#14.02 -- Inflation and Deflation (9.29)

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Chapter 14 -- Money and the Economy

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Video #14.02 Inflation and Deflation

Inflation and Deflation:

Inflation and Deflation Distinguish between nominal and real interest rates in regards to inflation Define inflation and distinguish between the different types and causes of inflation Describe the negative effects of high rates of inflation Describe the negative effects of deflation

Nominal, Real, and Expected Interest Rates:

Nominal, Real, and Expected Interest Rates Nominal interest rate: The interest rate actually charged (or paid) in the market; the market interest rate. Real interest rate: The interest rate after adjusting for inflation. Nominal interest rate = Real interest rate + Expected inflation rate.

Inflation: Increase in the Price Level:

Inflation: Increase in the Price Level One-Shot Inflation: One-time increase in the price level. An increase in the price level that does not continue.

One-Shot Inflation: Demand-Side Induced:

One-Shot Inflation: Demand-Side Induced AD curve shifts rightward from AD 1 to AD 2 . As a result, price level increases from P 1 to P 2 . The economy moves from point 1 to point 2.

One-Shot Inflation: Demand-Side Induced:

One-Shot Inflation: Demand-Side Induced At point 2, economy is in an inflationary gap. Real GDP > Natural Real GDP. U < U n . Wage rates rise. SRAS curve shifts leftward from SRAS 1 to SRAS 2 . Point 3 is long-run equilibrium.

One-Shot Inflation: Supply-Side Induced:

One-Shot Inflation: Supply-Side Induced SRAS curve shifts leftward from SRAS 1 to SRAS 2 , perhaps caused by an adverse supply shock. As a result, price level increases from P 1 to P 2 ; the economy moves from point 1 to point 2.

One-Shot Inflation: Supply-Side Induced:

One-Shot Inflation: Supply-Side Induced At point 2, the economy is in a recessionary gap. Real GDP < Natural Real GDP. U > U n . At this point, wage rates will fall and SRAS will shift rightward from SRAS 2 (back to SRAS 1 ). Point 1 is long-run equilibrium.

Inflation: Increase in the Price Level:

Inflation: Increase in the Price Level Continued Inflation : A continued increase in the price level.

Continuous Inflation Beginning with Shift in AD:

Continuous Inflation Beginning with Shift in AD AD curve shifts rightward from AD 1 to AD 2 . Economy initially moves from point 1 to point 2 and finally to point 3. Continued increases in price level are brought about through continued increases in aggregate demand.

Some Costs of Inflation:

Some Costs of Inflation Menu Costs: Physically changing prices, on items like menus, takes time and costs money. Shoeleather Costs: At high inflation rates, people try to avoid holding money, and resources are wasted as people change their behavior to avoid holding money. They make many trips to the bank and wear out their shoes. Redistribution of wealth: Unexpected inflation shifts wealth from lenders to borrowers. At high rates of inflation, borrowers actually pay back less than they borrowed in real value. Money Illusion: With uneven inflation, people are unable to distinguish between the nominal value of money and its real value. Price Confusion: One function of money is to provide a signal for consumers and businesses, but inflation distorts this signal and confuses both consumers and businesses.

Some Costs of Deflation:

Some Costs of Deflation Reduced Consumer Spending: If consumers expect prices to fall, especially for nonessential items, consumers will delay their purchases which will reduce aggregate demand. Redistribution of wealth: Unexpected deflation shifts wealth from borrowers to lenders. Deflation makes it much harder for borrowers to repay their debt, and they end up paying a higher cost for their debt. Menu Costs: Physically changing prices, on items like menus, takes time and costs money, both for inflation and deflation. Higher Unemployment: During times of deflation, businesses need to cut costs, but “sticky wages” may prevent wages from falling which may lead to cuts in the labor force. Ineffective Monetary Policy: One tool the Fed uses to improve the economy is to reduce interest rates, but the Fed is unable to use that tool during times of deflation.

Inflation and Deflation:

Inflation and Deflation Distinguish between nominal and real interest rates in regards to inflation Define inflation and distinguish between the different types and causes of inflation Describe the negative effects of high rates of inflation Describe the negative effects of deflation

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