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29.2 Shocks and Policy Responses - Coggle Diagram
29.2 Shocks and Policy Responses
examining effects of AS and AD shocks and subsequent effects of policy responses chosen by Bank
; assumption in our macro model that AD and AS shocks
do not
influence level of Y*
Demand Shocks
demand inflation → inflation arising from an inflationary output gap, caused in turn, by a positive AD shock
assume Y* and that our starting point is a stable long-run equilibrium with constant real GDP and P; we THEN suppose equilibrium is disturbed by a rightward shift in AD curve → ↑P and ↑Y
No Monetary Validation
*temporary inflation occurs, but economy's adjustment process eventually restores
EXPLANATION
: ↑AD = Y>Y* → inflationary gap opening up; excess demand → ↑W → AS curve shifting upward; as long as Bank holds money supply constant, rise in P (price level) moves economy upward and to the left along new AD curve, reducing inflationary gap (excess supply → spending less BECAUSE what you are receiving is MORE than what you're asking for; e.g. $1 gets you 3 apples, so you don't spend $3 therefore you end up spending less) ; EVENTUALLY gap is eliminated but equilibrium is established at a higher but stable price level
Monetary Validation
usage of expansionary monetary policy to validate demand shock created by inflationary gap; NOT beneficial
EXPLANATION
: inflationary gap → ↑W → AS curve shifting upward, HOWEVER, expansionary monetary policy = AD curve shifting
further
right; RESULT = ↑Y and ↑P but Y
remains
>Y* = sustained inflation (bank would continually use monetary policy to control inflation gradually doing same mistake over and over...)
↑M → ↓i → ↑I/NX → ↑AE → ↑AD
↑C,I,G,NX → ↑AE → ↑AD → ↑Pe
Supply Shocks
Basic Information
supply inflation = inflation arising from a negative AS shock that is not the result of excess demand in domestic markets for factors of production
supply shock is a rise in costs of raw materials e.g. oil; rise in wages due to supply inflation = AS curve shifting upward
initial effects of any negative supply shock are that ↑P while ↓Y (also stagflation); two ways Bank can handle this →
money validation
and
no money validation
No Monetary Validation
major concern is the speed of wage adjustment
; if wages do not fall rapidly, adjustment back to Y* can take a long time; SUCH A CONCERN usually is motivation for Bank to validate negative supply shocks (expansionary monetary policy → kick to the system through AD curve)
upward shift in AS curve → opening recessionary gap; ↓W and the factor prices → U↓; AS curve shifts down → ↑Y while ↓P; RESULT = AS curve shifting slowly downward stopping when Y = Y
(return to Y
and initial P value)
UPSIDE
= one time temporary inflation;
DOWNSIDE
= labour mkt asymmetry → return to Y* SLOWLY
Monetary Validation
Bank's monetary expansion shifts AD curve to the right and closes output gap; recessionary gap eliminated → ↑P
further
, rather than falling back to its original value; RESULT = higher ↑P but faster return to Y*
known example was wake of first OPEC oil-price shock in 1974
UPSIDE
= Return to potential Y more QUICKLY;
DOWNSIDE
= one time temporary inflation from Po to P2
↑M → ↓i → ↑I/NX → ↑AE → ↑AD
Is Monetary Validation of Supply Shocks Desirable?
even though monetary validation sounds like a good policy, usage of such validation gives possibility of
extending
period of inflation; inflation leads firms and workers to expect
further
inflation → ↑W →AS curve will continue shifting upward; IF Bank continues monetary validation, AD curve will also continue shifting upward RESULTING in a
wage-price spiral
wage-price spiral can only be halted if Bank stops validating expectational inflation initially caused by supply shock
; HOWEVER, the longer it waits to do so, the more firmly held will be the expectations that it will continue its policy (Bank) of validating the shocks
THEREFORE, economists agree that the wage-price spiral should not be allowed to begin with and THEREFORE Bank should refuse to validate any supply shock and accept whatever recessionary gap the shock creates
Accelerating Inflation
What would be the result if the Bank acted to maintain output above Y*?
