Chapter 19

What is the difference between nominal and real aggregate demand?

Please explain the difference in relation to the Year 2 and Year 3 of the accelerationist theory of inflation

 

Nominal aggregate demand (AD) refers to total spending in money terms, ie in pounds or dollars, whereas real aggregate demand refers to total spending in terms of the volumes of goods and services purchased.

Suppose that nominal or money AD was £1 billion in 2012 and then £1.1 billion in 2013, ie it increased by 10%. If average prices increased by 5% between 2012 and 2013, then the volume of goods and services purchased, ie the real level of AD, will have increased by only 5%. So, consumers will on average only be about 5% better off in real terms in 2013 compared to 2012.

Essentially, all that happens in the accelerationist theory of inflation model is that the government increases spending, which leads to an increase in nominal AD. This leads to an increase in GDP and in inflation (to 3% say) and a decrease in unemployment, particularly as workers' expectations of inflation lag actual inflation by a year. Next year, however, workers realise that inflation has increased to 3% and so demand and gain a 3% wage increase to catch up with inflation. As wages have now caught up with prices, the economy reverts back to the original equilibrium levels of output and employment, but with 3% inflation (for both prices and wages).

If the government thinks unemployment is again too high, it again increases its spending further, leading again to a increase in GDP and a further increase in inflation (to 6% say). Once again unemployment falls, as workers' expectations of inflation lag actual inflation by a year - they still expect 3%. The following year, workers once again realise that inflation has increased, now to 6% and so demand and gain a 6% wage increase to catch up with inflation. As wages have now caught up with prices, the economy reverts back to the original equilibrium levels of output and employment, but with 6% inflation (for both prices and wages).

This process or ever-increasing inflation will continue so long as the government continues to try and reduce unemployment by increasing its spending.

 

Year 2: Increase in AD leads to increase in prices due to increase in non inflationary wages (eg. overtime or by increasing the quantity of labour) This increase in price leads to inflation and reduction in unemployment

year 3: This price inflation results in wage inflation. So next time when there is an increase in aggregate demand the prices would rise even higher

so why is this inflation not a part of year 2?
Acc to the notes shouldn't it be 3% expected inflation + this extra rise in prices due to wage inflation?

Or is it so that the Real AD comes back to its original position due to the expected inflation + the increase due to wage inflation?

 

The Core Reading is vague here and so you wouldn't be expected to be too precise with your answers in the exam.

The main point is that each rise in AD leads to excess demand and hence a rise in prices generally throughout the economy. However, wages will not respond immediately because workers are assumed to still expect the previous (lower) level of inflation. This means that wages lag behind the general level of prices.

However, come the following year, workers' expectations of inflation will have adjusted upwards to the new higher level of inflation and so they negotiate their wages back up to the new higher level of prices. So, real wages return to their original level and unemployment returns to its natural rate back on the long-run Phillips curve (LRPC). Going forwards, as workers expect inflation to be at its higher rate, they will expect and will negotiate wages increases at the same rate as that higher inflation rate. Consequently, wage and price inflation will be the same at the new higher rate, with wages and prices increasing at the same rate, real wages unchanged and unemployment at its natural rate on the LRPC.

The economy will remain in such a position until something further changes. For example, if the government thinks that unemployment is too high and so increases AD further, then the process will be repeated in the following years, leading to short-term falls in unemployment each year, as workers' expectations of inflation lag actual inflation, followed by a return to the natural rate of unemployment once inflation expectations and money wages again catch up with inflation.