Chapter 28

Canadian Inflation, Unemployment, and Business Cycle

Inflation Cycles

Inflation is a process in which the price level is rising and money is losing value.
Demand-pull inflation is inflation that results from an initial increase in aggregate demand.
A demand-pull inflation can result from any influence that increases aggregate demand.
In a demand-pull inflation, initially:
o Aggregate demand increases
o Real GDP increases above potential GDP and the price level rises
o The money wage rate rises
o The price level rises further and real GDP decreases toward potential GDP
A one-time increase in aggregate demand raises the price level but does not always start a
demand-pull inflation.
For demand-pull inflation to occur, aggregate demand must persistently increase.
The quantity of money must persistently grow at a rate that exceeds the growth rate of
potential GDP.
The figure shows a demand-pull inflation.
Initially, aggregate demand increases and the AD curve shifts rightward from AD0 to AD1.
Real GDP increases to $1,250 billion and the price level rises from 110 to 113.
Now real GDP exceeds potential GDP.

The money wage rate begins to rise.

The SAS curve shifts leftward from SAS0 to SAS1.
Real GDP decreases toward potential GDP.
The price level rises further from 113 to 121.

The process repeats in an unending demand-pull inflation spiral.

Cost-push inflation is an inflation that results from an increase in costs.

The two main sources of cost-push inflation are:
o An increase in the money wage rate
o An increase in the money prices of raw materials
In a cost-push inflation, initially
o Short-run aggregate supply decreases
o Real GDP decreases below potential GDP and the price level rises
o The economy could become stuck in this stagflation situation for some time.

A one-time decrease in aggregate supply raises the price level but does not always start costpush inflation.
For cost-push inflation to occur, aggregate demand must increase in response to the cost-push.
Just like the case of demand-pull inflation, the quantity of money must persistently grow at a
rate that exceeds the growth rate of potential GDP if inflation is to become persistent.
In the figure, the price of oil rises.

Short-run aggregate supply decreases and the SAS curve shifts leftward from SAS0 to SAS1.
Real GDP decreases from $1,200 billion to $1,150 billion and the price level rises from 110 to
117. Stagflation occurs.
With no subsequent change in aggregate demand, the price level eventually falls.

The figure below shows the aggregate demand response to cost-push.

For cost-push inflation to take hold, aggregate demand must increase.

An increase in the quantity of money increases aggregate demand and the AD curve shifts
rightward from AD0 to AD1.
Real GDP increases to $1,200 billion and the price level rises to 121.
This process repeats to create an unending cost-push inflation spiral.

Inflation and Unemployment: The Phillips Curve

A Phillips curve is a curve that shows a relationship between inflation and unemployment.
There are two time frames for the Phillips curve:
o The short-run Phillips curve
o The long-run Phillips curve
The short-run Phillips curve is a curve that shows the tradeoff between inflation and
unemployment holding constant:
o The expected inflation rate
o The natural rate of unemployment
With a given expected inflation rate and a given natural rate of unemployment, there is an
inverse relationship between the inflation rate and the unemployment rate.

The figure above shows a short-run Phillips curve.

An unexpected change in the inflation rate brings a movement along the SRPC.

The long-run Phillips curve is a curve that shows the relationship between inflation and
unemployment when the actual inflation rate equals the expected inflation rate.
When the actual inflation rate equals the expected inflation rate, the unemployment rate equals
the natural rate of unemployment.
The figure shows a long-run Phillips curve.
It is the vertical LRPC.
The figure also shows that when the expected inflation rate changes, the short-run Phillips curve
shifts.
The short-run Phillips curve intersects the long-run Phillips curve at the expected inflation rate.

If the natural rate of unemployment changes, both the short-run Phillips curve and the long-run
Phillips curve shift.
An increase in the natural rate of unemployment shifts both curves rightward.
A decrease in the natural rate of unemployment shifts these two curves leftward.

In the figure, the natural rate of unemployment increases.

The Business Cycle

The Keynesian cycle theory regards fluctuations in investment driven by fluctuations in business
confidence summarized by the phrase animal spirits as the main source of economic
fluctuations.
The monetarist cycle theory regards fluctuations in both investment and consumption
expenditure, driven by fluctuations in the growth rate of the quantity of money as the main
source of economic fluctuations.
The new classical cycle theory regards unexpected fluctuations in aggregate demand as the
main source of economic fluctuations.
The new Keynesian cycle theory regards unexpected and expected fluctuations in aggregate
demand as the main source of economic fluctuations.
The real business cycle theory of the business cycle regards random fluctuations in productivity
as the main source of economic fluctuations.
The impulse in RBC theory is the growth rate of productivity that results from technological
change.
Two immediate effects follow from a change in productivity, which are:
o Investment demand changes
o The demand for labour changes

In the market for loanable funds, a technology shock decreases the demand for loanable funds,
and the real interest rate falls.

The decrease in productivity decreases the demand for labour and the LD curve shifts leftward
from LD0 to LD1.

The fall in the real interest rate lowers the return to current work and decreases the supply of
labour.
The LS curve shifts leftward from LS0 to LS1.
Employment decreases to 19.5 billion hours and the real wage rate falls to $34.50 an hour.
A recession is underway.