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Essay on Macro-Economics
We can define the INFLATION AND AGGREGATE SUPPLY as the INFLATION INERTIA and the phenomenon where inflation tends to change relatively slowly.
i. Inflation Expectations: Today’s expectations of future inflation help determine future inflation. Low inflation leads people to expect low future inflation.
ii. Long term wages and price contracts: Union contracts and sales contracts usually extend to three years. These long term contracts have in-build assurances about rate of inflation.
OUTPUT GAP AND INFLATION
Overtime inflation will change. These changes are causes by existence of output gap.
If (Y* - Y) = 0 is unchanged
(Y* - Y) > 0 falls
(Y* - Y) < 0 rises
AGGREGATE SUPPLY DIAGRAM
Long-run Aggregate Supply (LRAS) line is a vertical line showing the economy’s potential output (Y*).
Short-run Aggregate Supply (SRAS) line: horizontal line showing the current rate of inflation.
Short-run equilibrium output (Y) depends on intersection of SRAS and AD curves.
Long-run equilibrium occurs when actual output equals potential output and AD.
AD-AS DIAGRAM
SRAS
AD
LRAS
OUTPUT
Y Y*
SELF CORRECTING ECONOMY.
Whenever, SRAS is not equal to LRAS there will be an output gap.
When Y* > Y then (Y*-Y) > 0. i.e. there is a recessionary gap. Here inflation is above its equilibrium level and there is pressure for inflation to fall.
The SRAS shifts down until inflation equals *. Here AD =SRAS = LRAS
Similarly if Y* > Y then (Y*-Y) < 0. To eliminate the expansionary gap, SRAS will shift up until
SRAS = LRAS = AD
That is overtime, the economy is self correcting. Output gaps will disappear on their own.
INFLATION SHOCKS
A sudden change in the normal behavior of inflation unrelated to the nation’s output gap.
A shock which leads to rise in inflation is called an Adverse Inflation shock while a favorable inflation shock leads to fall in inflation.....
