Inflation and Aggregate Supply

Inflation and Aggregate Supply

Inflation and Aggregate Supply

Principles of Macroeconomics

Dr. Gabriel X. Martinez

Ave Maria University

Chapter 28: Inflation and AggregaChapter 28: Inflation and Aggregate Supplyte Supply

22Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

Inflation and Aggregate SupplyInflation and Aggregate Supply

Where does inflation come from?Where does inflation come from?– If people, businesses and government demand If people, businesses and government demand

more goods, their prices will rise.more goods, their prices will rise.– But if firms produce more goods, their prices will But if firms produce more goods, their prices will

fall.fall.

Inflation is determined by the interaction of Inflation is determined by the interaction of Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply for goods and services.for goods and services.

The Aggregate Demand CurveThe Aggregate Demand Curve



Aggregate Demand (Aggregate Demand (ADAD) Curve) Curve– Shows theShows the

relation betweenrelation between

short-run equilibrium output short-run equilibrium output Y Y and the rate of inflation, and the rate of inflation, ..

– For AD, changes in For AD, changes in cause changes in cause changes in YY..

Inflation, Spending, and Output: The Inflation, Spending, and Output: The Aggregate Demand CurveAggregate Demand Curve



Aggregate Demand (Aggregate Demand (ADAD) Curve) Curve– The name of the curve reflects the fact that The name of the curve reflects the fact that

short-run equilibrium short-run equilibrium outputoutput is determined by, is determined by, and and equalsequals, total planned , total planned spendingspending in the in the economy.economy.

– Increases in inflation reduce planned spendingIncreases in inflation reduce planned spending and short-run equilibrium output, so the and short-run equilibrium output, so the aggregate demand curve is downward-sloping.aggregate demand curve is downward-sloping.




Inflation and the Inflation and the ADAD Curve Curve– The Keynesian model assumes output adjusts The Keynesian model assumes output adjusts

to demand at preset prices in the short run.to demand at preset prices in the short run.– Prices do not remain fixed indefinitely: this Prices do not remain fixed indefinitely: this

means there can be inflation.means there can be inflation.



The Income-Expenditures Model (chapter 26) The Income-Expenditures Model (chapter 26) told us that equilibrium output is given bytold us that equilibrium output is given by

and that, including the effect of interest rates on and that, including the effect of interest rates on C and I (chapter 27)C and I (chapter 27)

This means real interest rates and equilibrium This means real interest rates and equilibrium output are inversely related.output are inversely related.

XNGITcCc

Y

1

1

rbaXNGITcCc

Y )(1

1

Eq 1




Where does Where does rr come from? come from? It is the It is the realreal opportunity cost of holding a opportunity cost of holding a

realreal stock of money stock of money– That is, holding an X amount of purchasing That is, holding an X amount of purchasing

power in the form of money.power in the form of money.




People’s Real Money Holdings are.People’s Real Money Holdings are.

Let’s think in terms of growth rates.Let’s think in terms of growth rates.– M rises at “the rate of money growth,” M rises at “the rate of money growth,” . .– P rises at “the rate of inflation”, P rises at “the rate of inflation”, ..

M

M

P

M



Inflation and Inflation and Real BalancesReal Balances

If If > > , , Real Money HoldingsReal Money Holdings rise. rise.– People’s money has more value, so spending People’s money has more value, so spending

rises.rises.

If If > > , , Real Money HoldingsReal Money Holdings fall. fall.– People’s money has less value, so spending People’s money has less value, so spending

falls.falls.


P

M

M

M

M

M



> > i i I , C I , C Y Y

< < i i I , CI , C YY

Inflation reduces the real money supply, Inflation reduces the real money supply, leading to a higher cost of borrowing money.leading to a higher cost of borrowing money.

As interest rates rise, expenditure falls.As interest rates rise, expenditure falls.


M

M

M

M

P

M

P

M



> > ↓ ↓ i i ↑↑ I I ↓↓, C , C ↓↓ Y Y ↓↓

< < ↑↑ i i ↓↓ I I ↑↑, C , C ↑↑ Y Y ↑↑

Inflation reduces the real money supply, Inflation reduces the real money supply, leading to a higher cost of borrowing money.leading to a higher cost of borrowing money.

As interest rates rise, expenditure falls.As interest rates rise, expenditure falls.


M

M

M

M

P

M

P

M



The Aggregate Demand The Aggregate Demand CurveCurve

Output Y

AD

Aggregate Demand Curve

An increase in reduces Y(all other factors held constant)

Infl

atio

n

High means lower M/P, higher i, lower C, I, and Y

Low means higher M/P, lower i, higher C, I, and Y



The Aggregate Demand The Aggregate Demand CurveCurve

Output Y

AD

Aggregate Demand Curve

An increase in reduces Y(all other factors held constant)

Infl

atio

n



Other Reasons for the Downward Slope of Other Reasons for the Downward Slope of the the ADAD Curve Curve– Distributional effects.Distributional effects.

Poorer people are more hurt by inflation (less Poorer people are more hurt by inflation (less financially sophisticated) and they spend more out of financially sophisticated) and they spend more out of their disposable income.their disposable income.

– Uncertainty.Uncertainty.– Prices of domestic goods and services sold Prices of domestic goods and services sold

abroad.abroad.




Movements Along the Movements Along the ADAD Curve Curve and and YY are inversely related are inversely related– Changes in Changes in cause a change in cause a change in YY– This means a This means a movement along movement along the the AD AD curvecurve increases increases r r increasesincreases plannedplanned

spending decreases spending decreases YY decreases decreases

– Note: the Note: the real balances function real balances function is unchanged.is unchanged.




