NAIRU and Inflationary Output Gap

Inflationary Output Gap (Y > Y*)

• This gap can lead to changes in the average level of wages.

NAIRU Definition

• NAIRU stands for the non-accelerating inflation rate of unemployment.

Calculating NAIRU and Actual Unemployment Rate

• NAIRU = Frictional Unemployment + Structural Unemployment.
• Actual Unemployment Rate = Frictional + Cyclical + Structural Unemployment.
• If Frictional = 3%, Cyclical = 2%, and Structural = 4%, then NAIRU = 7% and Actual Unemployment Rate = 9%.

Unemployment Rate vs. NAIRU

• If the unemployment rate exceeds the NAIRU, there's a negative output gap.

Economic Conditions and Wage Pressure

• If Y < Y*, there is downward pressure on wages.

Unemployment Rate Below NAIRU

• Demand forces will exert upward pressure on wages.

Inflationary Pressures and AD Curve

• Inflationary pressures from a rightward shift in AD will subside if not accompanied by continual increases in the money supply.

Unit Costs and AS Curve

• Unit costs rise and AS shifts upward if wage increases exceed productivity increases.

NAIRU and Unemployment Rate

• If the NAIRU is 8% and the actual unemployment rate is 5%, demand forces put upward pressure on wages.

NAIRU, Unemployment, and Labour Supply

• If NAIRU is 6% and the actual unemployment rate is 7%, the excess supply of labor will put downward pressure on wages.
• If NAIRU is 6.5% and the actual unemployment rate is 5%, the excess demand for labor will put upward pressure on wages.

Bank of Canada and Interest Rates

• If NAIRU is 6.5% and the actual unemployment rate is 5%, and the Bank of Canada reduces its overnight interest rate target, it will worsen the existing inflationary gap.

Sustained Inflation

• Persistent expectations of continued inflation can lead to sustained inflation

Inflation and Price Increases

• Expectations of higher future inflation can cause a sustained increase in the inflation rate.

Inflation Expectations and AS Curve

• Inflation persists because inflationary expectations cause the AS curve to continue shifting upwards.

Wage Increases

• Increases in nominal wages result from the output-gap effect plus the expectational effect.

Actual Inflation

• Actual inflation = Expected future inflation + Output-gap inflation + Supply-shock inflation.
• If expected future inflation is 2%, output-gap inflation is 0%, and supply-shock inflation is 0%, then actual inflation would be 2%.

Constant Inflation

• Constant inflation requires consistent levels of expected future inflation, output-gap inflation, and supply-shock inflation.
• Constant Inflation: 2% expected future inflation, 0% output-gap inflation, and 0% supply-shock inflation.

Expectational Effect of Inflation

• The expectational effect of inflation often plays a role in accelerating inflation and is not directly a monetary cause of inflation.

Inflation Rate Components

• If actual inflation is 5%, expected inflation is 2%, and output-gap inflation is 1%, then non-wage supply-shock inflation is 2%.

Wage Increases in Canada

• Average wages in Canada have increased due to the persistent expectation that the price level will increase.

Salary and Inflation

• To prevent a drop in real salary with 6% expected inflation, the nominal salary must increase by 6%.

AD/AS Model

• In the basic AD/AS macro model, actual inflation is the sum of output gap inflation, expected inflation, and supply-shock inflation.

Real Salary Change

• If salary increases by 6% and inflation is 12%, the real salary will change by -6%.

Constant Inflation in AD/AS Model

• In the AD/AS model with constant inflation, the AS curve shifts upward due to inflation expectations.

Central Bank and Inflation

• To stop sustained inflation, a central bank tries to stop the outward shift of the AD curve.

Inflationary Expectations

• Inflationary expectations keep shifting the AS curve upward, making it difficult to eliminate sustained inflation.

Constant Inflation Rate

• Constant inflation is possible when the AD curve shifts upwards at the same uniform rate as the AS curve.

Constant Inflation Illustration

• A constant inflation rate is illustrated by the AD curve shifting upward at the same rate as the AS curve.

Economy Without Supply Shocks

• Without supply shocks, if expected inflation is 3% and actual inflation is 3%, real GDP likely equals potential GDP.

Inflation Rate in Canada

• If Canada's actual inflation rate is fairly constant around 2%, the Bank of Canada accommodates this level with increases in the money supply.

AD/AS Model and Money Supply

• With sustained inflation, the rising price level increases the demand for money, pushing interest rates up, despite the money supply increase.

Movements of AS Curve

• Expectations of inflation are causing wage costs to rise continually.

Movements of AD Curve

• The central bank is increasing the money supply and validating the inflationary expectations.

Constant Inflation Rate

• Actual inflation equals expected inflation.
• A constant inflation rate of 3% corresponds to an annual increase in the equilibrium price level of 3%.
• The AS curve shifts upward by 3% per year and the AD curve shifts upward by 3% per year, leading to a constant inflation rate of 3%.

Long-Run Equilibrium

• A negative AD shock, with no change in the money supply, will eventually result in a lower price level and GDP at its potential level.

