Inflation and Disinflation
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 Inflation is the overall increase in prices =
increase in price level
 Changes constantly
 Hard to predict
 Higher rates of inflation = harder to predict
 anticipated inflation
 Unanticipated inflation
 Bank of Canada is committed to keep inflation at
about 2%/year
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 Inflation in AD-AS model:
 Changes in wages
 Increase in wages shifts AS upward
 Increases in other factor prices also shift AS upward
 We have seen what happens when Y = Y*
 Unemployment rate = natural rate of unemployment
 Terminology: natural rate of unemployment ≡ nonaccelerating inflation rate of unemployment, NAIRU
 Mark it as U*
 NAIRU = frictional rate + structural rate
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 Changes in wages
 Inflationary gap
 Can come from a positive AD shock
 There is an upward pressure on wages
 Because there’s increased demand for labour
 Recessionary gap
 Can come from a negative AD shock
 There is an downward pressure on wages
 Because there’s idle labour
 Y = Y*
 No pressure on wages
 Expected inflation
 Signing a labour contract
 Backward-looking expectations
 Rational expectations
 Demand for labour and real wage rate
 Expected inflation rate => increase in wage rate by inflation rate
 Change in wage rate = output-gap effect + expectation effect
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 Recall, increases in other factor prices also shift AS upward
 A negative AS shock
 Not from labour cost
 Actual inflation =
 change-in-wage-rate inflation + supply-shock inflation =
 output-gap inflation + expected inflation + supply-shock inflation
 Let say,
 No AD/AS shocks have happened for a while and none are expected
 Then actual inflation = output-gap inflation + expected inflation +
supply-shock inflation
 Means:
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Y = Y*
U = U*
Constant inflation
Liquidity preference theory: MD increases (P goes up), MS increases (the
central bank adjusts) => interest rate stays constant
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 Shocks and inflation:
 Positive AD shock
 Demand inflation
 No monetary validation
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Factor prices adjust
P rises and then stops going up
Short-lived inflation
New price level but not new inflation rate
 Monetary validation
 Bank of Canada:
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Sees an inflationary gap
Reduces interest rate
Money supply increases
AD increases
Get sustained inflation rate increase
Why would you do that?
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 Shocks and inflation:
 Negative AS shock
 Supply inflation
 No monetary validation
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Factor prices adjust
P rises and then falls and then stops changing
Short-lived inflation/deflation
Not new price level and not new inflation rate
 Monetary validation
 Bank of Canada:
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Sees a recessionary gap
Reduces interest rate
Money supply increases
AD increases
Get short-lived inflation
Why would you do that?
 Sticky wages
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 Shocks and inflation:
 No monetary validation
 Business cycle
 No sustained inflation OR no inflation
 Monetary validation
 No business cycle
 Sustained inflation OR new price level
 Canada vs USA in early 1970s (OPEC)
 Uh-oh! Monetary validation may give rise to a wageprice spiral
 A shock => monetary validation => expectations adjusted
upward => wages go up faster => inflation increases =>
(monetary validation) => expectations adjusted upward =>
wages go up faster => inflation increases => …
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 Shocks and inflation:
 Again, positive AD shock
 Monetary validation
 Maintains Y > Y*
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Adjusted expectations
Increased (accelerating) inflation rate
Means U < U* (NAIRU)
As long as there is inflationary gap there is accelerating inflation
 No monetary validation
 Allows return to Y > Y*
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No change in expectations
Constant inflation rate
Means U = U* (NAIRU)
No sustained inflationary gap = no accelerating inflation
 Sustained inflation comes from monetary validations
 Sustained inflation is a monetary phenomenon
 No increase in money supply, no sustained inflation
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 Disinflation:
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Happened to many, historically
Sustained inflation is a monetary phenomenon
To disinflate, have to stop monetary validation
Phases:
 Stop monetary validation
 Interest rate up (Ms does not increase anymore)
 Price level up
 But only till Y=Y*
 Stagflation
 Negative AS shock due to established expectations
 Will last till expectations adjust
 Recovery
 Reduced inflation expectation (AS down)
 Expansionary policy may help but is DANGEROUS (why?)
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 Disinflation:
 Phase 2 (stagflation) means reduced Y
 Lost output = cost of disinflation
 Sacrifice ratio = (cumulative loss of Y)/(% high
inflation - % low inflation)
 Speed of disinflation
 Adjustment of expectations
 In practice, usually significant political changes
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