Inflation and Disinflation 1

 Inflation is the overall increase in prices = increase in price level  Changes constantly  Hard to predict  Higher rates of inflation = harder to predict  anticipated inflation  Unanticipated inflation  Bank of Canada is committed to keep inflation at about 2%/year 2

 Inflation in AD-AS model:  Changes in wages  Increase in wages shifts AS upward  Increases in other factor prices also shift AS upward  We have seen what happens when Y = Y*  Unemployment rate = natural rate of unemployment  Terminology: natural rate of unemployment ≡ non- accelerating inflation rate of unemployment, NAIRU  Mark it as U*  NAIRU = frictional rate + structural rate 3

 Changes in wages  Inflationary gap  Can come from a positive AD shock  There is an upward pressure on wages  Because there’s increased demand for labour  Recessionary gap  Can come from a negative AD shock  There is an downward pressure on wages  Because there’s idle labour  Y = Y*  No pressure on wages  Expected inflation  Signing a labour contract  Backward-looking expectations  Rational expectations  Demand for labour and real wage rate  Expected inflation rate => increase in wage rate by inflation rate  Change in wage rate = output-gap effect + expectation effect 4

 Recall, increases in other factor prices also shift AS upward  A negative AS shock  Not from labour cost  Actual inflation =  change-in-wage-rate inflation + supply-shock inflation =  output-gap inflation + expected inflation + supply-shock inflation  Let say,  No AD/AS shocks have happened for a while and none are expected  Then actual inflation = output-gap inflation + expected inflation + supply-shock inflation  Means:  Y = Y*  U = U*  Constant inflation  Liquidity preference theory: M D increases (P goes up), M S increases (the central bank adjusts) => interest rate stays constant 5

 Shocks and inflation:  Positive AD shock  Demand inflation  No monetary validation  Factor prices adjust  P rises and then stops going up  Short-lived inflation  New price level but not new inflation rate  Monetary validation  Bank of Canada:  Sees an inflationary gap  Reduces interest rate  Money supply increases  AD increases  Get sustained inflation rate increase  Why would you do that? 6

 Shocks and inflation:  Negative AS shock  Supply inflation  No monetary validation  Factor prices adjust  P rises and then falls and then stops changing  Short-lived inflation/deflation  Not new price level and not new inflation rate  Monetary validation  Bank of Canada:  Sees a recessionary gap  Reduces interest rate  Money supply increases  AD increases  Get short-lived inflation  Why would you do that?  Sticky wages 7

 Shocks and inflation:  No monetary validation  Business cycle  No sustained inflation OR no inflation  Monetary validation  No business cycle  Sustained inflation OR new price level  Canada vs USA in early 1970s (OPEC)  Uh-oh! Monetary validation may give rise to a wage- price spiral  A shock => monetary validation => expectations adjusted upward => wages go up faster => inflation increases => (monetary validation) => expectations adjusted upward => wages go up faster => inflation increases => … 8

 Shocks and inflation:  Again, positive AD shock  Monetary validation  Maintains Y > Y*  Adjusted expectations  Increased (accelerating) inflation rate  Means U < U* (NAIRU)  As long as there is inflationary gap there is accelerating inflation  No monetary validation  Allows return to Y > Y*  No change in expectations  Constant inflation rate  Means U = U* (NAIRU)  No sustained inflationary gap = no accelerating inflation  Sustained inflation comes from monetary validations  Sustained inflation is a monetary phenomenon  No increase in money supply, no sustained inflation 9

 Disinflation:  Happened to many, historically  Sustained inflation is a monetary phenomenon  To disinflate, have to stop monetary validation  Phases:  Stop monetary validation  Interest rate up (M s does not increase anymore)  Price level up  But only till Y=Y*  Stagflation  Negative AS shock due to established expectations  Will last till expectations adjust  Recovery  Reduced inflation expectation (AS down)  Expansionary policy may help but is DANGEROUS (why?) 10

 Disinflation:  Phase 2 (stagflation) means reduced Y  Lost output = cost of disinflation  Sacrifice ratio = (cumulative loss of Y)/(% high inflation - % low inflation)  Speed of disinflation  Adjustment of expectations  In practice, usually significant political changes 11