3.5.2-4 Inflation

Inflation Consistent increase in the general price level Types Creeping Slow to moderate Hyper-inflation Triple digit Core inflation Excludes volatile goods like oil and agriculture

Functions of Money Medium of exchange Store of value Unit of account Allows deferral of payments over time Unit of account Goods and services can be put into common unit ***INFLATION DIMINISHES THESE FUNCTIONS

Deflation General price level decrease not to be confused with Disinflation (fall in rate of inflation ex. 7% to 3%)

Costs of Inflation Redistribution Effects Losers (loss of real income) Fixed incomes Lenders Savers ***Inflation erodes real interest rate Lender loans money at 7% Inflation = 6% Real return= 1%

Winners Borrowers Wealthy Erodes real debt of original loan Borrow at 7% Inflation=6% Real rate of borrowing=1% Wealthy Better information Find inflation resistant assets Land and fixed assets

Negative Effects on Growth Causes increased interest rates Lowers Investment Output Increases unemployment

Behavioral Distortions in the Economy Can affect present and future consumption of firms and households

Shoe Leather and Menu Costs Opportunity cost of shopping for the best prices (market analysis) Loss of productivity Menu Costs Increased opportunity costs of updating prices and “menus”

Breakdown of Monetary System Functions of money can wear down Hyper-inflation Currency becomes useless Revert back to barter economy High search costs to find co-wants and needs Disruptions to govt. sector Cash flow issues

Exchange Rates and Trade High inflation Causes domestic currency value to fall Why? Higher prices = less exports Currency Derived Demand falls Exchange rate falls Increased exports Decreased imports

3.5.3 Costs of Deflation Benign Deflation SRAS shift right Price decrease from A to C Economy is growing Real income increase

Malignant Deflation Decrease in AD leftward Output falls Savings increases and Consumption falls Investment falls DEFLATIONARY SPIRAL GREAT DEPRESSION

Solutions for Deflation Hard to fix Psychological element Increase inflationary expectations of households and firms Policies Quickly lowering interest rates Publicly announcing increase in target rate for inflation. Issue consumption certificates (tax rebate for consumption)-

3.5.4 Causes of Inflation 2 Main Causes are Keynesian in nature Cost-push Inflation pg. 433 Supply shift left Rising wages Fall in exchange rate= increase price of imported raw materials Increased labor taxes Stagflation = decrease in output + inflation Further S shift Higher wages bid up (to offset higher Prices) AD shift right Caused by increased wages and fiscal policies (transfer payments) Cost Push Spiral Continuing cycle of cost-push

Demand Pull Inflation AD shift in short run SRAS shift left Stimulatory fiscal/monetary policies Consumer confidence Result: higher prices Bids up wages SRAS shift left Higher wages =higher costs Cycle leads to Demand-pull spiral

Excess Monetary Growth Could be a cause of Demand Pull Inflation Increase Sm Drops interest rates Increases investment Increases AD Transmission Mechanism Classical/Monetarists Argue Money Supply is the best way to regulate the economy and inflation.