10–1 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 10 Inflation and Aggregate Supply

10–2 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–3 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–4 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–5 The AD Curve

10–6 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–7 Shifts in AD (cont.)

10–8 Shifts in AD (cont.)

10–9 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–10 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–11 Inflation Inertia

10–12 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Size of the Output Gap Y = Y*: inflation rate constant Y > Y*: inflation rate rises Y < Y*: inflation rate falls

10–13 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–14 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–15 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–16 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Long-Run Aggregate Supply LRAS is determined by Y* Does not depend on p LRAS is vertical

10–17 Aggregate Demand and Supply

10–18 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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*

10–19 Recessionary Gap

10–20 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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*

10–21 Inflationary Gap

10–22 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–23 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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 self- correcting mechanism

10–24 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–25 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–26 Policy Dilemma

10–27 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–28 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

10–29 Painful Inflation Reduction

10–30 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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)