Chap 14: Inflation and Disinflation

Chapter 14: Inflation and Disinflation

• Overview
  • The chapter discusses the concepts of inflation and disinflation, focusing on how sustained inflation can occur in an economy.
  • Emphasizes the role of expectations in the initiation and maintenance of inflation.
  • Integrates concepts of monetary policy, particularly inflation targeting, while skipping certain sections not included in the final exam (Section 14.2 and 14.3).

14.1 Adding Inflation to the Model

• Long-run Equilibrium

  • In theory, no inflation exists in the long-run equilibrium.
  • For inflation to manifest, the economy must be undergoing an adjustment process.
  • Constant (and often detrimental) inflation typically originates from supply-side factors.

• Impact of Wages on Prices

  • Labour is a crucial production factor affecting costs.
  • Changes in overall nominal wages can shift the Aggregate Supply (AS) curve.

Wages and the Output Gap

• Concept of Potential Output vs. Real GDP

  • When real GDP ($Y$) equals potential output ($Y^*$), production factors are fully employed.
  • Remaining unemployment (U) is structural or frictional and is referred to as the non-accelerating inflation rate of unemployment (NAIRU), denoted as $U^*$.
  • Key conditions:
  • For $Y < Y^$, $U > U^$ leads to a recessionary gap ($w
    ightarrow$ decrease).
  • For $Y > Y^$, $U < U^$ leads to an inflationary gap ($w
    ightarrow$ increase).

• Wages and Expected Inflation

  • Expectations regarding future inflation can trigger wage increases, resulting in actual inflation—a self-fulfilling prophecy.

Expectations and Inflation

• Types of Expectations
  • Backward-looking expectation: Belief that past trends will repeat, leading to inflation based on historical data.
  • Forward-looking expectation: Proactive mindset focusing on future possibilities, motivating present decisions.
  • Rational individuals should ideally form expectations in a forward-looking manner while learning from past experiences.

Constant Inflation

• Definition

  • Referring to a scenario where the inflation rate remains steady (e.g., 2%) over time, accompanied by wage increases.

• Graphical Representation

  • In the AD-AS diagram, if there are no fiscal policy changes or supply shocks, and $Y = Y^*$, the price level can consistently increase at a constant rate.

• Implications of Constant Inflation

  • Requires ongoing monetary expansion by the central bank to keep shifting the AD curve (termed monetary validation).
  • Recognizes inflation primarily as a monetary phenomenon.
  • Highlights that continuing monetary validation allows inflation to persist indefinitely, but this doesn't address hyperinflation scenarios.

13.2 Inflation Targeting

• Rationale Behind Targeting Inflation
  • High, unpredictable inflation is costly, while deflation poses significant risks.
  • Monetary policy is crucial in managing sustained inflation.
  • It’s essential to review Chapters 12 and 13 to understand the instruments used to achieve inflation targets.