A permanent shock will cause a permanent increase in the price level. If the shock occurs for only one
period, however, inflation will increase only during that period if policymakers choose either a neutral
or an accommodating response. It will then return to its previous level if expectations do not change
and if COLAs do not exist. Even if inflation returns to its previous level, though, there will be a
decrease in natural real GDP.
14. Inflation was so low in the late 1990s due to the beneficial supply shocks provided by falling oil and
import prices and a rapid rise in productivity growth. The decline in import prices was due to an
appreciation of the dollar during the late 1990s.
Inflation started to rise after 2003 as the same beneficial supply shocks of the late 1990s turned into
adverse supply shocks. The price of oil rose more than 500 percent between 2002 and mid-2008.
Import prices rose as the dollar depreciated from 2002 through 2008. The growth rate of productivity,
which had been strong from 1995 up through the first half of 2004, declined from 2005 to 2008.
15. a. Inflation and the output ratio both increase if nominal GDP growth increases, moving the economy
up along a given SP curve.
b. Inflation increases and the output ratio decreases if an adverse supply shock, which shifts the SP
curve upward, combines with a neutral policy response, which holds the rate of nominal GDP
growth constant.
c. Inflation is constant and the output ratio deceases if an adverse supply shock combines with an
extinguishing policy response, which reduces the rate of nominal GDP growth so as to prevent any
increase in the inflation rate.
d. Inflation decreases and the output ratio is constant if a beneficial supply shock, which shifts the SP
curve downward, combines with an accommodating policy, which reduces the rate of nominal GDP
growth.
16. The “headline” inflation rate is the actual inflation rate; it will move up in response to an adverse
supply shock and down when a beneficial supply shock hits the economy. The core inflation rate
excludes food and energy prices.
The Fed pays attention to the core inflation rate in deciding how to react to supply shocks. It the core
inflation rate does not change, it will ignore the supply shock; however, it will respond to a supply
shock if it sees that the supply shock is starting to have an impact on the core inflation rate.
17. The fact that fewer workers had cost-of-living-adjustments (COLAs) as part of their labor contracts
meant that nominal wages did not automatically increase when inflation initially rose as a result of the
sharp run up of oil prices between 2002 and mid 2008. The fact that labor costs did not increase as a
result of the rise in energy prices limited the impact of the adverse supply shock on the overall
inflation rate.
18. Okun’s Law shows that the unemployment rate is inversely related to the output ratio. The reason is
that if real GDP rises relative to natural real GDP, employers need to hire more workers in order to
produce the additional output, which drives down the unemployment rate.
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However, the fact that the unemployment rate moves in the opposite direction from the output ratio
does not allow us to say anything about the relationship between the inflation rate and the
unemployment rate. For example, demand shocks that initially move the output ratio and the inflation
rate in the same direction eventually cause the output ratio and the inflation rate to move in opposite
directions as the short-run Phillips curve shifts due to changes in expected inflation. During the initial
phase of the economy’s adjustment to the demand shock, the inflation and unemployment rates are
negatively correlated as they move in opposite directions. Thereafter, the correlation between the
unemployment and inflation rates becomes positive as the short-run Phillips curve shifts up or down.
Furthermore, supply shocks initially cause the output ratio and the inflation rate to move in opposite
directions, giving rise to a positive correlation between the inflation and unemployment rates. But
subsequent movements in the output ratio and the unemployment and inflation rates depend on
whether the government chooses a neutral, accommodating, or extinguishing policy response to the
supply shock. If the government chooses either an accommodating or extinguishing policy response,
then the correlation between the unemployment and inflation rates equals zero.
19. a. If the unemployment rate did not change, then there was also no change in the output ratio. A fall in
the inflation rate and no change in the output ratio result from an accommodating policy.
b. A decline in the unemployment rate results from a rise in the output ratio. A rise in the output ratio
and a fall in the inflation rate result from a neutral policy.
c. A decline in the unemployment rate results from a rise in the output ratio. An increase in the output
ratio and no change in the inflation result from an extinguishing policy.

