Inflation

1. Inflation

2. Learning Objectives • To understand the difference between a demand shock and a supply shock. • To understand the difference between demand inflation and supply inflation. • To construct the short-run and long-run Phillips curve as well as the expectations augmented Phillips curve. • To examine the effects of demand and supply changes on the rate of change in real GDP and the inflation rate. • To consider the impact of supply shocks on unemployment.

3. Demand Shock • A demand shock is a sustained acceleration or deceleration in aggregate demand, measured most directly as a sustained acceleration or deceleration in the growth rate of nominal GDP. • Demand inflation is a sustained increase in prices that is preceded by a permanent acceleration of nominal GDP growth.

4. Supply Shock • A supply shock is caused by a sharp change in the price of an important commodity that causes the inflation rate to rise or fall in the absence of demand. • Supply inflation is an increase in prices that stems from an increase in business costs not directly related to a prior acceleration of nominal GDP growth.

5. Real GDP, the Inflation Rate, and the Short-Run Phillips Curve • Demand Pull Inflation • A continuous increase in demand pulls the price level up continuously. • This type of inflation can be caused by large government budget deficits and excessive rates of growth of the money supply.

6. Aggregate Demand and the Phillips Curve LAS Top Graph: The economy starts in long-run equilibrium at point E0., where the price level equals 1.00. When AD0 shifts to AD1, the price level moves to 1.03 at point E1. Bottom Graph: The SP line is the short-run Phillips curve and it shows the relationship between the inflation rate and real GDP, when price change expectations equal zero. P SAS0 1.03 E1 1.00 E0 AD1 AD0 0 Y 100 106 p SP0(pe = 0) 3 E1 0 E0 -3 0 Y 100 106

7. One Shot Increase in Aggregate Demand and the Phillips Curve LAS P The economy starts in long-run equilibrium at point E0 . When AD0 shifts to AD1, the price level moves to 1.03 at point E1. At E1, there is upward pressure on the wage rate, causing SAS to shift up. As SAS shifts, we move to a point like D. SAS1 1.06 SAS0 D 1.03 E1 1.00 E0 AD1’ AD1 AD0 0 Y 100 106 p SP0(pe = 0) 3 E1 0 E0 -3 0 Y 100 106

8. Continuous Increase in Aggregate Demand and the Phillips Curve LAS The economy starts in long-run equilibrium at point E0. When AD0 shifts to AD1, the price level moves to 1.03 at point E1. At E1, there is continuous upward pressure on the wage rate, causing SAS to shift up over time. To prevent output from declining, AD must increase continuously. The SP line shows that to maintain Y above 100, AD must rise continuously and create a continuous 3% inflation. P SAS1 1.06 SAS0 E’1 D 1.03 E1 1.00 E0 AD1’ AD1 AD0 0 Y 100 106 p SP0(pe = 0) 3 E1 0 E0 -3 0 Y 100 106

9. The SP Curve • Why is there continuous upward pressure for higher wages in the model? • The short-run Phillips curve (SP curve) is a schedule relating real GDP to the inflation rate achievable given a fixed expected rate of inflation. • Consequently, the continuous upward pressure for higher wages exists because contracts fail to anticipate further inflation, and as a result fail to specify in advance the wage increases needed to keep up with inflation.

10. The Expectations Augmented Phillips Curve • The expectations augmented short-run Phillips curve (SP curve) shifts its position whenever there is a change in the expected rate of inflation. • Expectations of rising inflation shift the SP curve up and to the left. • Expectations of falling inflation shift the SP curve down and to the right.

11. Expectations • Forward-looking Expectations • Attempt to predict the future behavior of an economic variable, using an economic model that specifies the interrelationship of that variable with other variables • Backward-looking Expectations • Use only information on the past behavior of economic variables.

12. Expectations Augmented Short-Run Phillips Curve LP(pe=p) When people fully expect 3% inflation, the SP curve shifts up and to the left by 3%. Long-run equilibrium occurs at point E2. The vertical LP line shows all the possible positions of long-run equilibrium, where the actual and expected inflation rates are equal (pe=p). p SP1(pe=3) SP0(pe=0) E2 3 E1 E0 0 -3 Y 0 94 97 100 103 106 109

13. Policy Implication of the LP Curve • The policy implication of the long-run Phillips curve (LP curve) is that the best way to stabilize the economy is to adopt policies to keep real GDP equal to the natural rate of GDP. • Restrictive policies are required when AD>LRAS • Expansionary polices are required when AD<LRAS.

