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
- Do you teach any classes without graphs? BSP 101
- Where did the New Keynesian model get its name? The Keynesian part comes from its assumption of sticky prices.
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
- increase in the money supply
- other increases in AD
- supply shocks
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.
- shoe leather costs
- bracket creep
- distorts financial decisions
- menu costs
redistributes income from lenders to borrowers
- misperceptions theory
Why Policymakers Allow Inflation to Occur
- cost push inflation - higher costs shift up SRAS
- demand pull inflation - increases in total spending
Costs of Reducing Inflation
- cold turkey vs. gradual disinflation
Rules v. Discretion
case for rules
- 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
- hostage example
- monetary policy
- time inconsistency
- government has an incentive to renege on its promises
Ways to Achieve Central Bank Credibility
- policy rule
- appointing a "tough" central banker
- changing central banker's incentives
- increasing central bank independence