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ADJUSTING TO AN INFLATIONARY GAP: INFLATION
Let us now turn to what happens when the economy finds itself beyond full employ-
ment”that is, with an inflationary gap like that shown in Figure 7. When the aggregate
supply curve is S0S0 and the aggregate demand curve is DD, the economy will initially
reach equilibrium (point E) with an inflationary gap, shown by the segment BE.
According to some economists, a situation like this arose in the United States in 2006
and 2007 when the unemployment rate dipped below 5 percent. What should happen un-
der such circumstances? As we shall see now, the tight labor market should produce an
inflation that eventually eliminates the inflationary gap, although perhaps in a slow and
painful way. Let us see how.
When equilibrium GDP exceeds potential GDP, jobs are plentiful and labor is in great
demand. Firms are likely to have trouble recruiting new workers or even holding onto
their old ones as other firms try to lure workers away with higher wages.
F I GU R E 7
Rising nominal wages add to business costs, which shift the aggregate supply curve to
The Elimination of an
the left. As the aggregate supply curve moves from S0S0 to S1S1 in Figure 7, the inflation-
Inflationary Gap
ary gap shrinks. In other words, inflation eventually
erodes the inflationary gap and brings the economy to an
equilibrium at potential GDP (point F).
There is a straightforward way of looking at the eco- Potential
GDP
nomics underlying this process. Inflation arises because S1
buyers are demanding more output than the economy can
D
produce at normal operating rates. To paraphrase an old
S0
clich©, there is too much demand chasing too little supply.
Price Level (P )




Such an environment encourages price hikes.
Ultimately, rising prices eat away at the purchasing
F
power of consumers™ wealth, forcing them to cut back on
E
consumption, as explained in Chapter 8. In addition, ex- B
ports fall and imports rise, as we learned in Chapter 9.
Eventually, aggregate quantity demanded is scaled back to
S1
the economy™s capacity to produce”graphically, the econ- D
Inflationary
omy moves back along curve DD from point E to point F. gap
S0
At this point the self-correcting process stops. In brief:
If aggregate demand is exceptionally high, the economy Real GDP (Y )
may reach a short-run equilibrium above full employment



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Part 2
210 The Macroeconomy: Aggregate Supply and Demand



(an inflationary gap). When this occurs, the tight situation in the labor market soon forces
nominal wages to rise. Because rising wages increase business costs, prices increase; there
is inflation. As higher prices cut into consumer purchasing power and net exports, the in-
flationary gap begins to close.
As the inflationary gap closes, output falls and prices continue to rise. When the gap
is finally eliminated, a long-run equilibrium is established with a higher price level and
with GDP equal to potential GDP.
This scenario is precisely what some economists believe happened in 2006 and 2007.
Because they believed that the U.S. economy had a small inflationary gap in 2006 and
2007, they expected inflation to rise slightly”which it did, before receding again. But
remember once again that the self-correcting mechanism takes time because wages and
prices do not adjust quickly. Thus, while an inflationary gap sows the seeds of its own
destruction, the seeds germinate slowly. So, once again, policy makers may want to
speed up the process.


Demand Inflation and Stagflation
Simple as it is, this model of how the economy adjusts to an inflationary gap teaches us a
number of important lessons about inflation in the real world. First, Figure 7 reminds us
that the real culprit is an excess of aggregate demand relative to potential GDP. The aggre-
gate demand curve is initially so high that it intersects the aggregate supply curve beyond
full employment. The resulting intense demand for goods and labor pushes prices and
wages higher. Although aggregate demand in excess of potential GDP is not the only pos-
sible cause of inflation, it certainly is the cause in our example.
Nonetheless, business managers and journalists may blame inflation on rising wages.
In a superficial sense, of course, they are right, because higher wages do indeed lead
firms to raise product prices. But in a deeper sense they are wrong. Both rising wages
and rising prices are symptoms of the same underlying malady: too much aggregate de-
mand. Blaming labor for inflation in such a case is a bit like blaming high doctor bills
for making you ill.
Second, notice that output falls while prices rise as the economy adjusts from point E to
point F in Figure 7. This is our first (but not our last) explanation of the phenomenon of
stagflation”the conjunction of inflation and economic stagnation. Specifically:
Stagflation is inflation
that occurs while the
A period of stagflation is part of the normal aftermath of a period of excessive aggregate
economy is growing slowly
demand.
or having a recession.
It is easy to understand why. When aggregate demand is excessive, the economy will
temporarily produce beyond its normal capacity. Labor markets tighten and wages rise.
Machinery and raw materials may also become scarce and so start rising in price. Faced
with higher costs, business firms quite naturally react by producing less and charging
higher prices. That is stagflation.

A U.S. Example
The stagflation that follows a period of excessive aggregate demand is, you will note, a
rather benign form of the dreaded disease. After all, while output is falling, it nonetheless
remains above potential GDP, and unemployment is low. The U.S. economy last experi-
enced such an episode at the end of the 1980s.
The long economic expansion of the 1980s brought the unemployment rate down to a
15-year low of 5 percent by March 1989. Almost all economists believed at the time that
5 percent was below the full-employment unemployment rate, that is, that the U.S. econ-
omy had an inflationary gap. As the theory suggests, inflation began to accelerate”from
4.4 percent in 1988 to 4.6 percent in 1989 and then to 6.1 percent in 1990.
In the meantime, the economy was stagnating. Real GDP growth fell from 3.5 percent
during 1989 to 1.8 percent in 1990 and down to 20.5 percent in 1991. Inflation was eating
away at the inflationary gap, which had virtually disappeared by mid-1990, when the



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Chapter 10 211
Bringing in the Supply Side: Unemployment and Inflation?




