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Chapter 28

Canadian Inflation, Unemployment, and Business Cycle

Inflation Cycles

Inflation is a process in which the price level is rising and money is losing value.

Demand-pull inflationis inflation that results from an initial increase in aggregate demand.

A demand-pull inflation can result from any influence that increases aggregate demand.

In a demand-pull inflation, initially:

o Aggregate demand increases

o Real GDP increases above potential GDP and the price level rises

o The money wage rate rises

o The price level rises further and real GDP decreases toward potential GDP

A one-time increase in aggregate demand raises the price level but does not always start a

demand-pull inflation. For demand-pull inflation to occur, aggregate demand must persistently increase.

The quantity of money must persistently grow at a rate that exceeds the growth rate of

potential GDP.

The figure shows a demand-pull inflation.

Initially, aggregate demand increases and theADcurve shifts rightward fromAD0toAD1.

Real GDP increases to $1,250 billion and the price level rises from 110 to 113.

Now real GDP exceeds potential GDP.

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The money wage rate begins to rise.

The SAScurve shifts leftward from SAS0to SAS1.

Real GDP decreases toward potential GDP.

The price level rises further from 113 to 121.

The process repeats in an unending demand-pull inflation spiral.

Cost-push inflationis an inflation that results from an increase in costs.

The two main sources of cost-push inflation are:

o

An increase in the money wage rate

o An increase in the money prices of raw materials

In a cost-push inflation, initially

o Short-run aggregate supply decreases

o Real GDP decreases below potential GDP and the price level rises

o The economy could become stuck in this stagflation situation for some time.

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A one-time decrease in aggregate supply raises the price level but does not always start cost-

push inflation.

For cost-push inflation to occur, aggregate demand must increase in response to the cost-push.

Just like the case of demand-pull inflation, the quantity of money must persistently grow at a

rate that exceeds the growth rate of potential GDP if inflation is to become persistent.

In the figure, the price of oil rises.

Short-run aggregate supply decreases and the SAScurve shifts leftward from SAS0to SAS1.

Real GDP decreases from $1,200 billion to $1,150 billion and the price level rises from 110 to

117. Stagflation occurs.

With no subsequent change in aggregate demand, the price level eventually falls.

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The figure below shows the aggregate demand response to cost-push.

For cost-push inflation to take hold, aggregate demand must increase.

An increase in the quantity of money increases aggregate demand and theADcurve shifts

rightward fromAD0toAD1.

Real GDP increases to $1,200 billion and the price level rises to 121.

This process repeats to create an unending cost-push inflation spiral.

Inflation and Unemployment: The Phillips Curve

A Phillips curveis a curve that shows a relationship between inflation and unemployment.

There are two time frames for the Phillips curve:

o The short-run Phillips curve

o The long-run Phillips curve

The short-run Phillips curveis a curve that shows the tradeoff between inflation and

unemployment holding constant:

o The expected inflation rate

o The natural rate of unemployment

With a given expected inflation rate and a given natural rate of unemployment, there is an

inverse relationship between the inflation rate and the unemployment rate.

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In the figure, the natural rate of unemployment increases.

The Business Cycle

The Keynesian cycle theoryregards fluctuations in investment driven by fluctuations in business

confidence summarized by the phrase animal spirits as the main source of economic

fluctuations.

The monetarist cycle theoryregards fluctuations in both investment and consumption

expenditure, driven by fluctuations in the growth rate of the quantity of money as the mainsource of economic fluctuations.

The new classical cycle theoryregards unexpected fluctuations in aggregate demand as the

main source of economic fluctuations.

The new Keynesian cycle theoryregards unexpected and expected fluctuations in aggregate

demand as the main source of economic fluctuations.

The real business cycle theoryof the business cycle regards random fluctuations in productivity

as the main source of economic fluctuations.

The impulse in RBC theory is the growth rate of productivity that results from technological

change.

Two immediate effects follow from a change in productivity, which are:o Investment demand changes

o The demand for labour changes

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In the market for loanable funds, a technology shock decreases the demand for loanable funds,

and the real interest rate falls.

The decrease in productivity decreases the demand for labour and the LDcurve shifts leftward

from LD0to LD1.

The fall in the real interest rate lowers the return to current work and decreases the supply of

labour.

The LScurve shifts leftward from LS0to LS1.

Employment decreases to 19.5 billion hours and the real wage rate falls to $34.50 an hour.

A recession is underway.