Transcript Chapter 10

Chapter 10
Inflation and Aggregate Supply
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by Bernanke, Olekalns and Frank
10–1
Chapter 10: Inflation and
Aggregate Supply
• Inflation, spending, and output: aggregate demand
curve
• Inflation and aggregate supply
• Aggregate demand: aggregate supply diagram
• Sources of inflation
• Controlling inflation
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Aggregate Demand (AD)
• AD is another word for PAE
• AD relates demand to the rate of inflation (p) rather
than to GDP as in previous chapters
• Distinguish price level from its rate of change
• A rise in p reduces AD
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Why Does AD Slope Down?
• When p exceeds the RBA target, the RBA will
react by raising interest rates to reduce AD
• Inflation and wealth
• Inflation and income distribution
• Inflation and uncertainty
• Inflation and international competitiveness
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The AD Curve
10–5
Shifts in AD
• Exogenous changes in components of PAE
• Exogenous changes in the RBA policy reaction
function reflected in a higher or lower nominal and
real interest rate at any given rate of inflation
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10–6
Shifts in AD (cont.)
10–7
Shifts in AD (cont.)
10–8
What Influences Inflation Rate?
•
•
•
•
Expectations of the inflation rate
The size of the output gap between Y and Y*
Shocks to the cost of inputs
Shocks to Y*: affect the size of the output gap
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Inflation Expectations
• Influence the rate of wage increase that workers
ask for and employers agree to, and thus the
current rate of inflation
• Expectations are likewise influenced by current
inflation rates
• This makes inflation ‘inertial’
• Inertia is reinforced by labour contracts which
guarantee real wages, so wages follow prices and
prices then follow wages
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Inflation Inertia
10–11
The Size of the Output Gap
• Y = Y*: inflation rate constant
• Y > Y*: inflation rate rises
• Y < Y*: inflation rate falls
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Shocks to the Cost of Inputs
• Oil price shocks
• Successful attempts to raise money wages faster
than rises in labour productivity, causing labour
costs per unit of output, and prices, to rise
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Shocks to Y*
• Fall in labour force due to retirement of ‘baby
boomers’
• Rise in labour force due to immigration of skilled
workers
• Change in industrial relations which make it
more/less attractive for employers to hire workers
• Changes in taxes/pensions/unemployment
benefits which make it more/less attractive to seek
work
• Productivity-enhancing technology
• Rise in energy prices and capital obsolescence
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Short-Run Aggregate Supply
• SRAS depicts the current rate of inflation,
determined by inflationary expectations
• Like GDP, these expectations are constant in
the SR
• So SRAS is horizontal
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Long-Run Aggregate Supply
• LRAS is determined by Y*
• Does not depend on p
• LRAS is vertical
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10–16
Aggregate Demand and Supply
10–17
Recessionary Gap
• Y < Y*: cyclical unemployment so unemployment
is above the natural rate
• Workers ask for wage increases less than the
current inflation rate to reduce real wages and
keep/get jobs
• The inflation rate falls
• Shift along AD as the inflation rate falls
• Y increases
• This continues until Y = Y*
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Recessionary Gap
10–19
Inflationary Gap
• Y > Y*: unemployment below the natural rate
• Excess demand for labour: workers ask for, and
are granted, wage increases in excess of the
inflation rate
• The inflation rate rises
• AD falls as the inflation rate rises
• Y falls
• This continues until Y = Y*
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10–20
Inflationary Gap
10–21
Does the Economy Self-Correct?
• Yes, in the long run
• But how long is the ‘long run’?
• How long it takes to get out of a recessionary gap
without stimulus from the RBA depends on the
flexibility of real wages (money wages growing
slower than prices)
• This depends on the strength of unions and the
attitude of wage-fixing authorities
• When Keynes was writing, there was zero inflation,
so a fall in real wages required an absolute fall in
money wages, which was strongly resisted
• In Keynes’ time, ‘long run’ was ‘too long’ to wait
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Self-Correcting Inflationary Gaps
• This is achieved by a rise in the inflation rate
• In the view of the RBA, inflationary gaps should
not be allowed to develop, because inflation is so
harmful and difficult to eradicate once it has fed
into expectations
• So the RBA is not willing to rely on this selfcorrecting mechanism
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Causes of High Inflation
• Excessive spending
• Shocks to the cost of inputs (oil and labour)
combined with wage indexation
• Rapid depreciation of the currency, which raises
the domestic cost of imported raw materials,
combined with wage indexation
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Policy Dilemma for RBA
•
Suppose inflation shock lifts SRAS: two options
1. Do nothing: leads to a recession/unemployment, and
eventually a fall in the inflation rate, as wages rise more
slowly than prices
2. Increase AD: avoids recession but stabilises the rate of
inflation at the higher rate, which may be unacceptably
high
•
In the 1970s the RBA and other central banks
chose the first option, to force workers to accept a
fall in real wages following a wage ‘breakout’ and
rise in oil prices
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Policy Dilemma
10–26
Reducing Inflation Expectations
•
Two options
1. As in 1989, RBA imposes a recession, so wage growth
falls below price growth and the actual rate of inflation
falls. Costly in terms of unemployment and lost output
2. RBA announces a lower inflation target
•
If credible, expectations follow the lower target,
and workers and employers negotiate new wage
agreements which reflect the new target
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Reducing Inflation Expectations (cont.)
• The economy smoothly transits to lower inflation
• Illustrates the value of RBA credibility
• RBA maintains credibility by continually publicising
its inflation targets, achieving them, and operating
at ‘arms length’ from government/politicians
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Painful Inflation Reduction
10–29
Zero Inflation?
• Zero inflation is neither easy nor desirable
• To have zero inflation (a constant average price
level) significant areas of the economy
(manufacturing) must experience actual price falls
(deflation)
• This is because service prices (health care and
education etc.) must rise relative to goods prices
• Deflation creates bankruptcy for business in debt
• With zero inflation, the only way to reduce real
wages to cure unemployment would be to cut
money wages, which is strongly resisted with
strikes/riots (refer back to slide 22)
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