Macro 9

COLAs imply that a permanent supply shock will permanently raise the inflation rate unless...

... an extinguishing policy response to the initial impact of the supply shock prevents any increase at all of inflation and thus prevents any increase at all in the rate of change of nominal wage rates.

two important reasons why rational workers and firms may form their expectations by looking backward rather than forward:

1. People may have no reason to believe that an acceleration in nominal GDP growth will be permanent. May just want to wait and see what happens. 2. People know changes in wages and prices will adjust gradually to the acceleration in nominal GDP

Give a few reasons why the SP curve upward sloping

As output increases, the economy-wide inflation rate tends to rise, due to the sensitivity of raw materials prices to higher aggregate demand, and due to the tendency of business firms to boost prices more rapidly when aggregate demand is high.

Forward-looking expectations

Attempt to predict the future behavior of an economic variable, using an economic model that specifies the interrelationship of that variable with other variables.

Backward-looking expectations

Backward-looking expectations use only information on the past behavior of economic variables.

Explain COLA

COLA- cost of living agreements. With COLA protection for workers, a permanent adverse supply shock will permanently raise the inflation rate in the absence of an extinguishing policy, because contract negotiators will recognize that it is IMpossible for the economy to return to its original position after the one-period effect of the supply shock.

Economy is in long-run equilibrium when?

Economy is in long-run equillibrium ONLY when no pressure to change, and actual rate of inflation = expected.

whenever there is a supply shock, what is the trade-off for the FED?

FED faces the classic trade-off between inflation (preventing recession) and lost output (preventing COLAs)

Neutral policy

Following a supply shock, a neutral policy maintains unchanged nominal GDP growth so as to allow a decline in the output ratio equal to the increase of the inflation rate.

accommodating policy. what is it, how does it work

Following a supply shock, an accommodating policy raises nominal GDP growth so as to maintain the original output ratio. To do this, inflation must be allowed to rise by the full extent of the vertical shift in SP, so that inflation jumps from 6 to 9 percent per year. This ac- celeration of inflation requires an acceleration of nominal GDP growth from 6 to 9 percent per year.

Inflation

Inflation is a sustained upward movement in the aggregate price level that is shared by most products.

Real GDP grows whenever...

Real GDP grows whenever nominal GDP growth exceeds the inflation rate.

cold turkey approach

The cold turkey approach to disinflation operates by implementing a sudden and permanent slowdown in nominal GDP growth.

core inflation rate

The core inflation rate is the inflation rate for all products and services other than food and energy. The core inflation rate attracts attention because roughly a 2 percent annual rate of core inflation appears to be the inflation goal of the Federal Reserve.

Why does SP curve shift?

The expectations-augmented Phillips Curve (another name for the SP curve) shifts its position whenever there is a change in the expected rate of inflation.

short-run Phillips (SP) Curve

The schedule relating real GDP to the inflation rate achievable given a fixed expected rate of inflation

adaptive expectations: formula

This period's expected inflation rate equals last period's actual inflation rate, or p^e = p-1.

disinflation

a marked deceleration in the inflation rate.

Okun's Law

a regular negative relationship between the output ratio (Y/YN) andthe gap between the actual unemployment rate and the average rate of unemployment.

demand shock

a sustained acceleration or deceleration in aggregate demand, measured most directly as a sustained acceleration or deceleration in the growth rate of nominal GDP.

Demand inflation

a sustained increase in prices that is preceded by a permanent acceleration of nominal GDP growth.

what happens during/after an import price shock?

adverse import shock: dollar depreciates, so imports become more expensive. exchange rate increases, and suddenly prices also start going up in US because prices of similar goods that are coming from abroad are rising.

Supply inflation

an increase in prices that stems from an increase in business costs not directly related to a prior acceleration of nominal GDP growth.

Demand inflation can be caused by...

any demand factors. consumer and business confidence, the money supply, real wealth, the tightness or ease of credit conditions in financial markets, government spending, tax rates, transfers, and net exports.

extinguishing policy

attempts to eliminate entirely the extra inflation caused by the supply shock.

adaptive expectations... (define)

base expectations for next period's values on an average of actual values during previous periods.

Supply shock

caused by a sharp change in the price of an important commodity (e.g., oil) that causes the inflation rate to rise or fall in the absence of demand shocks.

At point e0 is there an expected inflation rate? if so what is it? what is the actual inflation rate?

expected rate is zero. and so is actual rate

What is the result of a continuous increase of AD?

inflation

LP Line. What does it show?

long-run phillips curve. Aka "correct expectations line" Shows all possible points where expected inflation = actual inflation

Three types of responses to supply shocks

neutral, accommodating, extinguishing policies

What inflation is expected along Sp0?

none

explain adverse oil price shock

oil prices affect all energy prices - gasoline, natural gas, coal, heating oil. a sharp increase in oil prices filter through rest of economy by raising prices of airline fares trucking prices, and prices of plastics and raw materials. oil price shock was adverse in 03-08.

adverse supply shock

one that makes inflation worse while causing real GDP to fall, as in the case of sharp increases in oil prices during the 1970s. - policymakers can only avoid this extra inflation at cost of reducing real GDP

beneficial supply shock

one that reduces inflation while causing real GDP to rise, as in the case of the sharp decline in oil prices in 1986, 1997-98, and 2009.

How does an increase in price of oil affect SP

supply shock. SP shifts up

neutral, accommodating, extinguishing policies are a response to?

supply shocks

Sacrifice ratio

the cumulative loss of output incurred during a disinflation divided by the permanent reduction in the inflation rate.

expected rate of inflation

the rate of inflation that is expected to occur in the future.

output ratio

the ratio of actual real GDP to natural real GDP.