Inflation in Economics at


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Inflation in Economics at

  1. 1. Inflation in Economics from<br /><br />
  2. 2. Inflation is the rise in the level of prices of goods and services in an economy over a certain period of time. <br />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. <br />Inflation<br /><br />
  3. 3. This is a loss of real value in the internal medium of exchange and unit of account in the economy. <br />A chief measure of inflation is the inflation rate, the annualized percentage change in a general price index over time.<br />Inflation<br /><br />
  4. 4. The principal explanation for inflation is excess demand. <br />When too much money chases few goods leads to prices being bid up. <br />In the later half of the nineteenth century, this was taken literally through the quantity theory of money.<br />Inflation is due to Excess Demand<br /><br />
  5. 5. 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. <br />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. <br />Change in Money Circulation<br /><br />
  6. 6. Inflation is generally, believed to be demand driven.<br />In contrast, supply side explanations for inflation depend on the existence of noncompetitive markets. <br />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.<br />Supply side Inflation<br /><br />
  7. 7. The resulting prices are then registered as inflation. <br />This strategy not only requires market power but also a buoyant economy. <br />One of the best examples is when OPEC used its market power to quadruple the price of petroleum in the early 1970s.<br />Supply side Inflation<br /><br />
  8. 8. 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. <br />The jumbo price rise also stimulated conservation and the use of substitutes.<br />Market Power and price rise<br /><br />
  9. 9. Central Banks usually seek to stabilize the rate of inflation. <br />In addition, some seek to keep the economy at full employment. <br />To do this, they usually focus on controlling an intermediate target. <br />What a Central Bank does?<br /><br />
  10. 10. In the past, this intermediate target was money supply. <br />Currently, most central banks focus on influencing interest rates. <br />Interest rates provide an instant feedback. <br />The interest rate that central banks do care about is the real interest rate (the nominal rate is less than the rate of inflation).<br />Plans of Central Bank to counter Inflation<br /><br />
  11. 11. If, instead, the central bank focused on maintaining a particular nominal rate, it could lead to wide swings in the money supply. <br />For example if the central bank targets a certain nominal interest rate, say 4 percent. To do this, say it increases the money supply. <br />Influencing Interest Rates<br /><br />
  12. 12. In the short run, rates fall to 4 percent. <br />But then inflation starts to grow and the interest rates start to rise. <br />The central bank would then increase the money supply even more.<br /> Should the central bank keep increasing the money supply, inflation will get worse.<br />Plans of Central Bank to counter Inflation<br /><br />
  13. 13. The result would be a runaway inflation. <br />To avoid this, the central bank should focus on real rates of interest. <br />When inflation starts to rise, real rates are likely to fall, correctly indicating that the economy is being stimulated.<br />Plans of Central Bank to counter Inflation<br /><br />
  14. 14. Many countries use inflation targeting. <br />With inflation targeting, the central bank announces an explicit inflation rate it wants to achieve. <br />Most of the time it commits itself to achieving this rate. <br />Inflation Targeting<br /><br />
  15. 15. Federal Reserve Bank and Taylor’s Rule<br />Although, the Federal Reserve Bank, the central bank in the United States, seeks price stability, it does not currently use inflation targeting. <br />Instead, it often appears to be following what is called Taylor’s Rule; named after John Taylor who first proposed the rule.<br /><br />
  16. 16. Federal Reserve Bank and Taylor’s Rule<br />The rule predicts how the bank determines the financial funds rate (the rate private banks charge other private banks to borrow money). <br />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. <br /><br />
  17. 17. Federal Reserve Bank and Taylor’s Rule<br />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:<br />Target r = 2 percent + rate of inflation + 0.5 (rate of inflation – 3 percent) + 0.5 (Real GDP gap)<br /><br />
  18. 18. 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). <br />If the bank was interested only in controlling inflation (ie., inflation targeting) the weight of on the real GDP gap would be zero. <br />Federal Reserve Bank and Taylor’s Rule<br /><br />
  19. 19. 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.<br />Federal Reserve Bank and Taylor’s Rule<br /><br />
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