Saturday, March 27, 2010

Demand Shocks and Accelerating Inflation

-An increase in consumption, investment, government expenditures, and net exports causes an increase in aggregate expenditure, a rightward shift in aggregate demand, and an increase in the equilibrium price level.

Aggregate demand will shift to the right as a result of this demand shock. Y is now greater than Y*, and thus we have an inflationary gap. however, wages adjust: excess demand for labour increases wages, which in turn increases firm costs. As a result, short run aggregate supply shifts to the left, and output returns to its original level, but at a higher price level. This is one-shot inflation. The price level is now at a higher equilibrium level, but since the demand shock is isolated, inflation will not be sustained.

Aggregate demand will shift to the right as a result of this supply shock. In response to this, SRAS shifts to the left due to wage adjustment. However, if the government tries to validate this change in supply by increasing the money supply (which lowers interest rates, and ultimately shifts AD to the right), this puts NEW INFLATIONARY PRESSURES on an economy: basically, the natural chain and anchor mechanism is fighting against government policy here, and the result is sustained inflation within an inflationary gap. The SRAS want to return output to Y*, but the government continues to artificially increase AD through monetary policy. As both AD and SRAS continue to shift right and left, respectively, the price level will continuously climb. =(


-We know that in most cases, demand shocks cause wage adjustment, and that if governments are not crafty, they may follow this up with monetary validation. If we look at this graphically, we can say that the inflation rate (the change in the price level divided by the original price level) could be graphically represented by the vertical distance between the original price point and the new price point.
-When AD and AS both shift up, the inflationary gap will persist.
-Graphically, we know that inflation is accelerating if the arrow between the price points gets longer and longer.

SO... two questions we need to answer are:

1) What creates persistent inflation (what causes inflation to hang around, instead of being a one-off)?

The answer: Validation


2) When is the inflation at a constant rate, and when is it at an accelerating rate (what causes inflation to get worse and worse)?

The answer: Expectations

-If the economy is running an inflationary gap caused by either increased aggregate demand (for an example, demand resulting from China's increased demand for raw materials) or increased aggregate supply (for an example, increase supply due to lower world prices of raw materials)...
-AND if the central bank wants to maintain the "good time" (aka: it uses monetary policy to validate this inflationary gap, and tries to keep the gap from being closed)...
-THEN, inflation will persist, and be accelerating.

In summary, if the BoC maintains a constant inflationary gap, then the actual inflation rate will persist and accelerate (the economy will continue to inflate at progressively larger rates over time).


1) EXPECTATION EFFECTS (remember, actual inflation is a combined result of gap inflation, expectation inflation, and supply shock inflation)
-An increase in aggregate demand causes an inflationary gap, and as we know, this ultimately causes prices to rise due to the wage change mechanism
-As a result, expectations are formed: workers demand that their wages rise at a similar rate over the next year to account for predicted inflation (for an example, let's say that they expect inflation to be 2%, then they will demand a 2% wage increase).
-If the BoC adds inflationary pressures by maintaining the gap, then this will create extra gap inflation of 2%, which stacks on top of the expectation inflation for a combined actual 4% rate of inflation.
-This overall 4% rate of inflation informs new expectations for the next year: workers will demand 4% wage increases, and those new expectation pressures stack onto persistent gap inflation for a total of 6% total inflation over the next year
-This continues on for quite a while, generating an inflationary spiral.

AS LONG AS THE BoC VALIDATES THE GAP, EXPECTATIONS ARE ALWAYS BEING REVISED UPWARDS (worker expect higher and higher inflation, and demand higher and higher wage increases). People come to expect this inflation, and build it into their wage demands.

-If the BoC wants to maintain output above Y*, it has to increase the rate of growth in the money supply.
-This is because the inflation rate is accelerating, and therefore, to accommodate for increase transaction demands due to higher prices, the BoC must accelerate the growth of money (basically, it must print a larger and larger quantity of money each year)
-This validation becomes more and more dramatic as time goes on

Let's summarize what we know!

We have an isolated shock ---> There will be no gap in the long run
We have have a repeated AS shock ---> There will be a persistent gap
We have a repeated AD shock ---> There will be a persistent gap

At Y*, persistent inflation will consist of only expectation inflation
With a Gap, there will be accelerating inflation, due to the gap inflation on top of expectation inflation

Cost push inflation from Y* lead to a recessionary gap
Demand pull inflation from Y* leads to an inflationary gap

AGAIN: Is monetary validation a good idea?
Yes, because monetary validation can eliminate recessions more quickly than simply letting "nature take its course"
No, because it causes inflation

Additionally, as we now know, monetary validation can create expected inflation to increase over time, creating a wage-price spiral. Some economists argue that the disadvantages of these increased expectations could be avoided if the BoC never validated gaps in the first place!

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