Inflation and Output

PART 4
The Economy in the Short Run
chapter 15
Inflation and
Output
Jenny Xu, Department of Economics, SFU

Volcker’s Disinflation
 In the late 1970s, inflation increased rapidly

 By 1979 US inflation = 11.3%; Canada = 9.2%
 Paul Volcker was appointed the Chairman of the US
Federal Reserve in Sept. 1979
 sharply increased interest rates
 GDP & employment fell sharply in the U.S.
 U.S. slowdown decreased demand for Canadian
exports
 Bank of Canada followed US lead in raising interest
rates
• Interest rates doubled – 1978 = 8.6%; 1981 = 17.8%
 Sharpest recession since the 1930s followed
• Unemployment rate in 1980 = 7.5%; in 1983 = 11.9%
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-2 Copyright © 2005 McGraw-Hill Ryerson Limited
Why? Extending the Basic Keynesian and AD-AS Models
 This chapter extends the basic Keynesian and AD-

AS models to allow for price inflation and the
reactions of Central Banks
 We use the aggregate demand-inflation
adjustment diagram to analyze the recessions of
the early 1980s & 1990s
I. Inflation, Spending and Output:
The Aggregate Demand/Inflation
(ADI) Curve
How does the predictable response of central banks affect aggregate

demand?
FIGURE 5.1
The Aggregate Demand/Inflation (ADI) Curve: Relationship between
short-run equilibrium output Y and the Rate of inflation rate π
When Inflation increases, Aggregate Demand declines: Why?
Why the ADI curve are downward-sloping?
 Because of Bank of Canada’s response to inflation

rate π
 Bank of Canada’s choice of the real interest rate
depends on the rate of inflation
 Bank’s stated goal:
- to maintain core inflation between 1 and 3%
 When π is high, BOC will try to reduce the aggregate
spending by setting a high interest rate.
Π increases  r increases  autonomous expenditure
decreases  Y decreases  ADI curve downward sloping
 Bank of Canada’s Policy Reaction Function - the
predictable action which a policymaker takes in
response to the state of the economy
FIGURE 15.2
An Example of a Bank of Canada Policy Reaction Function
Aggregate Demand and Inflation (π)
 After 1973 – surge in inflation.

 Central bank reaction function
 Increase in inflation (p) causes the bank to set a
higher real interest rate.
 Result: reduces both aggregate demand and short-
run equilibrium output.
 Aggregate demand (and equilibrium output) is
lower when inflation is higher.
Numerical Example of an Aggregate Demand (ADI) Curve
Shifts in Aggregate Demand (ADI)
 ADI curve
 = The relationship between inflation & Aggregate
Demand
holding all other factors other than inflation
constant
 When these other factors change, the ADI curve
shifts –examples:
 Changes in autonomous aggregate demand
 E.g. increase in demand for Canadian exports OR more
government spending
 Bank of Canada’s reaction function may also shift
 Example: 1988 - new lower target band for inflation set
Changes in Autonomous Aggregate Spending
 Autonomous planned aggregate expenditure

 The portion of PAE that is determined outside the
model
 E.g. increase in autonomous PAE – shifts ADI right
 If households desire to consume more at the same
income level, this shifts ADI rightwards
 If firms make more private sector investments at the
same interest rate, this shifts ADI rightwards
 If governments increase spending, this shifts ADI
rightwards
 If foreigners suddenly want to buy more Canadian
goods and services, this shifts ADI rightwards
 A decrease in autonomous PAE shifts ADI leftwards
FIGURE 15.3
Effect of an Increase in Exogenous Spending
ADI’
ADI
Increase in Exogenous Spending - 1
 Autonomous consumption
C  Suppose Consumers become more

optimistic and spend more – ADI shifts
rightwards
 Surveys track “consumer confidence”
 Major concern for current forecasts
 [1990 Gulf War saw a major decline in US
consumer confidence – shifted ADI left]
• A major change from previous wars
 Net taxes
T  Cut in taxes stimulates consumer spending

 Example: Martin tax cuts of 2001 stimulated
Canadian economy in 2002
• Helped Canada avoid US recession
 Increase in transfer payments has same
type of impact - stimulates consumer
spending
 Issue – income distributional impact
• Since high income people typically save a
greater % of their income, 1$ in tax cuts
or transfers received by the affluent
generally produces less stimulus to
aggregate demand than 1$ benefit
received by low income groups
 Autonomous private-sector investment
I  Development of a new cost-saving

technology will increase investment
spending by firms
 Example: the late 1990s saw a major
investment boom in USA in
telecommunications, computer industries
 “Dot.Com Boom” in investment has been
followed by “Dot.Com Bust” since 2000
 Government purchases
G  Increased spending directly increases

