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Inflation and
Disinflation
2. Expected Inflation
- some workers/firms raise wages in advance of inflation
For example:
- forward-looking?
- backward-looking?
- a combination of both?
Supply-
Actual Expected
= Output-gap + + shock
inflation inflation inflation inflation
Constant inflation
with Y=Y* occurs
when the rate of
monetary growth,
the rate of wage
increase, and
expected inflation
are all consistent
with the actual
inflation rate.
Demand Shocks
Continued validation
turns a transitory inflation
into sustained inflation.
Supply Shocks
If wages fall only
slowly (when Y<Y*),
the return to Y* after
a non-validated
negative supply
shock will be slow.
Monetary validation of
a negative AS shock
causes the initial rise in
P to be followed by a
further rise.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 30-12
Is Monetary Validation of Supply
Shocks Desirable?
But the longer it waits to do so, the more firmly held will be
the expectations that it will continue its policy of validating
the shocks.
Question:
What happens to inflation if the central bank tries to maintain
an inflationary gap through continued monetary validation?
Answer:
Inflation will accelerate.
Crucial factor:
- how quickly inflation expectations are revised
Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 30-20
Figure 30.6 Eliminating a
Sustained Inflation
Phase 1: Removing
Monetary Validation
Begin with a reduction
in the rate of monetary
expansion.
Starting at E1,
suppose the central
bank stops increasing
the money supply.
The AD curve stops shifting
- but inflation expectations keep AS curve shifting
Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 30-21
Phase 2: Stagflation
Stagflation caused by
continued shifts in AS
curve:
- slow-to-adjust
expectations
-wage momentum
Eventually, recovery
takes output to Y*, and P
is stabilized:
Either wages fall,
bringing the AS curve
back to AS2 …
…or the central bank
increases the money
supply sufficiently to shift
the AD curve to AD2.