1. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 9 Inflation: Its Causes and Cures

2. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-2 Definition: Inflation Inflation is a sustained upward movement in the aggregate price level that is shared by most products –The price level is notated P –Inflation is notated p = %∆P The Core Inflation Rate is the inflation rate for all products and services other than food and energy –The Federal Reserve target core inflation rate is about 2%

3. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-3 The Output Ratio and Inflation The Output Ratio is the ratio of actual real GDP to natural real GDP (i.e. Y/Y N ). –If Y/Y N = 100%, p is constant –If Y/Y N > 100%, p is accelerating –If Y/Y N < 100%, p is decelerating What affects the output ratio? –A Demand Shock is a sustained acceleration or deceleration in AD, measured most directly as a sustained acceleration or deceleration in the growth of nominal GDP –A Supply Shock is caused by a sharp change in the price of an important commodity (e.g. oil) that causes the inflation rate to rise or fall in the absence of demand shocks.

4. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-4 Figure 9-1 The Inflation Rate and the Output Ratio, 1960–2010

5. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-5 Temporary vs. Continuous Inflation A one-shot increase in AD will cause only temporary inflation as the output ratio rises above 100% and pushes up wages causing the SAS curve to shift back. A continuous increase in AD can potentially cause continued inflation as wages rise (shifting back the SAS curve) together with continued shifts to the right of the AD curve.

6. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-6 The Phillips Curve The Short-Run Phillips (SP) Curve is the schedule relating the inflation rate and real GDP given a fixed expected rate of inflation. –The Expected Rate of Inflation (p e ) is the rate of inflation that is expected to occur in the future. –The SP Curve is also known as the Expectations-Augmented Phillips Curve because it shifts its position whenever there is a change in the expected rate of inflation The Long-Run Phillips (LP) Curve gives the output ratio when inflation is accurately anticipated (i.e. p e = p). –Since prices and wages are perfectly flexible in the long-run, the LP curve is a vertical line at Y/Y N = 100%.

7. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-7 Figure 9-2 Relationship of the Short-Run Aggregate Supply (SAS) Curve to the Short-Run Phillips (SP) Curve

8. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-8 Figure 9-3 Effect on the Short-Run Phillips Curve of an Increase in the Expected Inflation Rate (p e ) from Zero to 3 Percent

9. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-9 Nominal GDP Growth and Inflation Recall: Nominal GDP (X) is related to the price level (P) and real GDP (Y) as follows: X = PY (Note: Lower case letters represent the growth rates of the same variables) When is the economy at a long-run equilibrium? –It must be operating on the SP curve. –Inflation must equal the growth rate of nominal GDP: x = p  real GDP growth = 0 (Or if y > 0  x = p + y) –The economy must be on the LP line with p e = p.

10. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-10 Table 9-1 Alternative Divisions of 6 Percent Nominal GDP Growth Between Inflation and Real GDP Growth

11. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-11 Figure 9-4 The Adjustment Path of Inflation and the Output Ratio to an Acceleration of Nominal GDP Growth from Zero to 6 Percent When Expectations Fail to Adjust

12. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-12 Different Types of Expectations The speed of adjustment of inflation expectations affects how long Y can be pushed beyond Y N 3 Types of Expectations – Forward-looking Expectations attempt to predict the future behavior of an economic variable using economic models – Backward-looking Expectations use only information on the past behavior of economic variables. – Adaptive Expectations base expectations for next period’s values on an average of actual values during previous periods.

13. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-13 Figure 9-5 Effect on Inflation and Real GDP of an Acceleration of Demand Growth from Zero to 6 Percent

14. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-14 The Cure for Inflation: Recession Theoretically, if an increase in nominal GDP causes inflation, then a recession should do the opposite. – Disinflation is a marked deceleration in the inflation rate. How can disinflation be achieved? –The “Cold Turkey” approach to disinflation operates by implementing a sudden and permanent slowdown in nominal GDP growth. The cost of disinflation is measured by the Sacrifice Ratio, which is the cumulative loss of output incurred during a disinflation divided by the permanent reduction in the inflation rate.

15. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-15 Figure 9-6 Initial Effect on Inflation and Real GDP of a Slowdown in Nominal GDP Growth from 10 Percent to 4 Percent

16. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-16 Figure 9-7 Adjustment Path of Inflation and Real GDP to a Policy That Cuts Nominal GDP Growth from 10 Percent in 1980 to 4 Percent in 1981 and Thereafter

17. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-17 International Perspective Did Disinflation in Europe Differ from That in the United States?

18. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-18 Demand vs. Supply Inflation Demand Inflation is a sustained increase in prices that is preceded by a permanent acceleration of nominal GDP growth. Supply Inflation is an increase in prices that stems from an increase in business costs not directly related to prior acceleration of nominal GDP growth.

19. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-19 Figure 9-8 Four-Quarter Growth Rate of the GDP Deflator and the Level of Nominal and Real Oil Prices, 1970-2010

20. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-20 Types of Supply Shocks Changes in business input costs (like P oil ) Weather shocks that affect farm prices Import price shocks due to fluctuating ER’s –If the value of the dollar falls, imported goods become more expensive. Productivity growth shocks that change the amount workers can produce

21. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-21 Policy Responses to Supply Shocks Following a supply shock, there are three possible policy responses: –A Neutral Policy maintains nominal GDP growth so as to allow a decline in the output ratio equal to the increase in the inflation rate. –An Accommodating Policy raises nominal GDP growth so as to maintain the original output ratio. –An Extinguishing Policy reduces nominal GDP growth so as to maintain the original inflation rate.

22. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-22 Figure 9-9 The Effect on the Inflation Rate and the Output Ratio of an Adverse Supply Shock That Shifts the SP Curve Upward by 3 Percent

23. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-23 The Role of Ιnflation During the Housing Bubble and Subsequent Economic Collapse Inflation and the Output Ratio Have No Systematic Relation

24. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-24 Figure 9-10 Effect of Adverse Supply Shocks in the 1970s and Beneficial Supply Shocks in the 1990s

25. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-25 Figure 9-11 Responses of the Inflation Rate (p) and the Output Ratio (Y/Y N ) to Shifts in Nominal GDP Growth and in the SP Curve (1 of 2)

26. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-26 Figure 9-11 Responses of the Inflation Rate (p) and the Output Ratio (Y/Y N ) to Shifts in Nominal GDP Growth and in the SP Curve (2 of 2)

27. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-27 Cures for Inflation Fundamental causes of inflation: –Excessive nominal GDP growth –Adverse supply shocks Government approaches to cure inflation –Slow nominal GDP growth –Create beneficial supply shocks Eliminate or weaken price- or cost-raising legislation Creative tax and/or subsidy policies Government should also recognize the presence of beneficial supply shocks to prepare policies in case of possible reversals

28. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-28 Unemployment (U) and Inflation (p) Economists often say, “There is a trade-off between unemployment and inflation.” –There also is a direct relationship between the output ratio and unemployment: (Y/Y N ) ↑  U ↓ –This relationship is known as Okun’s Law, which explicitly states that there is a regular negative relationship between the output ratio and the gap between actual unemployment and the average rate of unemployment –Okun’s Law is illustrated in Figure 9-12 (see next slide) Thus, the link between U and p is just the inverse of the relationship between (Y/Y N ) and p discussed above –Just as (Y/Y N ) cannot be above 100% without igniting inflation, U cannot be below pushed below U N

29. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-29 Figure 9-12 The U.S. Ratio of Actual to Natural Real GDP (Y/Y N ) and the Unemployment Rate, 1965–2010

30. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 9-30 Figure 9-13 The Unemployment Rate and the Inflation Rate, 1960–2010