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Chapter 8
Inflation: Its Causes and Cures
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Definition: Inflation
• Inflation is a sustained upward movement in the aggregate price level that is shared by most products.– The price level is notated P
– Inflation is notated p = %∆P
• The Core Inflation Rate is the inflation rate for all products and services other than food and energy.– The Federal Reserve target core inflation rate is about
2%.
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The Output Ratio and Inflation
• The Output Ratio is the ratio of actual real GDP to natural real GDP (i.e. Y/YN ).– If Y/YN = 100%, p is constant
– If Y/YN > 100%, p is accelerating
– If Y/YN < 100%, p is decelerating
• What affects the output ratio?– A Demand Shock is a sustained acceleration or deceleration in
AD, measured most directly as a sustained acceleration or deceleration in the growth of nominal GDP.
– A Supply Shock is caused by a sharp change in the price of an important commodity (e.g. oil) that causes the inflation rate to rise or fall in the absence of demand shocks.
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Figure 8-1 The Inflation Rate and the Output Ratio, 1960–2007
Sources: Bureau of Economic Analysis NIPA Tables and research by Robert J. Gordon. Details in Appendix C-4.
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Temporary vs. Continuous Inflation
• A one-shot increase in AD will cause only temporary inflation as the output ratio rises above 100% and pushes up wages causing the SAS curve to shift back.
• A continuous increase in AD can potentially cause continued inflation as wages rise (shifting back the SAS curve) together with continued shifts to the right of the AD curve.
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The Phillips Curve
• The Short-Run Phillips (SP) Curve is the schedule relating the inflation rate and real GDP given a fixed expected rate of inflation.– The Expected Rate of Inflation (pe) is the rate of inflation that is
expected to occur in the future.
– The SP Curve is also known as the Expectations-Augmented Phillips Curve because it shifts its position whenever there is a change in the expected rate of inflation.
• The Long-Run Phillips (LP) Curve gives the output ratio when inflation is accurately anticipated (i.e. pe = p).– Since prices and wages are perfectly flexible in the long-run, the LP
curve is a vertical line at Y/YN = 100%.
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Figure 8-2 Relationship of the Short-Run Aggregate Supply (SAS) Curve to the Short-Run Phillips (SP) Curve
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Figure 8-3 Effect on the Short-Run Phillips Curve of an Increase in the Expected Inflation Rate (pe) from Zero to 3 Percent
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Nominal GDP Growth and Inflation
• Recall: Nominal GDP (X) is related to the price level (P) and real GDP (Y) as follows:
X = PY(Note: Lower case letters represent the growth rates of the same variables)
• When is the economy at a long-run equilibrium?– It must be operating on the SP curve.
– Inflation must equal the growth rate of nominal GDP:
x = p real GDP growth = 0
(Or if y > 0 x = p + y)
– The economy must be on the LP line with pe = p.
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Table 8-1 Alternative Divisions of 6 Percent Nominal GDP Growth Between Inflation and Real GDP Growth
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Figure 8-4 The Adjustment Path of Inflation and the Output Ratio to an Acceleration of Nominal GDP Growth from Zero to 6 Percent When Expectations Fail to Adjust
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Figure 8-5 Effect on Inflation and Real GDP of an Acceleration of Demand Growth from Zero to 6 Percent
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Different Types of Expectations
• The speed of adjustment of inflation expectations affects how long Y can be pushed beyond YN.
• 3 Types of Expectations– Forward-looking Expectations attempt to predict
the future behavior of an economic variable using economic models.
– Backward-looking Expectations use only information on the past behavior of economic variables.
– Adaptive Expectations base expectations for next period’s values on an average of actual values during previous periods.
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The Cure for Inflation: Recession
• Theoretically, if an increase in nominal GDP causes inflation, then a recession should do the opposite.– Disinflation is a marked deceleration in the
inflation rate.
• How can disinflation be achieved?– The “Cold Turkey” approach to disinflation operates by
implementing a sudden and permanent slowdown in nominal GDP growth.
• The cost of disinflation is measured by the Sacrifice Ratio, which is the cumulative loss of output incurred during a disinflation divided by the permanent reduction in the inflation rate.
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Figure 8-6 Initial Effect on Inflation and Real GDP of a Slowdown in Nominal GDP Growth from 10 Percent to 4 Percent
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Figure 8-7 Adjustment Path of Inflation and Real GDP to a Policy That Cuts Nominal GDP Growth from 10 Percent in 1980 to 4 Percent in 1981 and Thereafter
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International Perspective: Did Disinflation in Europe Differ from That in the United States?
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Figure 8-8 Four-Quarter Growth Rate of the GDP Deflator and the Level of Nominal and Real Oil Prices, 1970–2007
Sources: Top frame: Bureau of Economic Analysis NIPA Tables. Details in Appendix C-4. Bottom frame: Energy Information Administration Monthly Energy Review. Details in Appendix C-4.
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Demand vs. Supply Inflation
• Demand Inflation is a sustained increase inprices that is preceded by a permanentacceleration of nominal GDP growth.
• Supply Inflation is an increase in prices that stems from an increase in business costs not directly related to prior acceleration of nominal GDP growth.
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Types of Supply Shocks
• Changes in business input costs (like Poil)
• Weather shocks that affect farm prices
• Import price shocks due to fluctuating exchange rates– If the value of the dollar falls, imported goods
become more expensive.
• Productivity growth shocks that change the amount workers can produce
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Figure 8-9 The Effect on the Inflation Rate and the Output Ratio of an Adverse Supply Shock That Shifts the SP Curve Upward by 3 Percent
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Policy Responses to Supply Shocks
• Following a supply shock, there are three possible policy responses:– A Neutral Policy maintains nominal GDP growth so as
to allow a decline in the output ratio equal to the increase in the inflation rate.
– An Accommodating Policy raises nominal GDP growth so as to maintain the original output ratio.
– An Extinguishing Policy reduces nominal GDP growth so as to maintain the original inflation rate.
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Figure 8-10 Effect of Adverse Supply Shock in the 1970s and Beneficial Supply Shocks in the 1990s
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Figure 8-11 Responses of the Inflation Rate (p) and the Output Ratio (Y/YN) to Shifts in Nominal GDP Growth and in the SP Curve (1 of 2)
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Figure 8-11 Responses of the Inflation Rate (p) and the Output Ratio (Y/YN) to Shifts in Nominal GDP Growth and in the SP Curve (2 of 2)
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Figure 8-12 The U.S. Ratio of Actual to Natural Real GDP (Y/YN) and the Unemployment Rate, 1965–2007
Sources: Appendix Table A-1. Bureau of Labor Statistics, Bureau of Economic Analysis, and research by Robert J. Gordon. Details in Appendix C-4.
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Figure 8-13 The Unemployment Rate and the Inflation Rate, 1960–2007
Source: Bureau of Labor Statistics and Bureau of Economic Analysis NIPA Tables. Details in Appendix C-4.
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Chapter Equations
(8.1)X PY
(8.2)x p y
(8.3)y x p
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Appendix Equations
General Linear Form Numerical Example
0.5 (1)e ep p gY z p p Y
(4)x p y
(5)N Nx y p y y
1 1 1
General Linear Form Numerical Example
(1 ) (2)e e ep jp j p p p
General Linear Form Numerical Example
0.5 (3)e ep p gY z p p Y
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Appendix Equations
1 (6)x p Y Y
1 (7)Y Y x p
11 1(1 ) ( ) (8)ep jp j p g Y x p z
1 11 1 1
General Linear Form Numerical Example
1 21 0.5 (9)
1 3ep jp j p g Y x z p p Y x
g