Inflation and Output

Inflation and Output

Jenny Xu, Department of Economics, SFU

chapter 15

PART 4The Economy in the Short Run

Principles of Macroeconomics, 2nd Canadian Edition Slide 15-2 Copyright © 2005 McGraw-Hill Ryerson Limited

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%


Why? Extending the Basic Keynesian and AD-AS Models

This chapter extends the basic Keynesian and AD-AS models to allow for price inflation and the reactions of Central Banks

We use the aggregate demand-inflation adjustment diagram to analyze the recessions of the early 1980s & 1990s

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?


Why the ADI curve are downward-sloping?

Because of Bank of Canada’s response to inflation rate π

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

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


FIGURE 15.2

An Example of a Bank of Canada Policy Reaction Function


Aggregate Demand and Inflation (π)

After 1973 – surge in inflation.

Central bank reaction function Increase in inflation (p) causes the bank to set a

higher real interest rate. Result: reduces both aggregate demand and short-

run equilibrium output.

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


Numerical Example of an Aggregate Demand (ADI) Curve


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


Changes in Autonomous Aggregate Spending

Autonomous planned aggregate expenditure The portion of PAE that is determined outside the

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

If households desire to consume more at the same 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


FIGURE 15.3

Effect of an Increase in Exogenous Spending

ADI

ADI’


Increase in Exogenous Spending - 1

C Autonomous consumption

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



T Net taxes

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



I Autonomous private-sector investment

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



G Government purchases

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



NX Net Exports

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


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 inflationThe 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 private-sector 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 private-

sector investment


A Tightening of Monetary PolicyFIGURE 15.4

ADI'

ADINew policyreactionfunction

Old policyreactionfunction


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

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 pricesLong-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


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.


A Virtuous Circle of Low Inflation and Low Expected InflationFIGURE 15.5


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;


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


The Aggregate Demand–Inflation Adjustment (ADI–IA) DiagramFIGURE 15.6

Long-run aggregate

supply LRAS

Aπ

Y Y*

Inflation adjustment IA

Aggregate demand ADI


Short-Run Equilibrium

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

Since, 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 short-run equilibrium output is demand determined Graphically, short-run equilibrium occurs at the

intersection of the AD curve and the IA curve


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


Suppose: No Output Gap

Y = Y* Actual output equals potential output

Firms are satisfied Sales equal normal production rates

• No unwanted accumulation of inventories• No unwanted depletion of inventories

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


Inflation and Recovery from a Recessionary Gap

If economy has a recessionary gap (Y<Y*) Elimination of gap occurs – given the reaction

function of the central bank!

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)


The Adjustment of Inflation When a Recessionary Gap ExistsFIGURE 15.7

LRAS

IA

IA'

ADI

A

B

π

π*

Y Y*


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


Inflation and Elimination of an Expansionary Gap

If Y > Y* - expansionary gap Elimination of gap implied by the central bank

reaction function

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*


The Adjustment of Inflation When an Expansionary Gap ExistsFIGURE 15.8

LRAS

π

π*

YY*

IA

AD

A

IA'B


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

A self-correcting policy mechanism Given enough time, output gaps tend to disappear

with the help of the central bank

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


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


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 Then the case for active stabilization is weaker

The BIG problems for policymaking in the real world are uncertainties in diagnosis & lags in policy impacts

Large gaps take longer to fix & have large costs Greater justification for policy intervention

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 ”.


War and Military Buildup as a Source of InflationFIGURE 15.9

π

Y*

LRAS

IA

ADI'ADI

B

A

π'

IAπ

Y* Y

ADI'

LRAS

B

A

IA'C

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

Y


Can central bank prevent the increase in inflation in this case?

Yes!

If the central can tighten the monetary policy- setting a higher real interest rate at any given level of inflation

This 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.


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


The Effects of an Adverse Inflation ShockFIGURE 15.10

π

Y′ Y*

π'

LRAS

IA'

IA

ADI

ADI'

A

B C

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.

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.


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.

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


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 macro-economy

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


The Effects of a Shock to Potential OutputFIGURE 15.11

π

Y*' Y*

π'

LRAS

IA'

IA

ADI

A

B

LRAS'Starting from

Long-run 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.


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


(b) FIGURE 15.4

A Tightening of Monetary Policy

ADI

ADI'

New policyreactionfunction

Old policyreactionfunction


The Short-Run and Long-Run Effects of a Monetary TighteningFIGURE 15.12

Y Y*

12% IA

C4% IA′

Y Y*

LRAS

B12%

ADI'

LRAS

BIA

ADI

ADI'

A

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)

Foreign trade effects accentuate impacts of monetary policy


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

Inflation and Output

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