Inflation and Deflation

Causes of Inflation

• Output gap inflation
• Expected inflation
• Demand/supply shock inflation

Constant Inflation

<aside> 💡 Constant inflation with $Y=Y^*$ occurs when the rate of monetary expansion, the rate of wage increase, and the expected rate of inflation are all equal to the actual inflation rate.

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Why do wages change?

• Output gap
  • Inflationary gap (Y > Y*) puts upward pressure on wages
  • Recessionary gap (Y < Y*) puts downward pressure on wages
  • When Y = Y*, unemployment equals NAIRU (the natural rate)
• Expectations of inflation
  • Expected inflation is a starting point for wage negotiations
• Change in wages are determined by these two effects ☝️

Wages and Aggregate Supply

• If wages rise, AS curve shifts up (to the left)
  • Net effect is inflationary - causes price level to rise
• If wages fall, AS curve shifts down (to the right)
  • Net effect is deflationary - cases price level to fall

Demand Shocks