Macroeconomics Second Semester Lecture 1
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Questions and Answers

What is the equation for expected inflation based on last period’s actual inflation?

The equation is $p_e = p - 1$, where $p$ represents actual inflation from the previous period.

How can disinflation be achieved regarding demand growth?

Disinflation can be achieved by slowing down demand growth significantly, which reduces the inflation rate.

What does the 'cold turkey' remedy for inflation entail?

'Cold turkey' involves a sudden and significant reduction in demand growth, such as dropping from 10% to 4%.

What is the relationship between supply shocks and supply inflation?

<p>Supply shocks, such as increases in business costs, can lead to supply inflation independent of nominal GDP changes.</p> Signup and view all the answers

How did oil price shocks contribute to inflation in the 1970s and early 1980s?

<p>Oil price shocks caused significant increases in costs for businesses, contributing to overall supply inflation during that period.</p> Signup and view all the answers

What are farm price shocks and their possible economic impact?

<p>Farm price shocks refer to rising prices of agricultural products that can cause supply inflation.</p> Signup and view all the answers

What role does expected inflation play in economic output according to the Short-Run Phillips Curve?

<p>Expected inflation influences real GDP; higher expectations can lead to increased actual inflation and potentially decreased output.</p> Signup and view all the answers

What immediate effects result from a sudden reduction in demand growth on inflation and GDP?

<p>Inflation may decrease while real GDP declines, as seen when output ratios fall due to austerity measures.</p> Signup and view all the answers

How did productivity growth trends from 1965 to 1980 contribute to inflation?

<p>Slowed productivity growth during this period contributed to higher inflation by making it more expensive to hire workers.</p> Signup and view all the answers

What is the impact of dollar depreciation on import prices and domestic inflation?

<p>Dollar depreciation makes imports more expensive, leading to higher domestic inflation.</p> Signup and view all the answers

What were the effects of the oil price spikes in the 1970s on inflation and GDP?

<p>The oil price spikes resulted in increased inflation and decreased real GDP.</p> Signup and view all the answers

Identify and explain one adverse and one beneficial supply shock.

<p>An adverse shock is the oil price spike in the 1970s, increasing inflation and reducing GDP; a beneficial shock is the oil price drop in 1986, decreasing inflation and increasing GDP.</p> Signup and view all the answers

Describe how the relationship between unemployment and inflation is characterized by economists.

<p>Economists describe a trade-off between unemployment and inflation, indicating a strong negative correlation between the unemployment rate and the output ratio.</p> Signup and view all the answers

What role did dollar appreciation play in inflation between 1995 and 2002?

<p>Dollar appreciation held down inflation during this period by making imports cheaper.</p> Signup and view all the answers

How did productivity growth from 1995 to 2004 affect inflation levels?

<p>Productivity growth surged during this period, contributing to low inflation rates in the late 1990s.</p> Signup and view all the answers

What challenge do policymakers face during adverse supply shocks?

<p>Policymakers must balance inflation control with maintaining GDP during adverse supply shocks.</p> Signup and view all the answers

What is demand-pull inflation, and what factors contribute to it?

<p>Demand-pull inflation is caused by a continuous increase in demand that raises the price level, often due to large government deficits and rapid money supply growth.</p> Signup and view all the answers

How does an increase in aggregate demand affect the AD curve?

<p>An increase in aggregate demand shifts the AD curve from AD0 to AD1, indicating a higher overall demand in the economy.</p> Signup and view all the answers

Explain the significance of the output ratio exceeding 100%.

<p>When the output ratio exceeds 100%, it indicates that actual GDP is higher than natural GDP, leading to increased wage pressure.</p> Signup and view all the answers

What is the relationship between the short-run aggregate supply (SAS) curve and price levels?

<p>The short-run aggregate supply (SAS) curve is positively sloped, meaning higher output levels are associated with higher price levels.</p> Signup and view all the answers

Describe the long-run implications when wages adjust in response to a rising output ratio.