Aggregate Demand
 Roads, hospitals, schools may also affect
potential output, but only in the longer term
 Buying more domestically produced
military hardware also has immediate
stimulative impact
• Wartime Demand for military goods was a
major factor in increased Aggregate Demand
during WWII, Korea, Viet Nam wars
- But in 1990 Gulf War, “hi-tech”, short war meant
stimulus to demand was smaller than the impact
of decline in consumer confidence
 Net Exports
NX  Increased demand for Canadian products

by foreigners
Example:
 During 1990s, US economy grew strongly –
implying strong demand for Canadian
exports, more than offsetting the decline in
Canadian government spending after 1995
Changes in the Bank of Canada’s Policy Reaction Function
and the ADI Curve (a)
 Bank of Canada’s reaction function

 the real interest rate the Bank of Canada sets at
each level of inflation
 The Bank of Canada may change its policy reaction
function (e.g. in 1988)
 Tightening monetary policy
 For a given inflation rate, the Bank of Canada sets a
higher real interest rate than before
 Same effect as a reduction of Autonomous private-
sector investment
 Easing monetary policy
 For a given inflation rate, the Bank of Canada sets a
lower real interest rate than before
 Same effect as a expansion of Autonomous private-
sector investment
FIGURE 15.4
A Tightening of Monetary Policy
New policy
reaction ADI
function ADI'
Old policy
reaction
function
Shifts in ADI vs. Movements Along ADI
 Movements along ADI

 Downward slope of ADI shows the inverse
relationship between inflation and aggregate
demand
 Changes in the inflation rate cause Bank of Canada to
change the real interest rate
 Changes in real interest rate cause changes in ADI and
short run equilibrium output & employment (with a lag)
 Shifts in ADI
 Caused by factors that change ADI at a given level of
inflation
 Autonomous changes in spending
 Changes in the Bank of Canada’s policy reaction
function
II. Inflation and Aggregate Supply
In the short run, how do firms decide how much to produce?

In the long run, is the amount the economy can produce
influenced by the inflation rate?
Expectations of Inflation influence behavior
- & behavior determines reality
 At any point in time, buyers and sellers have an
expectation of inflation when negotiating contracts - &
they will build it into the contract
 The higher the expectation of inflation, the higher is the
nominal price negotiated
 E.G., when firms expect higher wages and increases in the
costs of other inputs, their selling price will increase
 If wages and other costs are expected to increase, firms will
want to raise prices
 Long-term wage and price contracts build in increases in
wages and prices that depend on inflation expectations
 A low rate of expected inflation therefore tends to lead to a
low rate of actual inflation
 A high rate of expected inflation therefore tends to lead to a
high rate of actual inflation
Inflation Inertia
 Inflation inertia
 Low inflation tends to change relatively slowly.
 Expectations about future inflation are strongly
influenced by current inflation.
 This leads to long-term wage and price contracts that
preserve low inflation.
 When expected inflation = actual, nobody has a
reason to change behavior
 EQUILIBRIUM !!!
 BUT - other factors can upset the situation.
FIGURE 15.5
A Virtuous Circle of Low Inflation and Low Expected Inflation
Key factor that causes changes in inflation –output gap
 Key factor that causes changes in inflation –output

gap (Y-Y*)
 No Output Gap
 – Inflation will not change;
 Recessionary Gap
 – Inflation decreases;
 Expansionary Gap
 – Inflation increases;
ADI Diagram
 Long-run aggregate supply (LRAS)

 A vertical line showing the economy’s potential
output Y*
 In long run, Y = Y*
 Short-run aggregate supply/Inflation Adjustment
(IA)
 A horizontal line showing the amount supplied at the
current rate of inflation, as determined by past
expectations and pricing decisions
 Represents the fact that, in short run, firms produce
what the market can absorb, at preset prices
FIGURE 15.6
The Aggregate Demand–Inflation Adjustment (ADI–IA) Diagram
Long-run
aggregate
supply LRAS
A
π Inflation
adjustment IA
Aggregate demand ADI
Y Y*
Short-Run Equilibrium
 In the short run, the inflation rate is determined by

past expectations and pricing decisions
 Since, in the short run, firms produce what the
market can absorb at preset prices, total output
equals the level of demand that is consistent with
that inflation rate
 short-run equilibrium output is demand determined
 Graphically, short-run equilibrium occurs at the
intersection of the AD curve and the IA curve
Output Gap and Inflation
 Output gap
 The difference between potential output Y* and
actual output Y
 Y* - Y
 In the short run
 Y may equal Y*
 Y may differ from Y*
 Y > Y* expansionary gap
 Y < Y* recessionary gap
Suppose: No Output Gap
Y = Y*
 Actual output equals potential output
 Firms are satisfied
 Sales equal normal production rates
• No unwanted accumulation of inventories
• No unwanted depletion of inventories
 Firms have no incentive to change their prices relative
to other prices
• So if other prices are expected to rise at x%, firm will want
to increase own prices by the same %
 Inflation rate tends to remain the same
Inflation and Recovery from a Recessionary Gap
 If economy has a recessionary gap (Y<Y*)

