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Chapter 28 Inflation: Causes and Consequences Figure 28.1 Consumer Price Level in the U.S., 1939-2002 Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-2 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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-3 Figure 28.2 Price Level Effects of an Increase in the Money Supply Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-4 Figure 28.3 Price Level Effects of an Oil Price Increase Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-5 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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-6 Figure 28.4 Persistent Money Supply Growth and Inflation Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-7 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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-8 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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-9 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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-10 Figure 28.5 Demand-Pull Inflation Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-11 Figure 28.6 Cost-Push Inflation Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-12 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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-13 Figure 28.7 New Classical Suggestion: Cold Turkey Disinflation Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-14 Figure 28.8 New Keynesian Suggestion: Gradual Disinflation Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-15 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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-16 Figure 28.9 Strategies for Changing the Economy’s Equilibrium Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-17 Figure 28.10 Payoffs from Alternative Actions Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-18