April 2 & 7 Flashcards
(49 cards)
inflation in Canada from 1995-2020, and what it was it like before then?
from 1995-2020, inflation has been around the target of 2%
before that, there were big changes in CPI (inflation)
1970s and 1980s: high and volatile inflation
why do wages change? wages and the output gap
- excess demand for labour associated with inflationary gap puts UPWARD PRESSURE on nominal wages
- excess supply of labour associated with recessionary gap puts DOWNWARD PRESSURE on nominal wages (though this may happen slowly)
- absence of an inflationary or recessionary gap implies that demand forces aren’t exerting any pressure on nominal wages
how can we endogenously create changes in prices?
when wages in the economy change (this is the only way to endogenously control price changes)
wages will change, which shifts AS
what does the unemployment rate equal when GDP is equal to Y*?
NAIRU
NAIRU
non-accelerating inflation rate of unemployment
occurs when real GDP is equal to Y*
when Y > Y*, what’s U?
U < U*
unemployment is lower than NAIRU
so nominal wages increase (higher demand for workers)
when Y < Y*, what’s U?
U > U*
unemployment is greater than NAIRU
so nominal wages decrease (lower demand for workers)
the expectation of some specific ________ rate creates pressure for nominal wages to ______ by that ______
inflation
rise
rate
overall effect on wages
change in money wages = OUTPUT-GAP EFFECT + EXPECTATIONAL EFFECT
what’s key for the central bank in building their policy?
understanding how people form their expectations
this is key in keeping inflation within their desired range
how do people form their expectations?
- FORWARD LOOKING? (ie. listening to announcements from bank, effects of tariffs etc)
- BACKWARD LOOKING? (ie. BoC has kept inflation close to 2% since 1995)
- COMBO?
what determines what happens to the AS curve (from wages to prices)?
net effect of the 2 macro forces acting on wages (output gaps and inflation expectations) determine what happens to the AS curve
what’s a third factor that determines actual inflation?
supply shock inflation
ie. change in prices of materials used as inputs in production
constant inflation
inflation has been constant for several years
there’s no indication of impending change in monetary policy
with no indication of change and inflation stability, EXPECTED INFLATION will equal ACTUAL INFLATION
if expected inflation equals actual inflation…
Y must equal Y*
no output gap
but if there’s no output gap, what’s causing the inflation?
when does constant inflation with Y = Y* occur?
when the rate of monetary expansion, the rate of wage increase, and the expected rate of inflation are all consistent with the actual inflation rate
in order to generate sustained/constant inflation, what must the central bank do?
increase the money supply!
- wages costs are rising because of expectations of inflation (leftward shifts of AS curve)
- these expectations are validated by the central bank’s policy (increases the money supply - rightward shift of AD curve)
this balances out and keeps real GDP at Y*
(no gap has opened because the change in AD and AS are happening together)
how does central bank validate inflation expectations?
expectations of inflation = higher wages are demanded
this shifts AS curve leftward and increases prices
increased prices mean there’s a higher demand for money
so central bank increases the money supply to ensure the 2% increase is accounted for
demand inflation
inflation arising from an inflationary output gap caused by a positive AD shock
a demand shock that isn’t validated…
produces temporary inflation
3 options in response to demand inflation
- SMALL rightward AD shock - central bank can afford to do NOTHING
^ will allow economy to have temporary inflation a bit above 2%
^ as long as expectations haven’t changed
- LARGE rightward AD shock - CONTRACTIONARY MONETARY POLICY
^ necessary if inflation has been brought high enough that expectations have begun to change
^ increase interest rates, reduce AD to keep us near Y*
- MONETARY VALIDATION
^ central bank attempts to keep output gap open (either by keep MS constant or by increasing it)
^ wages are increasing, output is increasing, expectations about inflation are increasing and bank validates these expectations
^ PROBLEM: inflation will accelerate, fast
what does monetary validation of demand inflation do?
monetary validation: increasing the money supply
cause AD curve to shift further to the right
offsets the upward shift of the AS curve
continued validation of a demand shocks turns what would have been TRANSITORY INFLATION into SUSTAINED INFLATION FUELED BY MONETARY EXPANSION
what would happen if bank acted to keep output above Y*?
the ACCELERATION HYPOTHESIS predicts what would happen
states that when real GDP is held above potential, the PERSISTENT INFLATIONARY GAP WILL CAUSE INFLATION TO ACCELERATE
supply inflation
inflation arising from a NEGATIVE AS SHOCK
(that isn’t the result of excess demand in domestic markets for factors of production)