AD and AS Shifts

• A rightward shift in the AD curve and a leftward shift of the AS curve result in an increased price level and an uncertain effect on unemployment.
• A leftward shift in the AD curve and a leftward shift of the AS curve reduce GDP but have an uncertain effect on the price level.
• A leftward shift of the AD curve and a rightward shift of the AS curve reduce the price level but have an uncertain effect on unemployment.
• A rightward shift of the AD curve and a rightward shift of the AS curve increase GDP but have an uncertain effect on the price level.

Monetary Validations

• Responding to repeated negative supply shocks with monetary validations leads to continuous inflation.
• A positive demand shock, not validated by the Bank of Canada, will eventually result in a higher price level and GDP at potential output.

Inflationary Gap and Monetary Policy

• If there is an inflationary gap and the Bank of Canada does not respond, wages increase, and the AS curve shifts upward.

Recessionary Gap and Monetary Policy

• If there is a recessionary gap and the Bank of Canada holds the money supply constant, wages decrease, and the AS curve shifts downward.

Expansionary Monetary Policy

• Beginning from long-run equilibrium, an expansionary monetary policy causes aggregate demand for goods and services to exceed potential output.

Contractionary Monetary Policy

• Beginning from long-run equilibrium, a contractionary monetary policy causes potential output to exceed aggregate demand for goods and services.

Positive Demand Shock

• After a positive demand shock, when the economy returns to potential output, the price level will be higher than originally.

Oil Prices

• For Ontario, an oil user, higher world oil prices constitute a negative supply shock.
• For Alberta, an oil exporter, higher world oil prices constitute a positive demand shock.
• For Canada, as both an oil user and exporter, lower world oil prices constitute a negative demand shock and a positive supply shock.

Canadian Inflation in the 1970s

• High inflation in Canada at the end of the 1970s was mainly due to a substantial negative supply shock partly validated by monetary policy.

Economy at Full Employment

• A permanent rightward shift in the AD curve will cause inflationary pressures that will eventually subside unless accompanied by expansionary monetary policy.

OPEC Oil-Price Shock in 1973

• The Bank of Canada validated this negative supply shock with an increase in the money supply, the U.S. did not take that step. Canada experienced a large increase in its price level but almost no recession and the U.S. experienced a smaller increase in its price level but a significant recession.

Economy Movements

• The movement of the economy from E0 to E1 was likely caused by a positive demand shock associated with increased investment.

Monetary Validation

• The movement of the economy from E1 to E2 was likely caused by the monetary validation of an initial demand shock by the central bank, combined with ongoing inflation expectations.

Inflationary Gap at E1 to E2

• Because of the inflationary gap there is upward pressure on factor prices and the AS shifts upward; the Bank of Canada validates the demand shock.

Economy Movements from E0 - E1

• The movement of the economy from E0 to E1 was likely caused by a negative supply shock caused by higher input prices.

Economy Movements from E1 - E2

• The movement of the economy from E1 to E2 was likely caused by a monetary expansion by the Bank of Canada.

Economy at E1 with no policy response

• Compared to the price level and real GDP at E1, the economy will tend towards a new long-run equilibrium characterized by a lower price level and GDP at the potential level.

Economy At Full Employment

• If the economy is at full employment and the AS curve shifts upward, a recessionary gap will be created, which will eventually cause the AS curve to shift back downward if the central bank doesn't respond.
• If the central bank responds to a single negative supply shock with monetary validation, costs, the price level, and the money supply will increase.

supply shocks

• Repeated monetary validation to wage-push supply shocks leads to ongoing inflation.

Monetary Validation Definition

• "Monetary validation" refers to the money supply being increased in response to a supply or a demand shock that raises the price level.

Act of "Monetary Validation"

• The act of "monetary validation" by a central bank can perpetuate inflation.

Rationale for Validation

• A central bank might "validate" a negative supply shock because the economy might suffer a long slump before wages and prices fall enough to restore full employment.
• Isolated negative aggregate supply shocks, in the absence of monetary validation, will eventually be self-correcting as wages slowly fall.
• There can be strong pressure on the Bank of Canada to validate a large negative supply shock due to the slow adjustment of wages back to full employment.
• Continued negative supply shocks without monetary validation lead to rising unemployment until wage increases cease or are offset by other wage decreases.

Bank of Canada validating

• If the Bank of Canada validates a positive AD shock, there is a risk of continued inflation.

Increase in Word Oil Prices

• If an increase in world oil prices leads to an increase in world exports that leads to an increase in aggregate demand, this is called demand inflation.
• the Bank of Canada reduces the overnight interest rate in response to the increase in AD, this is called monetary validation.

Supply Inflation

• "Supply inflation" refers to inflation arising from a leftward shift of the AS curve that is not the result of excess demand for factors of production.

Demand Inflation

• "Demand inflation" refers to the inflation that results from any inflationary gap caused by a rightward shift of the AD curve.