14. Nominal GDP Growth and Inflation • Definitions: • Nominal GDP equals the price level times real GDP. • X = PY • The growth rate of nominal GDP equals the sum of the growth rates of the price level and real GDP • x = p + y where • x = Growth rate of nominal GDP • p = Growth rate of the price level • y = Growth rate of real GDP

15. 3 Propositions • When inflation is greater than the growth of nominal GDP, real GDP growth must fall. • When inflation equals the growth of nominal GDP, real GDP growth equals zero • When inflation is less than the growth of nominal GDP, real GDP growth is positive.

16. Nominal GDP Growth and Inflation Level of Variable Growth Rate of Variable Between Periods 0 and 1 Period X Y P x y p Alternative A 0 100 100 1.00 p = 9% 1 106 97 1.09 6 -3 9 Alternative B 0 100 100 1.00 p = 6% 1 106 100 1.06 6 0 6 Alternative C 0 100 100 1.00 p = 3% 1 106 103 1.03 6 3 3

17. Equilibrium in the Long-Run • Long run equilibrium is defined by the following three conditions: • The economy is on the SP curve. • x = p, which implies that y = 0. • x = p + y so if x = p, (x – p) = 0 and y = 0. • pe = p, price expectations are accurate.

18. Long-Run Equilibrium LAS P Top Graph: The economy starts in long-run equilibrium at point E0., where the price level equals 1.00. Bottom Graph: At the point E0, the economy is on the SP curve, pe = p = 0, and x = p. SAS0 1.00 E0 AD0 0 Y 100 p SP0(pe = 0) 3 0 E0 -3 0 Y 100

19. Acceleration in Nominal GDP: Effects Initially, the economy is at E0, with actual and expected inflation of 0%. A permanent 6% acceleration in nominal GDP growth moves the economy in the first period to point F. In the short-run if the expected rate of inflation fails to respond to faster actual inflation, the economy moves to point E3. The economy never moves to point D. LP (pe =p) p SP0(pe=0) 6 E3 F 2 D 0 E0 104 Y 0 94 97 100 103 106 112

20. Acceleration in Nominal GDP: Point E0 The permanent acceleration of GDP growth means that the economy cannot stay at point E0. One of the equilibrium conditions no longer holds. The 6% value of x exceeds the 0% initial value of p, so GDP must grow. With no price increases, firms respond to rising spending by producing more goods and services. The growth rate of real GDP becomes positive when nominal GDP growth exceeds the inflation rate. LP (pe =p) p SP0(pe=0) 6 E3 F 2 D 0 E0 104 Y 0 94 97 100 103 106 112

21. Acceleration in Nominal GDP: Point D The permanent acceleration of GDP growth also means that the economy cannot go to point D. One of the equilibrium conditions no longer holds. Point D does not lie on the SP curve, so it cannot represent a combination of output and inflation that is consistent with profit maximizing business behavior and zero expected inflation. LP (pe =p) p SP0(pe=0) 6 E3 F 2 D 0 E0 104 Y 0 94 97 100 103 106 112

22. Acceleration in Nominal GDP: Point F • The permanent acceleration of GDP growth means that in the short-run the economy will go to point F. • At point F, the inflation rate is 2%, while real GDP has grown by 4%; ie., y = x – p = 4% = 6% - 2%. • A 6% acceleration in the rate of growth of nominal GDP causes the economy to slide up the SP curve, dividing the growth in nominal GDP between real GDP growth and inflation. LP (pe =p) p SP0(pe=0) 6 E3 F 2 D 0 E0 104 Y 0 94 97 100 103 106 112

23. Acceleration in Nominal GDP: Point E3 • The permanent acceleration of GDP growth means that in the economy cannot stay at point F. • At point F, x does not equal p and pe does not equal p. • If x is greater than p, y must grow, moving the economy to the right of point F. • Real GDP must keep growing until inflation rises by enough so that x= p =6. • The economy must move to point E3. LP (pe =p) p SP0(pe=0) 6 E3 F 2 D 0 E0 104 Y 0 94 97 100 103 106 112

24. Acceleration in Nominal GDP: Point E4 The permanent acceleration of GDP growth means that in the long-run the economy cannot stay at point E3. At point E3, x = p, but pe still does not equal p. As labor negotiations react to the higher 6% rate of inflation, wage demands will rise, causing the SP curve to shift up and to the left. The SP curve will stop shifting only when the economy reaches point E4, where all equilibrium conditions are met. LP (pe =p) p SP0(pe=0) 6 E3 E4 F 2 D 0 E0 104 Y 0 94 97 100 103 106 112

