Chapter14 F2023

Ragan: Macroeconomics
Seventeenth Canadian Edition
Chapter 14
Inflation and Disinflation
Copyright © 2023 Pearson Canada Inc. 14 - 1

Chapter Outline/Learning Objectives
Section Learning Objectives

After studying this chapter, you will be able to
14.1 Adding Inflation 1. understand why wages tend to change in response
to the Model to both output gaps and inflation expectations.
2. describe how a constant rate of inflation can be
incorporated into the basic macroeconomic model.
14.2 Shocks and Policy 3. explain how AD and AS shocks affect inflation and
Responses real GDP.
4. explain what happens when the Bank of Canada
validates demand and supply shocks.
14.3 Reducing Inflation 5. understand the three phases of a disinflation.

6. explain how the cost of disinflation can be measured
by the sacrifice ratio.
Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 2

Fig. 14-1 Canadian CPI Inflation, 1965–2020

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 non-accelerating inflation rate of
unemployment.
So when Y > Y *, U < U*, and when Y < Y *, U > U*.
Nominal wage rates react to various pressures of demand.

These demand pressures can be stated either in terms of the
relationship between actual and potential GDP or in terms of the
relationship between the actual unemployment rate and the NAIRU.

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
Change in Output-gap Expectational

= +
Money Wages Effect Effect

Change in = Output-gap + Expectational
Money Wages Effect Effect
How do people form their expectations?

• forward-looking?
• backward-looking?
• a combination of both?

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.
Supply
Actual Expected
= Output-gap + + Shock
Inflation Inflation Inflation Inflation
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 has been constant for several years and there is no

indication of an impending change in monetary policy:
è expected inflation will equal actual inflation
If expected inflation equals actual inflation:
è Y must equal Y* è no output gap
But if there is no output gap, what is causing the inflation?

Constant Inflation
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.

Fig. 14-2 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
Fig. 14-3 A Demand Shock with
Demand Shocks No Validation
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.

Demand Shocks
Fig. 14-4 A Demand Shock with
Monetary validation of a Validation
positive demand shock
causes the AD curve to shift
further to the right,
offsetting the upward shift
in the AS curve.
Continued validation of a
demand shock turns what
would have been transitory
inflation into sustained
inflation fueled by monetary
expansion.
Accelerating Inflation
What would happen if the Bank acted to maintain output above Y*?
What happens is predicted by the acceleration hypothesis, which

states that when real GDP is held above potential, the persistent
inflationary gap will cause inflation to accelerate.

Supply Shocks
Fig. 29-5 A Supply Shock with and
Supply inflation is inflation without Validation
arising from a negative AS
shock that is not the result
of excess demand in the
domestic markets for factors
of production.
With no monetary
validation, the reduction in
wages and other factor
prices make the AS curve
shift slowly back down to
AS0.
Supply Shocks
Fig. 29-5 A Supply Shock with and
With monetary validation, without Validation
the AD curve shifts from AD0
to AD1.
The result is a higher price

level but a much faster return
to potential output than
would occur if the
recessionary gap were relied
on to reduce wages and other
factor prices.

Supply Shocks
Fig. 30-5 A Supply Shock with
Monetary validation of a and without Validation
negative AS shock causes
the initial rise in P to be
followed by a further rise.
One potential danger of

validation:
• a wage-price spiral
could be created

Inflation as a Monetary Phenomenon
The causes of inflation are:
1. Anything that shifts the AD curve to the right will cause the
price level to rise (demand inflation).
2. Anything that shifts the AS curve upward will cause the price
level to rise (supply inflation).
3. Increases in the price level caused by AD and AS shocks will
eventually come to a halt unless they are continually
validated by monetary policy.
Sustained inflation must be a monetary phenomenon.

Conclusions about inflation are:
1. Without monetary validation, positive demand shocks cause

inflationary output gaps and a temporary burst of inflation.
The gaps are removed as rising factor prices push the AS

curve upward, returning real GDP to its potential level but at a
higher price level.

2. Without monetary validation, negative supply shocks cause

recessionary output gaps and a temporary burst of inflation.
The gaps are eventually removed when factor prices fall

sufficiently to restore real GDP to its potential and the price
level to its initial level.

3. Only with continuing monetary validation can inflation

initiated by either supply or demand shocks continue
indefinitely.
Sustained inflation is everywhere and always caused by sustained

monetary expansion.

