Chapter 30 Inflation and Disinflation !
You will learn!
- wages respond to output gaps and inflation expectations !
- how constant rate of inflation is incorporated into basic microeconomic model !
- how AD and AS shocks affect !
- what happens when BOC validates demand/supply shocks (validation process)!
- three phases of inflation!
- how cost of disinflation is measured by sacrifice ratio !
Effects of Inflation !
- failure to anticipate inflation impost costs to labour market and capital market !
- labour market: two consequences!
- redistribution of income: higher anticipated inflation lowers real wage rate, employers gain at expense of worker. vice versa.!
- departure from full employment:higher than anticipated inflation lowers real wage rate, increases quantity of labour demanded, jobs easier to find, lowers unemployment rate !
- capital market: two main consequences for financial capital:!
- redistribution of income: inflation high, borrowers gain at expense of lenders !
- too much or too little Lending and borrowing!
- when inflation is higher than anticipated, real interest rate lowers than anticipated, borrows want to have borrowed more, lenders loaned less!
30.1 Adding Inflation to the Model!
Why do wages change?!
1. Output Gaps!
- Y > Y* upward pressure on wages!
- Y < Y* downward pressure on wages!
2. Expected Inflation !
- while actual wage increase may depend on bargaining power, 3 % epcted inflation can lead to 3$ increase in money wage so that real wages remain unchanged (money wage rise without output gaps)!
Change in Money Wages = Output-gap Effect + Expectational Effect !
How do people form expectations?!
1) Forward looking: based on expected economic conditions and gov. policies!
2) backward looking: based on past experience about inflation rate changes!
3) combination of both: change in money wage is cause by both. While inflationary gaps exert an upward pressure on prices, recessionary gaps put downward pressure !
From Wages to Prices!
- net effect of two macro forces acting on nominal wage (output gaps and inflation expectation) determines how AS shifts and price level change !
- since AS can shift for reasons non-related to wage, actual inflation depends on this this term.
Last term captures any AS shift caused by changes in prices of raw materials!
- Actual Inflation = Output gap inflation + expected inflation + supply shock inflation !
Constant Inflation !
- if inflation is constant, no indication of change in monetary policy: expected inflation = actual inflation !
- Y = Y* no output gap!
- if there is no output gap, what is causing inflation? : constant inflations required both expectation of inflation (shifts AS curve) and continued money supply (shifts AD) - validation of those expectations!
- occurs when rate of monetary growth, rate of nominal wage increase, and expected inflation are all consistent with actual inflation rate GRAPH!
Is Deflation a Problem?!
- when price levels are falling, firms and households defer spending (anticipating lower prices), this can shift AD to the left and cause recession !
30.2 Shocks and Policy Responses!
Demand Shocks !
- demand inflation results in rightward shift in Ad (due to fiscal or mon. policy)!
- demand shock that is not validated produces only temporary inflation (price level rises to P1 then to P2( when AS curve shifts left to adjust) !
With Monetary Validation !
- AD shifts further right by the time AS shifts left (due to natural tendency or expectation)!
- keeping open inflationary gap!
- continued validation turns a transitory inflation into sustained inflation !
Supply Shock with and iwhout validation!
- inflation due to AS shifts unrelated to excess demand is supply inflation!
- if wages fall slowly (when Y < Y*), the return to Y* after non-validated negative AS shock will be slow !
- if there is monetary validation, there will be a rightward shift in AD curve, and return to Y* will