Shifts of the Shifts of the ADAD Curve Curve– Any factor that Any factor that changes changes YY at a given at a given shifts the shifts the

ADAD curve. curve.– ShiftsShifts of the of the AD AD curve can be caused by:curve can be caused by:

Changes in exogenous spending.Changes in exogenous spending.– Higher G or Lower THigher G or Lower T– Higher I or Higher CHigher I or Higher C– Higher NXHigher NX

Changes in the Fed’s anti-inflation stance.Changes in the Fed’s anti-inflation stance.




Output Y

Infl

atio

n

AD

AD’

The new Fed policy increases r and AD shifts to AD’

Effect of A Shift In The Fed’s Effect of A Shift In The Fed’s Policy Reaction Function: A Shift in ADPolicy Reaction Function: A Shift in AD

Shifts of the Shifts of the ADAD Curve Curve– In the early 1980s, the In the early 1980s, the

Fed raised interest Fed raised interest rates dramatically, rates dramatically, causing two major causing two major recessions.recessions.

– This shifted the AD This shifted the AD curve to the left: Y fell curve to the left: Y fell at any level of at any level of ..



Output Y

ADExogenous Spending: spending unrelated to Y or r• Fiscal policy turns expansionary•Confidence rises•Foreign demand increases

AD’

An increase in exogenous spending shifts AD to AD’ and vice versaIn

flat

ion

Effect of An Increase In Exogenous Effect of An Increase In Exogenous Spending: A Shift of ADSpending: A Shift of AD

The Aggregate Supply CurveThe Aggregate Supply Curve



Inflation will remain roughly constant if the Inflation will remain roughly constant if the economy is operating at economy is operating at Y*Y* and there are no and there are no external shocks to the price level.external shocks to the price level.

We refer to this as “inflation inertia.”We refer to this as “inflation inertia.”– In physics, inertia refers to the propensity of In physics, inertia refers to the propensity of

bodies to maintain a constant speed once bodies to maintain a constant speed once forces have stopped acting on them.forces have stopped acting on them.

– Here, we mean that inflation tends to stay Here, we mean that inflation tends to stay constant unless something happens.constant unless something happens.

Inflation andInflation andAggregate SupplyAggregate Supply



Inflation InertiaInflation Inertia– In industrial economies (U.S.), inflation tends to In industrial economies (U.S.), inflation tends to

change slowly from year to year.change slowly from year to year.– The The inflation inertiainflation inertia occurs for two reasons: occurs for two reasons:

Inflation expectationsInflation expectations Long-term wage and price contractsLong-term wage and price contracts




A Virtuous Circle of Low Inflation and A Virtuous Circle of Low Inflation and Low Expected InflationLow Expected Inflation

If workers expect = 3%, they will ask for a 3% raise to keep their purchasing power.If firms give a 3% wage raise, they will raise their prices by no less than 3% to keep their profits; but by no more than 3% to stay competitive. So will be …?



Long-term Wage and Price ContractsLong-term Wage and Price Contracts– Union wage contracts set wages for several years.Union wage contracts set wages for several years.– Contracts setting the price of raw materials and Contracts setting the price of raw materials and

parts for manufacturing firms also cover several parts for manufacturing firms also cover several years.years.

– These long-term contracts reflect the inflation These long-term contracts reflect the inflation expectations at the time they are signed.expectations at the time they are signed.

– So if unions expected So if unions expected =3% in 2001, their =3% in 2001, their expectations will affect actual expectations will affect actual for years to come. for years to come.




The Output Gap and InflationThe Output Gap and Inflation– Now suppose you are selling all your production Now suppose you are selling all your production

and you are using your resources at normal and you are using your resources at normal rates.rates. The output gap is zero.The output gap is zero.

– You will try to remain competitive: don’t raise You will try to remain competitive: don’t raise prices too much, not too little. Raise prices as prices too much, not too little. Raise prices as much as wages and other costs.much as wages and other costs.

– So if everyone else raises prices and costs by So if everyone else raises prices and costs by 3%, you raise them by 3%.3%, you raise them by 3%.




The Output Gap and InflationThe Output Gap and Inflation– If everyone else raises prices and costs by 3%, If everyone else raises prices and costs by 3%,

you raise them by 3%.you raise them by 3%.– You try to keep your You try to keep your relative pricerelative price (that is, your (that is, your

price relative to all other goods) constant.price relative to all other goods) constant.– This means that This means that if the output gap is zero,if the output gap is zero,

inflation is constant.inflation is constant. This is what we mean by inflation inertia.This is what we mean by inflation inertia.




The Output Gap and InflationThe Output Gap and Inflation

Relationship of outputto potential output Behavior of inflation

1. No output gap Inflation remains unchangedY = Y*

The Aggregate Demand - The Aggregate Demand - Aggregate Supply DiagramAggregate Supply Diagram



Short-run Aggregate Supply (Short-run Aggregate Supply (SRASSRAS))– A horizontal line showing the current rate of A horizontal line showing the current rate of

inflation, as determined by past expectations inflation, as determined by past expectations and pricing decisions.and pricing decisions.

