Essay about ECON 102 Pdf

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Thursday March 19!

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Chapter 30 Inflation and Disinflation !
You will learn!
- wages respond to output gaps and inflation expectations !
- how constant rate of inflation is incorporated into basic microeconomic model !
- how AD and AS shocks affect !
- what happens when BOC validates demand/supply shocks (validation process)!
- three phases of inflation!
- how cost of disinflation is measured by sacrifice ratio !

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Effects of Inflation !
- failure to anticipate inflation impost costs to labour market and capital market !
- labour market: two consequences!
- redistribution of income: higher anticipated inflation lowers real wage rate, employers gain at expense of worker. vice versa.!
- departure from full employment:higher than anticipated inflation lowers real wage rate, increases quantity of labour demanded, jobs easier to find, lowers unemployment rate !
- capital market: two main consequences for financial capital:!
- redistribution of income: inflation high, borrowers gain at expense of lenders !
- too much or too little Lending and borrowing!
- when inflation is higher than anticipated, real interest rate lowers than anticipated, borrows want to have borrowed more, lenders loaned less!

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30.1 Adding Inflation to the Model!
Why do wages change?!
1. Output Gaps!
- Y > Y* upward pressure on wages!
- Y < Y* downward pressure on wages!

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2. Expected Inflation !
- while actual wage increase may depend on bargaining power, 3 % epcted inflation can lead to 3$ increase in money wage so that real wages remain unchanged (money wage rise without output gaps)!

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Change in Money Wages = Output-gap Effect + Expectational Effect !
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How do people form expectations?!
1) Forward looking: based on expected economic conditions and gov. policies!
2) backward looking: based on past experience about inflation rate changes!
3) combination of both: change in money wage is cause by both. While inflationary gaps exert an upward pressure on prices, recessionary gaps put downward pressure !

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From Wages to Prices!
- net effect of two macro forces acting on nominal wage (output gaps and inflation expectation) determines how AS shifts and price level change !
- since AS can shift for reasons non-related to wage, actual inflation depends on this this term.
Last term captures any AS shift caused by changes in prices of raw materials!
- Actual Inflation = Output gap inflation + expected inflation + supply shock inflation !

Constant Inflation !
- if inflation is constant, no indication of change in monetary policy: expected inflation = actual inflation !
- Y = Y* no output gap!
- if there is no output gap, what is causing inflation? : constant inflations required both expectation of inflation (shifts AS curve) and continued money supply (shifts AD) - validation of those expectations!
- occurs when rate of monetary growth, rate of nominal wage increase, and expected inflation are all consistent with actual inflation rate GRAPH!

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Is Deflation a Problem?!
- when price levels are falling, firms and households defer spending (anticipating lower prices), this can shift AD to the left and cause recession !

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30.2 Shocks and Policy Responses!
Demand Shocks !
- demand inflation results in rightward shift in Ad (due to fiscal or mon. policy)!
- demand shock that is not validated produces only temporary inflation (price level rises to P1 then to P2( when AS curve shifts left to adjust) !
With Monetary Validation !
- AD shifts further right by the time AS shifts left (due to natural tendency or expectation)!
- keeping open inflationary gap!
- continued validation turns a transitory inflation into sustained inflation !

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Supply Shock with and iwhout validation!
- inflation due to AS shifts unrelated to excess demand is supply inflation!
- if wages fall slowly (when Y < Y*), the return to Y* after non-validated negative AS shock will be slow !
- if there is monetary validation, there will be a rightward shift in AD curve, and return to Y* will
be
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