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Lecture notes: Inflation, unemployment, monetary policy
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Unit 15: Inflation,Unemployment, and Monetary
policy
What is inflation?
Inflation: The continuous and considerable increases in the general price level.
Zero inflation: A constant price level from year-to-year.
Deflation: A decrease in the general price level.
Disinflation: A decrease in the rate of inflation.
- Economic booms are accompanied by a dramatic increase in inflation.
- Inflation tends to be higher in poor than in rich countries
What is wrong with inflation?
- Decreases purchasing power of each unit of currency that you have.
- Erodes people’s financial assets
- Reduces the real value of debt
The Fisher equation
Real interest rate is equal to the difference between the nominal interest rate and expected inflation
-
Real interest rate (% per annum)=Nominal interest rate (% per annum) – the inflation rate(% per annum )
High rate of inflation reduces the performance of the economy
- Large price changes create uncertainty and make it more difficult for individuals and firms to
make decisions based on prices.
- It is harder for producers to distinguish between changes in relative prices (signal about
scarcity) and inflation.
- Menu costs as firms have to update their prices more frequently
What is wrong with deflation?
Deflation could have an even more dramatic consequence than high inflation.
When prices are falling, households will postpone consumption (particularly of durables) because
they expect goods will be cheaper in the future. This is similar to a negative shock to aggregate
demand.
, Deflation increases the real debt burden, which may lead households to cut consumption to return
to their target wealth.
Benefits of inflation:
- Greases the wheels of the labour market
- Gives monetary policy more room to manoeuvre.
Causes of inflation
The labour market at Nash equilibrium:
- The wage rate and the price level are consistent with the firms maximizing their profits, then
there will be no reason for either prices or wages to be changed.
- At this unemployment rate, the price level is constant ( zero inflation). This is the level of
unemployment where the wage-setting and price-setting curves intersect.
Inflation arises from conflicts among economic actors when they are powerful enough that their
claims on goods and services are inconsistent.
Inflation may be due to:
- Increases in the bargaining power of firms over their consumers
- Increases in the bargaining power of workers over the firms, due to higher bargaining power
or higher employment.
Figure 15.2: Three causes of inflation: Changes in bargaining power
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