CanadianInflation,Unemployment,andBusinessCycle.pdf

Canadian Inflation, 28 Unemployment, and Business Cycle Learning Objectives ? Explain how demand-pull and cost-push forces bring cycles in inflation and output ? Explain the short-run and long-run tradeoff between inflation and unemployment ? Explain how the mainstream business cycle theory and real business cycle theory account for fluctuations in output and employment Inflation Cycles In the long run, inflation occurs if the quantity of money grows faster than potential GDP. In the short run, many factors can start an inflation, and real GDP and the price level interact. To study these interactions, we distinguish two sources of inflation: ? Demand-pull inflation ? Cost-push inflation Inflation Cycles Demand-Pull Inflation An inflation that starts because aggregate demand increases is called demand-pull inflation. ? Demand-pull inflation can begin with any factor that increases aggregate demand. ? Examples: ? a cut in the interest rate ? an increase in the quantity of money ? an increase in government expenditure or a tax cut ? an increase in exports, or an increase in investment stimulated by an increase in expected future profits. Inflation Cycles Initial Effect of an Increase in Aggregate Demand Figure 28.1(a) illustrates the start of a demand-pull inflation. Starting from full employment, an increase in aggregate demand shifts the AD curve rightward. Inflation Cycles The price level rises, real GDP increases, and an inflationary gap arises. The rising price level is the first step in the demand-pull inflation. Inflation Cycles Money Wage Rate Response Figure 28.1(b) shows that the money wage rate rises and the SAS curve shifts leftward. The price level rises and real GDP decreases back to potential GDP. Inflation Cycles A Demand-Pull Inflation Process Figure 28.2 illustra