Nominal interest rate of a bond or loan = the stated interest rate.
Real interest rate = nominal interest - current or expected inflation.
If participants expect higher inflation, the net result will be higher nominal interest rates:
Lenders will be less willing to make loans or will demand higher nominal rates of interest in order to compensate for the perceived risk of inflation. Borrowers will seek more loanable funds in anticipation of higher prices.
Increases in the money supply will lead to higher price levels, unless there is a corresponding increase in real output.
Showing posts with label Inflation. Show all posts
Showing posts with label Inflation. Show all posts
Monday, November 17
Tradeoffs Between Unemployment and Inflation (the Phillips Curve)
The Phillips curve depicts an inverse relationship between inflation and the rate of unemployment. The higher rates of inflation imply lower rates of unemployment.
In short run,
Unexpected rise in inflation rate => decrease real wage of workers under long-term employment contract (Job seekers may underestimate the inflation and take job offers that they may not otherwise take or => reduce cost to employer =>stimulatese employment => reduce unemployment rate
Unexpected decline in inflation rate => increase real wage of workers => increase cost to employer => increase unemployment rate
In logn run,
Once inflation being anticipated => no long term reduction in unemployment rate
In short run,
Unexpected rise in inflation rate => decrease real wage of workers under long-term employment contract (Job seekers may underestimate the inflation and take job offers that they may not otherwise take or => reduce cost to employer =>stimulatese employment => reduce unemployment rate
Unexpected decline in inflation rate => increase real wage of workers => increase cost to employer => increase unemployment rate
In logn run,
Once inflation being anticipated => no long term reduction in unemployment rate
Anticipated vs. Unanticipated Inflation
Anticipated inflation:
Changes in price levels are widely anticipated and factored into all sorts of contracts. A low level (2-3%) is considered fine for a growing economy.
Unanticipated inflation:
Inflation that comes as a surprise to most people. It harms people who have fixed income {jobs, pension, savers} and beneficial for individuals who have fixed expenses {borrowers}.
Harmful consequence of unanticipated inflation
Changes in price levels are widely anticipated and factored into all sorts of contracts. A low level (2-3%) is considered fine for a growing economy.
Unanticipated inflation:
Inflation that comes as a surprise to most people. It harms people who have fixed income {jobs, pension, savers} and beneficial for individuals who have fixed expenses {borrowers}.
Harmful consequence of unanticipated inflation
- Distorts contracts
- Alter outcomes for long term projects
- Increase uncertainty
- Depresses investment and growth
Note:
- In general, steady rates of inflation can be anticipated successfully by economic decision makers.
Unanticipated inflation in the labor market
- Unanticipated inflation in the labor market =>workers work for less wages then what they think and employers may get higher profits due to the higher prices => transfer of income from workers to employers, probably higher employment than "full employment".
Unanticipated inflation in the financial capital market
- Unanticipated inflation in the financial capital market => lender lend loan out at less interest rate that they think and borrower s gain at the expense of lenders => transfer of income from lender to borrower.
Causes of Inflation
Demand-pull
An increase in aggregate demand, which will shift the aggregate demand curve to the right.
Factors creating a demand-pull inflation:
· Increase in government spending
· Increase in the supply of money
Cost-push
The aggregate supply curve shift to the left. Both result in higher price levels.
Factors which induce a cost-pull inflation:
An increase in aggregate demand, which will shift the aggregate demand curve to the right.
Factors creating a demand-pull inflation:
· Increase in government spending
· Increase in the supply of money
Cost-push
The aggregate supply curve shift to the left. Both result in higher price levels.
Factors which induce a cost-pull inflation:
- Increase in wage rates
- Increase in raw material costs
Increase in the price level in the rest of the worldif prices increase in other countries, residents of those countries will want to buy goods from domestic producers; i.e., exports will increase.
Inflation, Deflation, Stagflation, Consumer Price Index (CPI)
Inflation
The rate at which price of the representative basket of goods and services is rising over time.
Deflation
Refer to negative inflation that the rate at which price of the representative basket is falling.
Stagflation
High inflation plus low real GDP growth
Consumer Price Index (CPI)
To track the price of a representative basket of goods and services. Calculate as:
Inflation = (Current level of CPI - Previous level of CPI) / Previous level of CPI
CPI Bias
The rate at which price of the representative basket of goods and services is rising over time.
Deflation
Refer to negative inflation that the rate at which price of the representative basket is falling.
Stagflation
High inflation plus low real GDP growth
Consumer Price Index (CPI)
To track the price of a representative basket of goods and services. Calculate as:
Inflation = (Current level of CPI - Previous level of CPI) / Previous level of CPI
CPI Bias
- Quality adjustments - some price increases may reflect quality adjustments that are still counted entirely as inflation.
- New goods – new goods may be introduced that will be hard to compare to older substitutes.
- Substitution – if the price goes up for one good, consumers may substitute another good The CPI surveys do not check to see if consumers are substituting discount or outlet stores. Example is beef vs. pork.
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