A Tale of Two Graduating Classes: 2003 Versus 2007
Timing matters in life. The college graduates of 2007 were pretty
fortunate. The unemployment rate was a low 4.5 percent in May
and June of that year”close to its lowest level in a generation.
With employers on the prowl for new hires, starting salaries rose
and many graduating seniors had numerous job offers.
Things were not nearly that good for the Class of 2003 when it
hit the job market four years earlier. The U.S. economy had been




SOURCE: © Creatas Images/Jupiterimages
sluggish for a while, and job offers were relatively scarce. The un-
employment rate in May“June 2003 averaged 6.2 percent. Many
companies were less than eager to hire more workers, salary in-
creases were modest, and “perks” were being trimmed.
This accident of birth meant that the college grads of 2003
started their working careers in a less advantageous position
than their more fortunate brothers and sisters four years later.
What™s more, recent research suggests that the initial job mar-
ket advantage of the Class of 2007, compared to the Class of
2003, is likely to be maintained for many years.




recession started. Yet inflation remained high through the early months of the recession.
The U.S. economy was in a stagflation phase.
Our overall conclusion about the economy™s ability to right itself seems to run some-
thing like this:
The economy does, indeed, have a self-correcting mechanism that tends to eliminate
either unemployment or inflation. But this mechanism works slowly and unevenly. In
addition, its beneficial effects on either inflation or unemployment are sometimes
swamped by strong forces pushing in the opposite direction (such as rapid increases or de-
creases in aggregate demand). Thus, the self-correcting mechanism is not always reliable.



STAGFLATION FROM A SUPPLY SHOCK
We have just discussed the type of stagflation that follows in the wake of an inflationary
boom. However, that is not what happened when unemployment and inflation both
soared in the 1970s and early 1980s. What caused this more virulent strain of stagflation?
Several things, though the principal culprit was rising energy prices.
In 1973, the Organization of Petroleum Exporting Countries (OPEC) quadrupled the
price of crude oil. American consumers soon found the prices of gasoline and home heat-
ing fuels increasing sharply, and U.S. businesses saw an important cost of doing business”
energy prices”rising drastically. OPEC struck again in the period 1979“1980, this time
doubling the price of oil. Then the same thing happened again, albeit on a smaller scale,
when Iraq invaded Kuwait in 1990. Most recently, oil prices have been on an irregular up-
ward climb since 2002 because of the Iraq war, other political issues in the Middle East and
elsewhere, problems with refining capacity, and surging energy demand from China.
Higher energy prices, we observed earlier, shift the economy™s aggregate supply curve
inward in the manner shown in Figure 8 on the next page. If the aggregate supply curve
shifts inward, as it surely did following each of these “oil shocks,” production will de-
cline. To reduce demand to the available supply, prices will have to rise. The result is the
worst of both worlds: falling production and rising prices.
This conclusion is displayed graphically in Figure 8, which shows an aggregate de-
mand curve, DD, and two aggregate supply curves. When the supply curve shifts inward,
the economy™s equilibrium shifts from point E to point A. Thus, output falls while prices



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Licensed to:
Part 2
212 The Macroeconomy: Aggregate Supply and Demand



rise, which is precisely our definition of stagflation.
F I GU R E 8
In sum:
Stagflation from an Adverse Shift in Aggregate Supply
Stagflation is the typical result of adverse shifts of
the aggregate supply curve.
The numbers used in Figure 8 are meant to indicate
what the big energy shock in late 1973 might have
done to the U.S. economy. Between 1973 (represented
S1
(2000 = 100)
Price Level




by supply curve S0S0 and point E) and 1975 (repre-
S0
D
sented by supply curve S1S1 and point A), it shows real
A
GDP falling by about 1.5 percent, while the price level
36.0
E rises more than 13 percent over the two years. The gen-
31.8
D eral lesson to be learned from the U.S. experience with
supply shocks is both clear and important:
S1
S0 The typical results of an adverse supply shock are
lower output and higher inflation. This is one reason
why the world economy was plagued by stagflation
4,275 4,342
in the mid-1970s and early 1980s. And it can hap-
Real GDP
pen again if another series of supply-reducing events
takes place.
NOTE: Amounts are in billions of dollars per year.




APPLYING THE MODEL TO A GROWING ECONOMY
You may have noticed that ever since Chapter 5 we have been using the simple aggregate
supply and aggregate demand model to determine the equilibrium price level and the
equilibrium level of real GDP, as depicted in several graphs in this chapter. But in the real
world, neither the price level nor real GDP remains constant for long. Instead, both nor-
mally rise from one year to the next.
The growth process is illustrated in Figure 9, which is a scatter diagram of the U.S. price
level and the level of real GDP for every year from 1972 to 2007. The labeled points show
the clear upward march of the economy through time”toward higher prices and higher
levels of output.



Why Was There No Stagflation in 2006“2008?
As noted earlier, oil prices have climbed steeply, if irregularly, since question, part of the story is plain old good luck. Naturally, we can-
early 2002. Yet this succession of “oil shocks” seems not to have not expect good luck to continue forever.
caused much, if any, stagflation in the United States or in other indus- Finally, it can be argued that we did have a little bit of stagfla-
trial economies. This recent experience stands in sharp contrast to the tion. In late 2007 and early 2008, growth slowed sharply and
1970s and early 1980s. What has been different this time around? inflation rose.
In truth, economists do not have a complete answer to this
question, and research on it continues. But we do understand a few
things. Most straightforwardly, the world has learned to live with
less energy (relative to GDP). In the United States and many other
SOURCE: © Creatas Images/Jupiterimages




countries, for example, the energy content of $1 worth of GDP is

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