Chapter 8
Inflation: Its
Causes and
Cures
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Definition: Inflation
• Inflation is a sustained upward movement in the
aggregate price level that is shared by most
products.
– The price level is notated P
– Inflation is notated p = %∆P
• The Core Inflation Rate is the inflation rate for all
products and services other than food and energy.
– The Federal Reserve target core inflation rate is about
2%.
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The Output Ratio and Inflation
• The Output Ratio is the ratio of actual real GDP to natural
real GDP (i.e. Y/YN ).
– If Y/YN = 100%, p is constant
– If Y/YN > 100%, p is accelerating
– If Y/YN < 100%, p is decelerating
• What affects the output ratio?
– A Demand Shock is a sustained acceleration or deceleration in
AD, measured most directly as a sustained acceleration or
deceleration in the growth of nominal GDP.
– A Supply Shock is caused by a sharp change in the price of an
important commodity (e.g. oil) that causes the inflation rate to rise
or fall in the absence of demand shocks.
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Figure 8-1 The Inflation Rate and
the Output Ratio, 1960–2007
Sources: Bureau of Economic Analysis NIPA Tables and research by Robert J. Gordon. Details in Appendix C-4.
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Temporary vs. Continuous Inflation
• A one-shot increase in AD will cause only
temporary inflation as the output ratio rises
above 100% and pushes up wages causing
the SAS curve to shift back.
• A continuous increase in AD can
potentially cause continued inflation as
wages rise (shifting back the SAS curve)
together with continued shifts to the right of
the AD curve.
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The Phillips Curve
• The Short-Run Phillips (SP) Curve is the schedule
relating the inflation rate and real GDP given a fixed
expected rate of inflation.
– The Expected Rate of Inflation (pe) is the rate of inflation that is
expected to occur in the future.
– The SP Curve is also known as the Expectations-Augmented
Phillips Curve because it shifts its position whenever there is a
change in the expected rate of inflation.
• The Long-Run Phillips (LP) Curve gives the output ratio
when inflation is accurately anticipated (i.e. pe = p).
– Since prices and wages are perfectly flexible in the long-run, the LP
curve is a vertical line at Y/YN = 100%.
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Figure 8-2 Relationship of the Short-Run
Aggregate Supply (SAS) Curve to the ShortRun Phillips (SP) Curve
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Figure 8-3 Effect on the Short-Run Phillips
Curve of an Increase in the Expected
Inflation Rate (pe) from Zero to 3 Percent
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Nominal GDP Growth and
Inflation
• Recall: Nominal GDP (X) is related to the price level (P)
and real GDP (Y) as follows:
X = PY
(Note: Lower case letters represent the growth rates of the same variables)
• When is the economy at a long-run equilibrium?
– It must be operating on the SP curve.
– Inflation must equal the growth rate of nominal GDP:
x = p  real GDP growth = 0
(Or if y > 0  x = p + y)
– The economy must be on the LP line with pe = p.
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Table 8-1 Alternative Divisions of 6 Percent
Nominal GDP Growth Between Inflation and
Real GDP Growth
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Figure 8-4 The Adjustment Path of Inflation and the
Output Ratio to an Acceleration of Nominal GDP
Growth from Zero to 6 Percent When Expectations
Fail to Adjust
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Figure 8-5 Effect on Inflation and Real GDP
of an Acceleration of Demand Growth from
Zero to 6 Percent
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Different Types of Expectations
• The speed of adjustment of inflation expectations
affects how long Y can be pushed beyond YN.
• 3 Types of Expectations
– Forward-looking Expectations attempt to predict
the future behavior of an economic variable using
economic models.
– Backward-looking Expectations use only
information on the past behavior of economic
variables.
– Adaptive Expectations base expectations for next
period’s values on an average of actual values during
previous periods.
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The Cure for Inflation:
Recession
• Theoretically, if an increase in nominal GDP causes
inflation, then a recession should do the opposite.
– Disinflation is a marked deceleration in the
inflation rate.
• How can disinflation be achieved?
– The “Cold Turkey” approach to disinflation operates by
implementing a sudden and permanent slowdown in nominal GDP
growth.
• The cost of disinflation is measured by the Sacrifice Ratio,
which is the cumulative loss of output incurred during a
disinflation divided by the permanent reduction in the
inflation rate.
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Figure 8-6 Initial Effect on Inflation and Real
GDP of a Slowdown in Nominal GDP Growth
from 10 Percent to 4 Percent
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Figure 8-7 Adjustment Path of Inflation and Real
GDP to a Policy That Cuts Nominal GDP Growth
from 10 Percent in 1980 to 4 Percent in 1981 and
Thereafter
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International Perspective: Did
Disinflation in Europe Differ from
That in the United States?
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Figure 8-8 Four-Quarter Growth Rate of the
GDP Deflator and the Level of Nominal and
Real Oil Prices, 1970–2007
Sources: Top frame: Bureau of
Economic Analysis NIPA Tables.
Details in Appendix C-4. Bottom
frame: Energy Information
Administration Monthly Energy
Review. Details in Appendix C-4.
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Demand vs. Supply Inflation
• Demand Inflation is a sustained increase in
prices that is preceded by a permanent
acceleration of nominal GDP growth.
• Supply Inflation is an increase in prices
that stems from an increase in business
costs not directly related to prior
acceleration of nominal GDP growth.
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Types of Supply Shocks
• Changes in business input costs (like Poil)
• Weather shocks that affect farm prices
• Import price shocks due to fluctuating
exchange rates
– If the value of the dollar falls, imported goods
become more expensive.
• Productivity growth shocks that change
the amount workers can produce
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Figure 8-9 The Effect on the Inflation Rate
and the Output Ratio of an Adverse Supply
Shock That Shifts the SP Curve Upward by 3
Percent
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Policy Responses to Supply
Shocks
• Following a supply shock, there are three possible
policy responses:
– A Neutral Policy maintains nominal GDP growth so as
to allow a decline in the output ratio equal to the
increase in the inflation rate.
– An Accommodating Policy raises nominal GDP
growth so as to maintain the original output ratio.
– An Extinguishing Policy reduces nominal GDP growth
so as to maintain the original inflation rate.
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Figure 8-10 Effect of Adverse Supply Shock
in the 1970s and Beneficial Supply Shocks
in the 1990s
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Figure 8-11 Responses of the Inflation Rate
(p) and the Output Ratio (Y/YN) to Shifts in
Nominal GDP Growth and in the SP Curve
(1 of 2)
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Figure 8-11 Responses of the Inflation Rate
(p) and the Output Ratio (Y/YN) to Shifts in
Nominal GDP Growth and in the SP Curve
(2 of 2)
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Figure 8-12 The U.S. Ratio of Actual to
Natural Real GDP (Y/YN) and the
Unemployment Rate, 1965–2007
Sources: Appendix Table A-1. Bureau of Labor Statistics, Bureau of Economic Analysis, and research by Robert J. Gordon. Details in Appendix C-4.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
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Figure 8-13 The Unemployment Rate
and the Inflation Rate, 1960–2007
Source: Bureau of Labor Statistics and Bureau of Economic Analysis NIPA Tables. Details in Appendix C-4.
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Figure 8-14
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Figure 8-15
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Chapter Equations
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Chapter Equations
X  PY
x p y
y  x p
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(8.1)
(8.2)
(8.3)
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Appendix Equations
General Linear Form
Numerical Example
p  p e  gY  z
p  p e  0.5Y
General Linear Form
Numerical Example
p  jp1  (1  j ) pe1
p e  pe1
General Linear Form
Numerical Example
p  p e  gY  z
p  p e  0.5Y
(1)
(2)
(3)
x p y
(4)
x  yN  p  y  yN
(5)
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Appendix Equations
x  p  Y  Y 1
(6)
Y  Y 1  x  p
(7)
p  jp1  (1  j ) pe1  g (Y 1  x  p )  z (8)
General Linear Form
Numerical Example




1 
2
e

p
jp1  1  j  p1  g Y 1  x  z p 
p1  0.5 Y 1  x 


1 g 
3
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(9)
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Appendix Equations


1  e
p
p1  g Y 1  x  z 

1 g 
General Linear Form
Numerical Example
U  U N  hY
U  U N  0.5Y
General Linear Form
Numerical Example
U  U 1  h  y  y N 
U  U 1  0.5  y  y N 
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
(10)
(11)
(12)
8-34