Chapter 30
Inflation and
Disinflation
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In this chapter you will learn to
1. Describe the response of wages to change in both output gaps
and inflation expectations.
2. Explain how a constant rate of inflation is incorporated into the
basic macroeconomic model.
3. Describe the effects of aggregate demand and supply shocks on
inflation and real GDP.
4. Explain what happens when the Federal Reserve validates
demand and supply shocks.
5. Describe the three phases of a disinflation.
6. Explain how the cost of disinflation is measured by the sacrifice
ratio.
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Figure 30.1 U.S. CPI Inflation,
1965–2006
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Adding Inflation to the Model
Why Wages Change
1. Output Gaps
-
Y > Y* Î excess demand for labor (U<U*)
-
Y < Y* Î excess supply of labor (U>U*)
-
Y = Y* Î U=U*
U* = non-accelerating inflation rate of unemployment
2. Expected Inflation
- some workers/firms raise wages in advance of inflation
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Overall Effect on Wages
Change in = Output-gap
money wages
effect
+ Expectational
effect
For example:
• Y>Y* Îexcess labor demand Î2% wage increases
• 3% due to expected wages
• total money wages = 2% + 3% = 5%
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How do people form their
expectations?
- forward-looking?
- backward-looking?
- a combination of both?
APPLYING ECONOMIC CONCEPTS 30.1
How Do People Form Their
Expectations?
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2
From Wages to Prices
Overall effect on nominal wages determines how the AS curve
shifts
Î impact on price level
Actual
inflation
= Output-gap
inflation
+
Expected
inflation
+
Supplyshock
inflation
The last term captures any shifts in the AS curve caused by
things other than wage changes.
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Constant Inflation
If inflation has been constant for several years and there is no
indication of an impending change in monetary policy:
Î expected inflation will equal actual inflation
If expected inflation equals actual inflation:
Î Y must equal Y*
Î no output gap
But if there is no output gap, what is causing the inflation?
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30-8
Figure 30.2 Constant Inflation
without Supply Shocks
Constant inflation
with Y=Y* occurs
when the rate of
monetary growth,
the rate of wage
increase, and
expected inflation
are all consistent
with the actual
inflation rate.
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Figure 30.3 A Demand Shock
without Validation
Demand Shocks
Demand inflation results
from a rightward shift in the
AD curve.
A demand shock that is not
validated produces only
temporary inflation.
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30-10
Figure 30.4 A Demand Shock
with Validation
With monetary validation:
-the AD curve shifts
further to the right
- keeping open the
inflationary gap
Continued validation
turns a transitory inflation
into sustained inflation.
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Figure 30.5 A Supply Shock with
and without Validation
Supply Shocks
If wages fall only
slowly (when Y<Y*),
the return to Y* after
a non-validated
negative supply
shock will be slow.
Monetary validation of
a negative AS shock
causes the initial rise in
P to be followed by a
further rise.
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Is Monetary Validation of Supply
Shocks Desirable?
One potential danger of validation:
- a wage-price spiral could be created
Once started, a wage–price spiral can be halted only if the
Fed stops validating the supply shocks that are causing the
inflation.
But the longer it waits to do so, the more firmly held will be
the expectations that it will continue its policy of validating
the shocks.
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30-13
Accelerating Inflation
Question:
What happens to inflation if the central bank tries to maintain
an inflationary gap through continued monetary validation?
Answer:
Inflation will accelerate.
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Expectational Effects
The acceleration hypothesis:
- as long as an inflationary gap persists, expectations
of inflation will be rising
Î increases in the rate of inflation
Implications of rising expected inflation:
• To hold real GDP constant, expansionary monetary
policy is needed to shift the AD curve at an increasingly
rapid pace to offset the increasingly rapid shifts in the
AS curve.
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Inflation as a Monetary Phenomenon
The causes of inflation:
1. Anything that increases AD will cause P to rise.
2. Anything that increases factor prices will decrease AS
and cause P to rise.
3. Unless continual monetary expansion occurs, such
increases in P must eventually come to a halt.
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Inflation as a Monetary Phenomenon
The consequences of inflation:
1. In the short run, demand inflation tends to be
accompanied by an increase in output above Y*.
2. In the short run, supply inflation tends to be
accompanied by a decrease in output below Y*.
3. When costs and prices have fully adjusted, shifts in
either AD or AS affect P but leave output unchanged.
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Inflation as a Monetary Phenomenon
EXTENSIONS IN THEORY 30.1
The Phillips Curve and Accelerating
Inflation
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Inflation as a Monetary Phenomenon
Conclusions about inflation:
1. Without monetary validation, positive AD shocks
cause temporary inflation, and output returns to Y*.
2. Without monetary validation, negative AS shocks
cause temporary inflation, and output returns to Y*.
3. Inflation initiated by either AD or AS shocks can only
be sustained with continuing monetary validation.
Î Sustained inflation is always a monetary phenomenon!
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Reducing Inflation
The Process of Disinflation
Reducing inflation is often costly
– lost output and unemployment
Expectations can cause inflation to persist even after its
original causes have been removed.
Crucial factor:
- how quickly inflation expectations are revised
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Figure 30.6 Eliminating a
Sustained Inflation
Phase 1: Removing
Monetary Validation
Begin with a reduction
in the rate of monetary
expansion.
Starting at E1,
suppose the central
bank stops increasing
the money supply.
The AD curve stops shifting
- but inflation expectations keep AS curve shifting
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Phase 2: Stagflation
Stagflation caused by
continued shifts in AS
curve:
- slow-to-adjust
expectations
-wage momentum
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Phase 3: Recovery
Eventually, recovery
takes output to Y*, and P
is stabilized:
Either wages fall,
bringing the AS curve
back to AS2 …
…or the central bank
increases the money
supply sufficiently to shift
the AD curve to AD2.
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Figure 30.7 The Cost of
Disinflation: the Sacrifice Ratio
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Conclusion
Throughout the history of economics, inflation has been
recognized as a harmful phenomenon.
The high inflation rates that the United States experienced
in the 1970s and early 1980s were also experienced in
many other developed countries.
Some commentators have argued that inflation is now
“dead.” One of the reasons is the process of globalization
that has exerted greater competitive forces to keep
inflationary pressures at bay.
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The Death of Inflation?
APPLYING ECONOMIC CONCEPTS 30.2
The Death of Inflation?
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