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%

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Why? Extending the Basic Keynesian and AD-AS Models
 This

chapter extends the basic Keynesian and ADAS models to allow for price inflation and the reactions of Central Banks use the aggregate demand-inflation adjustment diagram to analyze the recessions of the early 1980s & 1990s

 We

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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?
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Why the ADI curve are downward-sloping?
 Because

rate π

of Bank of Canada’s response to inflation

 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 of Canada’s Policy Reaction Function - the predictable action which a policymaker takes in response to the state of the economy

 Bank

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FIGURE 15.2

An Example of a Bank of Canada Policy Reaction Function

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Aggregate Demand and Inflation (π)
 After

1973 – surge in inflation. bank reaction function

 Central

 Increase in inflation (p) causes the bank to set a

higher real interest rate.  Result: reduces both aggregate demand and shortrun equilibrium output.
 Aggregate

demand (and equilibrium output) is lower when inflation is higher.

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Numerical Example of an Aggregate Demand (ADI) Curve

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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

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Changes in Autonomous Aggregate Spending
 Autonomous

planned aggregate expenditure

 The portion of PAE that is determined outside the
 If households desire to consume more at the same   

model  E.g. increase in autonomous PAE – shifts ADI right
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

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FIGURE 15.3

Effect of an Increase in Exogenous Spending

ADI’ ADI

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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

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Increase in Exogenous Spending - 2 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

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Increase in Exogenous Spending - 3 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

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Increase in Exogenous Spending - 4 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

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Increase in Exogenous Spending - 5 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

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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 privatesector 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 privatesector investment

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FIGURE 15.4

A Tightening of Monetary Policy

New policy reaction function Old policy reaction function

ADI ADI'

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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

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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

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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.

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FIGURE 15.5

A Virtuous Circle of Low Inflation and Low Expected Inflation

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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;

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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

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FIGURE 15.6

The Aggregate Demand–Inflation Adjustment (ADI–IA) Diagram
Long-run aggregate supply LRAS

π

A

Inflation adjustment IA

Aggregate demand ADI

Y

Y*

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Short-Run Equilibrium
 In

the short run, the inflation rate is determined by past expectations and pricing decisions 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

 Since,

 short-run equilibrium output is demand determined  Graphically, short-run equilibrium occurs at the
intersection of the AD curve and the IA curve

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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

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Suppose: No Output Gap
Y

= Y*  Actual output equals potential output  Sales equal normal production rates
• No unwanted accumulation of inventories • No unwanted depletion of inventories

 Firms are satisfied

 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

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Inflation and Recovery from a Recessionary Gap
 If

economy has a recessionary gap (Y<Y*)
function of the central bank!

 Elimination of gap occurs – given the reaction
 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)

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FIGURE 15.7

The Adjustment of Inflation When a Recessionary Gap Exists

LRAS π A IA

π*

B

IA'

ADI

Y

Y*

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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

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Inflation and Elimination of an Expansionary Gap
 If

Y > Y* - expansionary gap
reaction function

 Elimination of gap implied by the central bank
 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*

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FIGURE 15.8

The Adjustment of Inflation When an Expansionary Gap Exists

LRAS

π*

B

IA' A AD

π

IA

Y*

Y

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A Self-Correcting Economic Model (with the help of the Central Bank!)
A

self-correcting policy mechanism
with the help of the central bank

 Given enough time, output gaps tend to disappear
 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

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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

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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  The BIG problems for policymaking in the real world

 Then the case for active stabilization is weaker
are uncertainties in diagnosis & lags in policy impacts
 Large

gaps take longer to fix & have large costs

 Greater justification for policy intervention

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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 ”.

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FIGURE 15.9

War and Military Buildup as a Source of Inflation

LRAS π' B π A IA
π

LRAS C IA' B A

IA

ADI' Y* Y ADI ADI' Y* Y

a) An increase in military spending shift ADI curve right to ADI’. So at the new shortrun 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’)

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Can central bank prevent the increase in inflation in this case?
 Yes!  If

the central can tighten the monetary policysetting a higher real interest rate at any given level of inflation 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.

 This  --

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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

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FIGURE 15.10

The Effects of an Adverse Inflation Shock

Starting from Long-run Equilibrium point A, an adverse inflation shock move IA curve to IA’. The new short-run equilibrium point B will imply a recessionary gap. If there is no active monetary policy, the economy will return to point A eventually. But the economy will suffer a long recession.

LRAS

π'

B

C

IA'

π

A

IA

ADI' ADI Y′ Y*

The Bank of Canada can ease the monetary policy by setting a lower real interest rate at any inflation rate. So this will shift the ADI curve right to ADI’, which help the economy to move back to the point C. At point C, the economy does not have any recessionary gap, but the cost of this strategy is that the inflation will remain at the high level.

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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. the central banks act aggressively to expand the aggregate demand, the recession will end more quickly, but inflation will stabilize at a higher level.

 If

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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 macroeconomy

 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

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FIGURE 15.11

The Effects of a Shock to Potential Output
Starting from Longrun Equilibrium point A, an adverse potential output shock move LRAS to LRAS’. So now A represents a expansionary gap. So the inflation will adjust and IA will move to IA’. According to the policy reaction function, the real 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.

LRAS'

LRAS

π'

B

IA' A

π

IA

ADI Y*' Y*

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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

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(b) FIGURE 15.4

A Tightening of Monetary Policy

New policy reaction function Old policy reaction function

ADI ADI'

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FIGURE 15.12

The Short-Run and Long-Run Effects of a Monetary Tightening

LRAS 12% B A IA 12% B

LRAS IA

ADI ADI' Y Y*

4%

C ADI' Y Y*

IA′

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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)
policy

 Foreign trade effects accentuate impacts of monetary

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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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