Answers to Problems in Textbook
1. a. Since real GDP grows by 3.2 percent, the output ratio equals 103.2 and the inflation rate increases
by 0.25(3.2) = 0.8 of a percentage point. Therefore, the inflation rate equals 4.0 percent, given that
the expected inflation rate equals 3.2 percent.
b. Since real GDP grows by 5.6 percent, the output ratio equals 105.6 and the inflation rate increases
by 0.25(5.6) = 1.4 percentage points. Therefore, the inflation rate equals 4.6 percent, given that the
expected inflation rate equals 3.2 percent.
c. Since real GDP declines by 2.4 percent, the output ratio equals 97.6 and the inflation rate decreases
by 0.25(2.4) = 0.6 of a percentage point. Therefore, the inflation rate equals 2.6 percent, given that
the expected inflation rate equals 3.2 percent.
d. Since real GDP declines by 4.4 percent, the output ratio equals 95.6 and the inflation rate decreases
by 0.25(4.4) = 1.1 percentage points. Therefore, the inflation rate equals 2.1 percent, given that the
expected inflation rate equals 3.2 percent.
e. Given the expected rate of inflation equals 3.2 percent, the points on your short-run Phillips curve
are: (95.6, 2.1); (97.6, 2.6); (103.2, 4.0); (105.6, 4.6).
f. Since real GDP grows by 2.8 percent, the output ratio equals 102.8 and the inflation rate increases
by 0.25(2.8) = 0.7 of a percentage point. Therefore, the inflation rate equals 2.1 percent, given that
the expected inflation rate equals 1.4 percent.
g. Since real GDP grows by 5.2 percent, the output ratio equals 105.2 and the inflation rate increases
by 0.25(5.2) = 1.3 percentage points. Therefore, the inflation rate equals 2.7 percent, given that the
expected inflation rate equals 1.4 percent.
©2012 Pearson Education, Inc. Publishing as Addison Wesley
Answers to Problems in Textbook
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h. Since real GDP declines by 1.6 percent, the output ratio equals 98.4 and the inflation rate decreases
by 0.25(1.6) = 0.4 of a percentage point. Therefore, the inflation rate equals 1.0 percent, given that
the expected inflation rate equals 1.4 percent.
i. Since real GDP declines by 6.4 percent, the output ratio equals 93.6 and the inflation rate decreases
by 0.25(6.4) = 1.6 percentage points. Therefore, the inflation rate equals –0.2 percent, given that
the expected inflation rate equals 1.4 percent.
j. Given the expected rate of inflation equals 1.4 percent, the points on your short-run Phillips curve
are: (93.6, –0.2); (98.4, 1.0); (102.8, 2.1); (105.2, 2.7).
k. The beneficial supply shock shifts the short-run Phillips curve down by 1.2 percentage points at
every output ratio. Therefore, the new points on the short-run Phillips curve are: (93.6, –1.4); (98.4,
–0.2); (102.8, 0.9); (105.2, 1.5).
2. a. An inflation rate equal to 0 is two percentage points below its expected level, so firms cut real GDP
by 2 percent, so that real GDP is 98 percent of natural real GDP. Therefore, the output ratio equals
98 when the inflation rate equals zero, given expected inflation equals 2. Use the same logic to
show that given the expected rate of inflation equals 2, the following points are also on the shortrun Phillips curve: (99, 1); (100, 2); (101, 3); (102, 4); and (103, 5).
b. If the output ratio initially equals 100 and the expected and actual rates of inflation are equal, the
economy is in long-run equilibrium and the inflation rate equals the growth rate of nominal GDP.
Therefore, the growth rate of nominal GDP initially equals 2 percent since the inflation rate
initially equals 2 percent.
c. The inflation rate plus the growth rate of real GDP must equal the growth rate of nominal GDP,
which now equals 4 as a result of the increase in government spending. The only point on the shortrun Phillips curve that is consistent with this combination of the growth rate in real GDP and
inflation rate is an output ratio equal to 101 and an inflation rate equal to 3, given that natural real
GDP is constant.
d. The economy is in long-run equilibrium when the economy is operating on its short-run Phillips
curve, the inflation rate equals the growth rate of nominal GDP, and the expected and actual
inflation rates are equal. That occurs when the inflation rate equals 4 percent, the growth rate of
nominal GDP.
The economy adjusts to the long-run equilibrium through shifts of the short-run Phillips curve as
the expected rate of inflation changes. The adjustment of the output ratio and inflation rate follows
a loop similar to the one shown in Figure 9-5 on page 279.
