Shocks and Policy Responses

Demand Shocks

• The central bank does not use monetary policy as a response to the demand shock and lets the market adjust itself.
• Excess demand leads to a rise in nominal wages, shifting the AS curve upward.
• Equilibrium is established at a higher price level, with output at potential GDP (Y*).
• Temporary inflation occurs until the new long-run equilibrium is reached.

• The Bank of Canada validates the demand shock through expansionary monetary policy.
• Increasing the money supply or decreasing the interest rate.
• This is done to "keep the good times going"
• Validation causes the AD curve to shift further right, offsetting the upward shift in the AS curve.
• The persistent inflationary gap pushes the AS curve upward, while monetary validation pushes the AD curve to the right.
• Real GDP remains above potential GDP, and the inflationary gap and price level continue to rise.
• Sustained inflation occurs as long as monetary validation continues.

Supply Shocks

No Monetary Validation

• A leftward shift in the AS curve due to factors such as rising raw material costs or domestic wage create supply inflation.
• Without monetary validation, the AS curve slowly shifts downward as nominal wages and factor prices fall.
• The adjustment process aims to return output to potential GDP and the price level to its initial value.

Monetary Validation

• The Bank of Canada validates the negative supply shock by increasing the money supply or decreasing the interest rate.
• Validation shifts the AD curve to the right, closing the output gap and leading to a further rise in the price level.
• The return to potential output is faster compared to the non-validated case, but inflation may be prolonged.

Accelerating Inflation

• Acceleration hypothesis: The hypothesis that when real GDP is held above potential, the persistent inflationary gap will cause inflation to accelerate.
• This happens if the Central Bank uses monetary policy in a way that extends the output gap.
• For example: using expansionary monetary policy during an inflationary gap.
• As long as an inflationary output gap persists, expectations of inflation will be rising, which will lead to increases in the actual rate of inflation.