The Aggregate Demand - Aggregate The Aggregate Demand - Aggregate Supply DiagramSupply Diagram



Output

Infl

atio

n,

Y*

Short-run aggregate supply, SRAS

The Aggregate Demand-Aggregate The Aggregate Demand-Aggregate Supply (Supply (AD-AS)AD-AS) Diagram Diagram



Short-run EquilibriumShort-run Equilibrium– Because inflation is inertial, it just is whatever is Because inflation is inertial, it just is whatever is

consistent with past pricing decisions.consistent with past pricing decisions. This inertial This inertial implies a certain level of M/P, which implies a certain level of M/P, which

determines the interest rate and expenditure.determines the interest rate and expenditure.

– Output is demand-determined in the short-run.Output is demand-determined in the short-run. Changes in autonomous expenditure change Y.Changes in autonomous expenditure change Y.

– Graphically, short-run equilibrium occurs at the Graphically, short-run equilibrium occurs at the intersection of the intersection of the ADAD curve and the curve and the SRASSRAS line. line.




Short-run EquilibriumShort-run Equilibrium– A situation in whichA situation in which

Inflation = the value determined by past expectations and Inflation = the value determined by past expectations and pricing decisionspricing decisions

AndAnd

Output = the level of short-run equilibrium output that is Output = the level of short-run equilibrium output that is consistent with that inflation rate.consistent with that inflation rate.

– Short-run equilibrium occurs at the intersection of the Short-run equilibrium occurs at the intersection of the ADAD curve and the curve and the SRASSRAS line. line.




Output

Infl

atio

n,

Aggregate demand, AD

A

Y*Y


Short-run equilibrium•Y: SRAS() = AD•Given the level of , M and G are relatively low.•Y < Y* -- recessionary gap




Output

Infl

atio

n,


A

Y* Y


Short-run equilibrium•Y: SRAS() = AD•Given the level of , M and G are relatively high.•Y > Y* -- expansionary gap




Output

Infl

atio

n,


Y*


Short-run equilibrium•Y: SRAS() = AD•Given the level of , M and G are just right.•Y = Y* -- no gap


A



This is just the old Keynesian model of This is just the old Keynesian model of chapter 26.chapter 26.– In chapter 26, prices were exogenous. Here In chapter 26, prices were exogenous. Here

inflation is exogenous. (It just “is”).inflation is exogenous. (It just “is”).– Different levels of autonomous expenditure, of Different levels of autonomous expenditure, of

G and T, and of M lead to different levels of Y.G and T, and of M lead to different levels of Y.– Output is demand-determined.Output is demand-determined.




Output is demand-determined: is this a good Output is demand-determined: is this a good thing or a bad thing?thing or a bad thing?– It’s good: we, as a society, can choose the level It’s good: we, as a society, can choose the level

of output we like.of output we like.




Output is demand-determined: is this a good Output is demand-determined: is this a good thing or a bad thing?thing or a bad thing?– It’s bad: if we don’t coordinate our decisions It’s bad: if we don’t coordinate our decisions

properly, expenditure may be too low, and we properly, expenditure may be too low, and we may end up with high unemployment.may end up with high unemployment.

– Recessions and over-expansions can happen Recessions and over-expansions can happen (and do happen) all the time. In the short-run, (and do happen) all the time. In the short-run, the economy can’t correct itself.the economy can’t correct itself.




Is the economy self-correcting in the Is the economy self-correcting in the short run?short run?

http://images.google.com/imgres?imgurl=http://bolivia.freeservers.com/images/homeless%2520family%2520big.JPG&imgrefurl=http://bolivia.freeservers.com/photo3.html&h=552&w=792&sz=87&tbnid=V_qPf5Im_18J:&tbnh=98&tbnw=142&hl=en&start=1&prev=/images%3Fq%3Dhomeless%2Bfamily%26svnum%3D10%26hl%3Den%26lr%3D%26safe%3Dactive%26rls%3DGGLD,GGLD:2004-49,GGLD:enhttp://archives.cnn.com/2001/WORLD/europe/08/28/britain.homeless/story.homeless.jpghttp://www.iamaw.org/publications/imail/photos/unemployment_line2.jpg




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The Adjustment Process to an The Adjustment Process to an Output GapOutput Gap



Three factors that can increase the inflation Three factors that can increase the inflation raterate– Output gapOutput gap– Inflation shockInflation shock– Shock to potential outputShock to potential output




The Output Gap and InflationThe Output Gap and Inflation– Recessionary Gap:Recessionary Gap:

If people are unemployed, they reduce their wage If people are unemployed, they reduce their wage demands.demands.

Lower wage rises lead to lower inflation.Lower wage rises lead to lower inflation.

– This process may take a long time.This process may take a long time. Long-term wage contracts.Long-term wage contracts. People’s life plans (college, vacations, social status) People’s life plans (college, vacations, social status)

around their wages.around their wages.– Taking a pay cut or slower wage growth is very traumatic.Taking a pay cut or slower wage growth is very traumatic.




The Output Gap and InflationThe Output Gap and Inflation– Expansionary Gap:Expansionary Gap:

If people are working overtime too much, they demand If people are working overtime too much, they demand faster raises.faster raises.

Higher “wage inflation” leads to higher inflation.Higher “wage inflation” leads to higher inflation.

– This process may be very fast.This process may be very fast. People are always happy to take higher wages or to People are always happy to take higher wages or to

raise prices.raise prices.




The Phillips CurveThe Phillips Curve

Strong workers

Weak workers

Needs 10 workers: Unemployment is low

Needs 10 workers: Unemployment is high

=>Inflation speeds up

=>Inflation falls




After being laid off from her job as a manager at Ford Motor After being laid off from her job as a manager at Ford Motor Co.'s [Mexican] unit, [Karina] Maldonado searched Co.'s [Mexican] unit, [Karina] Maldonado searched unsuccessfully for a job for unsuccessfully for a job for monthsmonths before settling on a before settling on a position selling cars at a Volkswagen AG dealership. Her position selling cars at a Volkswagen AG dealership. Her commute is two hours and her pay is half of what she commute is two hours and her pay is half of what she earned at Ford. earned at Ford.