<p>As wages adjust, they lead to a downward shift in the SAS curve, ultimately restoring the output ratio back to 100% and achieving long-term equilibrium.</p> Signup and view all the answers

What impact do oil price shocks have on the economy, particularly regarding supply inflation?

<p>Oil price shocks can lead to supply inflation by increasing production costs, which shifts the SAS curve leftward, raising prices.</p> Signup and view all the answers

How can changes in exchange rates influence inflation and output?

<p>Changes in exchange rates can affect inflation by altering import prices, which in turn can influence the output level in an economy.</p> Signup and view all the answers

What are the different types of supply shocks and their potential effects?

<p>Types of supply shocks include positive supply shocks, which boost output, and negative supply shocks, which raise prices and can decrease output.</p> Signup and view all the answers

Study Notes

Macroeconomics Second Semester Lecture 1

  • Subject: Inflation: Causes and Cures
  • Lecturer: Dr. Zeeshan Atiq
  • Institution: University of Karachi

Inflation Rate

  • Continuous Inflation: Sustained increase in aggregate demand causes inflation. Single events causing price jumps do not explain continuous inflation.
  • Impact of Inflation: Long-term small annual inflation rates significantly increase the price level, eroding purchasing power and savings.
  • Causes of Inflation: Driven by shifts in aggregate demand and supply, with demand shocks primarily affecting inflation and GDP fluctuations.
  • Economic Trade-offs: Reducing inflation can require recessionary periods, and the Fed may need restrictive policies to manage excessive aggregate demand.

Output Ratio

  • Understanding the Output Ratio: Compares actual real GDP to natural real GDP.
  • Above 100%: Actual real GDP is higher than natural real GDP.
  • Below 100%: Actual real GDP is lower than natural real GDP.

Demand and Supply Shocks

  • Demand Shocks:
    • Positive: Increases aggregate demand, raising both inflation and the output ratio temporarily above 100%.
    • Negative: Decreases aggregate demand, lowering both inflation and the output ratio (e.g., recessions).
  • Supply Shocks:
    • Adverse: Increases inflation while reducing the output ratio (e.g., oil price hikes).
    • Beneficial: Decreases inflation while increasing the output ratio (e.g., technological advancements).

Key Insights

  • Inflation and the output ratio can rise or fall together during demand shocks.
  • Supply shocks can cause inflation and the output ratio to move in opposite directions.

Real GDP, Inflation Rate, and the Short-Run Phillips Curve

  • Demand-Pull Inflation: Continuous increase in demand raises the price level, caused by factors like large government budget deficits and rapid money supply growth.
  • Understanding the Graph (Figure 2):
    • Aggregate Demand (AD): Shows total demand in the economy.
    • Short-Run Aggregate Supply (SAS): Shows the relationship between output and price level in the short run.
    • Output Ratio: Measures the ratio of actual to natural real GDP.
  • Initial Equilibrium (E0): Point of intersection of AD and SAS curves, where initial price index (Po) and nominal wage rate (Wo) are both 1.0.
  • Short-Run and Long-Run Supply Curves:
    • SAS Curve: Positively sloped, higher output raises price level.
    • LAS Curve: Vertical at 100% output ratio, long-term supply not affected by price level.

Effects on Wage and Output

  • Rising Output Ratio: If output ratio exceeds 100%, it indicates higher actual GDP than natural GDP, leading to upward pressure on wages, shifting the SAS curve upward.
  • Long-Run Implications: Over time, wages adjust, returning the output ratio to 100% and restoring long-term equilibrium.

How Continuous Inflation Occurs

  • Scenario 1 (One-Time Increase in Aggregate Demand): Aggregate demand shifts to AD₁, moving economy from E₁ to D. Necessary adjustment for maintaining equilibrium by shifting demand again, resulting in a higher price level, with upward pressure on wages.
  • Scenario 2 (Continuous Increase in Aggregate Demand): Constant increase in aggregate demand to maintain output ratio. The economy follows an upward path, indicating continuous inflation.

