Transcript Figure 8-12 Responses of the Inflation Rate (p)

Robert J. Gordon,
Macroeconomics, 10th edition,
2006, Addison-Wesley
Chapter 8:
Inflation: its Causes and Cures
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Explaining the inflation rate
 The AD SAS model implies that nay event that causes a single
upward shift in the economy’s AD curve will cause a single
upward jump in the price level.
 Sustained inflation requires a continuous increase in AD.
Inflation or deflation can be caused either by shifts in AD
(demand shocks) or in AS (supply shocks).
 The volatility history of the inflation rate
 Look at figure 8-1. The output ratio is the ratio of actual real
GDP to natural real GDP.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-1 The Inflation Rate and the Output Ratio, 1960–2004
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 How is inflation related to the output ratio.
 there is no unique relationship between inflation and output
ratio, but it is assumed that inflation remains constant when the
output ratio is 100, and accelerates when the output ratio is
above 100 and decelerates when output ratio is below 100.
 Demand shocks and supply shocks.
 When a positive demand shock (sustained acceleration or
deceleration in AD; measured as the growth rate of nominal
GDP), inflation increases and the output ratio rises temporarily
and a negative demand shock can cause inflation to decelerate.
 An adverse supply shock (cause by a sharp change in the price of
an important commodity that causes inflation to rise or fall) can
boost inflation while causing output ratio to decline. Look at
figure 8-1 again.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Real GDP, the inflation rate and the short run Phillips curve
 A continuous increase in demand pulls the price level up
continuously (demand pull inflation). This can be caused by
large government deficit and excessive growth of MS.
 Effects of an increase in AD
 Shifts AD upward and the economy initially moves to E1. P
increases to 103. This puts pressures on nominal wages to rise
and SAS shifts up causing P to rise to 106. Look at figure 8-2.
 How continuous inflation occurs.
 What happens to the output ratio and the price level as a result
of the upward shift from SAS0 to SAS1 there are two
possibilities.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-2 Relationship of the Short-Run Aggregate Supply (SAS) Curve to the
Short-Run Phillips (SP) Curve
Long run eq.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 A one shot increase in AD.
 AD remains at AD1, the economy shifts to D. To prevent the
output ratio from declining the AD must shift upward by exactly
the same shift of the SAS (from AD1 to AD1’) since price level
1.06 is ahead of the wage rate 1.03, there will be upward
pressures on the nominal wage rate.
 A continuous increase in AD.
 To keep the output ratio from declining the AD must increase
continuously and the economy will move straight upward along
the black arrows. The maintenance of a high output ratio
requires a continuous increase in AD and in the price level.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The SP curve
 Look at the bottom frame of 8-2, the SP curve shows that to maintain
the output ratio above 100, AD must be raised continuously to create a
continuous inflation. Along the SP curve, the economy is not in a long
run equilibrium because the price level is constantly racing ahead of
the nominal wage rage.
 There will be continuous pressures for higher wages. As labor
contracts fail to anticipate further inflation, and as a result they fail to
specify in advance the wage increases needed to keep up with inflation.
These wage contracts have an expected inflation of zero, Shown as the
SP0 curve in the frame
 The SP curve is the short run Phillips curve, it slops upward indicating
a +ve relationship between real GDP and inflation, additional reasons
for this relationship are the sensitivity of raw material prices to higher
AD and the tendency of firms to boost prices when AD is high.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The position of the SP curve is fixed by the rate of inflation
expected at the time current wage contracts were negotiated.
that is why it is called expectations augmented Phillips curve.
 The adjustments of expectations.
 So far we assume that expectations are constant i.e., people never
learn to anticipate inflation when negotiating contracts.
 Changing inflation expectations shift the SP curve
 If negotiators anticipate inflation in advance, the SP curve shifts
upward. Look at figure 8-3. now an output ratio above 100
cannot be achieved along SP1, unless actual inflation exceeds
3%, in which case the actual inflation would exceed the expected
inflation.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-3 Effect on the Short-Run Phillips Curve of an Increase in the Expected
Inflation Rate (pe) from Zero to 3 Percent
LAS
Only this point is qualified
No inflation is expected
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The economy in long run is in equilibrium (no pressures to
change) E1 does not quality, there are pressures to adjust
erroneous expectations (pe=0)
 The LP correct expectations line.