““At first I looked for something close to home and well- paid,” At first I looked for something close to home and well- paid,” Maldonado, who ran the auto parts division at Ford's Land Maldonado, who ran the auto parts division at Ford's Land Rover unit in Mexico … . “Then I said I'd take something Rover unit in Mexico … . “Then I said I'd take something anywhere, as long as it was in planning. In the end, I didn't anywhere, as long as it was in planning. In the end, I didn't care as long as it was a job.” care as long as it was a job.”

““Mexican Jobless Rate Has Biggest Rise in Almost Decade, Jan. 21, 2004” Mexican Jobless Rate Has Biggest Rise in Almost Decade, Jan. 21, 2004” (Bloomberg)(Bloomberg)



The Output Gap and InflationThe Output Gap and Inflation

Relationship of outputto potential output Behavior of inflation

1. No output gap Inflation remains unchangedY = Y*

2. Expansionary gap Inflation rises

Y > Y*

3. Recessionary gap Inflation falls

Y < Y*

For AS, changes in Y cause changes in For AS, changes in Y cause changes in ..



Output

Infl

atio

n,

Y*

Inertial level of inflation


Y > Y*

Y < Y*



The Output Gap and InflationThe Output Gap and Inflation– Suppose we start from Suppose we start from Y = Y*Y = Y*– An increase in exogenous spending creates and An increase in exogenous spending creates and

expansionary gap (expansionary gap (Y > Y*Y > Y*) – inflation increases.) – inflation increases.– A decrease in exogenous spending creates a A decrease in exogenous spending creates a

recessionary gap (recessionary gap (Y < Y*Y < Y*) and inflation ) and inflation decreases.decreases.





OVER a period of TIMEOVER a period of TIME,,if there’s a recession, wages will fall.if there’s a recession, wages will fall.– The “speed of adjustment” depends onThe “speed of adjustment” depends on

Wage and price contractsWage and price contracts Cultural normsCultural norms Laws and regulationsLaws and regulations The country’s experience with inflation and The country’s experience with inflation and

disinflation.disinflation.



In Short-run EquilibriumIn Short-run Equilibrium– Y may or may not = Y*Y may or may not = Y*

Remember there’s no reason for the economy to be Remember there’s no reason for the economy to be producing at full employment of resources in the producing at full employment of resources in the short run.short run.

– The inflation rate may or may not be stable.The inflation rate may or may not be stable. If Y > Y*, inflation will riseIf Y > Y*, inflation will rise If Y < Y*, inflation will fallIf Y < Y*, inflation will fall




Short-run Aggregate Supply (Short-run Aggregate Supply (SRASSRAS))

– If Y<Y*, SRAS shifts down.If Y<Y*, SRAS shifts down.– If Y>Y*, SRAS shifts up.If Y>Y*, SRAS shifts up.




Output

Infl

atio

n,

Y*





Long-run EquilibriumLong-run Equilibrium– A situation in whichA situation in which

actual output = potential outputactual output = potential outputandandthe inflation rate is stable.the inflation rate is stable.

– Graphically, long-run equilibrium occurs when Graphically, long-run equilibrium occurs when the the ADAD curve and the curve and the SRASSRAS line line intersect atintersect at potential outputpotential output..




Long-run aggregate supply (Long-run aggregate supply (LRASLRAS))– A vertical line showing the economy’s potential A vertical line showing the economy’s potential

output output Y*.Y*.– Potential Output is independent of inflationPotential Output is independent of inflation..

It depends on human capital, physical capital, It depends on human capital, physical capital, technology, laws, etc.technology, laws, etc.




Output

Infl

atio

n,

Long-run aggregate supply, LRAS

Y*




A Review of the Adjustment ProcessA Review of the Adjustment Process– Suppose there is a Recessionary GapSuppose there is a Recessionary Gap– Firms that are selling less than they want to will Firms that are selling less than they want to will

start to start to slow down pricesslow down prices..– Workers whose job is in danger slow down Workers whose job is in danger slow down

wage demands.wage demands.– As As falls, the real money supply expands, falls, the real money supply expands,

interest rates fall, and interest rates fall, and spending spending increasesincreases..




A Review of the Adjustment ProcessA Review of the Adjustment Process– As As YY increases, cyclical unemployment falls increases, cyclical unemployment falls

(Okun’s Law).(Okun’s Law).– Adjustment continues until long-run equilibrium Adjustment continues until long-run equilibrium

is reached.is reached.




Output

Infl

atio

n

AD

LRAS

A

Y

SRAS

Y*

SRAS’B

*

The Adjustment of Inflation The Adjustment of Inflation When A Recessionary Gap ExistsWhen A Recessionary Gap Exists

SRAS’



Output

Infl

atio

nLong-run aggregate

supply LRAS

A

AD

Y* Y

SRAS

B

Short-run Eq. Y•Expansionary gap Y > Y*•The economy overheats. rises, spending falls – Y falls•Long-run equilibrium at Y*, *

* SRAS’

The Adjustment of Inflation The Adjustment of Inflation When A Expansionary Gap ExistsWhen A Expansionary Gap Exists

The Self-Correcting EconomyThe Self-Correcting Economy

The Neo-Classical Synthesis of The Neo-Classical Synthesis of Classical and Keynesian Classical and Keynesian

EconomicsEconomics



The Self-Correcting EconomyThe Self-Correcting Economy– In the long-run the economy tends to be self-In the long-run the economy tends to be self-

correcting.correcting. The $13.3 trillion question: how long does it take to The $13.3 trillion question: how long does it take to

get to the long run?get to the long run?

