Chapter9EnsuringPriceStability1DefinitionandThreeStrainsofInflation2TheEconomicImpactsofInflation3ThesourceofInflation4ThePhilipsCurveInflationIsaFundamental

ConstraintonEconomicPolicy1DefinitionandThreeStrainsofInflation11Definition

Therateofinflationisthepercentagechangeinapriceindexfromoneperiodtothenext.Themajorpriceindexesaretheconsumerpriceindex(CPI)andtheGDPdeflator.Inflation(t)=[P(t)-P(t-1)]/P(t-1)×100Inflationisanincreaseintheoveralllevelofprices.1.2ThreeStrainsofInflation※lowinflation(Single-Digit)※GallopingInflation※Hyperinflation2TheEconomicImpactsofInflation2.1ImpactsonIncomesandWealthDistribution※BenefitDebtorsandHurtCreditors※BenefitThoseWhoHaveVariableIncomeandHurtThoseWhoHaveFixedIncome.※BenefitGovernmentsandHurtTaxPayers

inflationtax※BenefitEmployersandHurtEmployees2.2ImpactsonEconomicEfficiency※DistortPriceandPriceSignals

◎Inflationdistortsrelativeprices.

◎Consumerdecisionsaredistorted,andmarketsarelessabletoallocateresourcestotheirbestuse.※DistorttheUseofMoneyandIncreaseShoeleatherCosts

◎Shoeleathercostsaretheresourceswastedwheninflationencouragespeopletoreducetheirmoneyholdings.◎Inflationreducestherealvalueofmoney,sopeoplehaveanincentivetominimizetheircashholdings.

◎Lesscashrequiresmorefrequenttripstothebanktowithdrawmoneyfrominterest-bearingaccounts.◎Cash-managementschemesbecomemoreimportant.Extratripstothebanktaketimeawayfromproductiveactivities.※DistortTaxes

◎Inflationexaggeratesthesizeofcapitalgainsandincreasesthetaxburdenonthistypeofincome.◎Withprogressivetaxation,capitalgainsaretaxedmoreheavily.◎Withinflation,standarddeductionwoulddecline.

◎Theincometaxtreatsthenominalinterestearnedonsavingsasincome,eventhoughpartofthenominalinterestratemerelycompensatesforinflation.Theafter-taxrealinterestratefalls,makingsavinglessattractive.※MenuCosts

◎Menucostsarethecostsofadjustingprices.◎Duringinflationarytimes,itisnecessarytoupdatepricelistsandotherpostedprices.◎Thisisaresource-consumingprocessthattakesawayfromotherproductiveactivities.ConfusionandInconvenience※Confusionand

Inconvenience

◎WhentheFedincreasesthemoneysupplyandcreatesinflation,iterodestherealvalueoftheunitofaccount.◎Inflationcausesdollarsatdifferenttimestohavedifferentrealvalues.◎Therefore,withrisingprices,itismoredifficulttocomparerealrevenues,costs,andprofitsovertime.2.3Impactsonmacroeconomy3ThesourceofInflation3.1Demand-PullInflationDemand-PullInflationOccursWhenTooMuchSpendingChasesTooFewGoods3.2Cost-PushInflation

QuantityofOutputPriceLevel0Aggregatedemand3....andthepriceleveltorise.2....causesoutputtofall...1.Anadverseshiftintheshort-runaggregate-supplycurve...Short-runaggregatesupply,ASYAPAS2BY2P2Copyright?2004South-Western3.3ExpectationandInertialInflation

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Theprimarycauseofinflationisthegrowthinthequantityofmoney.3.4TheGrowthintheQuantityofMoney※TheQuantityEquationofMoneyM

V

=PYV:Thevelocityofmoneyisrelativelystableovertime.

Y:ThequantityofoutputequalspotentialGDPinthelongrun.(P

Y):Thenominalvalueofoutput

※

ThegrowthinthequantityofmoneycausesinflationwhenthequantityofoutputequalspotentialGDP.4ThePhilipsCurveThePhillipscurveshowstherelationshipbetweeninflationandunemployment.4.1Short-RunPhilipsCurve

※Pricesarebasedonaveragelaborcostperunitofoutput(WL/Q).W:rateofwage

L:laborhoursQ/L:laborproductivity

※Rateofinflation=rateofwagegrowth－rateofproductivitygrowth4.2TheNonacceleratingInflationRateofUnemployment(NAIRU)

※NAIRUisthatunemploymentratethatisconsistentwithaconstantinflation.4.3TheLong-RunP