EC2B3 Topic 5: Inflation and the Phillips Curve

Question 1

What is inflation?

Answer 1

The rate at which the general level of prices for goods and services is rising, eroding purchasing power.

Question 2

What does the Phillips Curve illustrate?

Answer 2

The inverse relationship between the rate of unemployment and the rate of inflation.

Question 3

True or False: According to the Phillips Curve, lower unemployment leads to higher inflation.

Answer 3

True

Question 4

Fill in the blank: The Phillips Curve suggests that there is a trade-off between _______ and inflation.

Answer 4

unemployment

Question 5

What can cause a shift in the Phillips Curve?

Answer 5

Changes in inflation expectations, supply shocks, or policy changes.

Question 6

What is meant by ‘stagflation’?

Answer 6

A situation characterized by stagnant economic growth, high unemployment, and high inflation.

Question 7

What happens to the Phillips Curve in the long run?

Answer 7

It is vertical at the natural rate of unemployment, indicating no trade-off between inflation and unemployment.

Question 8

Fill in the blank: The natural rate of unemployment is the level of unemployment that exists when the economy is _______.

Answer 8

at full capacity

Question 9

What are supply shocks?

Answer 9

Unexpected events that affect supply, leading to changes in prices and inflation.

Question 10

How do inflation expectations affect the Phillips Curve?

Answer 10

If expectations of inflation rise, the curve shifts upward, indicating higher inflation at any given level of unemployment.

Question 11

What is the short-run Phillips Curve?

Answer 11

A downward-sloping curve that shows the trade-off between inflation and unemployment in the short term.

Question 12

True or False: The long-run Phillips Curve suggests a stable trade-off between unemployment and inflation.

Answer 12

False

Question 13

What is the impact of monetary policy on the Phillips Curve?

Answer 13

Monetary policy can influence inflation and unemployment, shifting the Phillips Curve in the short run.

Question 14

Fill in the blank: The concept of the Phillips Curve originated from the work of economist _______.

Answer 14

A.W. Phillips

Question 15

What is the cyclical relationship of inflation with real GDP

Answer 15

• Procyclical (not stable over time)
• Less volatile than GDP
• Slightly lagging

Question 16

Mid way between new keynesian model and full price flexibility

Answer 16

Partial price adjustment model

Question 17

diff between big W and little w

Answer 17

W is wage in money terms

w is wage in real terms

w = W/P

Question 18

With imperfect competition. what does labour demand equal

Answer 18

Firm charge a price above MC –> labour demand MRPn = w = W/P

MRPn below MPn –> gap is profit margin

Question 19

What to do if MRPn < w or MRPn > w

Answer 19

If MRPn < w then price is too low
raise price and sell less

If MRPn > w then price is too high
lower price and sell more

Question 20

What are the links between real GDP and desired price changes

Answer 20

HIgher AD –> more workers –> pushes up w –> move alaong Ns curve –> dimishing returns to labour so MPn and MRPn decline –> marginal costs rise, eroding profit margins

Question 21

Relationship between outgaps and MRPn being > or < w

Answer 21

If Y< Y * then MRPn > w so price cut needed (deflation in recession)

If Y>Y * then MRPn < w so a price rise is desired (inflation in boom)

Larger gap between Y and Y * ; larger desired price change

Question 22

How does a price adjustment lead to a Phillips Curve

Answer 22

• Positiive rs between inflation and output gap

Thus there is an upward sloping PC when plotting π against Y
–> downward sloping if plotted against UE

Question 23

What causes PC to shift

Answer 23

• If natural output level rises and falls
• Inflation expectations change

Question 24

Why does inflation expectations lead to higher current inflation

Answer 24

Any firm adjusting its prices in current period will choose a price increase when expectations higher

Question 25

How can inflation be controlled using monetary policy if inflation is controlled by the Phillips curve

Answer 25

* Influence people's expectations * Move along PC by affecting demand; use transmission mechanism

