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Inflation is the rise in the general level of prices of goods and services in an economy over a period of time. The general prices level rises, each unit of currency buys lesser of the goods and services.

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inflation
Inflation
  • Inflation is the rise in the level of prices of goods and services in an economy over a certain period of time.
  • The general prices level rises, each unit of currency buys lesser of the goods and services. Consequently, inflation also reflects erosion in the purchasing power of money.
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inflation3
Inflation
  • This is a loss of real value in the internal medium of exchange and unit of account in the economy.
  • A chief measure of inflation is the inflation rate, the annualized percentage change in a general price index over time.
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inflation is due to e xcess demand
Inflation is due to Excess Demand
  • The principal explanation for inflation is excess demand.
  • When too much money chases few goods leads to prices being bid up.
  • In the later half of the nineteenth century, this was taken literally through the quantity theory of money.
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change in m oney circulation
Change in Money Circulation
  • It was believed that a change in the amount of money circulating in the economy would have a fairly immediate and proportional effect on general price levels.
  • Although this theory was not accepted back then, many economists now agree that change in the money supply affect the economy primarily through changes in the interest rates.
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supply side inflation
Supply side Inflation
  • Inflation is generally, believed to be demand driven.
  • In contrast, supply side explanations for inflation depend on the existence of noncompetitive markets.
  • If a firm, a group of firms gains sufficient power in a market, it may this market power by raising its prices in order to increase returns.
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supply side inflation7
Supply side Inflation
  • The resulting prices are then registered as inflation.
  • This strategy not only requires market power but also a buoyant economy.
  • One of the best examples is when OPEC used its market power to quadruple the price of petroleum in the early 1970s.
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market power and price rise
Market Power and price rise
  • When OPEC used its market power to quadruple the price of petroleum in the early 1970s; it was so effective that the supply side shock threw most of the capitalist world into a recession.
  • The jumbo price rise also stimulated conservation and the use of substitutes.
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what a central bank does
What a Central Bank does?
  • Central Banks usually seek to stabilize the rate of inflation.
  • In addition, some seek to keep the economy at full employment.
  • To do this, they usually focus on controlling an intermediate target.
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plans of central bank to counter inflation
Plans of Central Bank to counter Inflation
  • In the past, this intermediate target was money supply.
  • Currently, most central banks focus on influencing interest rates.
  • Interest rates provide an instant feedback.
  • The interest rate that central banks do care about is the real interest rate (the nominal rate is less than the rate of inflation).
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influencing interest rates
Influencing Interest Rates
  • If, instead, the central bank focused on maintaining a particular nominal rate, it could lead to wide swings in the money supply.
  • For example if the central bank targets a certain nominal interest rate, say 4 percent. To do this, say it increases the money supply.
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plans of central bank to counter inflation12
Plans of Central Bank to counter Inflation
  • In the short run, rates fall to 4 percent.
  • But then inflation starts to grow and the interest rates start to rise.
  • The central bank would then increase the money supply even more.
  • Should the central bank keep increasing the money supply, inflation will get worse.
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plans of central bank to counter inflation13
Plans of Central Bank to counter Inflation
  • The result would be a runaway inflation.
  • To avoid this, the central bank should focus on real rates of interest.
  • When inflation starts to rise, real rates are likely to fall, correctly indicating that the economy is being stimulated.
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inflation targeting
Inflation Targeting
  • Many countries use inflation targeting.
  • With inflation targeting, the central bank announces an explicit inflation rate it wants to achieve.
  • Most of the time it commits itself to achieving this rate.
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federal reserve bank and taylor s rule
Federal Reserve Bank and Taylor’s Rule
  • Although, the Federal Reserve Bank, the central bank in the United States, seeks price stability, it does not currently use inflation targeting.
  • Instead, it often appears to be following what is called Taylor’s Rule; named after John Taylor who first proposed the rule.
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federal reserve bank and taylor s rule16
Federal Reserve Bank and Taylor’s Rule
  • The rule predicts how the bank determines the financial funds rate (the rate private banks charge other private banks to borrow money).
  • To illustrate the rule, assume that if the economy is at full employment, the real federal funds rate (the federal rate minus the rate of inflation) would be 2 percent.
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federal reserve bank and taylor s rule17
Federal Reserve Bank and Taylor’s Rule
  • Next, assume the Fed wants the inflation rate to be 3 percent. According to Taylor’s rule, the bank might set the target federal funds rate (r) so that it equals:
  • Target r = 2 percent + rate of inflation + 0.5 (rate of inflation – 3 percent) + 0.5 (Real GDP gap)
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federal reserve bank and taylor s rule18
Federal Reserve Bank and Taylor’s Rule
  • The real GDP gap is the percent difference between real GDP and the full employment level of GDP (the level of GDP consistent with a stable inflation rate).
  • If the bank was interested only in controlling inflation (ie., inflation targeting) the weight of on the real GDP gap would be zero.
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federal reserve bank and taylor s rule19
Federal Reserve Bank and Taylor’s Rule
  • If the bank was interested only in keeping the economy at full employment, the weight on the (rate of inflation – 3 percent) term would be zero.
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www helpwithassignment com
www.HelpWithAssignment.com
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