(based on the idea that some people think BOC should not tighten its monetary policy when inflation rises above Y*)
acceleration hypothesis → the hypothesis that when real GDP is held above Y*, the persistent inflationary gap will cause inflation to accelerate
according to acceleration hypothesis, as long as an inflationary output gap persists, expectations of inflation will be rising, which will lead to increases in the actual rate of inflation
If BOC maintains constant inflationary gap, THEN actual inflation rate will accelerate
EXPLANATION
: BOC may start by validating 2% inflation, but soon 2% will become expected, and given the demand pressure the inflation rate will rise (limited supply leads to ↑P) to 3% and, if Bank insists on validating 3%, the rate will become 4% and so on; to avoid this → BOC has adopted inflation target of 2% (something that is unchanging); THROUGH THAT, don't have to worry about demand pressure always going up from previous inflation rates
the importance of expectations in accelerating inflation is real, and here is an example why:
EXAMPLE
: suppose inflationary output gap creates sufficient excess demand to push up wages by 2% per year; AS curve will also tend to be shifting upward at 2% per year; the persistence of inflation will make people likely come to expect that inflation will continue expectation of 2% inflation will tend to push up wages by that amount
in addition
to the demand pressure; as output-gap effect on wages is augmented by expectational effect, AS curve will begin to shift upward more rapidly
EXAMPLE Pt.2
: when expectations are for a 2% inflation and demand pressure is
also
pushing up wages up by 2%, the overall effect will be a 4% increase in wages; SOONER OR LATER HOWEVER, 4% inflation will come to be expected, and expectational effect will rise to 4%; new expectational component of 4%, when aded to output-gap component of 2% will create inflation rate of 6%, and so forth...
If real GDP is held above potential Y (thus unemployment rate is held below NAIRU), the inflation rate tends to accelerate;
NAIRU is therefore the lowest level of sustained unemployment consistent with a
non-accelerating
rate of inflation**
The Phillips Curve and Inflation Expectations
Phillips Curve = inverse relation b/w unemployment rate u, and the rate of change of nominal (W*) wages W
; seen that lower levels of unemployment are attained at the cost of higher rates of inflation
In 1960's, when level of wage and price inflation began to rise for any level of Y →
Phillips Curve beginning to shift up
→ BECAUSE original Phillips Curve included Gap inflation but not Expectation inflation...
the importance of expectations
– in Phillips curve – can be shown by the
expectations-augmented Phillips curve (the relationship b/w unemployment and the rate of increase of nominal wages that arises when the output-gap and expectations components of inflation are combined)
; ALSO
combination of output-gap inflation and expectational inflation leads to the inflation rate associated with any given positive output gap rises over time → accelerating inflation
the long-run Phillips curve is a vertical line above UY (or Y
)
*Expected Inflation = height of curve above axis at potential Y or potential U
Inflation as a Monetary Phenomenon
Milton Friedman states → Inflation is
always
and everywhere a monetary phenomenon
Are the
causes
of inflation monetary?
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
first two points tell us that a temporary burst of inflation doesn't need a monetary phenomenon; third point tells us
sustained
inflation
must
be accompanied by a monetary policy that allows money supply to continually increase ((expansionary monetary policy → ↑M → ↑P → ↑inflation?)
Are the
consequences
of inflation monetary?
1) In the short run, demand inflation tends to be accompanied by an increase in real GDP above its potential level.
2) In the short run, supply inflation tends to be accompanied by a decrease in real GDP below its potential level.
3) When all costs and prices are adjusted fully and real GDP has returned to its potential level, the only long-run effect of AD or AS shocks is a change in the price level
first two points tells us that inflation is not, in the short run, a purely monetary phenomenon b/c there are real consequences; the third point tells us that inflation is a monetary phenomenon from pov of long-run equilibrium
Important conclusions
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.
MODIFYING FRIEDMAN'S STATEMENT →
While AD and AS shocks may lead to temporary inflation even in the absence of any actions by the central bank,
sustained
inflation can occur only if there is continual monetary validation by the central bank;
sustained* inflation is always and everywhere caused by sustained monetary expansion