inflation Flashcards
why does a have to be > 1 in the Taylor rule?
More than 1 for 1 increase in the nominal rates of inflation as you have to get the real interest rate to rise to contract demand to get inflation down
what does the fisher equation say about wanting to change interest rates
you have to have the nominal interest rate move by more than inflation expectation
With sticky/partial sticky prices what replaces the supply curve
MM line
why is the yd-MM line downward sloping
Represents the negative relationship from inflation and GDP coming from the demand side
With the combination of the Phillips Curve and the Yd-MM line, what does the intersection show
Rate of inflation and the level of GDP the economy will get to
What will shift the Phillips Curve with
With inflation expectation and Y*
Future expectations
What will the Yd-MM line shift to
Demand shocks and if the CB changes the way it reacts to its economy
Expectations of the future economy
If the Taylor Principle Rule is satisfied, what does an increase in inflation expectation mean?
If the Taylor principle is satisfied (π > 1), an increase in inflation expectations leads to a larger increase in the nominal interest rate, raising the real interest rate and shifting the ππ β ππ line upwards. This reduces both output (π) and inflation (π) along the Phillips Curve.
How does higher expected future output affect the consumption curve
Higher expected future real GDP (πβ²) increases current consumption demand (πΆπ) due to the wealth effect and desire for consumption smoothing.
What does faster expected growth imply
Faster expected growth implies a higher marginal product of capital (πππΎβ²), leading to increased investment demand (πΌπ).
Investment demand is determined by the difference between the marginal product of capital and the real interest rate.
What is Investment demand determined by
Difference between MPK and real interest rate
what will a shift in an expansionary monetary policy do temporarily
will raise GDP for come time. Eventually inflation expectation with rise causing the Phillips Curve to shift up.
What does it mean for the economy when there is a shift along the Yd-MM line due to supply shocks
When the economy moves along the Yd - MM line due to the supply shock, inflation is high when output is low and unemployment is high - this is known as βstagflationβ.
What is the Lukas critique
The observed correlation between inflation and
economic activity is not structural: depends on policy and shocks
Why is inflation targeting important (5)
Is purchasing power going up or down?
- Volatility of inflation may destabilize the economy
- Unit of account for money - if the value of money keeps changing, hard to understand the value
- Financial contract - what will this money be worth in the future?
- Inefficiencies - medium of exchange but inflation erodes money, wasteful
- Menu costs - if firms have to keep changing prices you are wasting resources
What is the target inflation (pi *) set in the New Keynesian Model
The target for inflation (Ο*) is set at 0 in the New Keynesian model.
why is an inflation target of pi* the best (3)
According to nominal rigidities
βMenu costsβ are the expenses businesses face when they change prices. For example, printing new menus or updating price tags.
With zero inflation, businesses donβt need to adjust prices frequently, saving them money on these costs.
By keeping inflation (Ο) close to the target (Ο* = 0), the costs of inflation are minimized.
With zero inflation, individual price changes arenβt synchronized, meaning relative prices (the prices of goods compared to each other) stay more stable.
This stability helps businesses and consumers make decisions based on real changes in value, rather than just adjusting to inflation.
what does the MM line shift up with
Increase in real interest rate r
what would lead firms to change price
The output gap (Y - Y*) reveals the direction and size of the price changes that firms desire in order to restore their profit margins.
do firms just think about the present when setting prices
- Considering Future Conditions: Firms donβt just focus on the present when setting prices; they also think about future conditions. If they expect it will be beneficial to raise prices in the future, they anticipate positive future inflation (πβ²π).
- Impact on Current Prices: When a firm decides to adjust its prices now, it considers the expected future inflation. If future inflation is higher, the firm tends to increase prices by a larger amount in the current period.
- Effect on Current Inflation: Higher expectations of future inflation (πβ²π) lead to higher current inflation (π). We assume this effect is almost one-for-one, meaning if expected future inflation increases, current inflation also increases.
2 ways to influence inflation
- influence expectation of inflation - shifts Phillips curve
- Affect demand (output cap Y-Y*) - change interest rates so real interest rate r changes. r affects demand - affected output gap.
Transmission mechanism of monetary policy to inflation
Nominal interest rate up β real interest rate up β aggregate demand down β output gap (π β πβ) down β inflation down (Phillips curve)
What happens in a < 1
Rising inflation actually reduces real interest
rates, causing demand to rise and stoking more inflationary pressure
what makes the MM line upward sloping
- Monetary policy response to real GDP π makes ππ line upward sloping
Why does an inflation of 0 mean the output gap is closed (8)
- In a model with partial price adjustment, no inflation or deflation can only occur if firms are, on average, happy with their existing prices.
- This means the real wage (w) must be equal to the marginal revenue product of labor (MRPN).
- As a result, employment must be such that real GDP (Y) is on the Y^s (supply) curve.
- This implies that real GDP (Y) must be at the intersection of the Y^d (demand) and Y^s curves, which is the natural level of output (Y*).
- Therefore, there is no output gap - real GDP is at the natural level.
- This means there is no trade-off between targeting inflation at 0% and closing the output gap.
- The policy effectively replicates what would happen under flexible prices, canceling out the effect of the nominal rigidities.
When the actual real interest rate (r) is equal to the natural rate (r*), the economy is operating at its potential and there is no inflation pressure.
what does it mean when wage is lower than MPN
- The full Marginal Product of Labor (MPN) is the maximum potential output the worker could produce.
- However, the real wage (w) paid to the worker is less than this full MPN.
The key point is that in imperfect competition, the firm pays the worker a real wage (w) that is lower than the workerβs full productive capacity (MPN)
With fully flexible prices where will the economy always adjust to
The key is that with fully flexible prices, the economy will always adjust to reach the natural level of output (Y) and the natural rate of interest (r).
