1. Chapter 28 Inflation: Causes and Consequences

2. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-2 Figure 28.1 Consumer Price Level in the U.S., 1939-2002

3. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-3 Causes of Short-Term Price Level Fluctuations Nominal aggregate demand could rise due to a nominal money supply increase. Nominal aggregate demand could rise due to a short-run increase in velocity. A fall in the growth rate of aggregate supply could occur.

4. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-4 Figure 28.2 Price Level Effects of an Increase in the Money Supply

5. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-5 Figure 28.3 Price Level Effects of an Oil Price Increase

6. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-6 Sustained Changes in the Price Level: Inflation Sustained rates of change in the price level constitute inflation. Inflation arises when aggregate demand grows faster than aggregate supply. One-time shocks cannot by themselves produce inflation. Sustained money supply growth causes inflation but does not affect real output.

7. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-7 Figure 28.4 Persistent Money Supply Growth and Inflation

8. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-8 Costs of Expected Inflation Inflation is a tax on real money balances if they pay less than the market interest rate. If tax brackets are not indexed for inflation, then the problem of bracket creep occurs. Expected inflation can also distort financial decisions. Menu costs, or the costs of changing prices, are another cost.

9. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-9 Costs of Unexpected Inflation Because some contracts are set in nominal terms, wealth redistribution can occur. Inflation uncertainty causes distortion of information provided by prices. When inflation fluctuates significantly, relative prices may change. An extreme case of uncertain inflation occurs in a hyperinflation.

10. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-10 Inflation and Monetary Policy Cost-push inflation results from workers’ pressure for higher wages. Demand-pull inflation results from attempts to decrease the unemployment rate too low.

11. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-11 Figure 28.5 Demand-Pull Inflation

12. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-12 Figure 28.6 Cost-Push Inflation

13. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-13 Costs of Reducing Inflation Disinflation refers to a decline in long-run inflation. The new classical view argues for an immediate reduction in money growth. New Keynesians advocate slow and steady reduction in money growth.

14. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-14 Figure 28.7 New Classical Suggestion: Cold Turkey Disinflation

15. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-15 Figure 28.8 New Keynesian Suggestion: Gradual Disinflation

16. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-16 Central Bank Credibility A crucial factor in disinflationary policy is central bank credibility. Appointing a “tough” central banker is likely to increase central bank credibility. Some economists argue that the central bank should adopt a rules strategy. Other economists support a discretion strategy.

17. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-17 Figure 28.9 Strategies for Changing the Economy’s Equilibrium

18. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-18 Figure 28.10 Payoffs from Alternative Actions