-If a change in money wages is positive (wages increase), short run aggregate supply will decrease (it shifts to the left due to increased costs). This causes prices to rise, and the overall effect is inflationary
-If an change in money wages is negative (wages decrease), short run aggregate supply will increase (it shifts to the right due to lowered costs). This causes prices to fall, and the overall effect is deflationary.
Wages up --> Costs up ---> SRAS shifts left --> Equilibrium price level rises
Okay... so so far, we've talked about two causes of inflation: gap effects and worker expectations. There is, however, a third cause of inflationary pressures: AN EXOGENOUS SUPPLY SHOCK (for an example, a change in the price of raw materials, such as oil, can increase the general price level, which is why vegetables can start to cost more when the price of oil goes up).
SOOO
ACTUAL INFLATION IS A COMBINATION OF:
1: GAP INFLATION
2: EXPECTATION INFLATION
3: SUPPLY SHCOK INFLATION (even though that's a bit of an afterthought)
------------------------------------------
Next, we're going to talk about the difference between sustained/constant inflation and accelerating inflation.
CONSTANT/SUSTAINED INFLATION
-Here, we assume that there is no supply shock, and no output gaps
-As such, the ONLY cause for inflation when there is sustained inflation, is expectations
-This kind of inflation occurs when Y is equal to Y*
Let's summarize: constant inflation occurs when...
-There is no gap inflation
-There is no supply shock inflation
-Monetary growth is equal to the rate that wages increase at
-Actual inflation is equal to expected inflation
HOW IT WORKS:
1: Worker expectations trigger constant inflation (expectations cause workers to demand higher wages, which then causes SRAS to shift to the left)
2: The BoC validates the price increase by increase the money supply
SO.... let's say that we start off with expectation inflation at 2%. Workers anticipate future increases of 2% in the price level, so they demand higher wages, which causes SRAS to shift to the left as money wages rise. When the government validates this increase, they increase the money supply, which shifts SRAD to the right. Because of the way that this mechanism works, the price level will rise at the exact same rate as is predicted (because expectations are what catalyze the change). Actual inflation is equal to expected inflation, and output remains at Y*. THIS IS CONTINUOUS INFLATION AT A CONSTANT RATE.
NOTE* This isn't expansionary monetary policy- the BoC is not reducing the overnight target rate here- interest rates aren't affect by this. The BoC is merely accommodating for the growing demand for money by steadily increasing the nominal money supply. As such, the real money supply remains constant (so the ratio of money in the economy and the average price of products remains the same).
INFLATIONARY SUPPLY SHOCKS (negative supply shocks which temporarily inflate prices)
-Remember, in all cases of inflation, the price level rises to a new equilibrium level. In temporary inflationary situations, the price will simply remain at the new level, whereas in cases of persistent inflation, the equilibrium price level will continue to rise.
Inflationary supply shocks are caused by increased cost of productive inputs (for an example, an increase in the price of oil). This, in turn, causes costs to rise, which shifts SRAS to the left, and increases the price level while decreasing output.
BUT... as we know from previous chapters, this change is NOT permanent. Eventually, the higher unemployment which accompanies the supply-shock-recession puts downward pressures on wages, eventually causing them to fall. As a result of these wage-related cost savings to firms, the short run aggregate supply will shift back to its original level: costs will be the same as they once were, even though workers are being paid less. As SRAS shifts to the right, the price level and output level both shift back to what they were originally. SO, WE CAN CONCLUDE THAT INFLATIONARY SUPPLY SHOCKS ONLY CAUSE INFLATION IN THE SHORT RUN, AND THAT THERE IS NO SUSTAINED INFLATION HERE.
OKAY.. BUT WHAT HAPPENS WHEN WE HAVE AN ISOLATED SUPPLY SHOCK WHICH IS MONETARILY VALIDATED BY THE BoC?
Well, we start out at macroeconomic equilibrium, and then we shift SRAS to the left. This increases the price level and decreases the output level. After this, if the government tries to correct this recessionary gap by increasing the money supply (the money supply increases, which lowers interest rates, which increases investment and net exports, which drives aggregate expenditure up and shifts aggregate demand to the right), aggregate demand will shift to the right, which will bring output back to its equilibrium level, but at a higher general price level. As such, there will be more inflation than if the government does not intervene, but prices will still settle at the new equilibrium level, and inflation will not be persistant.
OKAY... BUT WHAT HAPPENS WHEN WE HAVE REPEATED SUPPLY SHOCKS WITHOUT MONETARY VALIDATION?
For an example, lets say we have cost push inflation, which occurs due to repeated increases in firms' costs. What happens then? Well, either the economy will stabilize at a higher price level and a smaller output level, OR persistent unemployment will erode the power of unions, causing monetary wages to fall, and bringing short run aggregate supply back to its original levels.
OKAY... BUT WHAT HAPPENS WHEN WE HAVE REPEATED SUPPLY SHOCKS WHICH ARE VALIDATED BY THE GOVERNMENT?
Well, then economies can enter into an inflationary spiral. For an example, if unions consistently negotiate to increase their monetary wages, and the government consistently validates this decrease in SRAS by printing more money, then an economy will experience consistent inflation (albeit, often the wage increases are very small, so inflation persists at a small but constant level). Basically, monetary validation reinforces price increases and offsets the natural tendency of Ye to return to Y* on its own, hence sustained inflation.
So.... is monetary validation of supply shocks desirable or undesirable? Yes and No!
No, because the BoC should allow for unemployment, which will eventually eliminate the output gap through the natural chain and anchor process.
Yes, because nations can avoid severe (albeit temporary) recessions by using monetary validation (although this comes at the cost of creating higher prices)
So its sort of a dilemma: governments must choose between long stretches of unemployment (no validating) or inflation (validating).
What is STAGFLATION? Stagflation is when supply shocks and monetary validating occur simultaneously, which leads to a NEGATIVE COMBINATION OF INFLATION AND UNEMPLOYMENT
Persistent Recessionary Gaps + Persistent Inflation: Continous SRAS shocks continue to push SRAS to the left, while continuous validation continues to push AD to the right. The overall effect on the output level is neutral, so the original recessionary gap is never closed. At the same time, both supply shocks and monetary validation continuously push up the price level, so the equilibrium price level will continuously rise while the economy remains in a recession. =(
No comments:
Post a Comment