14.3 Reducing Inflation

Question 1

What is Disinflation?

Answer 1

Disinflation

A reduction in the rate of inflation.

Question 2

What are two notable periods of disinflation for Canada?

Answer 2

In 1981–1982, when inflation fell from more than 12 percent to 4 percent

In 1990–1992, when inflation fell from 6 percent to less than 2 percent.

Question 3

The process of reducing inflation can be divided into three phases. What are they?

Answer 3

In the first phase, the monetary validation is stopped and any inflationary gap is eliminated.

In the second phase, the economy still suffers from declining output and rising prices—stagflation.

In the final phase, the economy experiences both increasing output and increasing prices, but the inflation then comes to an end.

Question 4

What does removing monetary validation do?

Answer 4

This policy action slows the rate at which the AD curve is shifting upward.

Question 5

What is an extreme case of menetary tightening?

Answer 5

An extreme case of monetary tightening in this setting is one where the Bank of Canada adopts a “cold-turkey approach”:

Interest rates are increased so much that the growth rate of the money supply is reduced to zero and the upward shift of the AD curve is halted abruptly.

Question 6

What does a tight money policy do?

Answer 6

Question 7

If the excess demand from the inflationary output gap were the only influence on nominal wages, what would the effect of removing monetary policy be?

Answer 7

Question 8

Other then excess demand, what to wages also depend on?

Answer 8

As we explained earlier, wages depend not only on current excess demand but also on inflation expectations.

Question 9

What is the effect of inflation expectation in the process of disinflation?

Answer 9

Once inflation expectations have been established, it is not always easy to get people to revise them downward, even in the face of announced changes in monetary policies.

Hence, the AS curve continues to shift upward, causing the price level to continue to rise and output to fall. A recessionary gap is created. The combination of rising prices and a reduction in output (or its growth rate) is called stagflation.

Question 10

In the face of stagflation, what does the ease with which the BoC can end inflation depend on?

Answer 10

The ease with which the Bank of Canada can end such an inflation depends on how easy it is to change these expectations of continued inflation.

This change is more difficult to the extent that expectations are backward-looking and easier to the extent that expectations are forward-looking.

Question 11

What happens to inflation if most people are backward-looking when forming their expectations?

Answer 11

If most people are backward-looking when forming their expectations, inflation will remain high even well after the Bank of Canada has implemented its tight monetary policy.

In this case, the AS curve will continue shifting upward and the stagflation will endure.

Question 12

What happens during stagflation if most people are forward-looking and the Bank’s policy announcements are credible?

Answer 12

if most people are forward-looking and the Bank’s policy announcements are credible, the change in the Bank’s policy will be widely acknowledged and expected inflation will fall relatively quickly.

In this case, the upward shifts of the AS curve will soon come to an end.

Question 13

What does the percistence of inflation after the inflationary gap has been removed, and the depth of the associated recessionary gap during the stagflationary phase depend on?

Answer 13

The persistence of inflation after the inflationary gap has been removed, and the depth of the associated recessionary gap during the stagflationary phase, depend on how quickly inflation expectations are revised downward.

Question 14

How does the BoC attempt to inflence expectations?

Answer 14

By making regular speaches and announcements in an attempt to anchor inflation expectations.

Question 15

What is the final phase of disinflation?

Answer 15

Recovery

The final phase is the return to potential output.

Question 16

During the recovery phase the move back to potential output can be accomplished in either of two ways. What are they?

Answer 16

First, the recessionary gap may reduce factor prices, thereby shifting the AS curve downward, reducing prices but increasing real GDP.

Second, an expansionary monetary policy can shift the AD curve upward, increasing both prices and real GDP.

Question 17

Graph of the 3 phases of Eliminating sustained inflation

Answer 17

Question 18

What do many economits worrk about in regards to relying on the AS curve to shift downward to return the econonmy to potential output?

Answer 18

Many economists worry about relying on the AS curve to shift downward to return the economy to potential output. Their concern is that it will take too long for wages to fall sufficiently to shift the AS curve—though output will eventually return to potential, the long adjustment period will be characterized by high unemployment.

Question 19

What do some economists worry about in terms of temporary monetary expeansion?

Answer 19

Other economists worry about a temporary monetary expansion because they fear that expectations of inflation may be rekindled when the Bank’s monetary expansion shifts the AD curve to the right.

And if inflationary expectations are revived, the Bank will then be faced with a tough decision—either it must let another recession develop to break these new inflation expectations or it must validate the inflation to reduce unemployment. In the latter case, the Bank is back where it started, with validated inflation on its hands—and diminished credibility.

Question 20

What is the short-term pain and long-term gain in regards to disinflation?

Answer 20

As the forgoing discussion suggests, disinflation is a classic example of a policy that brings short-term pain for long-term gain.

The long-term gain is the reduced costs to individuals and firms associated with the lower rate of inflation; the short-term pain is the temporary loss in economic activity and rise in unemployment that occurs during the process of disinflation.

Question 21

What is the cost of disinflation?

Answer 21

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

Question 22

What is the Sacrifice ratio?

Answer 22

Sacrifice ratio

The cumulative loss in real GDP, expressed as a percentage of potential output, divided by the percentage-point reduction in the rate of inflation.

Question 23

The Cost of Disinflation: The Sacrifice Ratio
(Graph)

Answer 23

Question 24

What determines the size of the sacrafice ratio?

Answer 24

The sacrifice ratio is larger the deeper the recession and the longer it takes real GDP to return to potential.

Question 25

What is the principal lesson from this chapter concerning sustained inflation?

Answer 25

Whatever forces might be created by technological change and globalization, and whatever measures central banks might take during economic crises, the principal lesson from this chapter is that sustained inflation is best viewed as a monetary phenomenon.

As such, it can ultimately be controlled by appropriate monetary policy. As long as central banks remain committed to keeping inflation close to its formal target, the best expectation for the future is that inflation will remain low and stable.

Question 26

Can the​ Bank’s policy responses to negative supply shocks influence the credibility it is likely to have when trying to end a sustained​ inflation?

Answer 26

Yes. If the Bank of Canada tends to respond to adverse supply shocks by not validating them​ and, instead, forcing the requisite reduction in wages and other factor​ prices, then it will acquire the reputation of being​ “hard” on inflation.

In this​ case, by showing that they are prepared to experience the recession necessary to fight the inflationary effects of an adverse supply​ shock, they have also revealed that they are prepared to experience the recession needed to reduce a sustained inflation.

Private agents will therefore be more inclined to believe the​ Bank’s announced intentions to disinflate.