1 / 11

Inflation and Disinflation

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

ajay
Download Presentation

Inflation and Disinflation

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Inflation and Disinflation

  2. 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

  3. 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

  4. 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

  5. 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: MD increases (P goes up), MS increases (the central bank adjusts) => interest rate stays constant

  6. 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?

  7. 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

  8. 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 => …

  9. 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

  10. 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 (Ms 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?)

  11. 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

More Related