Reading 26

Reading 26 - Inflation Sunday, August 31, 2008 9:42 PM

Inflation is overall sustained increases in prices. Defined as a period where the price level is increasing and purchasing power of a currency is decreasing. • Price level measured by CPI. • 2 types • Demand Pull(most cases)  Due to increase in AD(increase in gov't spending, increased money supply, weaker currency or higher exports)  Usually results in lower unemployment  IN the SR, it leases to greater output and higher prices • However, rising costs cause the SRAS curve to shift to the left bring equilibrium back(same GDP) at a higher price level • Cost Push  Due to decrease in AS(increased money wage rates and higher raw material prices)  Usually results in higher unemployment  In the SR, output is below potential GDP and higher prices. • This could lead to gov't stimulation which increases AD to shift to the right, bringing back same GDP level but higher prices. Unanticipated inflation in labor causes inefficiencies and redistributes wealth and income • If greater than expected, real wages decrease and income shifts from employee to employer • Unemployment below natural rate • Reverse happens is inflation less than anticipated Unanticipated inflation in financial capital markets causes redistribution of income and disequilibirum for lending and borrowing. • In inflation is below than expected, real interest rates are too high • Income shifted from borrowers to lenders Philips curve shows tradeoff between inflation and unemployment. • As it increases, unemployment falls in SR • It only shifts up or down based on expectations of inflation. • As it falls, unemployment rises. • When actual inflation rate = expected, you have natural rate of unemployment. • LRPC is vertical line and represent natural rate of unemployment • Any change to natural rate shifts LRPC left or right. •

Quiz Notes • Unanticipated increases in inflation hurts people who hold fixed rate instruments where they receive payments. Anyone making payments on a fixed rate instrument benefits from increases in inflation.

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If demand is falling and supply is increasing, there will be no pressure for the price of goods to increase. Therefore, inflation should fall. Inflation causes bond prices to fall, not rise, and yields to rise because investors will require the higher yield in anticipation of the inflation.