EC140 Lecture Notes - Lecture 18: Output Gap, Nairu, Rational Expectations
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Inflation is a rise in the average level of prices. Commonly measured as the annual percentage change in cpi. First step add sustained / constant inflation to the model. Output gap: inflationary gap (y > y*) puts upward pressure on wages, recessionary gap ( u < y*) puts downward pressure on wages, when y = y* unemployment equals nairu. Expectations of inflation: expected inflation is a starting point for wage negotiations (maintains real wage) Change in wages determined by these two effects. Backward looking expectations: what has inflation been in the recent past, does not respond to expected policy changes. Forward looking expectations: consider current economic conditions, account for changes in government policy, extreme version rational expectations. Change in wages caused by output gap and expected inflation. If wages rise, as curve shifts up (to the left: net effect is inflationary caused price level to rise.
