EC 230

Lecture 37 - Inflation

from last time
what causes long-term inflation?
costs of inflation
why policymakers allow inflation to occur
costs of reducing inflation
rules v. discretion
ways to achieve central bank credibility

From Last Time

What Causes Long-Term Inflation?

The inflation rate equals the rate of change of the price level and is equal to the rate of growth of AD minus the rate of growth of real GDP.

sources of short-run increases in the price level

Long-term inflation (repeated increases in the price level over a long period of time) are the result of persistent growth in the money supply.

Costs of Inflation

The costs of inflation differ depending on whether the inflation was anticipated or not, and on whether the economy's institutions have adapted to the presence of inflation.

expected inflation

unexpected inflation

Why Policymakers Allow Inflation to Occur

Costs of Reducing Inflation

Rules v. Discretion
rules policy
policy settings are maintained regardless of short-term fluctuations in economic activity
discretionary policy
adjusted periodically in order to deal with changing conditions in the economy
case for rules
time inconsistency
government has an incentive to renege on its promises

Ways to Achieve Central Bank Credibility

  1. policy rule
  2. appointing a "tough" central banker
  3. changing central banker's incentives
  4. increasing central bank independence

David A. Latzko
318 COB
Department of Business and Economics
Wilkes University
Wilkes-Barre, PA 18766
phone: (717) 408-4718
fax: (717) 408-4917