 Elimination of gap occurs – given the reaction
function of the central bank!
 Firms not selling as much as expected will slow the
rate at which they increase their prices
 This will cause the inflation rate to fall
 Short Run Aggregate Supply/Inflation Adjustment
curve (IA) shifts down
 As inflation falls, the Bank of Canada lowers the real
interest rate
 Output rises and unemployment falls (with a lag)
FIGURE 15.7
The Adjustment of Inflation When a Recessionary Gap Exists
LRAS
A
π IA
B
π* IA'
ADI
Y Y*
Expansionary Gap
 Expansionary output gap

 Y > Y*
 Actual output is greater than potential output
 Firms are over-utilizing resources
 Sales exceed normal production rates
• Inventories are depleted – firms have to react
 Firms have incentive to increase prices more than the
increase in their costs
 If all firms do this then …..
 Inflation rate tends to increase
Inflation and Elimination of an Expansionary Gap
 If Y > Y* - expansionary gap

 Elimination of gap implied by the central bank
reaction function
 Firms experiencing high demand will
 Increase prices more than costs
 This will cause the inflation rate to rise
 Short Run IA shifts up
 As inflation rises, the Bank of Canada raises the real
interest rate
 Output falls and unemployment rises (with lag)
 Y falls towards Y*
FIGURE 15.8
The Adjustment of Inflation When an Expansionary Gap Exists
LRAS
B
π* IA'
A
π IA
AD
Y* Y
A Self-Correcting Economic Model
(with the help of the Central Bank!)
A self-correcting policy mechanism

 Given enough time, output gaps tend to disappear
with the help of the central bank
 This result contrasts with the simple version of the
Keynesian model which
 - focuses on the short run when prices do not adjust
and ignores the long-run adjustment period
 - does not incorporate the Bank of Canada’s policy
reaction function
Long Run Equilibrium
 LR equilibrium
 Actual output equals potential output and the
inflation rate is stable
 Y = Y*
 Graphically, it is where the AD curve, the IA line, and
the LRAS line all intersect at a single point
 Central Bank is satisfied with inflation, so no changes
to interest rates
Timing
 If self-correction (with the bank’s fixed reaction

function) is too slow, then more aggressive
stabilization may be needed
 Change of reaction function is possible
 Fiscal policy may also be useful
 If correction is rapid
 Then the case for active stabilization is weaker
 The BIG problems for policymaking in the real world
are uncertainties in diagnosis & lags in policy impacts
 Large gaps take longer to fix & have large costs
 Greater justification for policy intervention
III. Sources of Change in Inflation
What kinds of economic shocks might change the rate of

inflation?
Why might inflation change ?(a)
 Excessive Aggregate Demand (AD)

 Too much spending chasing too few goods
 If the economy is already close to capacity, then a
surge in spending may cause an expansionary gap (Y
> Y*)
 Example: US wartime spending during Viet Nam war in
1960s
 It is known as “demand-pull inflation ”.
FIGURE 15.9
War and Military Buildup as a Source of Inflation
LRAS LRAS
C
π' IA'
B B
π IA
IA A
A
π
ADI'
Y* Y ADI ADI' Y* Y
a) An increase in military spending shift ADI curve right to ADI’. So at the new short-
run equilibrium point B, there is a expansionary gap.
b) This gap leads to a rising in inflation. So IA curve will move up to IA’, which leads to
an increase in real interest rate because of the BOC’s policy response function.
Then the economy will move to point C. At this point, the output Is back to the
potential output (Y*), but the inflation is higher than before( from π to π’)
Can central bank prevent the increase in inflation in this
case?
 Yes!
 If the central can tighten the monetary policy-

setting a higher real interest rate at any given level
of inflation
 This can shift the ADI curve leftwards and thus
offsets the increase in demand by the government
 -- eliminating or at least moderating the
inflationary impact of the military purchases.
Sources of Change in Inflation (b)
 Inflation Shocks - Sudden change in the normal

behavior of inflation, unrelated to output gap.
 Example: 1973 oil price shock. (In 1973, at the time
of the Yom Kippur War between Israel and a coalition
of Arab nations, OPEC cut its supplies of crude oil to
the industrialized nations, quadrupling world oil
prices.)
 Output down, inflation up
 May take a long time to return to previous output and
inflation levels
FIGURE 15.10
The Effects of an Adverse Inflation Shock
Starting from LRAS The Bank of

