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1. Inflation in Economics from HelpWithAssignment.com www.HelpWithAssignment.com

2. 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. • www.HelpWithAssignment.com

3. 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. • www.HelpWithAssignment.com

4. 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. • www.HelpWithAssignment.com

5. 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. • www.HelpWithAssignment.com

6. 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. • www.HelpWithAssignment.com

7. 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. • www.HelpWithAssignment.com

8. 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. • www.HelpWithAssignment.com

9. 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. • www.HelpWithAssignment.com

10. 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). • www.HelpWithAssignment.com

11. 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. • www.HelpWithAssignment.com

12. 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. • www.HelpWithAssignment.com

13. 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. • www.HelpWithAssignment.com

14. 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. • www.HelpWithAssignment.com

15. 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. • www.HelpWithAssignment.com

16. 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. • www.HelpWithAssignment.com

17. 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) • www.HelpWithAssignment.com

18. 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. • www.HelpWithAssignment.com

19. 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. • www.HelpWithAssignment.com

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