14.2 Shocks and Policy Responses Flashcards
(41 cards)
In this section, what is the central assumption we make in our macro model and what is its purpose?
In this analysis, we make a central assumption in our macro model—that AD and AS shocks do not influence the level of potential output, .
With this assumption in place, a central prediction of our model is that the long-run effect of AD and AS shocks involves no change in real GDP because the economy’s adjustment process brings real GDP back to (the unchanged) .
What is Demand inflation?
Demand inflation
Inflation arising from an inflationary output gap caused, in turn, by a positive AD shock.
What are some potential reasons fora positive AD shock?
The shift in the AD curve could have been caused by a reduction in tax rates; by an increase in such autonomous expenditure items as investment, government, and net exports; or by an expansionary monetary policy.
When does demand inflation often occur?
Demand inflation often occurs at the end of a strong business-cycle upswing, when real GDP exceeds Y* , causing excess demand to develop in the markets for labour, intermediate goods, and final output.
What are some simplifying assumptions that we make in our study of demand inflation?
First, we continue to assume that Y* is constant.
Second, we assume that initially there is no inflation at all.
These two assumptions imply that our starting point is a stable long-run equilibrium, with constant real GDP and price level, rather than the long-run equilibrium with constant inflation.
We then 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.
What two cases is it important to distuinguish between when studying positive AD shocks.
It is important next to distinguish between the case in which the Bank of Canada validates the demand shock and the case in which it does not.
In the case where the BoC holds money supply constant, what happens to inflation and the inflationary gap provided by a positive AD shock?
**A demand shock that is not validated produces temporary inflation, but the economy’s adjustment process eventually restores potential GDP and stable prices. **
As long as the Bank of Canada holds the money supply constant, the rise in the price level moves the economy upward and to the left along the new AD curve, reducing the inflationary gap.
Eventually, the gap is eliminated, and equilibrium is established at a higher but stable price level, with output at Y* .
In this case, the initial period of inflation is followed by further inflation that lasts only until the new long-run equilibrium is reached.
Graph of a demand shock with no validation
What happens when a positive demand shock is validated by the central bank?
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.
What two forces are at play when a positive demand shock is validated by Central Bank monitary policy?
Two forces are now brought into play. Spurred by the inflationary gap, the increase in nominal wages causes the AS curve to shift upward. Fuelled by the expansionary monetary policy, however, the AD curve shifts further to the right.
As a result of both of these shifts, the price level rises, but real GDP remains above . Indeed, if the shift in the AD curve exactly offsets the shift in the AS curve, real GDP and the inflationary gap will remain constant.
What type of inflation is the result of continued validation of a demand shock?
Continued validation of a demand shock turns what would have been transitory inflation into sustained inflation fuelled by monetary expansion.
What is Supply Inflation?
Supply inflation
Inflation arising from a negative AS shock that is not the result of excess demand in the domestic markets for factors of production.
What are some examples of supply shocks?
An example of a supply shock is a rise in the costs of raw materials, such as oil.
Another is a rise in domestic wages not due to excess demand in the labour market. The rise in wages might occur, as we saw earlier, because of generally held expectations of future inflation. These shocks cause the AS curve to shift upward.
What are the initial effects of any negative supply shock?
The initial effects of any negative supply shock are that the price level rises while output falls
A Supply Shock With and Without Validation (Graph)
Adverse supply shocks initially raise prices while lowering output.
If there is no monetary validation, the reduction in wages and other factor prices makes the AS curve shift slowly back down to AS0 .
If there is monetary validation, the AD curve shifts from AD0 to AD1, as shown by arrow ②.
Equilibrium is re-established at E2 with output equal to potential output but with a higher price level, P2.
What happens after an AS shock in the case of no validation?
What is a major concern about the adjustment process of the AS curve in the face of an AS shock?
A major concern in this case is the speed of wage adjustment.
If wages do not fall rapidly in the face of excess supply in the labour market, the adjustment back to potential output can take a long time.
For example, suppose the original AS shock raised firms’ costs by 6 percent. To reverse this shock and return real GDP to , firms’ costs must fall by 6 percent. If nominal wages fell by only 1 percent per year, it would take several years to complete the adjustment.
In conclusion, what is a major problem that can arrise from an AS shock that is not validated by the central bank?
Whenever wages and other factor prices fall only slowly in the face of excess supply, the recovery to potential output after a non-validated negative supply shock will take a long time.
What does Monetary validation ofa negative supply shock cause?
Monetary validation of a negative supply shock causes the initial rise in the price level to be followed by a further rise, resulting in a higher price level but a much faster return to potential output than would occur if the recessionary gap were relied on to reduce wages and other factor prices.
What is the most Dramatic example of a negative supply shock?
The most dramatic example of a supply-shock inflation came in the wake of the first OPEC oil-price shock.
In 1974, the member countries of the Organization of the Petroleum Exporting Countries (OPEC) agreed to restrict output. Their action caused a threefold increase in the price of oil and dramatic increases in the prices of many petroleum-related products, such as fertilizer and chemicals.
The resulting increase in industrial costs shifted AS curves upward in all industrial countries. At this time, the Bank of Canada validated the supply shock with large increases in the money supply, whereas the Federal Reserve (the U.S. central bank) did not.
As the theory predicts, Canada experienced a large increase in its price level but almost no recession, while the United States experienced a much smaller increase in its price level but a deeper recession.
Is Monetary Validation of Supply Shocks Desirable?
Suppose the Bank of Canada were to validate a large negative supply shock and thus prevent what could otherwise be a protracted recession. Expressed in this way, monetary validation sounds like a good policy. Unfortunately, however, the cost of monetary validation in this situation is the possibility of extending the period of inflation. If this inflation leads firms and workers to expect further inflation, then point in Figure 14-5 will not be the end of the story.
What is a potential consiquence of monetary validation of a negative supply shock?
As expectations for further inflation develop, and wages continue to rise, the AS curve will continue to shift upward. But if the Bank continues its policy of validation, then the AD curve will also continue to shift upward.
It may not take long before the economy is in a constant inflation, as first shown in Figure 14-2. In this situation, real GDP equals Y* and there is no output gap, but there are ongoing costs to households and firms coming from the constant inflation.
How can costant inflation be halted? What is the name for the situation that occurs in this case?
Once begun, a constant inflation can be halted only if the Bank of Canada stops validating the expectational inflation initially caused by the supply shock.
The longer it waits to do so, the more firmly held will be the expectations that it will continue validating the shocks. Such a situation of a constant inflation is sometimes referred to as a wage-price spiral.
What can be lost when reducing a constant inflation?
As we will see later in the chapter, reducing a constant inflation, especially one with firmly entrenched inflationary expectations, can be very costly in terms of lost output and employment.