ECON203 Final Exam Study Notes
(Chapters 14, 15, 16, 19 Overview)
Introduction to Macroeconomics (Concordia University)
, ECON203
Chapter 14 Inflation and Disinflation
14.1 Adding Inflation to the Model
Why Wages Change: Wages and the Output Gap
1. The excess demand for labour that is associated with an inflationary gap (Y > Y*)
puts upward pressure on nominal wages.
2. The excess supply of labour associated with a recessionary gap (Y < Y*) puts
downward pressure on nominal wages, though the adjustment may be quite slow.
3. The absence of either an inflationary or a recessionary gap (Y = Y*) implies that
demand forces are not exerting any pressure on nominal wages.
Wages and the Output Gap
When real GDP is equal to Y*, the unemployment rate is equal to the NAIRU, which
stands for the nonaccelerating inflation rate of unemployment.
When real GDP exceeds potential GDP (Y > Y*), the unemployment rate will be less than
the NAIRU (U< U*). There is an inflationary gap characterized by excess demand for
labour, and nominal wages tend to rise.
When real GDP is less than potential GDP (Y< Y*), the unemployment rate will exceed
the NAIRU (U> U*). There is a recessionary gap characterized by excess supply of
labour, and nominal wages tend to fall.
If the Bank of Canada underestimates the unemployment rate associated with the
potential GDP, which is the definition of NAIRU, then it would inaccurately conclude that
there is a recessionary gap in the economy. In trying to close the perceived recessionary
gap, the policies implemented by the Bank would push the economy into an inflationary
gap.
If the NAIRU is higher than the actual unemployment rate, then the economy would be
experiencing an inflationary output gap. Excess demand for labour will cause nominal
wages to rise; this is the output-gap effect.
Wages and Expected Inflation
, The expectation of some specific inflation rate creates pressure for nominal wages to
rise by that rate.
Overall Effect on Wages:
From Wages to Prices
The net effect of the two macro forces acting on wages ‒ output gaps and inflation
expectations ‒ determines what happens to the AS curve.
The best example of a non-wage supply shock is a change in the prices of materials
used as inputs in production.
Constant Inflation
If inflation and monetary policy have been unchanged for several years, the expected
rate of inflation will tend to equal the actual rate of inflation.
In the absence of supply shocks, if expected inflation equals actual inflation, real GDP
must be equal to potential GDP.
Constant inflation with Y = Y* occurs when the rate of monetary expansion, the rate of
wage increase, and the expected rate of inflation are all consistent with the actual
inflation rate.
To have a sustained and constant level of inflation, the AD curve has to shift to the right at
the same rate as the AS curve shifts to the left. If both curves are not shifting at the same
rate, then the level of inflation will not be constant.
Applying Economic Concepts 14-1 ‒ discusses deflation, the reasons that some
people seem to fear its effect on the economy, and why these fears may be misplaced.
, When inflation is low and relatively stable, firms and consumers build it into their
expectations, central banks build it into their policy decisions, and the economy can
operate with real GDP equal to potential output.
Constant Inflation with No Supply Shocks
Wage costs are rising because of expectations of inflation, and these expectations are
being validated by the central bank’s policy. Real GDP remains at Y*.
14.2 Shocks and Policy Responses
Demand inflation is inflation arising from an inflationary output gap caused, in turn, by
a positive AD shock.
A demand shock that is not validated produces temporary inflation.
The shift in the AD curve could have been caused by a reduction in tax rates; by an
increase in such autonomous expenditure items as investment, government, and net
exports; or by an expansionary monetary policy.
(Chapters 14, 15, 16, 19 Overview)
Introduction to Macroeconomics (Concordia University)
, ECON203
Chapter 14 Inflation and Disinflation
14.1 Adding Inflation to the Model
Why Wages Change: Wages and the Output Gap
1. The excess demand for labour that is associated with an inflationary gap (Y > Y*)
puts upward pressure on nominal wages.
2. The excess supply of labour associated with a recessionary gap (Y < Y*) puts
downward pressure on nominal wages, though the adjustment may be quite slow.
3. The absence of either an inflationary or a recessionary gap (Y = Y*) implies that
demand forces are not exerting any pressure on nominal wages.
Wages and the Output Gap
When real GDP is equal to Y*, the unemployment rate is equal to the NAIRU, which
stands for the nonaccelerating inflation rate of unemployment.
When real GDP exceeds potential GDP (Y > Y*), the unemployment rate will be less than
the NAIRU (U< U*). There is an inflationary gap characterized by excess demand for
labour, and nominal wages tend to rise.
When real GDP is less than potential GDP (Y< Y*), the unemployment rate will exceed
the NAIRU (U> U*). There is a recessionary gap characterized by excess supply of
labour, and nominal wages tend to fall.
If the Bank of Canada underestimates the unemployment rate associated with the
potential GDP, which is the definition of NAIRU, then it would inaccurately conclude that
there is a recessionary gap in the economy. In trying to close the perceived recessionary
gap, the policies implemented by the Bank would push the economy into an inflationary
gap.
If the NAIRU is higher than the actual unemployment rate, then the economy would be
experiencing an inflationary output gap. Excess demand for labour will cause nominal
wages to rise; this is the output-gap effect.
Wages and Expected Inflation
, The expectation of some specific inflation rate creates pressure for nominal wages to
rise by that rate.
Overall Effect on Wages:
From Wages to Prices
The net effect of the two macro forces acting on wages ‒ output gaps and inflation
expectations ‒ determines what happens to the AS curve.
The best example of a non-wage supply shock is a change in the prices of materials
used as inputs in production.
Constant Inflation
If inflation and monetary policy have been unchanged for several years, the expected
rate of inflation will tend to equal the actual rate of inflation.
In the absence of supply shocks, if expected inflation equals actual inflation, real GDP
must be equal to potential GDP.
Constant inflation with Y = Y* occurs when the rate of monetary expansion, the rate of
wage increase, and the expected rate of inflation are all consistent with the actual
inflation rate.
To have a sustained and constant level of inflation, the AD curve has to shift to the right at
the same rate as the AS curve shifts to the left. If both curves are not shifting at the same
rate, then the level of inflation will not be constant.
Applying Economic Concepts 14-1 ‒ discusses deflation, the reasons that some
people seem to fear its effect on the economy, and why these fears may be misplaced.
, When inflation is low and relatively stable, firms and consumers build it into their
expectations, central banks build it into their policy decisions, and the economy can
operate with real GDP equal to potential output.
Constant Inflation with No Supply Shocks
Wage costs are rising because of expectations of inflation, and these expectations are
being validated by the central bank’s policy. Real GDP remains at Y*.
14.2 Shocks and Policy Responses
Demand inflation is inflation arising from an inflationary output gap caused, in turn, by
a positive AD shock.
A demand shock that is not validated produces temporary inflation.
The shift in the AD curve could have been caused by a reduction in tax rates; by an
increase in such autonomous expenditure items as investment, government, and net
exports; or by an expansionary monetary policy.