3. a. The expected inflation rate in the second period equals 3 percent since that is the actual inflation
rate in the first period. Therefore, the inflation rate is three percentage points below its expected
level when it equals 0, resulting in firms producing only 97 percent of natural real GDP. Therefore,
(97, 0) is a point on the new short-run Phillips curve, given that expected inflation equals 3 percent.
The remaining points on the new short-run Phillips curve are: (98, 1); (99, 2); (100, 3); (101, 4);
and (102, 5).
b. If monetary policymakers wish to reduce inflation to 2 percent in the second period, then they must
cut the growth rate of nominal GDP enough so that the output ratio equals 99, because that is the
output ratio on the new short-run Phillips curve when the inflation rate equals 2 percent. Since the
output ratio is 101 in the first period, real GDP must fall by 2 percent in the second period for the
output ratio to equal 99 in the second period. Therefore, the growth rate of real GDP must equal –2
percent in the second period. Since the nominal GDP growth rate is the sum of the inflation rate
and the real GDP growth rate, monetary policymakers must reduce the nominal GDP growth rate to
0 percent in the second period in order to reduce the inflation rate to 2 percent in the second period.
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108
Chapter 9
Inflation: Its Causes and Cures
c. The expected inflation rate in the third period equals 2 percent since that is the actual inflation rate
in the second period, given the monetary contraction. Therefore, the inflation rate is two percentage
points below its expected level when it equals 0, resulting in firms producing only 98 percent of
natural real GDP. Therefore, (98, 0) is a point on the new short-run Phillips curve, given that
expected inflation equals 2 percent. The remaining points on the new short-run Phillips curve are:
(99, 1); (100, 2); (101, 3); (102, 4); and (103, 5).
To maintain an inflation rate of 2 percent, monetary policymakers would have to provide a growth
rate for nominal GDP so that the output ratio equals 100, because that is the output ratio on the new
short-run Phillips curve when the inflation rate equals 2 percent. Since the output ratio is 99 in the
second period, real GDP must rise by 1 percent in the third period for the output ratio to equal 100
in the third period. Therefore, the growth rate of real GDP must equal 1 percent in the third period.
Since the nominal GDP growth rate is the sum of the inflation rate and the real GDP growth rate,
monetary policymakers must increase the nominal GDP growth rate to 3 percent in the third period
in order to maintain the inflation rate at 2 percent in the third period.
The economy is in long-run equilibrium when the economy is operating on its short-run Phillips
curve, the inflation rate equals the growth rate of nominal GDP, and the expected and actual
inflation rates are equal. Therefore, to maintain the inflation rate at 2 percent in the long run,
monetary policymakers need to maintain the growth rate of nominal GDP at 2 percent in the
long run.
d. The short-run Phillips curve does not shift when the actual inflation rate deviates for the expected
inflation rate if workers and employers expect monetary policymakers to take actions to quickly
restore inflation to its long-run equilibrium of 2 percent.
e. If workers and employers expect monetary policymakers to take actions to quickly restore inflation
to its long-run equilibrium of 2 percent, then the second period’s short-run Phillips curve is the
same as that of the first period. To reduce inflation to 2 percent in the second period from 3 percent
in the first period, monetary policymakers must reduce nominal GDP enough so that the output
ratio equals 100, because that is the output ratio on the short-run Phillips curve when the inflation
rate equals 2 percent. Since the output ratio is 101 in the first period, real GDP must fall by 1
percent in the second period for the output ratio to equal 100 in the second period. Therefore, the
growth rate of real GDP must equal –1 percent in the second period. Since the nominal GDP
growth rate is the sum of the inflation rate and the real GDP growth rate, monetary policymakers
must reduce the nominal GDP growth rate to 1 percent in the second period in order to reduce the
inflation rate to 2 percent in the second period.
To maintain an inflation rate of 2 percent, monetary policymakers would have to provide a growth
rate for nominal GDP so that the output ratio continues to equal 100 in the third period, because
that is again the output ratio on the short-run Phillips curve when the inflation rate equals 2 percent.
