The Inflation Process
Inflation
Agenda
• Definition:
π(t) = {[ ( P(t) – P(t-1) ] / P(t-1) } * 100
• Inflation
¾ The triangle model
• DAD, SAS and Inflation Adjustment
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Inflation
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Inflation Expectations
• Three explicit factors
• If people expect a particular level of
inflation, that level will likely occur even
without any pressure from the output or
labor market.
¾ Called the triangle model
• π depends on 3 components:
¾ Inflationary expectations or πe.
¾ Excess demand or πED.
¾ Inflation shocks or πZ.
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Inflation Expectations
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Inflation Expectations
• Key Assumption: Inflation expectations, πe,
are formed by simple adaptive expectations.
• Modeling inflationary expectations is
extremely difficult.
¾ Rational expectations
¾ πe = π(t-1)
• Based on forward-looking behavior.
¾ Adaptive expectations
• Based on backward-looking behavior
¾ Dependent on effect of staggered wage and price behavior.
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Excess Demand
Inflation Expectations
• Excess demand inflation, πED, is measured
by the output gap.
• Key Assumption: Because of wage and price
stickiness, current inflation depends on lagged
excess demand.
¾ πED = f [ Y(t) – Yn(t) ]
¾ πED = f [ Y(t-1) – Yn(t-1) ]
• Where f > 0
• The bigger is f, the faster is the change in π(t) for any
given (lagged) output gap.
• The bigger is the (lagged) output gap, the faster is the
change in π(t) for any given f.
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Inflation Shocks
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Inflation Shocks
• Inflation shocks, Z, are assumed to be
exogenous.
• Key Assumption: Inflation shocks affect
inflation contemporaneously.
¾ Changes in input costs that are independent of
demand.
¾ πZ = Z(t)
• Changes in imported goods prices, especially oil.
– Price versus exchange rate
• Changes in competitive pressures.
¾ Can be favorable (-) or unfavorable (+).
¾ Can be temporary or permanent.
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Inflation
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SAS Curve
• π(t) = π(t-1) + f [ Y(t-1) – Yn(t-1) ] + Z(t)
• The Short-run Aggregate Supply (SAS)
curve was based on P-level adjustment
¾ Expected inflation, plus
¾ Excess demand inflation, plus
¾ Inflation shocks.
• The Short-run Aggregate Supply (SAS)
curve is now based on π adjustment
• This is the new SAS curve
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2
SAS Curve
AD Curve
π
• The Aggregate Demand (AD) curve is
based on levels of the underlying variables.
¾ Level of Ap, Md, and Ms =>
level of Y and P.
SAS
π
Y
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DAD Curve
DAD Curve
π
• The Dynamic Aggregate Demand (DAD)
curve is based on growth rates of the
underlying variables.
¾ Growth rate of Ap, Md and Ms =>
growth rate of Y and P (or π).
¾ R is still measured in level terms
DAD
Y
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The DAD-SAS Model
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The DAD – SAS Model
π
• Graphically
¾ Subscripts now represent years (or time
periods) rather than sequential equilibrium
levels.
SAS0
π
DAD0
Y0 = Yn
Y
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The DAD – SAS Model
and π Adjustment
Demand Shocks
• π adjustment can occur because of:
• Types of DAD Shock
¾ Favorable (increases Y relative to Yn)
¾ Demand shocks,
¾ Inflation shocks, or
¾ Supply shocks.
•
•
•
•
Faster growth of (increased) Ap
Lower t
Faster growth of (increased) Ms
Slower growth of (decreased) L0
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Demand Shocks
Demand Shocks and π Adjustment
• Types of DAD Shock
• Favorable demand shock.
• Increase DAD, raise Y (relative to Yn),
leave π unchanged in the current time
period.
¾ Unfavorable (decreases Y relative to Yn)
•
•
•
•
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Slower growth of (decreased) Ap
Higher t
Slower growth of (decreased) Ms
Faster growth of (increased) L0
¾ π adjustment does NOT take place in the
current time period because it depends on
• the lagged adjustment to excess demand, and
• inflationary expectations
¾ which depend on lagged π.
