Session 11

Question 1

Inflation and inflation rate?

Answer 1

• A generalized rise in the overall level of prices (cost of living)
• Also can be seen as a decline in the purchasing power of money
• Annual percentage increase in the average price level

Question 2

Consumer price index (CPI)? Steps to construct?

Answer 2

• An index that tracks the average price consumers pay over time for a representative “basket of goods and services
• CPI is an inflation measure that is most commonly discussed in the news and most relevant to ordinary consumers

Government agencies construct it with:
1. Find out what people buy: survey consumers to determine spending habits on various goods and services
2. Collect prices: gather price information from a range of sources, including retailers, service providers, and landlords
3. Tally up the cost of the basket: aggregate the total cost of the basket, giving higher weights to more commonly consumed items
4. Calculate inflation: determine the inflation rate by calculating the percentage change in the cost of the basket over time

Question 3

Challenges in measuring the cost of living with CPI?

Answer 3

1. Quality improvements can hide price decreases (quality of phones increased, price increase reflects this)
2. New products can reduce cost of living (Smartphone reduced costs, as it replaced many goods)
3. People adapt consumption decisions (Prices rise, people adapt and update consumption basket)

Question 4

Personal consumption expenditure deflator (PCE)?

Answer 4

used for monetary policy, like the Federal Reserve’s target inflation rate of 2%
- PCE includes wider range of goods and services compared to the CPI, accounting for indirect consumption like medical care paid by employers/government (may not align with consumers actual spending, CPI is preferred for calculating inflation adjusted wages)

• goods and services in the PCE basket are continually updated to account for changing patterns of spending. So the PCE avoids the substitution bias and tends to be lower (may not reflect consumption of low-income individuals, less flexibility to substitute)

Question 5

Producer price index (PPI)?

Answer 5

measures the price of inputs into the production process- it measures the inflation experienced by businesses

Question 6

GDP deflator?

Answer 6

is a measure of inflation based on the basket of all goods and services produced domestically

• Unlike the CPI, it includes capital goods but excludes imported goods
• GDP deflator = Nominal GDP/Real GDP x 100
• Challenges to interpretation: (for small economies reliant on few key sectors a price surge may inflate deflator, when prices are generally stable), (Deflator ignores imported goods, if economy relies highly on imports, deflator may not fully capture consumer price inflation)

Question 7

Nominal/Real interest rate?

Answer 7

Nominal interest rate is the stated interest rate without a correction for the effects of inflation

Real interest rate is the interest rate in terms of changes in your purchasing power, ≈ Nominal interest rate − Inflation rate

Question 8

Nominal/Real variable

Answer 8

Nominal variable is a variable measured in currency units

Real variable is a variable adjusted to account for inflation

• Because the value of a Euro decreases, we prefer making comparisons between real variables instead of nominal variables
• To compute the real value of a good, economists adjust nominal variables into currency units from a specific year (base year)
• 2012 as a base year, formula is as follows (Slides):
  Real value 2012 = Nominal value in year T € x Price level in 2012/Price level in year T

Question 9

Money Illusion?

Answer 9

refers to the (mistaken) tendency to focus on nominal amounts instead of real amounts.

• Distort decision-making
• Lead to mis-pricing
• Create nominal wage-rigidity (employees often do not respond negatively to real wage decreases due to inflation as long as their nominal wages are constant)

Question 10

Three functions of money?

Answer 10

1. Medium of exchange (used to buy goods)
2. Unit of account (terms in which prices are quoted)
3. Store of value (a way to transfer purchasing power to the future)

Question 11

Hyperinflation? What does it do to three functions of money?

Answer 11

is extremely high rates of inflation. Has terrible effects on life and erodes all three functions of money:

1. Medium of exchange: people often resort to barter, using cigarettes and other commodities instead of money
2. Unit of account: as the value of money becomes very volatile, money ceases being a reliable measure of value
3. Store of value: under hyperinflation, people race to spend their cash before it becomes worthless

Question 12

Causes of Hyperinflation and challenges to end it?

Answer 12

Causes:
- Governments can generate revenue by printing money at virtually zero cost, using it to purchase goods ← seignorage
- The ease of printing money tempts governments to do so in the face of serious fiscal problems like wars, reparations, and external debts

Challenges:
- Hyperinflation creates expectations of future inflation, leading to immediate consumer spending, which in turn further hikes up prices
- So the government is forced to print even more money to cover expenses
- With expectations of future inflation, escaping hyperinflation becomes difficult
- Often, ending hyperinflation requires major monetary/fiscal reforms that convince the public that the inflation will stabilize

Question 13

Costs of inflation?

