Lecture 6: Inflation Flashcards
(29 cards)
What is inflation?
The percentage rate of change in the overall price level over time.
How do nominal contracts contribute to inflation costs?
They are slow to adjust to rising prices, causing real wages and taxes to distort economic behavior.
What are “shoe-leather costs” in relation to inflation?
The increased effort and time people spend managing cash due to inflation reducing purchasing power.
What are menu costs?
The transaction costs businesses incur when frequently changing prices due to inflation.
How does inflation affect relative prices?
Some prices adjust faster than others, distorting price signals and causing inefficiencies.
What is nominal illusion?
When people mistake nominal changes (like a wage increase) for real gains, ignoring inflation.
How can inflation negatively impact long-term growth?
It makes R&D more expensive due to higher nominal interest rates, reducing innovation and economic growth.
What are key risks of deflation?
Price uncertainty, high real interest rates, and increased real burden of debt, leading to lower spending.
How has inflation evolved since the 1970s?
Inflation rates have declined significantly in recent decades.
What does the Philips Curve show?
A negative correlation between inflation and unemployment in the short run.
Why does inflation rise when unemployment falls?
In low unemployment, wages rise, boosting demand and leading to higher prices.
What causes the Philips Curve to shift upwards?
Higher inflation expectations, increased markup, or stronger wage bargaining power.
How do inflation expectations affect inflation?
If people expect inflation, they demand higher wages, contributing to actual inflation.
Can governments control unemployment via inflation?
Only in the short term; in the medium term, expectations adjust, weakening the trade-off.
When did the Philips Curve break down, and why?
During 1970s stagflation, when inflation and unemployment rose together, defying the original model.
What is NAIRU?
The Non-Accelerating Inflation Rate of Unemployment — the unemployment rate at which inflation is stable.
Why do we need to extend the IS-LM model in the medium run?
To account for inflation, real interest rates, and resource constraints like the labor market.
What’s the difference between nominal and real interest rates?
Nominal is the stated rate, real is adjusted for inflation.
How does a central bank influence the real interest rate?
By adjusting the nominal interest rate, it indirectly affects the real rate through inflation expectations.
What is the Taylor Rule used for?
A guideline for central banks to set interest rates based on inflation and GDP gaps.
What is a risk premium?
An extra return demanded by investors to compensate for the risk of default.
How does the IS-LM model incorporate risk premium?
By adjusting investment decisions to account for real interest rates and perceived risk.
What does the Taylor Rule suggest if inflation is above the target?
The central bank should raise interest rates to slow down the economy.
Which two main economic factors does the Taylor Rule respond to?
Inflation deviations from the target and the output gap (difference between actual and potential GDP).
