Inflation Flashcards
Define inflation
• A sustained increase in overall level of prices (6 months or longer)
• Percentage change in prices > 0
o Inflation rises every dollar you own buys smaller percentage of good or services
How do we measure the level of prices (what indices- CPI, Implicit deflator)?
• CPI
(consumer Price index)
o Core index (leaves out food and energy)
o CPI for year x: (total $ expenditure in Year X/ total $ expenditure in base year) * 100
• Implicit deflator (GDP deflator)
(price index for all GDP)
o Used to deflate nominal to get real GDP
• Real GDP =nominal GDP/ (P/100)
• P= GDP deflator
How do we measure inflation?
• CPI
o Measure of consumer goods and services
• Gas, food, clothing, and auto
o Measures price change from perspective of purchaser
• PPI [not sure if you need to know this but just in case]
(producer price indexes)
o Family of indexes that measure the average change over time in selling prices by domestic producers of goods and services
o Perspective of the seller
What can cause inflation in the short-run?
• Demand pull inflation
(price levels rise because of an imbalance in the agg supply and demand)
o Agg D outweighs agg S prices increase
o Caused by increases (shifts or shcoks) in agg D which increase prices and output
• Cost-push or Supply shock inflation
o Higher cost of production factors decrease in agg supply (the total amount of total production)
o Upward shifts in agg supply increase prices but slows or reduces output resulting in stagflation
• Wage- price sprials
o Workers would demand higher wages
• Shifting agg S up and reducing output and unemp
o Fed responded by lowering interest rates to reduce unemp resulting higher prices leading to new wage demand and inflations up
• Self-limiting
o Price rise
o Stops-higher P
What can cause inflation in the long-run?
• Demand and supply shocks self limiting
o Prices up then stop
o Unless D continues to increase
o Only increase in MS
What harm does anticipated inflation cause? (menu and shoe leather costs)
• Menu costs
(costs that result in price changes)
o Ex. Restaurant wants to change menu price, the cost of changing the menus (to show new price) comes into consideration
• Shoe leather cost
(opportunity cost of efforts intended to counteract the effects of inflation)
o Comes from the idea that people will cope with inflation by keeping less cash on hand and make more trips to the bank
o People inefficiently reducing their holding of money, which earns no interest and loses purchasing power with inflation
o Economy waste resources going ‘back and fourth to the bank’ to reduce their money holding
What harm does unanticipated inflation cause?
• Distortion of the price system
o Results in economic inefficiency
o Relative and absolute price changes get confused
• Use to a price increase in a good signaling a substitute for that good
• With inflation we confuse increase of general level prices with increase in price of individual items relative to others
• Lenders lose to borrowers
o Borrowers pay back in ‘cheaper’ dollars
• Real interest rate falls with inflation thus lenders lend less
• Bracket creep
(increasing tax brackets and taxes with no increase in real income)
o Tax distortion
o Tax distortions
o Tax on nominal (unadjusted income) income
• Harms those on fixed (set amounts of periodically paid income) income
What is deflation and what harm does it cause?
• Deflation
(sustained decrease in general level of prices)
o Generally cause by recession/depression
• Weak demand
• Distortions of the price system [repeated above]
• Real interest rates increase
o R real = r nominal- (-infalation)
• Monetary policy may lost traction
o Real interest rates increase despite nominal decline
• Great depression
• Debt burden
o Borrowers lose to lenders
• Harder to pay back loans as prices and wages are falling
o Increases
• Depression
• Deflationary spiral
o Demand falls, prices fall, consumes and business defer purchases waiting for lower prices, and demand falls further
o Dump assets to pay debt further reducing P
o Financial accelerator
(small change in financial markets can produce a large change in economic conditions and creates a feedback loop)
• y down financial sector problems, y down further
What is hyperinflation? What causes it? What are the consequences?
• Hyperinflation
(extreme inflation)
o Price increase are so out of control the concept of inflation is meaningless
• Germany 322% (8/22-11/23)
• Zimbabwe 231,000,000%
• Causes
o Government faces extraordinary demands for spending
• Cannot finance by taxes or borrowing
• Only option to print more money
• Higher and higher prices till gov collapses
• Consequences
o Eliminates confidence in money
• Money loses value
• Results in people no longer using money
o Results in barter or new currency
• Barter is exchange good and services for other goods and services
• New currency is adopting another countries stable currency
U.S. dollars
What’s the short-run Phillip’s curve? What policy does it imply?
• Short-run Phillip’s curve
(inverse or negative relationship between inflation and the level of unemployment)
o Inversely related to unemp
o Trade off between inflation and unemp
• Policy makers can choose to reduce unemp at cost of additional inflation
• Policy implied
o Keynesian
What causes the short-run Phillips curve to shift up?
• Higher inflation rates [don’t know if this is right]
What’s the long-run Phillip’s curve? What’s the implications of the slope of the long-run Phillip’s curve?
• Long-run Phillips curve
(vertical line at the natural rate of unemployment)
o Inflation and unemployment unrelated in long-run
• Vertical slope representing no tradeoff between inflation and unemployment
What is the relationship between the Fed credibility and inflation? Between inflation expectations and inflation? Between unemployment and inflation?
• Fed credibility and inflation
o When Fed does not have creditability it is difficult to stop the rise of inflation
• Inflations expectations and Inflation
o Adaptive expectation
• People use past info as the predicator of future events
If inflation was higher the normal in past, people expect it to be higher then anticipated in future
o Rational expectation
• Use all available information, past and present, to precit future
If inflation was higher then normal in past, people will take that into consideration, along with current economic indicators, and anticipate its future performance.
• Unemployment and inflation
o Trade-off between inflation and unemployment
• Phillips curve
o Unemp falls, workers are empowered to push for higher wages, firms try pass high wages cost on to consumers, resulting in higher price and increase in inflation
o Low inflation rate or low unemployment not both