25. Acceleration in Nominal GDP: Summary SP1(pe=6) Initially, the economy is at E0, with actual and expected inflation of 0%. A permanent 6% acceleration in nominal GDP growth moves the economy in the first period to point F. If the expected rate of inflation fails to respond to faster actual inflation, the economy eventually moves to point E3. As expectations adjust, the economy moves to point E4. LP (pe =p) p SP0(pe=0) 6 E4 E3 F 2 0 E0 104 Y 0 94 97 100 103 106 112

26. Adjustment Loop Initially, the economy is at E0, with actual and expected inflation of 0%. When expectations do not adjust and the nominal growth of GDP increases by 6%, the economy moves along the black path to E3. But, if expectations adjust fully to the last period’s actual inflation, the economy moves along the red path to E4. For example, if inflation increases by 2% as the economy moves from E0 to F, the SP curve shifts to the left by 2% in the next period, so the economy moves to point H. LP (pe =p) p SP0(pe=0) 9 5 E3 4 6 3 6 E4 7 H 2 8 3 1 F 0 E0 Y 0 94 97 100 103 106 112

27. Adjustment Loops: Path Characteristics • An acceleration of demand growth raises the inflation rate and real GDP in the short run. • In the long run, if expectations adjust to the actual behavior of inflation, the inflation rate rises by exactly the same amount as nominal GDP, and any increase in real GDP along the way is only temporary. • Following a permanent increase in nominal GDP growth, inflation always experiences a temporary period when it overshoots the new growth rate of nominal GDP.

28. Overshooting • Overshooting occurs because the economy arrives at its long-run inflation rate in period 3 before expected inflation has caught up with actual inflation. • The subsequent points that lie above 6% reflect the combined influence on inflation of: • The continued upward demand pressure that raises actual inflation above expected inflation whenever the economy is to the right of the LP line. • The upward adjustment of expectations.

29. Disinflation • Disinflation is a marked deceleration in the inflation rate. • Recessions cause a decrease in aggregate demand and result in disinflation. • The “cold turkey” remedy for inflation operates by implementing a sudden and permanent slowdown in nominal GDP growth.

30. Deceleration in Nominal GDP: Effects Initially, the economy is at E5, with actual and expected inflation of 10%. A permanent 6% deceleration in nominal GDP growth moves the economy in the first period to point K. At point K, the inflation rate has fallen by 2% and real GDP has fallen by 4%. As expectations adjust and the SP curve shifts down and right, the economy moves to point E6. LP (pe =p) SP2(pe=10) p 13 SP3(pe=4) 10 E5 K 8 4 E6 Y 0 94 96 100 103 106 109

31. Adjustment Loop Initially, the economy is at E4, with actual and expected inflation of 10%. A permanent 6% deceleration in nominal GDP growth causes a recession and disinflation. The red line between E4 and 1981 traces the same path as between E5 and K in the previous slide. For the remaining years, the economy follows the red path. LP (pe =p) p 12 E4 1980 10 1981 8 6 1982 1990 4 E5 1983 1986 1985 2 1984 Y 0 94 96 98 100 102 104 106

32. The Output Cost of Disinflation • The cost of disinflation is a slump in output. • The alternative is to live with inflation and no growth in GDP. • The sacrifice ratio is the cumulative loss of output incurred during a disinflation divided by the permanent reduction in the inflation rate. • The sacrifice ratio illustrates the trade-off between permanently reducing inflation and learning to live with it.

33. Real World Sacrifice Ratio • The real world the cumulative loss of output is measured by the ratio of actual GDP to full employment GDP. • The cumulative loss of output during 1980-85 was 26.4%. During that period, inflation fell from 9% to 3%. The sacrifice ratio was 4.4. • The recession of the early 1990s reduced inflation by 1.7% while the cumulative loss of output was 4.7. The sacrifice ratio was 2.8

34. Supply Disturbances • Supply inflation is an increase in prices that stems from an increase in business costs not directly related to a price acceleration of nominal GDP growth. • During the 1970s, changes in nominal GDP growth did not explain changes in the inflation rate very well. • The US inflation rate exhibited volatile accelerations and decelerations that were not preceded by changes in nominal GDP growth.