Therefore, there can be no growth in real GDP in the third period. Since the nominal GDP growth
rate is the sum of the inflation rate and the real GDP growth rate, monetary policymakers must
increase the nominal GDP growth rate to 2 percent in the third period in order to maintain the
inflation rate at 2 percent in the third period.
f. The reason that monetary policymakers have to reduce the growth rate of nominal GDP less in the
second period once they have established a record of maintaining an inflation rate of 2 percent is
that they do not have to overcome the effect of how a change in the actual inflation rate affects the
expectations of workers and employers concerning the inflation rate. It also means that the third
period’s increase in the growth rate of nominal GDP is less because it took a smaller decrease in
real GDP in the second period to reduce inflation to the level desired by monetary policymakers.
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Answers to Problems in Textbook
109
4. a. Since natural real GDP grows by 3 percent every year, it equals 1.03(11,000) = 11,330 in the first
year. It equals 1.03(11,330) = 11,669.9 in the second year. It equals 1.03(11,669.9) = 12,020 in the
third year. It equals 1.03(12,020) = 12,380.6 in the fourth year, and it equals 1.03(12,380.6) =
12,752 in the fifth year.
b. Since actual real GDP falls by 2 percent in the first year, and then grows by 4 percent in the second
year, 5.5 percent in the third year, 4.2 percent in the fourth year, and 3.5 percent in the fifth year,
actual real GDP equals 0.98(11,000) = 10,780 in the first year. It equals 1.04(10,780) = 11,211.2 in
the second year. It equals 1.055(11,211.2) = 11,827.8 in the third year. It equals 1.043(11,827.8) =
12,324.6 in the fourth year, and it equals 1.035(12,324.6) = 12,756 in the fifth year.
c. The output ratio equals (10,780/11,330)(100) = 95.1 in the first year. It equals (11,211.2/
11,669.9)(100) = 96.1 in the second year. It equals (11,827.8/12,020.0)(100) = 98.4 in the third
year. It equals (12,324.6/12,380.6)(100) = 99.5 in the fourth year, and it equals
(12,756/12,752)(100) = 100.0 in the fifth year.
d. The cumulative loss of output equals 4.9 + 3.9 + 1.6 + 0.5 + 0 = 10.9 percent.
e. The reduction in the inflation rate equals 3.5 – 1.1 = 2.4 percentage points. Therefore, the sacrifice
ratio equals 10.9/2.4 = 4.5.
5. a. Since the output ratio equals 100 and the inflation rate equals 2 percent, that combination of the
output ratio and the inflation rate is on the long-run Phillips curve. Therefore, the expected inflation
rate equals 2 percent. Since natural real GDP is constant and actual real GDP grows by 2 percent
for every 1 percent increase in the inflation rate above its expected level, the following points are
on the short-run Phillips curve: (95, –0.5); (97, 0.5); (99, 1.5); (100, 2); (101, 2.5); (103, 3.5); and
(105, 4.5).
b. Since the inflation rate equals the growth rate of nominal GDP at points on the long-run Phillips
curve when natural real GDP is constant, the growth rate of nominal GDP equals 2 percent.
c. The SP curve shifts up by 3 percentage points, the amount of the adverse supply shock. Therefore,
the following points are on the new SP curve: (95, 2.5); (97, 3.5); (99, 4.5); (100, 5); (101, 5.5);
(103, 6.5); and (105, 7.5).
d. If government follows a neutral policy, then the rise in the inflation rate and the fall in the actual
real GDP are equal at 2 percentage points, and the output ratio equals 98 and the rate of inflation
equals 4 percent. Also note that the sum of the growth rate of actual real GDP plus the rate of
inflation equals –2 + 4 = 2 percent, the growth rate of nominal GDP.
e. If the government follows an accommodating policy, then the output ratio remains at 100, but the
inflation rate rises to 5 percent. The combination of a 0 percent growth rate in actual real GDP plus
a 5 percent inflation rate requires that the growth rate of nominal GDP increase from 2 percent to 5
percent.
f. If the government follows an extinguishing policy, then the inflation rate remains at 2 percent, but
the output ratio declines to 94. The combination of a negative 6 percent growth rate in actual real
GDP plus a 2 percent inflation rate requires that the nominal GDP decrease by 4 percent.
©2012 Pearson Education, Inc. Publishing as Addison Wesley