More Irritating Details About Inflation

The Phillips Curve & Accelerating Inflation

-We know what the Phillips curve is. I'm not explaining it again.

-At Y* and U*, there is no gap inflation

-When the economy is in an inflationary gap, the BoC must validate for wage inflation

-In the 1960s, the level of wage and price adjustment began to rise for any level of output (the whole phillips curve shifted to the right)

-Why? Because the original phillips curve included only gap inflation and ignored expectation inflation (which impacts wage changes, obviously)

-This newly-shifted phillips curve is called the expectations-augmented phillips curve. There is still an inverse relation between the unemployment rate and the rate of changes of nominal wages, but with the effect of expectation inflation built into the model.

-Expectation inflation is graphically represented by the height of the phillips curve above the X axis at U*

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Demand Shocks and Accelerating Inflation

INFLATIONARY DEMAND SHOCKS AND INFLATION

-An increase in consumption, investment, government expenditures, and net exports causes an increase in aggregate expenditure, a rightward shift in aggregate demand, and an increase in the equilibrium price level.

IF THE GOVERNMENT DOES NOT VALIDATE INFLATION CAUSED BY AN ISOLATED DEMAND SHOCK

Aggregate demand will shift to the right as a result of this demand shock. Y is now greater than Y*, and thus we have an inflationary gap. however, wages adjust: excess demand for labour increases wages, which in turn increases firm costs. As a result, short run aggregate supply shifts to the left, and output returns to its original level, but at a higher price level. This is one-shot inflation. The price level is now at a higher equilibrium level, but since the demand shock is isolated, inflation will not be sustained.

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Inflation and Supply Shocks

FROM WAGE CHANGES TO PRICE CHANGES

-If a change in money wages is positive (wages increase), short run aggregate supply will decrease (it shifts to the left due to increased costs). This causes prices to rise, and the overall effect is inflationary

-If an change in money wages is negative (wages decrease), short run aggregate supply will increase (it shifts to the right due to lowered costs). This causes prices to fall, and the overall effect is deflationary.

Wages up --> Costs up ---> SRAS shifts left --> Equilibrium price level rises

Okay... so so far, we've talked about two causes of inflation: gap effects and worker expectations. There is, however, a third cause of inflationary pressures: AN EXOGENOUS SUPPLY SHOCK (for an example, a change in the price of raw materials, such as oil, can increase the general price level, which is why vegetables can start to cost more when the price of oil goes up).

SOOO

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