Inflation

Question 1

inflation rate and how it can be measured

Answer 1

the percentage increase in the price level.

can be measured using the GDP deflator 100x(nominal GDP/real GDP)

or the consumer price index (CPI, the price of a fixed bundle of consumer goods)

Question 2

CPI vs GDP deflator

Answer 2

the CPI excludes all capital goods (goods that are used to make other goods rather than being bought by consumers) without regard as to whether they’re imported or exported.

the GDP deflator excludes all imported goods without regard as to whether they’re consumer or capital. The goods used in the GDP deflator change every year

Question 3

Disadvantages of inflation

Answer 3

1. Relative price distortions because different firms will raise their prices at different times. This makes it harder to tell what is VALUED more. This can lead to a misallocation of resources.
2. Consumers may start to believe that their purchasing power is changing when it isn’t. This can lead to a misallocation of resources and may have a negative psychological effect on consumers.
3. Fiscal drag- people may be dragged into higher tax brackets than warranted by their real incomes.
4. The higher the inflation rate gets, the more unpredictable it becomes. This makes risk-averse people more disadvantaged and makes financial planning more difficult.

Question 4

The benefit of inflation

Answer 4

employers can reduce real wages without having to give employees wage- cuts (which is difficult to do because wages are sticky and downward rigid)

Question 5

Bringing inflation down

Answer 5

bringing inflation down can be very hard to do if people have come to expect it to continue being high and have started to take it into account when increasing prices and wages, making it “baked in”

the central bank can bring inflation down by creating a recession 😨 (by not increasing the money supply in line with the inflation. Just announcing that they intend to do this can reduce inflation although consumers and investors know they are often reluctant to do so)

the central bank ANCHORS ⚓️ expectations by making its inflation target known (the bank of england’s is 2%). This prevents unusually high inflation from being baked in

Question 6

Hyperinflation

Answer 6

inflation of 50% or higher per month

previously mentioned costs of inflation become huge under hyperinflation

money loses its value, so people use foreign currencies or use a barter system

Question 7

The creation of hyperinflation

Answer 7

hyperinflation is created by an extremely large and rapid increase in the money supply

although it’s a monetary problem, it has fiscal roots because governments print excessive money when they need money for government spending but can’t raise the money from taxes or selling bonds.

this revenue is called seigniorage (SEEN-your-idge)

governments may also print money because inflation encourages people to spend before it gets even higher, acting as a tax on people who aren’t spending yet

Question 8

Ending hyperinflation

Answer 8

making the government less dependent on seigniorage (by cutting spending and increasing taxes probably)

anchoring expectations, such as by:

declaring a fixed rate of money supply growth (like in the case of normal inflation, this often doesn’t work because people don’t think the central bank will be willing to stick to it. growth in the money supply is also very hard to verify)

declaring an inflation target (again), though governments may lie about the level of inflation they’re having and whether they’ve achieved these targets

having a fixed exchange rate against a stable foreign currency (exchange rates change rapidly so it’s easy for central banks to see if they’re printing too much or too little and adjust accordingly)

Question 9

deflation

Answer 9

negative inflation

bad because:

causes consumers to delay purchases, which decreases AD and exacerbates the recession

increases the REAL value debtors OWE, causing them and creditors (bc they aren’t getting their money back) to go bankrupt. This also exacerbates the recession

makes the REAL interest rate positive even when the nominal interest rate is at the lower bound. This means the interest rate can be too high for firms when they’re technically too low to be made lower through conventional monetary policy