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Figure 24.8 (Macro 11) Inflation Adjustment and Changes in Inflation

Figure 24.8 (Macro 11) Inflation Adjustment and Changes in Inflation

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Inflation Adjustment Line (IA)

• The flat IA indicates that firms and workers

adjust (change) prices and wages in such a

way that the inflation remains intact in the

short run as real GDP changes.

• There are two reasons why inflation stays

steady even if real GDP is changing:

expectations about continuing inflation and

staggered wage and price setting in the


Copyright â 2001 by H


Reason #1

Pricing decisions for the whole economy

require that the price expectations of other

firms be taken into account. Similarly, wage

adjustments are made in the context of

existing and future wage agreements.

Copyright © 2001 by H


Reason #1

• Expectations about the price and wage

decisions of other firms lead firms to raise

prices by more than expected inflation if

demand is high and by less than expected

inflation if demand is low. A parallel

process governs wage adjustments.

Copyright © 2001 by H


Reason #2

• Not all wages and prices are changed at the

same time. Rather, they are staggered over

months and even years.

• Staggered wages and prices act to slow

down the rapid adjustment of prices. This

also introduces a dependency between

current and past price and wage decisions.

• On any given day, the vast majority of

wages and prices do not change much.

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Inflation Adjustment

• Expectations, when combined with staggered

decisions, make recent past inflation

a factor in current inflation. Moreover, because the

strength of a price adjustment relative to inflation

expectations will depend on whether demand is

high or low across the economy, the relation

between real and potential GDP determines

whether inflation increases, decreases, or remains

unchanged. For example, if real GDP is below

potential, inflation decreases.

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Inflation Adjustment Line

• Three assumptions about the IA line are

needed . First, the IA line represents the rate

of inflation in the economy at a point in

time. It is flat, indicating that prices are

sticky in the short run. Second, the IA line

shifts after GDP departs from potential.

Third, any change in expectations or

materials prices will shift the IA line.

• These assumptions and the horizontal IA

line receive statistical support in real world.

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Combining the Aggregate Demand/Inflation Curve and

the Price Adjustment Line

• When the ADI curve and PA line are

combined, as in Figure 27.10, the rate of

inflation and real GDP are determined. This

may occur above, below, or at potential


• The intersection of the ADI curve and the

IA line gives a pair of observations on real

GDP and inflation at any point time.

Copyright © 2001 by H


Figure 24.10

(Macro 11)

Determining Real GDP and Inflation

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Figure 24.8 (Macro 11) Inflation Adjustment and Changes in Inflation

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