Chapter 12 The Business Cycle, Inflation, and Deflation

2 percent

suppose the velocity of circulation increases by 2 percent and potential GDP grows by 4 percent. The trend inflation rate will equal zero if the quantity of money grows by

rational expectation

best forecast available is one based on all the relevant information; not necessarily correct; when correct, economy operates at full employment

cost-push inflation graph

factor price rise shifts SAS leftward and price level rises; the Fed increases AD to restore full employment and the price level rises again

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; assume that the money wage rate is rigid

keynesian cycle thoery

fluctuations in investment driven by fluctuations in business confidence; "animal spirits"; main source of fluctuations in aggregate demand

two effects of RBC impulse

investment demand changes and the demand for labor changes; people decide when to work

real business cycle theory

random fluctuations in productivity as the main source of economic fluctuations; assumed to result mainly from fluctuations in the pace of technological change

new Keynesian cycle theory

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

stagflation occurs

when the price level is rising and simultaneously real GDP is decreasing

two main sources of cost increases

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

criticisms and defenses of RBC theory

1. money wage rate is sticky, and to assume otherwise is at odds with a clear fact 2. intertemporal substitution is too weak a force to account for large fluctuations in labor supply and employment with small real wage rate changes 3. productivity shocks are as likely to be caused by changes in aggregate demand as by technological change

inflation rate equation

= money growth rate + rate of velocity change - real GDP growth rate

negative

during a deflation, the inflation rate is

an increase in aggregate demand and a decrease in aggregate supply (both answers A and C are correct)

Which of the following can start an inflation?

an increase in exports

Which of the following factors could start a demand-pull inflation?

productivity and GDP move closely together

Which of the following pieces of evidence is most consistent with the real business cycle theory?

the unemployment rate and inflation

a Phillips curve measures the relationship between

rightward; leftward

a demand-pull inflation process consists of ____ shifts in the AD curve and _____ shifts in the SAS curve

might trigger a cost-push inflation

a rise in the price level because of an increase in the price of oil

demand-pull inflation graph

aggregate demand increases and raises price level and increases GDP; money wage rate rises, and SAS shifts leftward; price level rises further and real GDP declines

stagflation

combination of a rising price level and decreasing real GDP

a decrease in short-run aggregate supply

cost-push inflation starts with

factors that change aggregate demand

cut in interest rate, increase in the quantity of money, an increase in government expenditure, a tax cut, increase in exports, or an increase in investment stimulated by an increase in expected future profits

two sources of inflation

demand-pull inflation and cost push inflation

RBC impulse theory

growth rate of productivity that results from technological change; generated by process of research and development that leads to the creation and use of new technologies

expected inflation

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

Mainstream business cycle theory graph

if potential GDP increases and the LAS curve shifts right, a greater than expected increase in aggregate demand brings inflation; if aggregate demand curve shifts to AD1 the economy remains at full capacity; if it shifts to AD2, a recessionary gap arises; if it shifts to AD3, an inflationary gap arises

How to end deflation?

increase the growth rate of the money stock

cost-push inflation

inflation that is kicked off by an increase in costs; higher the cost of production, the smaller is the amount that firms are willing to produce; if money wage rate rises or if the prices of raw materials rise, firms decrease their supply of goods and services

demand-pull inflation

inflation that starts because aggregate demand increases; kicked off by any of the factors that change aggregate demand; persistently increase

a tradeoff between inflation and unemployment so that higher inflation is related to lower unemployment

moving along the short-run Phillips curve indicates

What causes expected inflation?

people expect inflation, so the money wage rate increased at the price level increased; actual and expected increase in aggregate demand

deflation

persistently falling price level; inflation rate is negative

mainstream business cycle theory

potential GDP grows at a steady rate while aggregate demand grows at a fluctuating rate

new classical cycle theory

rational expectation of the 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; unexpected fluctuations in aggregate demand bring fluctuations in real GDP around potential GDP

if aggregate demand grows slower than expected

real GDP falls below potential GDP and the inflation rate slows

if aggregate demand grows faster than expected

real GDP rises above potential GDP; inflation rate exceeds its expected rate and economy behaves like it does in demand-pull inflation

productivity

real business cycle theory says that the factor leading to the business cycle is represented by changes in

consequences of deflation

redistributes income and wealth, lowers real GDP and employment, and diverts resources from production; low nominal interest rate which brings an increase in quantity of money that people plan to hold and decreases in the velocity of circulation

Phillips Curve

relationship between inflation and unemployment

long-run Phillips Curve

relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate; vertical line at the natural rate in unemployment rate

short-run Phillips curve

relationship between inflation and unemployment, holding constant the expected inflation rate and the natural rate of unemployment; movements along the curve if inflation rises or falls

change in natural unemployment rate

shifts both the short-run and long-run Phillips curves; if natural unemployment rate increases, the long-run curve shifts to the right; if expected inflation is constant, the short-run Phillips curve shifts to the right

change in expected inflation

shifts the short-run Phillips curve, but not the long-run Phillips curve; if inflation rate falls, curve shifts to the left; if it rises, curve shifts to the right

What causes deflation?

the quantity of money is growing too slowly