Unit 15 - Inflation, Unemployment and Monetary Policy Flashcards
What is Disinflation
A decrease in the rate of inflation
What is the fisher equation and what does it represent
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
What is Consumer Price Index (CPI)
(common measure of inflation)
Measures the general level of prices that consumers have to pay for goods and services, including consumption taxes
What is the GDP deflator
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
Why does a high inflation mean the economy works less well
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
Why is deflation bad
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.
What could cause inflation
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
How does higher wages (low unemployment) increase inflation
Increases workers bargaining power (low unemployment) –> higher wages –> higher cost of production –> high prices and inflation
Why is an upswing in the business cycle associated with inflation
Higher AD –> higher employment –> higher wages –> higher cost of production –> higher prices
What is the wage-price spiral
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)
What does Expected inflation + Bargaining gap =
Inflation
What is the Inflation Stabilizing Rate of Unemployment
The unemployment rate at which inflation is constant (originally known as the ‘natural rate’ or the non-accelerating rate of unemployment)
Effect on unemployment and inflation:
Supply Shock
Demand Shock
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
How will central banks set a policy rate
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.
How does interest rate affect assets
When the interest rate goes down, the price of assets goes up
Households who own assets will be wealthier, which will increase their consumption.
Why is consistent policymaking and good communication with the public important
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
What is the exchange rate
Number of units of home currency that can be exchanged for one unit of foreign currency
How does interest rate affect exchange rate
Interest rates affect demand for home currency in the foreign exchange market, so affects the exchange rate (appreciation/depreciation)
What is Quantitive easing
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
What is a limitation of Monetary Policy
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”
Monetary Policy vs fiscal Policy
M = reduce nominal interest rates
f = reduce tax, government spending
What is the best outcome for the policymaker
the level of employment (and unemployment) that maintains labour market equilibrium, to avoid consistently rising or falling inflation
What is Inflation targeting
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