The SP Curve: Short-Run Phillips Curve

  • SP Curve Overview: Plots inflation rate against the output ratio, showing the relationship between real GDP and inflation. Named after A. W. H. Phillips.
  • Upward Slope: Higher output ratios are associated with higher inflation rates.
  • Continuous Inflation: To maintain an output ratio above 100%, aggregate demand must continuously increase.
  • Non-Equilibrium State: At points above 100% output ratio, the economy is not in long-run equilibrium due to wages lagging behind prices.

Why the SP Curve Slopes Upward

  • Sensitivity to Demand: Higher aggregate demand raises material prices, increasing inflation.
  • Wage Pressure: Continuous upward pressure on wages due to insufficient anticipation of inflation in labor contracts.

The Adjustment of Expectations

  • Inflation and Expectations: Initially, people do not anticipate inflation in labor contracts. The price level rises faster than nominal wages, lacking inflation adjustments.
  • Impact on the SP Curve: When people start to expect inflation, the short-run Phillips Curve (SP curve) shifts upward.
  • Shift Due to Expected Inflation: When a 3% inflation rate is expected, the SP curve shifts upward to SP₁. The new equilibrium is E₂ where expected inflation matches actual inflation at 3%.

Recession as a Cure for Inflation

  • Achieving Disinflation: Disinflation refers to a significant decrease in the inflation rate.
  • Methods: Reversing the process that caused inflation, slowing down demand growth (x).
  • The "Cold Turkey" Approach: Involves a sudden reduction in demand growth (e.g., from 10% to 4%). This can cause a recession by leading to a decline in the output ratio.

Types of Supply Shocks

  • Supply Inflation: Caused by sharp changes in business costs unrelated to nominal GDP growth (e.g., oil shocks).
  • Oil Shocks: A significant cause of supply inflation, especially in the 1970s and early 1980s. Various examples of adverse and beneficial shocks are detailed.
  • Farm Price Shocks: Related to rising prices of raw materials, especially farm products, usually temporary.
  • Import Price Shocks: Foreign exchange rates affect import prices; dollar depreciation increases import costs leading to higher inflation, while appreciation has the opposite effect.
  • Productivity Growth Shocks: Rapid productivity growth makes hiring workers cheaper, influencing inflation.

Relationship Between Unemployment Rate and Inflation Rate

  • Trade-off: Economists frequently discuss trade-offs between unemployment and inflation.
  • Strong Negative Correlation: There's a strong negative correlation between the unemployment rate and the output ratio.
  • Mirror Image: The relationship between the output ratio and inflation rate mirrors the relationship between the unemployment rate and inflation rate.

Nominal GDP Growth and Inflation

  • Nominal GDP (X): Product of price level (P) and real GDP (Y).
  • Growth rate of nominal GDP (x) equals the sum of inflation rate (p) and growth rate of real GDP (y).

Factors Affecting Unemployment

  • Aggregate Demand Factors:
    • Private Sector: Business and consumer optimism, increases in foreign income boosting net exports.
    • Government Sector: Higher government spending, lower tax rates, higher money supply.

Okun's Law

  • Arthur M. Okun introduced the relationship in the 1960s.
  • Negative Slope: Output ratio decreases, unemployment rate increases.
  • Change in Unemployment Rate: 0.5 times the percentage change in the output ratio (in the opposite direction).

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Lecture 1 Inflation Causes and Cures PDF

Description

Delve into the key concepts of inflation, its causes, and potential cures in this first lecture of the second semester of Macroeconomics. Learn about the impact of continuous inflation on purchasing power and the necessary economic trade-offs in managing inflation. This insightful lecture by Dr. Zeeshan Atiq from the University of Karachi covers essential macroeconomic principles.

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