inflation

Examples of inflation in the following topics:

• Using Monetary Policy to Target Inflation

  • Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting.
  • if inflation appears to be above the target, the bank is likely to raise interest rates.
  • if inflation appears to be below the target, the bank is likely to lower interest rates.
  • This is viewed by inflation targeters as leading to increased economic stability.
  • Assess the use of inflation targets and goals in monetary policy

• Arguments For and Against Inflation Targeting Policy Interventions

  • When inflation falls below this range, the Fed would lower interest rates and raising the money supply in order to push inflation up.
  • Proponents of inflation targeting argue that a volatile inflation rate has negative effects for an economy.
  • Further, inflation targeting is a transparent way to explain interest rate policy and to anchor consumers' expectations about future inflation.
  • Others suggest targeting long-run inflation, which takes the exchange rate into account, rather than the short-term inflation rate.
  • Argue that central banks should maintain inflation targets, Argue that central banks should not maintain inflation targets

• Distribution Effects of Inflation

  • Unexpectedly high inflation tends to transfer wealth from creditors to debtors and from the rich to the poor.
  • When there is inflation, the value of the money borrowers pay back is less.
  • When inflation is expected, it has few distribution effects between borrowers and lenders.
  • This is because the inflation rate is built in to the nominal interest rate, which is the sum of the real interest rate and expected inflation.
  • Part of the reason that lenders charge interest is to recoup the cost of inflation over time.

• Differences Between Real and Nominal Rates

  • Nominal rate refers to the rate before adjustment for inflation; the real rate is the nominal rate minus inflation: r = R - i or, 1+r = (1+r)(1+E(r)).
  • The real rate is the nominal rate minus inflation.
  • If the lender is receiving 8% from a loan and inflation is 8%, then the real rate of interest is zero, because nominal interest and inflation are equal.
  • Where r is the real rate, i is the inflation rate, and R is the nominal rate.
  • Since the future inflation rate can only be estimated, the ex ante and ex post (before and after the fact) real rates may be different; the premium paid to actual inflation may be higher or lower.

• The Short-Run Phillips Curve

  • The short-run Phillips curve depicts the inverse trade-off between inflation and unemployment.
  • The Phillips curve depicts the relationship between inflation and unemployment rates.
  • As unemployment rates increase, inflation decreases; as unemployment rates decrease, inflation increases.
  • When the unemployment rate is 2%, the corresponding inflation rate is 10%.
  • As unemployment decreases to 1%, the inflation rate increases to 15%.

• Inflation Premium

  • An inflation premium is the part of prevailing interest rates that results from lenders compensating for expected inflation.
  • An inflation premium is the part of prevailing interest rates that results from lenders compensating for expected inflation by pushing nominal interest rates to higher levels.
  • Actual interest rates (without factoring in inflation) are viewed by economists and investors as being the nominal (stated) interest rate minus the inflation premium.
  • In the Fisher equation, π is the inflation premium.
  • Since the inflation rate over the course of a loan is not known initially, volatility in inflation represents a risk to both the lender and the borrower.

• Introduction to Inflation

  • The reasons for inflation depend on supply and demand.
  • In Keynesian economics, there are three types of inflation.
  • Demand-pull inflation is inflation that occurs when total demand for goods and services exceeds the economy's capacity to produce those goods.
  • One major reason for cost-push inflation are supply shocks.
  • Built-in inflation is the result of adaptive expectations.

• Relationship Between Expectations and Inflation

  • In contrast, anything that is real has been adjusted for inflation.
  • However, suppose inflation is at 3%.
  • As aggregate demand increases, inflation increases.
  • Now, if the inflation level has risen to 6%.
  • Efforts to lower unemployment only raise inflation.

• The Long-Run Phillips Curve

  • In the long run, inflation and unemployment are unrelated.
  • When unemployment is above the natural rate, inflation will decelerate.
  • Consequently, an attempt to decrease unemployment at the cost of higher inflation in the short run led to higher inflation and no change in unemployment in the long run.
  • According to the theory, the simultaneously high rates of unemployment and inflation could be explained because workers changed their inflation expectations, shifting the short-run Phillips curve, and increasing the prevailing rate of inflation in the economy.
  • Although the economy starts with an initially low level of inflation at point A, attempts to decrease the unemployment rate are futile and only increase inflation to point C.

• The Phillips Curve

  • The Phillips curve shows the inverse relationship between inflation and unemployment: as unemployment decreases, inflation increases.
  • The Phillips curve relates the rate of inflation with the rate of unemployment.
  • The Phillips curve argues that unemployment and inflation are inversely related: as levels of unemployment decrease, inflation increases.
  • The Phillips curve shows the inverse trade-off between inflation and unemployment.
  • In this image, an economy can either experience 3% unemployment at the cost of 6% of inflation, or increase unemployment to 5% to bring down the inflation levels to 2%.