im28 - Chapter 28 Inflation: Causes and Consequences...

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Chapter 28 Inflation: Causes and Consequences Overview This chapter presents an analysis of inflation. It discusses the causes of inflation, its costs, and policies to deal with it. The chapter begins by pointing out that any one-time rightward shifts of the AD curve or leftward shifts of the SRAS curve will lead to an increase in the price level. Most students should easily grasp this point. A more subtle point, with which some students may have difficulty, is the concept that long-term inflation—sustained increases in the price level—is principally a monetary phenomenon. Hence a federal budget deficit will not result in long-term inflation unless it leads the Fed to undertake a sustained increase in the rate of growth of the money supply. The costs of expected inflation are identified as shoe leather costs, menu costs, and distortions to the financial system arising from the tax system being defined in nominal terms. The costs of unexpected inflation include unanticipated redistributions of wealth and a reduction in the value of prices as indicators of value or as signals for resource allocation. This last cost is identified as the most serious cost of inflation. This point is one that many students may have trouble understanding. The author illustrates it by discussing the collapse in the usefulness of prices during a hyperinflation. It may be worthwhile to expand on this point in lecture, particularly as students usually are intrigued by the details of the German hyperinflation of 1922–1923. The tendency of policymakers to want to keep output close to its full-employment level is identified as a key reason why inflation persists. A simple AD-AS analysis of cost-push and demand-pull inflation is presented, and the earlier conclusion that long-term inflation is impossible without ratification through sustained increases in the money supply by the Fed is repeated. The differing views of new classical and new Keynesian economists on the costs of disinflation are discussed. Disinflation is more costly in the new Keynesian view because wages and prices are perceived as reacting only sluggishly to policy announcements. The importance of the credibility of the Fed in determining the costs of a disinflation policy is stressed. It is illustrated with a payoff matrix—which should be familiar to most students from their economic principles course—that shows that the reactions of firms to a policy of disinflation depends on whether they find it credible. The chapter concludes with a brief discussion of the difficulties involved in using price controls to restrain inflation.
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165 Hubbard • Money, the Financial System, and the Economy, Sixth Edition Outline I. Explaining Price Level Changes A) We can isolate the determinants of price level changes by using a modified version of the equation of exchange: π = + , where represents the inflation rate, represents the rate of growth of the nominal money supply, represents the rate of growth of velocity, and represents
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im28 - Chapter 28 Inflation: Causes and Consequences...

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