Inflation in Economics at Help With Assignment

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` Inflation is the rise in the level of prices of goods

and services in an economy over a certain period

of time.

` The general prices level rises, each unit of currency buys lesser of the goods and services.

Consequently, inflation also reflects erosion in the

purchasing power of money.




` This is a loss of real value in the internal medium

of exchange and unit of account in the economy.

` A chief measure of inflation is the inflation rate, the

annualized percentage change in a general priceindex over time.




` The principal explanation for inflation is excess

demand.

` When too much money chases few goods leads to

prices being bid up.` In the later half of the nineteenth century, this was

taken literally through the quantity theory of

money.




` It was believed that a change in the amount of

money circulating in the economy would have a

fairly immediate and proportional effect on general

price levels.` Although this theory was not accepted back then,

many economists now agree that change in the

money supply affect the economy primarily

through changes in the interest rates.




` Inflation is generally, believed to be demand

driven.

` In contrast, supply side explanations for inflation

depend on the existence of noncompetitivemarkets.

` If a firm, a group of firms gains sufficient power in

a market, it may this market power by raising its

prices in order to increase returns.




` The resulting prices are then registered as

inflation.

` This strategy not only requires market power but

also a buoyant economy.` One of the best examples is when OPEC used its

market power to quadruple the price of petroleum

in the early 1970s.




` When OPEC used its market power to quadruple

the price of petroleum in the early 1970s; it was so

effective that the supply side shock threw most of

the capitalist world into a recession.` The jumbo price rise also stimulated conservation

and the use of substitutes.




` Central Banks usually seek to stabilize the rate of

inflation.

` In addition, some seek to keep the economy at full

employment.` To do this, they usually focus on controlling an

intermediate target.




` In the past, this intermediate target was money

supply.

` Currently, most central banks focus on influencing

interest rates.` Interest rates provide an instant feedback.

` The interest rate that central banks do care about

is the real interest rate (the nominal rate is less

than the rate of inflation).




` If, instead, the central bank focused on

maintaining a particular nominal rate, it could lead

to wide swings in the money supply.

` For example if the central bank targets a certainnominal interest rate, say 4 percent. To do this,

say it increases the money supply.




` In the short run, rates fall to 4 percent.

` But then inflation starts to grow and the interest

rates start to rise.

` The central bank would then increase the moneysupply even more.

` Should the central bank keep increasing the

money supply, inflation will get worse.




` The result would be a runaway inflation.

` To avoid this, the central bank should focus on

real rates of interest.

` When inflation starts to rise, real rates are likely tofall, correctly indicating that the economy is being

stimulated.




` Although, the Federal Reserve Bank, the central

bank in the United States, seeks price stability, it

does not currently use inflation targeting.` Instead, it often appears to be following what is

called Taylor¶s Rule; named after John Taylor who

first proposed the rule.




` The rule predicts how the bank determines the

financial funds rate (the rate private banks charge

other private banks to borrow money).

` To illustrate the rule, assume that if the economy

is at full employment, the real federal funds rate

(the federal rate minus the rate of inflation) would

be 2 percent.




` Next, assume the Fed wants the inflation rate to

be 3 percent. According to Taylor¶s rule, the bank

might set the target federal funds rate (r) so that itequals:

` Target r = 2 percent + rate of inflation + 0.5 (rate of

inflation ± 3 percent) + 0.5 (Real GDP gap)




` The real GDP gap is the percent difference

between real GDP and the full employment level

of GDP (the level of GDP consistent with a stable

inflation rate).` If the bank was interested only in controlling

inflation (ie., inflation targeting) the weight of on

the real GDP gap would be zero.


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