inflation

Question 1

why does a have to be > 1 in the Taylor rule?

Answer 1

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

Question 2

what does the fisher equation say about wanting to change interest rates

Answer 2

you have to have the nominal interest rate move by more than inflation expectation

Question 3

With sticky/partial sticky prices what replaces the supply curve

Answer 3

MM line

Question 4

why is the yd-MM line downward sloping

Answer 4

Represents the negative relationship from inflation and GDP coming from the demand side

Question 5

With the combination of the Phillips Curve and the Yd-MM line, what does the intersection show

Answer 5

Rate of inflation and the level of GDP the economy will get to

Question 6

What will shift the Phillips Curve with

Answer 6

With inflation expectation and Y*
Future expectations

Question 7

What will the Yd-MM line shift to

Answer 7

Demand shocks and if the CB changes the way it reacts to its economy
Expectations of the future economy

Question 8

If the Taylor Principle Rule is satisfied, what does an increase in inflation expectation mean?

Answer 8

If the Taylor principle is satisfied (𝑎 > 1), an increase in inflation expectations leads to a larger increase in the nominal interest rate, raising the real interest rate and shifting the 𝑌𝑑 − 𝑀𝑀 line upwards. This reduces both output (𝑌) and inflation (𝜋) along the Phillips Curve.

Question 9

How does higher expected future output affect the consumption curve

Answer 9

Higher expected future real GDP (𝑌′) increases current consumption demand (𝐶𝑑) due to the wealth effect and desire for consumption smoothing.

Question 10

What does faster expected growth imply

Answer 10

Faster expected growth implies a higher marginal product of capital (𝑀𝑃𝐾′), leading to increased investment demand (𝐼𝑑).
Investment demand is determined by the difference between the marginal product of capital and the real interest rate.

Question 11

What is Investment demand determined by

Answer 11

Difference between MPK and real interest rate

Question 12

what will a shift in an expansionary monetary policy do temporarily

Answer 12

will raise GDP for come time. Eventually inflation expectation with rise causing the Phillips Curve to shift up.

Question 13

What does it mean for the economy when there is a shift along the Yd-MM line due to supply shocks

Answer 13

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 “stagflation”.

Question 14

What is the Lukas critique

Answer 14

The observed correlation between inflation and
economic activity is not structural: depends on policy and shocks

Question 15

Why is inflation targeting important (5)

Answer 15

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

Question 16

What is the target inflation (pi *) set in the New Keynesian Model

Answer 16

The target for inflation (π*) is set at 0 in the New Keynesian model.

Question 17

why is an inflation target of pi* the best (3)

Answer 17

According to nominal rigidities
“Menu costs” are the expenses businesses face when they change prices. For example, printing new menus or updating price tags.
With zero inflation, businesses don’t need to adjust prices frequently, saving them money on these costs.

By keeping inflation (π) close to the target (π* = 0), the costs of inflation are minimized.

With zero inflation, individual price changes aren’t 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.

Question 18

what does the MM line shift up with

Answer 18

Increase in real interest rate r

Question 19

what would lead firms to change price

Answer 19

The output gap (Y - Y*) reveals the direction and size of the price changes that firms desire in order to restore their profit margins.

Question 20

do firms just think about the present when setting prices

Answer 20

1. Considering Future Conditions: Firms don’t 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 (𝜋′𝑒).
2. 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.
3. Effect on Current Inflation: Higher expectations of future inflation (𝜋′𝑒) 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.

Question 21

2 ways to influence inflation

Answer 21

1. influence expectation of inflation - shifts Phillips curve
2. Affect demand (output cap Y-Y*) - change interest rates so real interest rate r changes. r affects demand - affected output gap.

Question 22

Transmission mechanism of monetary policy to inflation

Answer 22

Nominal interest rate up ⇒ real interest rate up ⇒ aggregate demand down ⇒ output gap (𝑌 − 𝑌∗) down ⇒ inflation down (Phillips curve)

Question 23

What happens in a < 1

Answer 23

Rising inflation actually reduces real interest
rates, causing demand to rise and stoking more inflationary pressure

Question 24

what makes the MM line upward sloping

Answer 24

• Monetary policy response to real GDP 𝑌 makes 𝑀𝑀 line upward sloping

Question 25

Why does an inflation of 0 mean the output gap is closed (8)

Answer 25

1. In a model with partial price adjustment, no inflation or deflation can only occur if firms are, on average, happy with their existing prices.
2. This means the real wage (w) must be equal to the marginal revenue product of labor (MRPN).
3. As a result, employment must be such that real GDP (Y) is on the Y^s (supply) curve.
4. 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*).
5. Therefore, there is no output gap - real GDP is at the natural level.
6. This means there is no trade-off between targeting inflation at 0% and closing the output gap.
7. 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.

Question 26

what does it mean when wage is lower than MPN

Answer 26

• 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 worker’s full productive capacity (MPN)

Question 27

With fully flexible prices where will the economy always adjust to

Answer 27

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).