CHAP 14

• Inflationary gap

  When Y > Y*, it puts upward pressure on nominal wages
• Recessionary gap

  When Y < Y*, it puts downward pressure on nominal wages
• NAIRU

  Non-accelerating inflation rate of unemployment
• When real GDP is equal to Y*

  The unemployment rate is equal to the NAIRU
• When real GDP exceeds potential GDP (Y > Y*)

  The unemployment rate will be less than the NAIRU (U < U*)
• When real GDP is less than potential GDP (Y < Y*)

  The unemployment rate will exceed the NAIRU (U > U*)
• Expected inflation


  Creates pressure for nominal wages to rise by that rate
• The net effect of output gaps and inflation expectations determines what happens to the AS curve
• Non-wage supply shock


  A change in the prices of materials used as inputs in production
• If inflation and monetary policy have been unchanged for several years, the expected rate of inflation will tend to equal the actual rate of inflation
• In the absence of supply shocks, if expected inflation equals actual inflation, real GDP must be equal to potential GDP

  
• Constant inflation with Y = Y* occurs when the rate of monetary expansion, the rate of wage increase, and the expected rate of inflation are all consistent with the actual inflation rate
• Demand inflation


  Inflation arising from an inflationary output gap caused by a positive AD shock
• Supply inflation

  Inflation arising from a negative AS shock that is not the result of excess demand in the domestic markets for factors of production
• Acceleration hypothesis

  When real GDP is held above potential, the persistent inflationary gap will cause inflation to accelerate
• Causes of inflation

  • Any Shifts in the AD curve to the right - price level rise (demand)
  • Any Shifts in the AS curve upward - price level rise (supply)
  • Increases in the price level caused by AD and AS shocks come to a stop unless they're validated
• Consequences of inflation

  • (Short) Demand inflation tends to be accompanied by an increase in real GDP above its potential level
  • (Short) Supply inflation tends to be accompanied by a decrease in real GDP below its potential level
  • Only long-run effect of AD or AS shocks is a change in the price level
• Without monetary validation, positive demand shocks cause inflationary output gaps and a temporary burst of inflation

  • gaps are removed s rising factor prices push the AS curve up, and return Y to Y* but at a higher Price level
• Without monetary validation, negative supply shocks cause recessionary output gaps and a temporary burst of inflation

  • gaps are filled eventually when factor prices fall to restore Y at Y* and the price level at it's initial level
• Only with continuing monetary validation can inflation initiated by either supply or demand shocks continue indefinitely
• Sustained inflation is always and everywhere caused by sustained monetary expansion
• Disinflation

  A reduction in the rate of inflation
• Notable periods of disinflation in Canada

  • 1981–1982, when inflation fell from more than 12 percent to 4 percent
  • 1990–1992, when inflation fell from 6 percent to less than 2 percent

  
• The sacrifice ratio is the cumulative loss in real GDP, expressed as a percentage of potential output, divided by the percentage-point reduction in the rate of inflation
• Throughout the history of economics, inflation has been recognized as a harmful phenomenon
• Canada and several other countries have adopted formal inflation-targeting regimes, which have successfully kept inflation low and stable
• The concerns about the dangers of rising inflation were prominent during the COVID-19 pandemic of 2020-2021
• The policy response by central banks to the COVID-19 pandemic may have resulted in a large monetary expansion that higher inflation is inevitable
• Sustained inflation is best viewed as a monetary phenomenon
• As long as central banks remain committed to keeping inflation close to the formal target, the best expectation for the future is that inflation will remain low and stable
• In the absence of either an inflationary or a recessionary gap (Y = Y*) implies that demand forces are not exerting any pressure on nominal wages.
• There is an inflationary gap characterized by excess demand for labour, and nominal wages tend to rise.


  When Y > Y*
• When Y < Y* and U > U*

  There is a recessionary gap characterized by excess supply of labour, and nominal wages tend to fall.
• Change in Money wages = Output-gap Effect + Expectational Effect
• Actual Inflation = Output gap inflation + Expected Inflation + Supply Shock Inflation
• When inflation is low and relatively stable, firms and consumers build it into their expectations, central banks build it into their policy decisions, and the economy can operate with real GDP equal to potential output.
• Constant Inflation with No Supply Shocks

  
  

  Wage costs are rising because of expectations of inflation, and these expectations are being validated by the central bank’s policy. Real GDP (Y) remains at Y*.
• A demand shock that is not validated produces temporary inflation.

  
• • Monetary validation of a positive demand shock causes the AD curve to shift further to the right, offsetting the upward shift in theAS curve.
  • Continued validation of a demand shock turns what would have been transitory inflation into sustained inflation fueled by monetary expansion.

  
• • With no monetary validation, the reduction in wages and other factor prices make the AS curve shift slowly back down to AS0.
  • With monetary validation, AD0 shifts to AD1