Answer 13

1. Menu costs for sellers: marginal cost of adjusting prices
2. Shoe-leather costs for buyers: costs incurred trying to avoid holding cash
3. Confusing price signals: difficulty in linking prices changes to actual demand shifts (For unexpected inflation)

Question 14

Inflation fallacy?

Answer 14

Belief that inflation destroys purchasing power, as it raises costs of living and incomes

Question 15

Deflation and its negative consequences?

Answer 15

is a generalized decrease in the overall price level (negative inflation).

• People delay consumption due to expected lower prices
• Reduced spending decreases output → prices fall further
• Spending falls further → more deflation… a vicious cycle
• Real interest rate becomes higher, which also further depresses spending

Question 16

Central bank and mandate?

Answer 16

• Precursors of central banks were clearing houses, where bank settled interbank claims without moving money
• Due to bank failures central banks were established. They issue base money (currency + reserves), influencing the broader money supply
  -> Currency: cash held by households, firms and banks

-> Reserves: balances held by commercial banks in their accounts at the central bank

Mandate:
- Price stability: when inflation remains low, stable and predictable, is the main mandate of central banks
- Guard against the inflation rate being either too low or too high. Price increases should be:
-> Small enough not to create the problems that come with high inflation for people and businesses
-> Large enough to avoid bad scenarios that may unfold if inflation falls too low (e.g. deflation)

• Some central banks have a dual mandate. This means that in addition to price stability it should also promote maximum employment. In practice, because high inflation tends to increase employment, this dual mandate introduces a trade-off

Question 17

Quantitative Easing (QE)

Answer 17

is a novel monetary policy that aims to increase aggregate demand by buying assets, even when the policy interest rate is zero (i.e., short-term interest rate cannot be lowered further).

Key aspects:
- The central bank buys bonds and other financial assets
- Focuses on purchasing the long-term government bonds to target longer-term interest rates
- These purchases raise asset prices and increase money supply, boosting spending and borrowing

Question 18

Direct instruments of monetary policy?

Answer 18

are more common in countries with not very developed financial markets and effective as temporary measures

1. Interest rate controls (Constraints on various commercial bank interest rates)
2. Credit ceilings (Restrictions on the quantity rather than the price of credit)
3. Direct lending policy (Requires banks to allocate credit to specific sectors, such as agriculture)

Question 19

Indirect instruments of monetary policy

Answer 19

central bank controls the price or volume of its own liabilities (reserve money), which in turn affects interest rates and volume of credit throughout the banking system. Examples (all of these are transactions with financial institutions, not the public directly):

1. Legal reserve requirements (Commercial banks must maintain a specified fraction of their liabilities as reserves at the central bank)
2. Discount window (A facility through which commercial banks can obtain very short- term, emergency loans from the central bank)
3. Open market operations (Involves the central bank’s purchase or sale of securities. Open market purchases of securities raise bank reserves, net domestic assets, and the monetary base. Regular operations are necessary to maintain target interest rates.
4. Repurchase operations (Repos). (A repo involves the central bank buying securities (such as government bonds) with an agreement to sell them back at a set time at a higher price, effectively providing a short-term loan. Reverse repos involve central bank selling securities and agreeing to repurchase them, temporarily reducing market liquidity.

Question 20

Monetary transmission mechanisms?

Answer 20

1. Short and long term rates
   - Economic effects: Higher interest rates incentivize saving over spending, reducing immediate consumption. Increased borrowing costs lead to decreased investment, as the cost of financing rises.
2. Asset prices
   - Economic effects: Lower asset prices can reduce perceived wealth, leading to a decrease in private consumption expenditure. Falling stock prices can reduce the value of collateral, making banks less willing to lend.
3. Expectations
   - If the change in monetary policy is anticipated by market participants, however, its impact on expectations may be small
   - The effect on expectations can be uncertain, adding to the unpredictability of policy changes. Modern central banks try to manage expectations through increased transparency and communication
   - Forward guidance: tool to manage expectations on the long-term interest rates. →announce future interest rates, to affect expected returns and long-term rates today
4. Exchange rate mechanisms
   - Economic effects:
   - Arise in domestic interest rates makes domestic currency assets more appealing, typically leading to an appreciation of the domestic currency
   - This appreciation can further reduce (foreign) demand for domestic output
   - Changes in the exchange rate can also alter the price of imported goods (“exchange rate pass-through”), leading to substitution of domestic goods with foreign goods, which magnifies the effect of policy

-> look at notes to understand