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Inflation and Disinflation

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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

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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

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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

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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

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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?

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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

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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 => …

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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

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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?)

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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