The LR equilibrium is reached becauseThe LR equilibrium is reached because– Unemployment weakens workers, so “wage inflation” slows.Unemployment weakens workers, so “wage inflation” slows.– Over-employment strengthens workers, so “wage inflation” Over-employment strengthens workers, so “wage inflation”

speeds up.speeds up.




The Self-Correcting EconomyThe Self-Correcting Economy– The Keynesian model does The Keynesian model does notnot include a self- include a self-

correcting mechanism.correcting mechanism. It applies to the short run.It applies to the short run.

– The Keynesian model concentrates on the The Keynesian model concentrates on the short-run with no price adjustment.short-run with no price adjustment.

– The self-correcting mechanism concentrates on The self-correcting mechanism concentrates on the long-run with price adjustments.the long-run with price adjustments.




The Self-Correcting EconomyThe Self-Correcting Economy– If the self-correcting mechanism is slowIf the self-correcting mechanism is slow

Active Fiscal and Monetary policy may be needed to Active Fiscal and Monetary policy may be needed to help stabilize the economy.help stabilize the economy.

– If the self-correcting mechanism is fastIf the self-correcting mechanism is fast Fiscal and monetary policy are not effective and may Fiscal and monetary policy are not effective and may

destabilize the economy.destabilize the economy.




The Self-Correcting EconomyThe Self-Correcting Economy– The speed of correction will depend on:The speed of correction will depend on:

The use of long-term contracts.The use of long-term contracts. The efficiency and flexibility of labor markets.The efficiency and flexibility of labor markets.

– Fiscal and monetary policy are most useful Fiscal and monetary policy are most useful when attempting to eliminate when attempting to eliminate largelarge output gaps. output gaps.




Output

Infl

atio

n

AD’

LRAS

A

Y

SRAS

ACTIVISTACTIVIST Policy when Adjustment is Policy when Adjustment is SLOWSLOW

A hike in G, a cut in T, or an increase in M shift the AD curve to the right and reduce the output gap.

AD

Y*

What happens if we do nothing?



Output

Infl

atio

n

AD

LRAS

A

Y

SRAS

ACTIVISTACTIVIST Policy when Adjustment is Policy when Adjustment is SLOWSLOW A decrease in

M, a cut in G, or a cut in T shift the AD curve to the left and reduce the output gap.

AD’

Y*

What happens if we do nothing?



Output

Infl

atio

n

LRAS

A

Y

SRAS

ACTIVISTACTIVIST Policy when Adjustment is Policy when Adjustment isFASTFAST

AD’

If the adjustment process is faster than what policymakers think, activist expansionary policy may overshoot its target because SRAS shifts quickly.

AD

Y*

SRAS’B

The economy now has an expansionary gap

What happens if we choose to do

nothing?



Output

Infl

atio

n

AD

LRAS

A

Y

SRAS

ACTIVISTACTIVIST Policy when Adjustment is Policy when Adjustment isFASTFAST

AD’

SRAS’B

Again, the economy adjusts faster than expected and the economy now has a recessionary gap.

Y*

What happens if we choose to do

nothing?



Sources of InflationSources of Inflation What Do You Think?What Do You Think?

– Is activist fiscal policy a good thing?Is activist fiscal policy a good thing? Remember it’s very inflexible: it takes a long time to Remember it’s very inflexible: it takes a long time to

act and to take effect.act and to take effect.

– Is activist monetary policy a good thing?Is activist monetary policy a good thing? It’s more flexible, quick, and reversible, but it’s still It’s more flexible, quick, and reversible, but it’s still

very imprecise and uncertain.very imprecise and uncertain. Can a government economist really figure out the Can a government economist really figure out the

actions of millions of people making trillions of actions of millions of people making trillions of transactions?transactions?

Can they “play it by ear” cutting and raising interest Can they “play it by ear” cutting and raising interest rates as the economy reacts?rates as the economy reacts?

Sources of InflationSources of Inflation



Fighting InflationFighting Inflation

Before we talk about where inflation comes Before we talk about where inflation comes from, let’s talk about what the Fed does to from, let’s talk about what the Fed does to fight it.fight it.

Obviously, the Fed can’t control Wal-mart’s Obviously, the Fed can’t control Wal-mart’s pricing decisions and it can’t control the pricing decisions and it can’t control the wages demanded by GM’s workers.wages demanded by GM’s workers.

But it can seriously affect the amount of But it can seriously affect the amount of unemployment in the economy.unemployment in the economy.



Fighting InflationFighting Inflation

If the Fed raises interest rates and slows the If the Fed raises interest rates and slows the economy down, it will generate economy down, it will generate unemployment.unemployment.

Higher unemployment makes workers weak Higher unemployment makes workers weak and moderates their wage demands.and moderates their wage demands.– Firms’ costs rise more slowly.Firms’ costs rise more slowly.

Desiring to sell products, firms raise prices Desiring to sell products, firms raise prices more slowly.more slowly.– Price inflation falls.Price inflation falls.



Anti-Inflation PolicyAnti-Inflation Policy

Suppose the Public is tired of high inflation.Suppose the Public is tired of high inflation. The Central Bank may want to have The Central Bank may want to have

contractionary monetary policies.contractionary monetary policies.– Lower Lower , higher interest rates., higher interest rates.

