Unit 15 - Inflation, Unemployment and Monetary Policy

Question 1

What is Disinflation

Answer 1

A decrease in the rate of inflation

Question 2

What is the fisher equation and what does it represent

Answer 2

Represents Real interest rate which shows how many goods in the future one can get for the goods not consumed now

Real interest rate = Nominal interest rate – Expected inflation

Question 3

What is Consumer Price Index (CPI)

(common measure of inflation)

Answer 3

Measures the general level of prices that consumers have to pay for goods and services, including consumption taxes

Question 4

What is the GDP deflator

Answer 4

A measure of the level of prices for domestically produced output. Ratio of Nominal GDP to Real GDP.

Allows GDP to be compared across countries and over time

Question 5

Why does a high inflation mean the economy works less well

Answer 5

Inflation obscures true relative prices leading to inefficient allocation of resources

Uncertainty of future prices makes it difficult to make investment and saving decisions

Menu costs as firms have to update their prices more frequently

Question 6

Why is deflation bad

Answer 6

When prices are falling, households will postpone consumption (particularly of durables) because they expect goods will be cheaper in the future. This is equivalent to a negative shock to aggregate demand.

Increases the real debt burden, which may lead households to cut consumption to return to their target wealth.

Question 7

What could cause inflation

Answer 7

Increases in bargaining power of firms over their consumers e.g. reduction in competition

Increases in the bargaining power of workers over firms, due to higher bargaining power or employment

Question 8

How does higher wages (low unemployment) increase inflation

Answer 8

Increases workers bargaining power (low unemployment) –> higher wages –> higher cost of production –> high prices and inflation

Question 9

Why is an upswing in the business cycle associated with inflation

Answer 9

Higher AD –> higher employment –> higher wages –> higher cost of production –> higher prices

Question 10

What is the wage-price spiral

Answer 10

The increased prices due to increased wages leads to another demand for higher wages to accommodate for new prices. Cycle starts again (higher wages –> more production costs –> higher prices)

Question 11

What does Expected inflation + Bargaining gap =

Answer 11

Inflation

Question 12

What is the Inflation Stabilizing Rate of Unemployment

Answer 12

The unemployment rate at which inflation is constant (originally known as the ‘natural rate’ or the non-accelerating rate of unemployment)

Question 13

Effect on unemployment and inflation:

Supply Shock
Demand Shock

Answer 13

A negative supply shock can lead to increased unemployment and inflation at the same time

A negative demand shock will increase unemployment and reduce inflation

Question 14

How will central banks set a policy rate

Answer 14

Choose the desired level of aggregate demand, based on the labour market equilibrium and the Phillips curve

Estimate the real interest rate, which will produce this level of aggregate demand (using the multiplier model)

Calculate the nominal policy rate that will produce the appropriate market interest rate.

Question 15

How does interest rate affect assets

Answer 15

When the interest rate goes down, the price of assets goes up

Households who own assets will be wealthier, which will increase their consumption.

Question 16

Why is consistent policymaking and good communication with the public important

Answer 16

It builds confidence

This can lead firms to expect higher demand and therefore increase investment
Households may be confident that they will not lose their jobs, and they may increase their consumption

Question 17

What is the exchange rate

Answer 17

Number of units of home currency that can be exchanged for one unit of foreign currency

Question 18

How does interest rate affect exchange rate

Answer 18

Interest rates affect demand for home currency in the foreign exchange market, so affects the exchange rate (appreciation/depreciation)

Question 19

What is Quantitive easing

Answer 19

Central bank purchases of financial assets aimed at increasing investment by reducing yields

CB raises demand for bonds and other financial assets →
pushes up the price and decreases the yield on bonds →
boosts spending because both the cost of borrowing and return to holding financial assets has gone down

Question 20

What is a limitation of Monetary Policy

Answer 20

when the economy is in a slump, a nominal interest rate of zero may not be low enough to stabilize the economy

“Zero Lower Bound”

Question 21

Monetary Policy vs fiscal Policy

Answer 21

M = reduce nominal interest rates

f = reduce tax, government spending

Question 22

What is the best outcome for the policymaker

Answer 22

the level of employment (and unemployment) that maintains labour market equilibrium, to avoid consistently rising or falling inflation

Question 23

What is Inflation targeting

Answer 23

Monetary policy regime where the central bank uses policy instruments to keep the economy close to an inflation target

Making the central bank independent from the government gives inflation targets credibility and prevents an inflation spiral by setting expectations