Question 26

Transmission mechanism

Answer 26

Nominal IR up --> real IR up --> AD down --> output gap (Y - Y * ) down --> inflation down (PC) CB should adjust IR in response to fluctuations in inflation

Question 27

Taylor rule

Answer 27

Rule of thumb for how CB should set IR

Question 28

Desireable features of the Taylor rule

Answer 28

* Positive *b* is systematic stabilising response to business cycles --> cut IR in recessions, raise IR in booms Stabilise inflation through a>1; more than one for one reaction of nominal IR to inflation. Known as the 'Taylor Principle'

Question 29

Why is the 'Taylor Principle'

Answer 29

Failure to do this means rising inflation actually reduces real interest rate causing demand to rise and stoking more inflationary pressure

Question 30

MM line in response to Real GDP Y and inflation

Answer 30

MP response to real GDP Y makes MM line upward sloping (+ve correlation) MP response to inflation shifts the MM line when π changes (+ve correlation)

Question 31

How do you summarise the Y(d) curve and monetary policy

Answer 31

Summarise with a single line in the same diagram as the Phillips Curve (Yd - MM)

Question 32

Draw the Yd - MM line

Answer 32

Yd - MM represents combination of output demand Yd and stance of monetary policy - shifts for same reasons as Yd does and in same direction - Shifts with expectations - Shifts with change in monetary policy reaction

Question 33

What does the intersection of PC and Yd-MM line determine

Answer 33

Inflation (π) and GDP Y

Question 34

How do expectations impact Yd - MM

Answer 34

If taylor principle satisfied: - larger i so r and MM shift up - so Yd - MM shifts left, reducing Y and π along Phillips curve if taylor principle not satisfied: - effect on Yd - MM is the opposite Higher expected future growth shifts Yd and Yd-MM to the right

Question 35

How do demand shocks helps us observe a stable PC

Answer 35

If policy doesn't offset the shocks, Yd-MM line shifts, tracing out a PC in the data PC plays role of supply, stable position due to temp. nature

Question 36

Draw temporary supply shocks

Answer 36

Question 37

Draw the permanent shift in demand/monetary policy, with adjustment of inflation expectations

Answer 37

Supply shocks move the PC around due to Y * changing Passes through inflation expectation. Y * down , PC inwards Y * up, PC outwards inflation counteracted and you see no rs between output and inflation

Question 38

why is inflation bad for real GDP and other reasons

Answer 38

Real GDP: - PC implies volatality in inflation destabilises the real economy - Control of inflation helps to manage the business cycle Other: - long term planning is difficult - price out of line sith supply demand - tax distortions Redistribution: - Arbitrary gains or losses for creditors or debtors, workers or firms

Question 39

Analyse strict inflation targetting

Answer 39

if π = 0 - Firms happy w price --> w = MRPn --> employment on Ys curve --> at Y * so no output gap Policy replicates flexible price equilibrium R must shadow R * (need i = r = r * )

Question 40

Draw strict inflation targetting

Answer 40

Question 41

Why does aiming for π = 0 lead to inefficient output

Answer 41

Real GDP Y = Y * (as if prices were fully flexible but still imperfect competition) Implies MRPn = w * = MRS (l,c) which implies --> MPn > MRS (l,c) as MPn > MRPn

Question 42

How do supply shocks interact with strict inflation targetting

Answer 42

Causes real GDP fluctuations too much

Question 43

Draw a negative supply shock in rigid wages. Show the difference in flexible and strict inflation targetting

Answer 43

if strict inflation targetting; N is where MRPn = wage

Question 44

Core inflation?

Answer 44

Inflation excl food and energy

Question 45

Why should CB focus on core inflation

Answer 45

Costs of inflation is where greatest nominal rigidity, while energy and food is v flexible CB mitigate nominal rigidity by targeting inflation where prices would be slower to adjust