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Unformatted text preview: 1 241 Inflation and the DAD – SAS Model: A General Framework for Macroeconomic Analysis, Part 4 242 Agenda • Inflation and the Triangle Model. • The DAD – SAS Model. • Inflation Adjustment and the Attainment of General Equilibrium. • Inflation, Disinflation, and Deflation. 243 Inflation and the triangle model • Definition of inflation: π t = { ( P t – P t1 ) / P t1 } * 100 ¾ Where P is the general price level. 244 Inflation and the triangle model • Three explicit factors for explaining inflation. ¾ Called the triangle model. • Inflation, π , depends on 3 components: ¾ Inflationary expectations, π e . ¾ Excess demand, π ED . ¾ Inflation shocks, π Z . 2 245 Inflation and the triangle model • Inflationary expectations, π e : ¾ If people expect a particular level of inflation, that level will likely occur even without any pressure from the output or labor market. 246 Inflation and the triangle model • Inflationary expectations, π e : ¾ Modeling π e is extremely difficult. • Rational expectations – Based on forwardlooking behavior. • Adaptive expectations – Based on backwardlooking behavior ¾ Dependent on effect of staggered wage and price behavior. 247 Inflation and the triangle model • Inflationary expectations, π e : ¾ Key Assumption : Inflation expectations are formed by simple adaptive expectations. π e = π t1 248 Inflation and the triangle model • Excess demand inflation, π ED : ¾ Excess demand is measured by the output gap. π ED = f ( Y – Y* ) • Where f > 0. • The bigger is the output gap, the faster is the change in π t for any given f. • The bigger is f, the faster is the change in π t for any given output gap. 3 249 Inflation and the triangle model • Excess demand inflation, π ED : ¾ Key Assumption : Because of wage and price stickiness, current excess demand inflation depends on lagged excess demand. π ED t = f ( Y t1 – Y* t1 ) 2410 Inflation and the triangle model • Inflation shocks, π Z : ¾ Inflation shocks are assumed to be exogenous. • Changes in input costs that are independent of demand. – Changes in imported goods prices, especially oil. » Foreign price versus exchange rate. – Changes in competitive pressures. 2411 Inflation and the triangle model • Inflation shocks, π Z : ¾ Key Assumption : Inflation shocks affect inflation contemporaneously. π Z t = Z t 2412 Inflation and the triangle model • Inflation: π t = π t1 + f ( Y t1 – Y* t1 ) + Z t ¾ Expected inflation, plus ¾ Excess demand inflation, plus ¾ Inflation shocks. • This is also the new SRAS curve. 4 2413 The SRAS curve • The original SRAS curve was based on Plevel adjustment • The new SRAS curve is now based on π adjustment 2414 The SRAS Curve Y π 2415 The Phillips curve and the SRAS curve • The expectationsaugmented Phillips curve: π = π e – f ( u – u ) • Okun’s Law: ( Y*  Y ) / Y* = 2( u – u ) ¾ or u – u = 0.5 ( Y*  Y ) /...
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 Spring '08
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 Deflation, Inflation, triangle model, DAD–SAS model

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