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Demand Shocks and π Adjustment, 1
π
Yn
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Demand Shocks and π Adjustment, 2
π
SAS0
π0
Yn
SAS0, SAS1
π0, π1
DAD0
Y0
Y
DAD0 DAD1
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Y0
Y1
Y
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4
Demand Shocks and π Adjustment, 3
Yn
π
Demand Shocks and π Adjustment, 4
π
π2
π0, π1
SAS2
SAS0, SAS1
Yn
π3
π2
π0, π1
SAS3
SAS2
SAS0, SAS1
DAD0 DAD1
Y0
Y2 Y1
Y
DAD0 DAD1
Y0 Y3Y2 Y1
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Demand Shocks and π Adjustment, 5
Y
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Major Point
Yn
π
πx
• The economy reaches Yn through the
repetition of π adjustment year after year.
SASx
π3
π2
π0, π1
SAS3
SAS2
SAS0, SAS1
¾ Each year, conditions in the previous year
determine π in the current year:
• Inflationary expectations and
• Excess/insufficient demand.
DAD0 DAD1
Y0 Y3Y2 Y1
Yx
Y-hat
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Inflation Shocks, Z
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Inflation Shocks, Z
• Types of Inflation Shocks
• Types of Inflation Shock
¾ Unfavorable (increases π)
¾ Favorable (reduces π)
• Higher imported goods and/or raw material prices
• Lower imported goods or raw material prices
¾ Especially oil
¾ Weaker currency
¾ Especially oil
¾ Stronger currency
• Reduced competitive pressures
• Increased competitive pressures
¾ Exogenous wage push
¾ Reduced globalization
¾ Increased regulation
¾ Globalization
¾ Decreased regulation
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5
Unfavorable Inflation Shock
Inflation Shocks and π Adjustment, 1
Yn
π
• Increase SAS, lower Y (relative to Yn),
increase π in the current time period.
¾ π adjustment DOES take place in the current
time period.
SAS0
π0
DAD0
Y0
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Inflation Shocks and π Adjustment, 2
Yn
π
Y
Inflation Shocks and π Adjustment, 3
Yn
π
π1
SAS1
π1
π2
SAS1
SAS2
π0
SAS0
π0
SAS0
DAD0
Y1
Y0
Y
DAD0
Y1 Y2
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Inflation Shocks and π Adjustment, 4
π
Yn
Y0
π
SAS1
SAS2
SAS3
π1
π2
π3
π0
SAS0
π0, πx
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Yn
SAS1
SAS2
SAS3
SAS0, SASx
DAD0
Y
Y
Inflation Shocks and π Adjustment, 5
π1
π2
π3
Y1Y2Y3Y0
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DAD0
35
Y1Y2Y3Y0
Yx
Y
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Major Point
DAD, SAS and π Adjustment
• The economy reaches Yn through the
repetition of p-dot adjustment year after
year.
• Summary of (Short-term) Effects
¾ Favorable DAD Shock
• Higher Y (relative to Yn) and π.
¾ Unfavorable DAD Shock
¾ Each year, conditions in the previous year
determine p-dot in the current year:
• Lower Y (relative to Yn) and π.
• Inflationary expectations and
• Excess/insufficient demand.
¾ Favorable SAS Shock
• Higher Y (relative to Yn) and lower π.
¾ Unfavorable SAS Shock
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Supply Shocks
• Lower Y (relative to Yn) and higher π.
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Supply Shocks and π Adjustment
π
• Supply shocks occur when there are
permanent shifts in
¾ Productivity
¾ Competitive pressures
• Supply shocks change Yn.
¾ Because Yn changes, the π adjustment process
is short-circuited.
¾ This results in permanently changed π.
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Yn1
Yn0
π1
SAS1
π0
SAS0
DAD0
Y1
Y0
Y
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Major Point
• The economy moves to its new Yn and results in a
permanent change in π without any change in
DAD.
• It is likely that the new Yn will be reached through
a repetition of π adjustment year after year.
¾ Each year, conditions in the previous year determine π
in the current year:
• Inflationary expectations and
• Excess/insufficient demand.
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