14.3 Reducing Inflation
The Process of Disinflation
Reducing inflation is often costly
• lost output and unemployment
Expectations can cause inflation to persist even after its original

causes have been removed.
Crucial factor:
• how quickly inflation expectations are revised

Canada has had two notable periods of disinflation:
1.1981-1982, when inflation fell from more than 12 percent to 4
percent
2.1990-1992, when inflation fell from 6 percent to less than 2 percent

Phase 1: Removing Monetary Validation
Fig. 30-6(i) Eliminating a Sustained Inflation

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
Phase 2: Stagflation
Fig. 30-6(ii) Eliminating a Sustained Inflation
Stagflation caused by
continued shifts in AS
curve:
• slow-to-adjust
expectations
• wage momentum

Phase 3: Recovery
Fig. 30-6(iii) Eliminating a Eventually, recovery

Sustained Inflation takes output to Y*,
and P is stabilized:
• Either wages fall,

bringing the AS3
curve back to AS2.
• Or the central
bank increases the
money supply
sufficiently
to shift the AD
curve to AD2.
The Cost of Disinflation
Fig. 29-7 The Cost of Disinflation: The Sacrifice Ratio
The sacrifice ratio is the
cumulative loss in real
GDP, expressed as a
percentage of potential
output, divided by the
percentage-point
reduction in the rate of
inflation.
Suppose this cumulative
loss is 10% of Y*and
inflation fell by 4
percentage points. The
sacrifice ratio is
10/4 = 2.5.
Exercise 10 chapter 30
What is the relationship between the sacrifice ratio and the central bank’s
credibility?
a.Explain why a more credible policy of disinflation reduces the costs of

disinflation.
b.Explain how you think that the Bank of Canada might be able to make its
disinflation policy more credible.
c.Can the Bank’s policy responses to negative supply shocks influence the
credibility it is likely to have trying to end a sustained inflation?

Exercise 11 chapter 30
In the summer of 2006, a time when US inflation was rising and output was above
potential, a story in The Globe and Mail reported that the release of strong
employment-growth data for the United States led to a plunge in prices on the US
stock market.
a. Explain why a high employment growth would lead people to expect the US
central bank to tighten its monetary policy.
b. Explain why higher US interest rates would lead to lower prices of US stocks.
c. How would you expect this announcement to affect Canada?

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Chapter14 F2023

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Ragan: Macroeconomics

Seventeenth Canadian Edition

Copyright © 2023 Pearson Canada Inc. 14 - 1

Section Learning Objectives

14.3 Reducing Inflation 5. understand the three phases of a disinflation.

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 2

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 3

Why Wages Change

2. The excess supply of labour associated with a recessionary gap

3. The absence of either an inflationary or a recessionary gap

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 4

So when Y > Y *, U < U*, and when Y < Y *, U > U*.

Nominal wage rates react to various pressures of demand.

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 5

The expectation of some specific inflation rate creates pressure for

Overall Effect on Wages

Change in Output-gap Expectational

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 6

How do people form their expectations?

Copyright © 2014 Pearson Canada Inc. Chapter 30, Slide 7

The best example of a non-wage supply shock is a change in the

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 8

If inflation has been constant for several years and there is no

è expected inflation will equal actual inflation

If expected inflation equals actual inflation:

è Y must equal Y* è no output gap

But if there is no output gap, what is causing the inflation?

Copyright © 2014 Pearson Canada Inc. Chapter 30, Slide 9

Constant inflation with Y = Y* occurs when the rate of monetary

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 10

Wage costs are rising because of expectations of inflation, and these

A demand shock that

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 12

What happens is predicted by the acceleration hypothesis, which

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 14

The result is a higher price

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 16

One potential danger of

Copyright © 2014 Pearson Canada Inc. Chapter 30, Slide 17

The causes of inflation are:

Sustained inflation must be a monetary phenomenon.

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 18

Conclusions about inflation are:

1. Without monetary validation, positive demand shocks cause

The gaps are removed as rising factor prices push the AS

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 19

Conclusions about inflation are:

2. Without monetary validation, negative supply shocks cause

The gaps are eventually removed when factor prices fall

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 20

Conclusions about inflation are:

3. Only with continuing monetary validation can inflation

Sustained inflation is everywhere and always caused by sustained

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 21

The Process of Disinflation

Reducing inflation is often costly

• lost output and unemployment

Expectations can cause inflation to persist even after its original

• how quickly inflation expectations are revised

Copyright © 2014 Pearson Canada Inc. Chapter 30, Slide 22

Copyright © 2017 Pearson Canada Inc. Chapter 29, Slide 23

Fig. 30-6(i) Eliminating a Sustained Inflation

Starting at E1, suppose

So when Y > Y , U < U, and when Y < Y , U > U.