inflation and disinflation

heyy there! am sorry, i've not did all of curves yet lol. but u can pull up a chair :)

Learning Objectives :

I.          Describe the response of wages to change in both output gaps and inflation expectation

What are the forces that cause wages to change?

Two main forces are the output gap and expectations of future inflation. Wages may be affected by forces that are associated with neither output gaps not expectations of inflatio, such as government guidelines, uniono power and employers’ optimism. Because there are many such forces that tend to act independently of one another, they may be regarded as random shocks and must be analyzed as separate causes for shiftf in the AS curve.

And how change in money wages were influenced by output gaps :

1.       The excess demand for labor that is associated with an inflationary gap (Y>Y*) puts upward pressure on money wages

2.       The excess supply of labor associated with a recessionary gap (Y<Y*) puts downward pressure on money of wages

3.       The absence of either an inflationary gap (Y=Y*) means that demand forces do not exert any pressure on money wages

when real GDP = Y* , the unemployment rate is said to be equal to the NAIRU ( Non Accelerating Inflation Rate of Unemployment or Natural Rate of unemployment, its symbol U*).

The NAIRU is not zero. Instead, even when Y=Y*, there may be a substantial amount of frictional and structured unemployment caused:

-          When real Y<Y*, (or U>U*), there is a recessionary gap characterized by excess supply of labor and wages are assumed to fall

-          When Y>Y* (or U,U*), there is an inflationary gap characterized by excess demand for labor and wages are assumed to rise

Wage and Expected Inflation

Suppose that both emloyers and employers expect 3% inflation next year. Workers will start negotiations from a base of a 3% increase in money wages, which would hold their real wages constant. So, The expectation of some specific inflation rate pressure for money wages to rise by that rate.

The key point is that money wages can rise even if no inflationary gap is present. As long as people expect prices to rise, their behavior will put upward pressure on money wages.

Overall Effrct on Wages

We can now think of change in money wages as resulting from two different forces as follows :

Change in money wages = output gap effect + expectational effect

From Wages to Prices

We’ve just seen that inflationary output gaps and expectations of future inflatio put pressure on wages to rise and hence cause the AS curve to shift upward. Recessiinary output gaps and expectation of future deflation put pressure or wages to fall and hence cause the AS curve to shift downward.

The net affect of two fprces acting on wages, output gaps and inflation expectations, determines what happens to the AS curve:

-          The net affect of the output gap effect and the expectational effect is to raise wages then the AS curve will shift up = inflationary

-          The net effect of the output gap and expectational effect is to reduce wages, then the AS curve will shift down = deflationary

We can then decompose actual inflation into its three component parts as follow :

Actual inflation = Output gap inflation + expected inflation + Supply shock inflation

II.                  Explain how a constan rate inflation  is incorporates into the basic macroeconomis model

Lets us suppose the inflation rate is 2 percent per year and has been 2 percent for several years. This is what is meant by a constan inflation. In such setting, people with backward looking expectation ( people look at the past in order to predict what will happen in the future) about inflation will expect the actual level to continue into the future. Then people with forward looking or rational expectation ( the theory that people understand how the economy works and learning quickly from their mistakes so that even though random errors may be made, systematic and presistent errors are not) will expect the actual rate inflation rate to continue. So central bank will be attempting to alter its monetary policy.

If in inflation and monetary policy have been constant for several years, the expected rate of inflation will tend to equal the actual rate of inflation.

Figure : Constant inflation without supply shock

In the absence of supply shocks, if expected inflation equals actual inflation, real GDP must be equal to potential GDP.

  

Constant inflation with Y=Y* occurs when the rate of monetary growth, the rate of wage increase and the expected rate of inflation are all consistent with the actual inflation rate.

The key point about constant inflation in our macro model is that there is no output gap effect operating on wages.

III.                Describe the effect of aggregate demand and supply shocks on inflation and real GDP and explain what happens when federal reserve validates demand and supply shock

Demand Shocks

Any rightward shift in the AD curve that creates an inflationary output gap or inflation arising from inflatinary output gap caused, in turn by a positive AD shock also create what are called demand inflation. The shift in the AD curve could have been caused by a reduction in taxes, by an increase in such autonomous expenditure items as C,I,G, net exports or by expansionary monetary policy.

To begin our study of demand inflation, we make simplifying assumptions :

-          We assume that Y* is constant

-          We assume that there is no ongoing inflation

These two assumptions imply that our starting point is stable long-run equilibrium, with constant real GDP and price level, rather than the long-run equilibrium with constant inflation.

Then, we suppose that this long-run equilibrium is disturbed by a rightward shift in the AD curve. This shift causes the price level and output to rise. Next, its important to distinguish between the case in which the federal reserve validates the demand shock and the case in which it doesnt.

Figure : A demand shock without validation

A demand shock that isnt validated produces temporary inflation, but the economy adjustment process eventually restores potential GDP and stable prices.

Figure : A demand shock with validation

Monetary validation of a positive demand shock causes the AD curve to shift further to the right, offsetting the upward shift in the AS curve and thereby leaving an inflationary gap despite the ever rising price level.

Supply Shocks

Any leftward shift in the AS curve that isnt caused by excess demand in the markets for factors of production  or inflation arising from negative AS shock.

Figure : A supply shock with and without validation

Whenever wages and other factors prices fall only slowly in the face of excess supply, the recorvery to potential output after a non-validated on the federal reserve to validate negative supply shock.

Monetary validation of a negative supply shock causes the initial rise in the prices level to be followed by a further rise, resulting in a higher price level than would occur if the recessionary gap were relied on to reduce factor prices.

IV.                Describe the three phases of a disinflation

The Process of reducing sustained inflation can be divided into three phases :

-          Phase 1 : Removing the inflationary gap

The elimination of a sustained inflation begins with a demand contraction to remove the inflationary gap.

-          Phase 2 : Stagflation

Expectations and wage momentum lead to stagflation, with falling output and continuing inflation.

-          Phase 3 : recovery

After expectations are reserved, recorvery takes output to Y* and the price level is stabilized

V.                 Explain how the cost of disinflation is measured by the sacrifice ratio

The foregoing discussion of the process of disinflation makes the cost of disinflation pretty clear :

The cost of disinflation is the loss of output that is generated in the process

But how costly is the process of disinflation? Economic have derived a simple measure of the cost of disinflation based on the depth and length of the recession and on the amount of disinflation. This measure, called sacrifice ratio, is defined as the cumulative loss in real GDP, expressed as percentage of potential output divided by the percentage point reduction in the rate of inflation.