An increase in real gdp increases disposable income

An increase in real GDP increases disposable income but also increase income taxes.
The increase in consumption expenditure will be less than if taxes had stayed the
same. So, the effect on real GDP is less.
Inflation Cycles
Increases in Aggregate Demand
Fig. 28.1 pg. 678
(a) Initial effect
 Start in long-run equilibrium at Point A
 The AD curve shifts to the right
 The initial effect is ↑ real GDP and ↑ price level
 Real GDP > Potential GDP  Inflationary gap
(b)The Money Wage Adjusts
Fig. 28.1 pg. 678
 Since real GDP > potential GDP,
Unemployment < natural rate of unemployment
 Labour is in short supply so the money wage will begin to rise
 SAS ↓ and shifts to the left
 Real GDP returns to the level of potential GDP and the price level ↑ further
NOTE
This outcome is a one-time price increase and NOT an inflation.
For an inflation to take place, this process ( ↑AD ↓SAS) would have to persist.
A Demand-Pull Inflation Process
Fig. 28.2 pg. 679
Question : What would cause an on-going demand-pull process?

 Costs of production increase and SAS ↓, shifts to the left
 The initial effect is ↓real GDP and ↑ price level
 Real GDP < potential GDP  Recessionary gap
NOTE
 The ↑ costs lead to a one-time increase in the price level, NOT inflation.
(b)Response
Fig. 28.3 pg. 681
 Since real GDP < potential GDP,
Unemployment > natural rate of unemployment
 In an attempt to restore full-employment, the Bank could ↑money supply and
↑AD
 Now, real GDP = potential GDP, price level ↑further
March 10, 2015
Re-cap Chapter 28
We can identify two sources of inflation:
I. Demand-pull inflation
 Starts with an ↑ aggregate demand (AD), for any number of reasons. See
examples of slide 6.
 ↑ AD  AD shifts right
 Outcomes
o ↑ real GDP (inflationary gap)
o ↑ price level
In the new short-run equilibrium, unemployment is low, so money wages ↑.
 ↑ money wages  ↓ SAS (shift left)
 Outcomes
o Real GDP = potential GDP
o Price level is higher
An inflationary spiral will result ONLY if the Bank ↑ MS  ↑ AD, and the cycle repeats
itself.
II. Cost-push inflation
 Starts with an increase in a firm’s cost of production – the result of an ↑ in
the cost of factors of production
 ↓SAS  SAS shifts left
 Outcomes
 ↓real GDP
 ↑price level
In the new short-run equilibrium, assuming the Bank wants to ↑output and
↓unemployment, the Bank will stimulate (↑) AD.
 Outcomes

o Real GDP = potential GDP
o Price level is higher
An inflationary spiral will result ONLY if costs continue to increase and the Bank
continues to respond to the recession by ↑MS  ↑AD.
Example Questions: