Chap 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).

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.

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.

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.

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.

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.