This will lead to a recession for a while, but This will lead to a recession for a while, but then inflation will fall.then inflation will fall.



AD

LRAS

A

Y*

SRAS10%•Eq. At A (Y = Y*) = 10%

Short-Run Effects of an Short-Run Effects of an Anti-inflationary Monetary PolicyAnti-inflationary Monetary Policy

Output

Infl

atio

n

Y

B

AD’

•Fed shifts AD to AD’•Short run eq. At B•Y < Y* -- recessionary gap



Long-Run Effects of an Long-Run Effects of an Anti-inflationary Monetary PolicyAnti-inflationary Monetary Policy

Output

Y*

Infl

atio

nLRAS

C

Y

SRASB

AD’

10%

•Short-run eq. at B•Recessionary gap -- Y < Y*

SRAS’3%

falls to 3% and Y rises to Y*•Long-run eq. -- lower @ Y*



U.S. MacroeconomicU.S. MacroeconomicData, 1978-1985Data, 1978-1985

Nominal Real% Growth in Unemployment Inflation interest interest

Years real GDP rate (%) rate (%) rate (%) rate (%)

1978 5.5 6.1 7.6 8.3 0.7

1979 3.2 5.8 11.4 9.7 -1.7

1980 -0.2 7.1 13.5 11.6 -1.9

1981 2.5 7.6 10.3 14.4 4.1

1982 -2.0 9.7 6.2 12.9 6.7

1983 4.3 9.6 3.2 10.5 7.3

1984 7.3 7.5 4.3 11.9 7.6

1985 3.8 7.2 3.6 9.6 6.0




Suppose autonomous expenditure rises Suppose autonomous expenditure rises dramatically.dramatically.

We know this will lead to an expansionary We know this will lead to an expansionary gap.gap.

If Y > Y*, the SRAS curve will eventually If Y > Y*, the SRAS curve will eventually shift upwards, leading to higher inflation in shift upwards, leading to higher inflation in the long run.the long run.



Output

Infl

atio

n

•Increase in military spending causes AD to increase•Creates an expansionary gap -- Y > Y*

AD

LRAS

A

Y*

SRAS

War and Military Buildup War and Military Buildup As A Source of InflationAs A Source of Inflation

Y

B

AD’



Output

Infl

atio

n

Y

B

AD’

LRAS

A

SRAS

Y*

’SRAS’C

•Because the economy is overheated, increases

•SRAS shifts to SRAS’

•Long-run equilibrium back to Y* with *





Does the Fed have the power to prevent the Does the Fed have the power to prevent the increased inflation that is induced by a rise increased inflation that is induced by a rise in military spending?in military spending?– Hint: Can the Fed reduce Hint: Can the Fed reduce ADAD??

What is the cost of avoiding inflation during What is the cost of avoiding inflation during a military buildup?a military buildup?



Output

Infl

atio

n

•The CB could counteract the expansionary fiscal policy with contractionary monetary policy.•This avoids high inflation.

AD

LRAS

A

Y*

SRAS


Y

B

AD’




Economic NaturalistEconomic Naturalist– How did inflation get started in the United States How did inflation get started in the United States

in the 1960s?in the 1960s? 1959-63 inflation averaged about 1%1959-63 inflation averaged about 1% By 1970 inflation was 7%By 1970 inflation was 7% Fiscal policyFiscal policy

– Increases in defense spendingIncreases in defense spending 1965 = $50.6 billion or 7.4% of GDP1965 = $50.6 billion or 7.4% of GDP 1968 = $81.9 billion or 9.4% of GDP1968 = $81.9 billion or 9.4% of GDP




Economic NaturalistEconomic Naturalist– How did inflation get started in the United States How did inflation get started in the United States

in the 1960s?in the 1960s? Fiscal policyFiscal policy

– Increased spending on Great Society and war on poverty Increased spending on Great Society and war on poverty initiativesinitiatives

Monetary policyMonetary policy– The Fed did not try to offset the increase in government The Fed did not try to offset the increase in government

spendingspending




Source of Inflation: Inflation ShockSource of Inflation: Inflation Shock– A sudden (and temporary) change in the normal A sudden (and temporary) change in the normal

behavior of inflation, unrelated to the nation’s behavior of inflation, unrelated to the nation’s output gap.output gap. OPEC embargo of 1973OPEC embargo of 1973 Drop in oil prices in 1986Drop in oil prices in 1986



The Effects of An The Effects of An Adverse Inflation ShockAdverse Inflation Shock

Output

Infl

atio

n

AD

LRAS

A

Y*

SRAS

• Equilibrium @ A--Y* = Y

Y’

BSRAS’

• Inflation shock, increases to ’ (SRAS’)

• Short-run eq. At B, Y < Y*; recessionary gap and higher inflation (stagflation)

’




Output

Infl

atio

n

AD

LRAS

A

Y*

SRAS


Y’

BSRAS’

• Inflation shock, increases to ‘ (SRAS’)• Short-run eq. At B, Y < Y*; recessionary gap

and higher inflation (stagflation)

’

•No policy -- falls; long-run eq. at A




In the “no policy” scenario, the economy In the “no policy” scenario, the economy went back to full employment and to the old went back to full employment and to the old level of inflation eventually.level of inflation eventually.

But, in the meanwhile, it suffered high levels But, in the meanwhile, it suffered high levels of unemployment (and it’s hard to find a of unemployment (and it’s hard to find a reason why this is ok).reason why this is ok).



