L23 - Inflation

Question 1

Who are the main central banks and what has been their role in terms of inflation?

Answer 1

Over the past two decades central banks of the developed world
including
- the Bank of England,
- the ECB and
- the FED, 

have adopted inflation targeting as a monetary policy strategy.

• Consequently, they have successfully held the inflation rate to about
  one percentage point on either side of their target rates per annum.
• Variations outside of the target range for inflation have been due to
  supply-side rather than demand-side shocks.

Question 2

What is a Demand Shock?

Answer 2

events that lead to unanticipated changes in planned aggregate
expenditure
- Demand Pull inflation

Question 3

How does the Demand Shock affect inflation on a graph?

Answer 3

• Looking a a graph with Inflation (π) on the y-axis and Output (Y) on the x-axis
• With an upwards sloping SRAS supply curve
• Downwards sloping AD curve
• Vertical LRAS
• Where Equilibrium is at the point where all three lines intercept
• An unanticipated increase in government budget deficit shifts the AD curve to the right.
• At the new short-run equilibrium (point B), actual output has risen above potential output Y*, creating an expansionary gap.
• This gap leads to a rise in inflationary expectations, shown as an upward movement of the SRAS line.
  At the new long-run equilibrium point C, actual output has fallen back to the level of potential output, but inflation is higher

Question 4

What is a Supply Shock?

Answer 4

unanticipated events that lead to firms changing their planned output
levels.
- Cost push inflation

Question 5

How can a Supply Shock affect inflation on a graph?

Answer 5

• An unanticipated increase in energy or other costs shifts the SRAS curve to the left.
• At the new short-run equilibrium point B, actual output has fallen below potential output Y* creating a recessionary gap.
• If the central bank does not intervene, this gap leads to a fall in inflationary expectations, shifting the SRAS curve back towards
  SRAS{1}, and the economy will revert back to the initial long-run equilibrium point A, with Y = Y*and π = π{1}.

Question 6

What is the link between money nominal money and the price level?

Answer 6

• hence between money growth and inflation
  -People demand for money because of its purchasing power over goods - real money.
• From our lecture on demand for money, we have summarised the
  motives for holding money as:
  M/P = L(Y ,r)
• Output and interest rates are both held constant
• In money market equilibrium, real money supply and demand are
  equal - the equation always holds.
• The changes in nominal money lead to equivalent changes in the price
  level (and money wages), with no effect on output and employment.

Question 7

What is Pure Inflation?

Answer 7

• Pure inflation is when goods and input prices rise at the same rate.
• Input prices and output prices: changes in input prices will affect
  production and prices.
• Rises in input prices will shift the SRAS curve to the left and falls will
  shift it to the right.
• There are two main categories of inputs whose prices can change in the
  short run:
  1 - materials and fuels, and
  2 - labour.

Question 8

Why is Inflation generally considered to be undesirable?

Answer 8

• Inflation is generally considered to be undesirable, especially when it is unexpected, because it distorts the signals that are provided by the price system;
• it creates arbitrary redistribution from debtors to creditors;
• it creates incentives for speculative as opposed to productive investment activity;
• and is usually costly to eliminate.

Question 9

What is Hyperinflation?

Answer 9

• are periods when inflation rates are very large.
• During such periods there tends to be a ‘fight from cash’, i.e. people
  hold as little cash as possible.
• For Example,. Germany’s inflation between 1922 and 1923 was 5% and
  29,720.
• Ukraine’s inflation topped 10,000%
  Zimbabwe may have exceeded a trillion per cent - produced 100 Trillion
  Zimbabwean dollars.
• Other countries that experienced hyperinflation include Hungary
  1945-46, Brazil in the late 1980s.
• Large government budget deficits help to explain such periods.
• Persistent inflation must be accompanied by continuing money supply
  growth.

Question 10

What is Stagflation?

Answer 10

• where output is stagnant or constant but price levels are still rising

Question 11

What is the Nominal Interest Rate?

Answer 11

• market interest rate.

- The annual percentage increase in the nominal value of a Financial asset.

Question 12

What is the Real Interest Rate?

Answer 12

• The annual percentage increase in the purchasing power of a Financial
  asset.
• The real interest rate on any asset equals the nominal interest rate on
  that asset minus the inflation rate.

Real Interest rate(r) = nominal interest rate(i) - Inflation rate(π)

Therefore,
r = i - π

Question 13

What is the Fisher Hypothesis?

Answer 13

• The Fisher hypothesis is that a 1% rise in inflation leads to a similar rise in nominal interest rates so real interest rates change little.
• The Fisher hypothesis says that higher inflation rate leads to similarly higher nominal interest rates.