Page 197 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes Figure 11.4 shows that the economy starts at an equilibrium of zero actual inflation, zero expected
inflation, and 5.5 per cent unemployment which, let us suppose, happens to be the natural rate
of unemployment. Now government comes along and expands the economy with expansionary
monetary or fiscal policy to point A on the short run curve so that there will be 3 per cent
inflation and 4 per cent unemployment. The 3 per cent actual inflation exceeds 0 per cent expected
inflation, which causes a shift up in expectations of inflation. This increase in expectations causes
the short run curve to shift up from PC to PC .
1 2
Figure 11.4

Example: After expectations of inflation have shifted up fully, instead of being able to
achieve 4 per cent unemployment at B, let us say the government is willing to accept 6 per cent
inflation and uses expansionary monetary or fiscal policy to try to maintain unemployment at
4 per cent, which is 1.5 per cent below the natural rate. Expectations of inflation would shift upto
6 per cent and the short run curve would shift up to PC . Now, the government finds that to keep
3
the economy at 4 per cent unemployment would require an even more expansionary policy and
an inflation rate of 9 per cent (C). And even that 9 per cent is only temporary; as long as the
unemployment rate is less than the natural rate, actual inflation will be above expected inflation,
the short run curve will be shifting up, and inflation will be accelerating.

Caselet India’s Agricultural Sector Slipping into Stagflation
Indian governments hate inflation , but inflation seems attached to this government like
an irritating limpet. For most of 2010, the government battled to bring down the rate at
which prices went up and by November, 2010 its efforts seemed to be working: headline
inflation slipped to 7.5%. But the following month, it’s roared back up to 8.4%. Worse, the
surge is being driven by something that hits people straight in the gut: food prices.

This worried everyone, including Prime Minister Manmohan Singh so much, that he
spent two days last week meeting his senior Cabinet colleagues to find out exactly what’s
driving prices up and what to do about it.
Contd...

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