Sources of InflationSources of Inflation Suppose that instead monetary policy turns Suppose that instead monetary policy turns

expansionary.expansionary.– Faced with a positive output gap (a recession), Faced with a positive output gap (a recession),

the Fed increases M.the Fed increases M.– Higher M/P Higher M/P lower interest rates lower interest rates higher C higher C

and I and I higher output. higher output.– AD shifts right.AD shifts right.– Short-run equilibrium (AD and SRAS intersect) Short-run equilibrium (AD and SRAS intersect)

and long-run equilibrium (Y=Y*) coincide at a and long-run equilibrium (Y=Y*) coincide at a higher level of inflation.higher level of inflation.




Output

Infl

atio

n

AD

LRAS

A

Y*

SRAS


Y’

BSRAS’

• Inflation shock, increases to ‘ (SRAS’)• Short-run eq. At B, Y < Y*; recessionary gap

and higher inflation (stagflation)

’

AD’

C

• With policy--AD shifts to AD’; Y = Y*; rises to ’




The oil shock changed inflation temporarily.The oil shock changed inflation temporarily. Inflation only Inflation only persistspersists if monetary policy is if monetary policy is

sufficiently expansionary.sufficiently expansionary.– We express this by saying that monetary policy We express this by saying that monetary policy

is “accomodating”, that is, it goes along with is “accomodating”, that is, it goes along with shocks to the economy so to eliminate output shocks to the economy so to eliminate output gaps, at the expense of higher inflation.gaps, at the expense of higher inflation.

– But inflation has costs: uncertainty, difficulty in But inflation has costs: uncertainty, difficulty in planning, etc.planning, etc.



A Shock To Potential OutputA Shock To Potential Output

Now, suppose potential output falls:Now, suppose potential output falls:– A macroeconomic change (such as higher oil A macroeconomic change (such as higher oil

prices) causes a change in the behavior of firms prices) causes a change in the behavior of firms so that they accumulate less capital.so that they accumulate less capital.

Potential output can also risePotential output can also rise– Improvements in technology, human capital, Improvements in technology, human capital,

physical capital, etc.physical capital, etc.



The Effects of a The Effects of a Shock To Potential OutputShock To Potential Output

Output

Infl

atio

n

AD

LRAS

A

Y*

SRAS

•Equilibrium at A -- Y* = Y

Y*’

LRAS’ •Y* falls to Y*’•Y > Y* -- expansionary gap increases--SRAS rises to SRAS’•Equilibrium at B

•Y = Y*’ increased to ‘ •Decline in output is permanent

BSRAS’’




Aggregate Supply ShockAggregate Supply Shock– Either an inflation shock or a shock to potential Either an inflation shock or a shock to potential

outputoutput– Adverse aggregate supply shocks of both types Adverse aggregate supply shocks of both types

reduce output and increase inflationreduce output and increase inflation




Shocks to Potential OutputShocks to Potential Output– Aggregate supply shockAggregate supply shock

Inflation shocksInflation shocks– Stagflation and Temporary reduction in outputStagflation and Temporary reduction in output– ““New Economy” and Temporary increase in outputNew Economy” and Temporary increase in output

Potential output shocksPotential output shocks– Stagflation and Permanent reduction in outputStagflation and Permanent reduction in output– ““New Economy” and Permanent increase in outputNew Economy” and Permanent increase in output



U.S. Macroeconomic Data, U.S. Macroeconomic Data, Annual Averages, 1985-2000Annual Averages, 1985-2000

% Growth in Unemployment Inflation ProductivityYears real GDP rate (%) rate (%) growth (%)

1985-1995 2.8 6.3 3.5 1.4

1995-2000 4.0 4.6 2.4 2.5



Economic NaturalistEconomic Naturalist

Output

Infl

atio

n

AD

•Equilibrium at B -- Y*’ = Y

Y*’

BSRAS’

LRAS’

’

LRAS

A

Y*

SRAS

•Productivity increases•Y*’ shifts to Y*•Recessionary gap -- Y*’ < Y* falls to •Equilibrium at A

•Lower inflation; higher output




Economic NaturalistEconomic Naturalist– Can inflation be too low?Can inflation be too low?




Fiscal or monetary policy can increase Fiscal or monetary policy can increase output above Y* temporarily, in the short output above Y* temporarily, in the short run.run.– Inflation might rise slightly, so there’s a Inflation might rise slightly, so there’s a short-short-

run output-inflation trade-off.run output-inflation trade-off. But in the long run, Y goes back to Y*, but at But in the long run, Y goes back to Y*, but at

higher inflation.higher inflation.– Inflation rises but output doesn’t, so there’s Inflation rises but output doesn’t, so there’s no no

long-run output-inflation trade-off.long-run output-inflation trade-off.



1968

1956

195719661967

19551964 1960 1958

19611963

1962195419591965

4

3

2

1

Unemploymentrate

0 4 5 6

Inflationrate

The Phillips Curve (1954-1968)The Phillips Curve (1954-1968)



The Breakdown of the Short-Run The Breakdown of the Short-Run Phillips CurvePhillips Curve

In the early 1970s, the relationship between In the early 1970s, the relationship between inflation and unemployment began to break inflation and unemployment began to break down.down.

Unemployment was high, but so was Unemployment was high, but so was inflation.inflation.– This phenomenon was termed stagflationThis phenomenon was termed stagflation..

StagflationStagflation – the combination of high and – the combination of high and accelerating inflation and high accelerating inflation and high unemployment.unemployment.



