Week 8 Flashcards
(18 cards)
What is inflation targeting, and how does it guide the RBA’s policy?
Inflation targeting is a central bank strategy where the RBA aims to keep inflation within a specified range (2-3% in Australia). This goal shapes policy actions, guiding interest rate adjustments to stabilize inflation around the target.
Describe the policy reaction function (PRF) used by the RBA.
The PRF shows how the RBA adjusts the real interest rate in response to changes in inflation relative to the target, increasing rates when inflation rises above the target to curb demand and lower inflation.
How is the Aggregate Demand (AD) curve derived, and what does it represent?
The AD curve represents the relationship between inflation and output, derived from the equilibrium where Y=PAE. A higher inflation rate lowers real money balances, reducing consumption and investment, hence lowering output.
What factors can shift the AD curve?
The AD curve shifts due to changes in government spending, inflation expectations, and monetary policy adjustments, such as a change in the inflation target.
How does a lower inflation target affect the policy reaction function and AD curve?
A lower target increases the interest rate for a given inflation level (inflation hawk approach), shifting the AD curve leftward, which reduces demand and helps control inflation.
Conversely, what happens if the inflation target is raised?
A higher target reduces the interest rate for a given inflation level (inflation dove approach), shifting the AD curve rightward, supporting higher output and demand.
What is inflation inertia, and why does it occur?
Inflation inertia is the tendency for inflation to persist due to adaptive expectations and contracts, where workers and firms base wage/price decisions on past inflation rates, sustaining inflation over time.
What factors cause the AS curve to shift?
The AS curve shifts due to supply shocks (e.g., changes in resource prices or productivity) and adjustments in inflation expectations, where higher expected inflation shifts AS upward.
Define an output gap and its implications for inflation.
The output gap is the difference between actual output (Y) and potential output (Y). A positive gap (Y > Y) leads to demand-pull inflation, while a negative gap (Y < Y*) reduces inflationary pressures.
How does aggregate expenditure (PAE) impact both inflation and output?
PAE affects output directly by influencing demand. A high PAE relative to potential output drives up inflation, while low PAE can decrease inflation by reducing demand pressures.
What characterizes short-run equilibrium in the AD-AS model?
In the short run, output can deviate from potential due to price and wage stickiness, resulting in temporary output gaps. Inflation may vary based on current demand pressures but has not yet adjusted fully.
Describe long-run equilibrium in the AD-AS model.
Long-run equilibrium occurs when actual output equals potential output, and inflation stabilizes around expected levels. Self-correcting mechanisms adjust prices and wages, closing any output gaps.
How did Australia experience disinflation in the 1990s?
Australia reduced inflation through disciplined monetary policy, setting an explicit inflation target. This anchored expectations, leading to a sustained reduction in inflation without high unemployment.
What are the benefits of low, stable inflation for an economy?
Low inflation promotes economic stability, protects purchasing power, and supports long-term planning and investment, reducing the need for costly disinflationary policies.
What were some policy mistakes that contributed to the Great Inflation?
Policy errors included underestimating inflationary pressures, excessive fiscal stimulus, and a failure to respond adequately to rising inflation, allowing it to become embedded in expectations and wages.
What lesson does the Great Inflation provide for modern monetary policy?
The experience underscores the importance of maintaining credible inflation targets and taking timely actions to prevent inflation from spiraling, highlighting the role of expectations management.
How does an adverse supply shock affect the AD-AS model?
An adverse supply shock (e.g., oil price hike) shifts the AS curve leftward, increasing inflation while reducing output, creating a dilemma for policymakers who must choose between stabilizing inflation or output.
What is a policy response to adverse supply-driven inflation?
Policy responses may include tolerating temporary inflation to avoid output loss or implementing targeted supply-side interventions (e.g., subsidies) to mitigate the impact on production costs.
