Review

1
Review

• Circular Flow
• GDP C I G NX
• AD C I G NX
• MV PY
• Fiscal and Monetary Policy

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The Circular Flow

• This shows that GDP is a flow. Any increase in C
  I G NX will increase AD.
• Expectations, Tax rates, Exchange Rates, Money
  Supply, etc.

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A shift in AD
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What is the impact of an increase in AD

• On Employment?
• On Growth?
• On Prices?
• The Balance of Payments?

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Macro Policy

• Expansionary or Contractionary Fiscal Policy.
• Expansionary or Contractionary Monetary Policy.

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Monetary Policy

• Increases in Base increase Money Supply.
• M mmB

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The Direct Effect

• The direct effect a change in M is a change in PY
  
• If V is constant.

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The Indirect Effect

• The indirect effect is through lower (short run)
  interest rates
• More investment because credit is cheaper.
• More consumption because credit is cheaper.
• Less saving because of lower return.

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Inflation

• What is inflation?
• How is inflation generated?
• How do people forecast inflation?
• What are the costs of inflation?

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The relationship between Inflation and

• Employment is represented by the Phillips Curve.
• Interest rates depends.
• Correlated with the nominal rate.
• Independent of the real rate.

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Causes of Inflation

• Inflation can result from an increase in AD or a
  decrease in SAS.
• Demand pull
• Cost push

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Demand-Pull Inflation

• An increase in
• The money supply,
• Government purchases, or
• Increase in exports

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A Demand-Pull Rise in the Price Level
LAS
Increase in AD raises price level and
increases real GDP...
130
Price level (GDP deflator, 1992 100)
SAS0
121
113
110
AD1
100
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
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A Demand-Pull Rise in the Price Level
LAS
130
SAS1
Price level (GDP deflator, 1992 100)
SAS0
121
wages rise, and SAS shifts leftward. Price level
rises further, and real GDP declines
113
110
AD1
100
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
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A Demand-PullInflation Process

• For inflation to proceed, the quantity of money
  must persistently increases.

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A Demand-Pull Inflation Spiral
LAS
SAS2
133
SAS1
Price level (GDP deflator, 1992 100)
125
SAS0
121
113
AD2
110
Repeated increases in AD create a price-wage
spiral
AD1
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
18
Cost-Push Inflation

• Starts with an increase in
• the prices of raw materials, or
• money wage rates

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A Cost-Push Inflation Spiral
LAS
Oil producers and the Fed feed cost-price inflatio
n spiral
133
SAS1
129
Price level (GDP deflator, 1992 100)
SAS0
121
117
110
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
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A Dilemma for the FED
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A Cost-Push Inflation Spiral
SAS2
LAS
Oil producers and the Fed feed cost-price inflatio
n spiral
133
SAS1
129
Price level (GDP deflator, 1992 100)
SAS0
121
117
110
AD2
AD1
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
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Anticipating Inflation

• The failure to correctly anticipate inflation
  results in unintended consequences.
• On firms, workers, borrowers and lenders.

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Rational Expectations

• A forecast based on all available relevant
  information is called a rational expectation.

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Rational Expectationsand Actual Inflation

• If wages increase with the anticipated increase
  in aggregate demand, the SAS curve will shift up
  at the same rate as the AD curve and real GDP
  will not change.
• Peoples expectations of inflation caused the
  actual inflation.

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Effects of Anticipated Inflation

• Potential GDP declines for three reasons
• 1. Transactions costs
• 2. Tax effects
• 3. Increased uncertainty

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Inflation Tax

• Inflation can works as a tax.
• The Central Bank buys government bonds and
  increases the money supply.
• Thus the government deficits are financed by
  monitizing the debt.
• The quantity of money increases, causing
  inflation.
• The government has in effect received the revenue
  from inflation.

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Inflation and Unemployment The Phillips Curve

• The aggregate supply aggregate demand model
  does not focus directly on inflation and
  unemployment.
• The Phillips curve shows a relationship between
  Inflation and unemployment.

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Relationship or Theory?

• What is assumed to be constant?

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The Short-Run Phillips Curve
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The Long-Run Phillips Curve
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A Change in theNatural Unemployment Rate
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Phillips Curves in the United States
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Phillips Curves in the United States
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Interest Rates and Inflation

• Recall that the real interest rate is the nominal
  interest rate minus the (expected) inflation
  rate.
• When the inflation rate changes, nominal interest
  rates change to compensate for the decrease in
  the value of money.

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Inflation and the Interest Rate
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Have you learned?

• What are expansionary and contractionary fiscal
  policy?
• What are expansionary and contractionary monetary
  policy?
• When there is expansionary monetary policy, what
  are the direct effect on AD of the increase in
  the money supply and what is the indirect effect
  on AD of the increase in the money supply?
• What is demand pull inflation?
• What is cost push inflation?
• For inflation to "proceed" or continue, what must
  persistently happen?
• If we have a cost push inflation, what is the
  dilemma for policy makers?

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Have you learn?

• If inflation is unanticipated (a larger increase
  in prices than is expected), what is the impact
  on firms, workers, borrowers and lenders?
• What are the transaction or "boot leather costs"
  of inflation?
• How inflation can work as a tax?
• Why uncertainty about inflation makes long-term
  planning more difficult?
• What is the relationship shown in a Phillips
  curve?
• What happens to the Phillips Curve when the
  expected inflation rate and the natural rate of
  unemployment change?
• Why the nominal interest rate is usually a bit
  more than the inflation rate?