The Phillips Curve ??The Phillips Curve ??(1969-1981)(1969-1981)

1969 1973

19701972

1971

1979

1974

1978

1976

1977

1980

1981 1975

8

6

4

2

Unemploymentrate

0 4 5 7

Inflationrate

6



The Long-Run and Short-Run The Long-Run and Short-Run Phillips CurvesPhillips Curves

The solution is to look at the relation The solution is to look at the relation between between changeschanges in inflation and the in inflation and the unemployment rate.unemployment rate.




The line that best fits the scatter of points for the period The line that best fits the scatter of points for the period 1970-2000 is:1970-2000 is:

1π π 6 1 0t t t

% . u-

- = -

Since 1970, there has been a negative relation between the unemployment rate and the change in the inflation rate in the United States.

Change in Inflation Change in Inflation versus Unemployment versus Unemployment in the United States, in the United States, 1970-20001970-2000




Nowadays, governments aren’t playing a Nowadays, governments aren’t playing a Phillips Curve game.Phillips Curve game.

In the 1970s, it became very clear that In the 1970s, it became very clear that inflation is costly and pointless.inflation is costly and pointless.

Most Central Banks are in favor of low-and-Most Central Banks are in favor of low-and-stable inflation.stable inflation.

The (modified) Phillips curve is still valid, The (modified) Phillips curve is still valid, and changes in and changes in are due to exogenous are due to exogenous shocks.shocks.



What have we learned today?What have we learned today?

The Aggregate Demand curve is a negative The Aggregate Demand curve is a negative relation between inflation and output.relation between inflation and output.– Higher inflation reduces the real money supply, Higher inflation reduces the real money supply,

which raises interest rates, makes investment which raises interest rates, makes investment more expensive, and reduces output.more expensive, and reduces output.

– This is a movement along the AD curve.This is a movement along the AD curve. The AD shifts right with expansionary Fiscal The AD shifts right with expansionary Fiscal

policy (higher G, lower T) or expansionary policy (higher G, lower T) or expansionary Monetary policy (higher M).Monetary policy (higher M).




The Short-Run Aggregate Supply curve is The Short-Run Aggregate Supply curve is horizontal in (Y, horizontal in (Y, ) space.) space.– In the short run, inflation is constant (“inertial”), In the short run, inflation is constant (“inertial”),

so changes in output don’t change so changes in output don’t change ..

The SRAS shifts if there is an output gap.The SRAS shifts if there is an output gap.– If Y<Y*, SRAS shifts down.If Y<Y*, SRAS shifts down.– If Y>Y*, SRAS shifts up.If Y>Y*, SRAS shifts up.




Short-run equilibrium output takes place Short-run equilibrium output takes place where AD and SRAS intersect.where AD and SRAS intersect.– Because inflation is inertial, it just is.Because inflation is inertial, it just is.– This inertial This inertial implies a certain level of M/P, implies a certain level of M/P,

which determines the interest rate and which determines the interest rate and expenditure.expenditure.

– Output is demand-determined in the short-run.Output is demand-determined in the short-run.




In the long run, Y = Y*In the long run, Y = Y*– If Y > Y* in the short run, inflation rises. This If Y > Y* in the short run, inflation rises. This

reduces M/P, raises interest rates, lowers reduces M/P, raises interest rates, lowers expenditure, and makes Y fall until Y = Y*.expenditure, and makes Y fall until Y = Y*.

– If Y < Y*, the recession causes wages to fall, If Y < Y*, the recession causes wages to fall, leading to lower inflation, etc., until Y rises to Y*.leading to lower inflation, etc., until Y rises to Y*.

– In the long-run, output is supply-determined.In the long-run, output is supply-determined.




In the long run, the economy is self-In the long run, the economy is self-correcting.correcting.– Overly expansionary monetary or fiscal policy Overly expansionary monetary or fiscal policy

can expand Y for a while, but will only lead to can expand Y for a while, but will only lead to more inflation in the long run.more inflation in the long run. Remember “inflation is a monetary phenomenon, Remember “inflation is a monetary phenomenon,

always and everywhere”?always and everywhere”?

– Recessions and depressions cure themselves Recessions and depressions cure themselves because workers accept lower wages.because workers accept lower wages.




In the long run, the economy is self-In the long run, the economy is self-correcting.correcting.– Activist policy only makes sense if the Activist policy only makes sense if the

economy’s self-correcting mechanism is very economy’s self-correcting mechanism is very slow.slow.




The Fed can fight inflation by creating The Fed can fight inflation by creating recessions in the short-run.recessions in the short-run.– It can also fight deflation –falling prices – (or It can also fight deflation –falling prices – (or

uncomfortably low inflation) by cutting interest uncomfortably low inflation) by cutting interest rates.rates.

Supply-side shocks such as oil shocks or Supply-side shocks such as oil shocks or shocks to productivity can generate shocks to productivity can generate temporary or permanent changes in inflation temporary or permanent changes in inflation and output.and output.




The Phillips Curve is a negative relation The Phillips Curve is a negative relation between unemployment and inflation.between unemployment and inflation.– Unexpected rises in inflation make workers Unexpected rises in inflation make workers

cheaper to hire, lowering inflation.cheaper to hire, lowering inflation.– The government took advantage of it in the The government took advantage of it in the

1960s, which led to its disappearance.1960s, which led to its disappearance. It is now a negative relation between the It is now a negative relation between the

changechange in inflation and the unemployment in inflation and the unemployment rate.rate.

Inflation and Aggregate Supply

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