 The LP shows all possible points where expected inflation rate
turns out to be correct. To the right of the LP line, inflation
turns to be higher than expected, and the expected inflation rate
will be raised. To the left of the LP line inflation turns to be
lower than expected and inflation will be reduced.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Nominal GDP growth and inflation
 The SP curve is a single relationship between inflation rate and
output ratio. Starting with the levels of prices (P) nominal GDP
(X) and real GDP (Y).
X = PY
 In this chapter we are interested in the growth rates of these
variables x, p, and y, such that;
x=p+y
 The growth rate of nominal GDP equals inflation plus growth
rate of real GDP. Look at table 8-1.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Table 8-1 Alternative Divisions of 6 Percent Nominal GDP Growth Between
Inflation and Real GDP Growth
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Effects of an acceleration in nominal GDP growth
 How do x affect real GDP Y and inflation p. Look at figure 8-4, if
p = pe = 0 and if nominal GDP growth is zero, y must also be
zero.
y=x–p
0=0–0
 The continuing adjustment
 The economy can’t stay at point F (out of long run equilibrium).
It violates 2 of the 3 requirements of long term equilibrium (x=p,
and that expectations are accurate).
 The long run equilibrium meets three conditions; 1: growth of
natural GDP = zero, 2: x=p, 3: inflation expectations are
accurate (pe=p)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
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
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Expectations and the Inflation cycle
 Forward-looking expectations
 Predicting the future behavior of an economic variable using a
model of the interrelation of that variable with other variables.
Contract negotiators will use a 6% inflation if accelerated
inflation in the long run is 6%. This would move the economy
from point E0 to E4 in figure (8-4).
 The rationality of backward-looking expectations.
 This simply adjusts expectations to what has already happened
in the past. There are two important reasons why rational agents
for expectations by looking backward:
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
There may be no reason to believe that an acceleration in
nominal GDP will be permanent.
2. Even if the acceleration of nominal GDP is permanent existing
contracts and agreements (formal or informal) may prevent
actual inflation from adjusting immediately, as changes in
wages and prices will adjust gradually to acceleration of
nominal GDP. The most popular form of backward-looking
expectations is “adaptive expectations”.
1.
 Adjustment loops.
 Look at figure 8-5, the orange path exhibits several
characteristics of the inflation process:
1. Acceleration of demand growth raises inflation and output ratio
in the short run
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-5 Effect on Inflation and Real GDP of an Acceleration of Demand
Growth from Zero to 6 Percent
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
2. In the long run inflation rate (p) rises by exactly the same
amount as (x)
3. Following a permanent increase in nominal growth (x), inflation
(p) always experience a temporary period when it overshoots the
new growth rate of nominal GDP.
 Recession as a cure for inflation
 To eliminate inflation, we have to set in reverse the process of
inflation (disinflation: deceleration of inflation).
 The Cold Turkey remedy for inflation
 Look at figure 8-6. Cold turkey operates by implementing a
sudden and permanent slowdown in nominal GDP.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-6 Initial Effect on Inflation and Real GDP of a Slowdown in Nominal
GDP Growth from 10 Percent to 4 Percent
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The process of adjustment to the new long run equilibrium
 The process of adjustment comes to end when inflation equals
the new growth rate of GDP, and expected inflation has declined
to its long run equilibrium value.
 The downward spiraling loop
 Look at figure 8-7.
 The output cost of disinflation
 The cold turkey (figure 8-7) leads to a sudden drop in nominal
GDP. Thus the cost of disinflation is a slump in output.
 A conventional method of the cost of disinflation is the sacrifice
ratio; the cumulative loss of output incurred during a
disinflation divided by the permanent reduction in inflation rate.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
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
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The importance of supply shocks
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
International Perspective Did Disinflation in Europe Differ from That in the
United States?
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-8 The Inflation Rate and the Output Ratio, 1980–95
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-9 Four-Quarter Growth Rate of the GDP Deflator and the Level of
Nominal and Real Oil Prices, 1970–2004
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-10 The Effect on the Inflation Rate and the Output Ratio of an Adverse
Supply Shock That Shifts the SP Curve Upward by 3 Percent
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-11 Effect of Adverse Supply Shocks in the 1970s and Beneficial Supply
Shocks in the 1990s
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-12 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)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-12 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)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-12 Responses of the Inflation Rate (p) and the Output Ratio (Y/YN) to
Shifts in Nominal GDP Growth and in the SP Curve
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-13 The U.S. Ratio of Actual to Natural Real GDP (Y/YN) and the
Unemployment Rate, 1965–2004
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-14 The Unemployment Rate and the Inflation Rate, 1960–2004
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-15
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 8-16
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University