Long-run Canada can ease
Equilibrium point the monetary
A, an adverse policy by setting a
inflation shock lower real interest
move IA curve to rate at any
IA’. The new inflation rate. So
short-run B C this will shift the
π' IA'
equilibrium point ADI curve right to
B will imply a ADI’, which help
recessionary gap. A the economy to
If there is no π IA move back to the
active monetary point C. At point
policy, the C, the economy
economy will does not have
return to point A any recessionary
eventually. But
ADI' gap, but the cost
the economy will of this strategy is
suffer a long ADI that the inflation
recession. Y′ Y* will remain at the
high level.
So inflationary shock really pose a dilemma for policy
makers!
 If the central banks leave their policies

unchanged, a “steady-as-she-goes” approach –
inflationary will eventually subside, but the nation
may experience a lengthy and severe recession.
 If the central banks act aggressively to expand the
aggregate demand, the recession will end more
quickly, but inflation will stabilize at a higher level.
Random Shocks to Output ?
 Shocks to potential output (adverse aggregate

supply shocks) can happen
 Example: Weather shocks & crop losses ?
 “Real Business Cycles” literature argues that random
shocks to potential output are the source of
unavoidable short run fluctuations in the macro-
economy
 Long-term shocks can affect potential output trend
but this is a different problem - permanently lower
rate of output growth
 Examples:
• Costs of energy conservation after 1973
• Increase in costs of security after 9/11
FIGURE 15.11
The Effects of a Shock to Potential Output
Starting from Long-

LRAS' LRAS run Equilibrium point
A, an adverse
potential output
shock move LRAS to
LRAS’. So now A
represents a
expansionary gap. So
the inflation will
B adjust and IA will
π' IA' move to IA’.
According to the
policy reaction
A function, the real
π IA interest rate will
increase, which
induce the economy
to move to the new
long-run equilibrium
point B. Note that
the decline in output
is permanent.
ADI
Y*' Y*
IV. Controlling Inflation
 What should policymakers do if inflation is too

high?
 Bank reaction function implies a given speed of
reduction of inflation
 Inflation can be slowed faster by policies that reduce
aggregate demand more aggressively
 I.e. change in central bank’s reaction function
 Costs
 more lost output & more unemployment
 Benefits
 faster transition to lower trend inflation
(b) FIGURE 15.4
A Tightening of Monetary Policy
New policy
reaction ADI
function ADI'
Old policy
reaction
function
FIGURE 15.12
The Short-Run and Long-Run Effects of a Monetary Tightening
LRAS LRAS
B A B
12% IA 12% IA
C
ADI 4% IA′
ADI' ADI'
Y Y* Y Y*
V. Limitations of the Aggregate
Demand-Aggregate Supply Model
Limitations of the Aggregate Demand-Aggregate Supply Model (b)
 Like the basic Keynesian model, ADI model is

framed in terms of level of potential output
 Can rephrase in growth terms – potential output (Y*)
grows over time
 Recessionary gap can open even when actual output
is growing, if growth is less than normal
 So far, have assumed that net exports are
autonomous BUT
 Decreases in the real interest rate will cause a
depreciation of the Canadian dollar
 Net exports will increase (with a lag)
 Foreign trade effects accentuate impacts of monetary
policy
Macro Economics in an Open Economy
 So far – we have been discussing a closed

economy
 C + I + G = GDP
 But Exports are almost 40% of Canada’s GDP – so a
more accurate assumption is:
 C + I + G + (X – M) = GDP
 Chapter 16 considers trade

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PART 4

The Economy in the Short Run

Jenny Xu, Department of Economics, SFU

 In the late 1970s, inflation increased rapidly

 This chapter extends the basic Keynesian and AD-

How does the predictable response of central banks affect aggregate

When Inflation increases, Aggregate Demand declines: Why?

 Because of Bank of Canada’s response to inflation

 After 1973 – surge in inflation.

 Autonomous planned aggregate expenditure

C  Suppose Consumers become more

T  Cut in taxes stimulates consumer spending

 Autonomous private-sector investment

I  Development of a new cost-saving

G  Increased spending directly increases

NX  Increased demand for Canadian products

 Bank of Canada’s reaction function

 Movements along ADI

In the short run, how do firms decide how much to produce?

 Key factor that causes changes in inflation –output

 Long-run aggregate supply (LRAS)

Aggregate demand ADI

 In the short run, the inflation rate is determined by

 If economy has a recessionary gap (Y<Y*)

 Expansionary output gap

 If Y > Y* - expansionary gap

A self-correcting policy mechanism

 If self-correction (with the bank’s fixed reaction

What kinds of economic shocks might change the rate of

 Excessive Aggregate Demand (AD)

 If the central can tighten the monetary policy-

 Inflation Shocks - Sudden change in the normal

Starting from LRAS The Bank of

 If the central banks leave their policies

 Shocks to potential output (adverse aggregate

Starting from Long-

 What should policymakers do if inflation is too

 Like the basic Keynesian model, ADI model is

 So far – we have been discussing a closed

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