35. Types of Supply Shocks • Supply shocks can be adverse or beneficial. • Adverse supply shocks make inflation worse and cause real GDP to fall. • A rise in the price of an important resource. • Weather changes that disrupt agriculture. • Beneficial supply shocks reduce inflation and cause real GDP to rise. • A fall in the price of an important resource. • Lower real price of imports.

36. Supply Shocks and the SP Curve • Adverse supply shocks shift the SP curve up and left. • At every level of output, inflation is higher or at every inflation rate output is lower. • Beneficial supply shocks shift the SP curve down and right. • At every level of output, inflation is lower or at every inflation rate output is higher.

37. Adverse Supply Shock and the SP Curve LP (pe =p) p The economy begins at point E4 with an output ratio of 100% and actual and expected inflation of 6%. The supply shock shifts the SP curve up and to the left. The impact of the supply shock depends on the policy response. SP3(pe=6) 12 SP2(pe=6) 9 E4 6 3 0 Y/YN 0 88 91 94 97 98 100 103 106

38. Adverse Supply Shock and the SP Curve The impact of the supply shock depends on the policy response. An accommodating policy moves the economy from point E4 to point N. A neutral policy moves the economy from point E4 to point L. An extinguishing policy moves the economy from point E4 to point M. p SP3(pe=6) 12 SP2(pe=6) N 9 L 8 E4 M 6 3 0 Y/YN 0 88 91 94 96 97 100 103 106

39. Policies • A neutral policy maintains nominal GDP growth to allow a decline in the output ratio equal to the increase of the inflation rate. • An accommodating policy raises nominal GDP growth to maintain the original output ratio. • An extinguishing policy reduces nominal GDP growth to maintain the original inflation rate.

40. The Impact of Supply Shocks in Subsequent Periods • If the supply shock occurs in only one period, the SP curve shifts back to its original position when the shock is reversed. • This happens, however, only if inflation expectations are not changed by the supply shock. • Is this plausible?

41. The Impact of Supply Shocks in Subsequent Periods • The response of the expected inflation rate to the supply shock depends on: • whether people view the supply shock as permanent or temporary and on • whether labor contracts incorporate cost-of-living agreements that automatically boost wages by a percentage that is related to the inflation rate.

42. The Impact of Supply Shocks in Subsequent Periods • COLAs • COLAs automatically incorporate the one-period increase of inflation into faster growth of nominal wages in the next period. • This means that it is not possible to return to the point E4 because the expected rate of inflation will shift up above the original 6%, causing the SP curve to shift up.

43. COLAs and Monetary Policy • COLAs imply that a permanent supply shock will permanently raise the inflation rate unless an extinguishing policy response to the initial impact of the supply shock prevents any increase of inflation and the rate of change in nominal wage rates. • Therefore, COLAs present a policy dilemma for the makers of monetary policy.

44. Social Costs of Inflation and Monetary Policy • The Fed faces a trade-off between inflation and lost output. • If the Fed imposes an extinguishing policy, the loss in output could be severe as GDP falls. • However, if the Fed pursues an accommodating or neutral policy the social costs of permanently higher inflation might be relatively small.

45. Beneficial Supply Shocks • Beneficial supply shocks shift the SP curve downward and to the right. • This means that policy makers may choose between lower inflation, a higher output ratio or both. • Gordon (p253) attributes the excellent economy of the late 1990s on the deceleration of inflation which he argues was not due to “brilliant” monetary policy, but rather to four beneficial supply shocks.

46. Beneficial Supply Shocks • Four Beneficial Supply Shocks of the 1990s. • Lower real price of energy • Lower real price of imports • Faster decline in the real prices of computers • Slower inflation in medical care

47. Beneficial Supply Shocks and Unemployment • The beneficial supply shocks of the 1990s also help to explain the decline in the natural rate of unemployment. • As GDP rises, unemployment falls. • During the 1990s the natural rate of unemployment fell. • From 1995 and until 2001, the unemployment rate was below the natural rate of unemployment. • During this period, the rate of inflation decelerated up through mid-1999.

48. Explanations of the Decline in the Natural Rate of Unemployment • Demographic Changes • The fraction of teenagers and young adults fell in the 1980s and 1990s. • These groups typically have higher rates of unemployment. • Higher rates of imprisonment of young males. • In 1998, 2.3% of young males were imprisoned, up from 1.15% in 1985. • Temporary help agencies and the Internet • These agencies help firms fill vacancies faster.