Chap 12 - Inflation, Jobs, and the Business Cycle.

What are the 2 main sources of cost increases?

1. An increase in the money wage rate 2. An increase in the money prices of raw materials

Macroeconomic Forecasting Agencies

1. Banks 2. Insurance Companies 3. Labor Unions 4. Large Corporations

Examples of factors that can start demand-pull inflation?

1. Cut in the interest rate 2. An increase in the quantity of money 3. An increase in government expenditure 4. A tax cut 5. An increase in exports 6. An increase in investment stimulated by an increase in expected future profits.

What are the 2 sources of inflation?

1. Demand-pull inflation 2. Cost-push inflation

2 Times Frames of the Phillips Curve

1. Short-Run 2. Long-Run

What year did you U.S. experience the demand-pull inflation

1960 (2%), 1966 (3%)...in 1967 with the Vietnam War and an increase in pending, increase in growth rate of money and the aggregate demand increase quickly. By 1974 the inflation rate had gone from 2% to 11 %.

When did cost-push inflation occur in the U.S.?

1970s...It began in 1974 when OPEC raised the price of oil fourfold. From 1975 - 1977 the Fed repeatedly allowed the quantity of money to grow quickly and inflation proceeded at a rapid rate. 1979 & 1980 Opec again pushed oil prices higher. The Fed decided not to do anything and the result was a recession but also, eventually , a fall in inflation.

Cost-Push Inflation

An inflation that is kicked off by an increase in costs.

Cost-Push Inflation / Money Wage Rate

At a given price level, the higher the cost of production, the smaller is the amount that firms are willing to produce. E.g. if the money wage rate rises or if the price of raw materials rise, firms decrease their supply of goods and services. Aggregate supply decreases and the short-run aggregate supply curve shifts leftward.

Assumption by Keynesian and Monetarist

Both the Keynesian and Monetarist cycle theories simply assume that the money wage rate is rigid and don't explain the rigidity.

New Keynesian Cycle Theory

Emphasizes the fact that today's money wage rates were negotiated at many past date, which means that past rational expectations of the current price level influence the money wage rate and the position of the SAS curve. In this theory, both unexpected and currently expected fluctuations in aggregate demand bring fluctuations in real GDP around potential GDP.

Monetarist Cycle Theory

Fluctuations in both investment and consumption expenditure, driven by fluctuations in the growth rate of the quantity of money, are the main source of fluctuations in aggregate demand.

Keynesian Cycle Theory

Fluctuations in investment driven by fluctuations in business confidence - summarized by the phrase "animal spirits" - are the main source of fluctuations in aggregate demand.

Expected Inflation

If inflation is expected, the fluctuations in real GDP that accompany demand-pull and cost-push inflation don't occur. Instead, inflation proceeds as it does in the long run, with real GDP equal to potential GDP and unemployment at is natural rate.

Demand-Pull Inflation

Inflation that starts because aggregate demand increase. -Demand-pull inflation is triggered by an increase in aggregate demand and fueled by ongoing money growth. Real GDP cycles above full employment.

Mainstream Business Cycle Theory

Potential GDP grows at a steady rate while aggregate demand grows at a fluctuating rate.

Real Business Cycle Theory (RBC)

Random fluctuations in productivity as the main source of economic fluctuations. *main result - technological change, international disturbances, climate fluctuations or natural disasters.

Demand-Pull Inflation / Money Wage Rate Response

Real GDP cannot remain above potential GDP forever. With Unemployment below its natural rate, there is a shortage of labor. The money wage rate begins to rise. Short-run aggregate supply decreases (shifts leftward) and the price level rises further and real GDP begins to decrease.

Cost-Push Inflation / Aggregate Demand Response

Real GDP decreases, unemployment rises above its natural rate. There is often an outcry of concern and a call for action to restore to full employment. - Suppose the Fed cuts the interest rate and increases the quantity of money, this will increase the aggregate demand (shifts rightward) and restore full employment.

If the natural unemployment rate increase, what happens to the short-run Phillips curve and the long-run Phillips curve?

Shifts both curves rightward. The new long-run curve intersects the new short-run curve at the expected inflation rate.

Changes in the Natural Unemployment Rate

Shifts both the short-run and long-run Phillips curves.

If the expected inflation rate increases by 10 percentage points, how do the short-run Phillips curve and the long-run Phillips curve change?

Short-Run Phillips Curve - Shifts Upward Long-Run Phillips Curve - The long-run curve does not shift. The new short-run intersects the long-run at the new expected inflation rate.

How can inflation increase?

The aggregate demand must persistently increase.

Rational Expectation

The best forecast possible, a forecast that uses all the available information.

Stagflation

The combination of a rising price level and decreasing real GDP.

The RBC Impulse

The growth rate of productivity that results from technological change.

How can the aggregate demand persistently increase?

The quantity of money must persistently increase.

New Classical Cycle Theory

The rational expectation of the price level which is determined by potential GDP and expected aggregate demand, determines the money wage rate and the position of the SAS curve. In this theory only unexpected fluctuations in aggregate demand bring fluctuations in real GDP around potential GDP.

Phillips Curve

The relationship and the short-run tradeoff between inflation and unemployment.

Long-Run Phillips Curve

The relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate. (The long-run Phillips curve is vertical at the natural unemployment rate) The short-run intersects the long-run at the expected inflation rate. A change in the expected inflation rate shifts the show-run but it does not shift the long-run.

Short-Run Phillips Curve

The relationship between inflation and unemployment, holding constant... 1. The Expected Inflation Rate 2. The Natural Unemployment Rate

The RBC Mechanism

Two effects follow from a change in productivity that sparks a expansion or a contraction: Investment demand changes and the demand for labor changes. - Technological changes make some existing capital obsolete and temporarily decreases productivity. Firms expect this and lower there profit expectations. The initial effect is a decrease in investment demand and a decrease in the demand for labor.

Can technological changes decrease productivity?

Yes, technological changes can make human capital obsolete, productivity can temporarily fall. More jobs are destroyed than created and more businesses fail than start up.