Accelerationist theory of inflation

[Jinnentonix]

Hi there

I've been trying to better understand how this theory works and there's one bit which I'm having difficulty on.

I can understand that, if the government attempts to reduce unemployment below NAIRU, the resultant demand pull inflation will cause people to expect higher levels of inflation. This new expectation will cause the Phillips curve to shift upward.

The textbook states words to the effect that, after the Phillips curve shifts upwards, 'if nominal AD continued to increase at the same rate, real aggregate demand would fall and unemployment would return to NAIRU' (see page 12 of chapter 19).

This explanation is somewhat vague to me at least. That is, I don't understand fully why the economy moves from B to C on the diagram on page 11.

Firstly, I don't understand what 'same rate' means. Is it implied that nominal AD increased by 3%? Wondering if this example could be illuminated with numerical examples regarding nominal AD?

Secondly, how does the fact that the nominal AD increase is swallowed by prices increases directly affect employment (but see my proposed explanation below).

Thirdly, is this a valid explanation for exam purposes?
1. An increase in inflationary expectations would cause workers to demand higher wages.
2. These wage demands would cause those firms to cut output and employment (thus causing unemployment rate to revert to NAIRU) along the new Phillips curve.

Could it be said that the ultimate outcome is that employment reverts to NAIRU and the demand pull inflation caused by the government's actions in raising AD is replaced by expectations-based inflation - which now persists until expectations are changed?

Thanks for any help!

 

[freddie]

This is tricky and it does seem to miss a step. As you say when the govt increases real Agg D, say by increasing the money supply by x%, this causes output to rise and unemployment to fall but prices to rise by say 3%. This causes people to revise expectations of inflation so they expect 3% next year and the Phillips curve shifts to the right. What happens next depends on what the govt does.

If the govt continues to increase the money supply by only x%, this will be a decrease in real terms (because inflation is running at 3%) so there will be a decrease in real Agg D and so output will fall and unemployment will rise and we're back at NAIRU but with 3% inflation. (This is basically a combination of two moves - an increase in demand for higher wages to 6% (3% on top of inflation), ie up from B to D, and fall in real Agg D taking output down and unemployment up, ie from D to C.) However, if the govt increases the money supply by x +3% then real Agg D will be maintained and the inflation will rise to 6%, ie from B to D.

Hope this helps.

 

[Jinnentonix]

Yeah, that's what I thought - that the shift in the curve brings the economy up from B to D and then back to C!

I suppose this can be expressed alternatively in the form of an AD/AS curve with shifts in the AD curve and a reflexive shift in the AS curve.

Thanks a lot!