L23 - Inflation Flashcards
Who are the main central banks and what has been their role in terms of inflation?
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.
What is a Demand Shock?
events that lead to unanticipated changes in planned aggregate
expenditure
- Demand Pull inflation
How does the Demand Shock affect inflation on a graph?
- 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
What is a Supply Shock?
unanticipated events that lead to firms changing their planned output
levels.
- Cost push inflation
How can a Supply Shock affect inflation on a graph?
- 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}.
What is the link between money nominal money and the price level?
- 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.
What is Pure Inflation?
- 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.
Why is Inflation generally considered to be undesirable?
- 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.
What is Hyperinflation?
- 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.
What is Stagflation?
- where output is stagnant or constant but price levels are still rising
What is the Nominal Interest Rate?
- market interest rate.
- The annual percentage increase in the nominal value of a Financial asset.
What is the Real Interest Rate?
- 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
What is the Fisher Hypothesis?
- 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.