Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 8 Inflation: Its Causes and Cures

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter 8

Inflation: Its Causes and Cures

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-2

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%.


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.


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.


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.


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%.


Figure 8-2 Relationship of the Short-Run Aggregate Supply (SAS) Curve to the Short-Run Phillips (SP) Curve


Figure 8-3 Effect on the Short-Run Phillips Curve of an Increase in the Expected Inflation Rate (pe) from Zero to 3 Percent


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.


Table 8-1 Alternative Divisions of 6 Percent Nominal GDP Growth Between Inflation and Real GDP Growth


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


Figure 8-5 Effect on Inflation and Real GDP of an Acceleration of Demand Growth from Zero to 6 Percent


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.


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.


Figure 8-6 Initial Effect on Inflation and Real GDP of a Slowdown in Nominal GDP Growth from 10 Percent to 4 Percent


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


International Perspective: Did Disinflation in Europe Differ from That in the United States?


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.


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.


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


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


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.


Figure 8-10 Effect of Adverse Supply Shock in the 1970s and Beneficial Supply Shocks in the 1990s


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)


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)


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.


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.


Figure 8-14


Figure 8-15


Chapter Equations


Chapter Equations

(8.1)X PY

(8.2)x p y

(8.3)y x p


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


(1 ) (2)e e ep jp j p p p


0.5 (3)e ep p gY z p p Y


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


1 21 0.5 (9)

1 3ep jp j p g Y x z p p Y x

g


Appendix Equations

11

1(10)

1ep p g Y x z

g


0.5 (11)N NU U hY U U Y

1 1


0.5 (12)N NU U h y y U U y y

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Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 8 Inflation: Its Causes and Cures