Expansionary Monetary Policy

• If the Bank of Canada attempts to maintain "good times" by implementing an expansionary monetary policy, it would be acting to de-stabilize the economy.
• An inflation that begins as a result of any demand or supply shock will eventually come to a halt if there is no monetary validation.
• If the economy is in long-run equilibrium and the AS curve shifts upward, the aggregate demand curve shifts up and results in a higher price level if the central bank validates the shock.
• Central banks should never validate a negative supply because to avoid the possibility of entrenching expectations and creating a wage-price spiral.

Acceleration Hypothesis

• The acceleration hypothesis states that when the central bank holds an inflationary gap constant, inflation will tend to accelerate.
• If the central bank tries to hold real GDP above potential GDP, inflation will accelerate over time.
• According to the "acceleration hypothesis," the inflation rate will accelerate when actual output is held above potential output.
• If the central bank tries to keep real GDP constant at $550 billion, the inflation rate is likely to rise above 4%.

Inflation Target

• The Bank of Canada has formally adopted an inflation target of 2% to avoid the temptation of validating positive economic shocks that could lead to accelerating inflation.
• Continuous increases in the money supply are needed for sustained inflation.
• The view that sustained inflation is possible only with continuous monetary validation is closely associated with Milton Friedman.
• The statement that "inflation is everywhere and always a monetary phenomenon" is closely associated with Milton Friedman.
• The statement "Inflation is everywhere and always a monetary phenomenon" does not hold true for temporary bursts of inflation that are not accompanied by a monetary expansion.

Phillips Curve

• The Phillips curve originally appeared to demonstrate a trade-off between inflation and unemployment, this was later thought to be deficient because inflationary expectations had not been incorporated.
• The idea that the Phillips curve is vertical in the long run, implying no trade-off between inflation and unemployment, is based on the premise that inflationary expectations fully adjust to actual inflation.

Disinflation

• The elimination of the inflationary gap would normally be initiated by the Bank of Canada stopping the ongoing monetary expansion.

Economic Changes

• In Phase 2 of disafllation, the upward shift of the AS curve is normally caused by inflationary expectations that cause wages to continue rising.

During Disinflation

• In Phase 3 of disinflation, the movement of the economy from E3 to E4 is often caused by the Bank of Canada implementing an expansionary monetary policy.
• If the AS curve continues to drift upward during Phase 2 of the disinflation process, the economy will experience rising unemployment and falling output.
• The upward drift of the AS curve will generally continue longer, with rising unemployment and falling output, when firms and consumers do not regard the central bank's disinflation policy as credible.

Recovery Phase

• Real GDP can return to potential either by the AS curve falling slowly back to AS2 or by a monetary expansion which shifts the AD curve to AD2.
• The disadvantage of implementing an expansionary monetary policy to shift equilibrium from E3 to E4 is the danger of reviving expected inflation and having to repeat the phases of the disinflation.
• The movement of the economy from E3 to E2 could be due to a slow fall in wages due to a recessionary gap.
• A contractionary monetary policy that has been imposed to reduce inflation will most likely lead to a recession that will be short if inflation expectations adjust rapidly and accurately.
• It is difficult for the Bank of Canada to remove a sustained inflation without producing stagflation because inflationary expectations cause the AS curve to continue shifting upward. Stagflation can occur for this reason.

1980s and Disinflation

• One of the results of the restrictive monetary policy adopted by the Bank of Canada in the early 1980s was that inflation fell dramatically but was accompanied by a major recession.
• Of the three phases of a disinflation, the first phase consists of the central bank slowing the rate of monetary expansion.

Characterized Phases of Inflation

• Of the three phases involved in the elimination of a sustained inflation in Canada, the second phase is characterized by stagflation with falling output and continuing inflation.
• If a central bank is to successfully end a sustained inflation, it is essential that it change people's expectations of future inflation.
• The process of disinflation can involve some period of increased inflation and reduced output, referred to as stagflation.
• If the central bank implements a contractionary monetary policy in an effort to reduce the inflation rate, the short-run effect of this policy is likely to be that unemployment will rise further beyond the NAIRU.

The Sacrifice Ratio

• The sacrifice ratio is a measure of the cumulative loss in real GDP due to a disinflation.
• The sacrifice ratio is calculated by dividing the cumulative loss of real GDP due to disinflation by the number of percentage points by which inflation fell.
• In general, the sacrifice ratio will be greater, the longer it takes to revise inflationary expectations downwards.
• In general, the sacrifice ratio will be smaller, the shorter it takes to revise inflationary expectations downwards.
• If the current inflation rate is 4% and the Bank of Canada wants to reduce it to 2%, and the sacrifice ratio is 2, the Bank of Canada is prepared to accept a decline of real GDP of 4% of potential output as the cost of disinflation.
• The sacrifice ratio reflects the cost of disinflation as measured by the loss in economic activity.
• Policymakers must weigh the future benefits of lower inflation against the immediate costs of reduced output and higher unemployment.
• Estimated range is between 2% and 4%.
• If the sacrifice ratio is 3 then it costs 3% of GDP to reduce inflation by 1 percentage point.
• Estimates for the sacrifice ratio for many developed economies suggest that reducing inflation by 1 percentage point "costs" the economy between 2 and 4 % of real GDP.