7 - Inflation, phillips curve

Define inflation

Inflation is the rate at which the general level of price for goods and services rises - this reduces the purchasing power of money in the economy

What do firms set prices based off

Expected inflation

Output

Supply shocks

why does expected inflation = inflation

Firms will adjust their prices according to inflation so if they all expect inflation to be a certain percentage they will adjust accordingly resulting in an actual inflation of what they expected

What are the two theories of expected inflation

Rational - Assume that inflationary expectations are the best forecasts based on public information

Adaptive - Assume expectations are based on past inflation

What is the equation of adaptive expectations

What is the equation for the phillips curve

Where V = supply shock

What does a phillips curve show

The short run relationship between output and inflation

Phillips curve shows economic boom raises inflation and recession decreases inflation

What is a supply shock

A supply shock is a major event which causes a major change in firms’ production costs

E.g: raw material price change, wage increase

Equation for output/ aggregate expenditure

Y = C + G + I + NX

Equation for real rate of interest

r = i - pie^e

Increase in real interest rate decreases aggregate expenditure

I = nominal

How does interest rate affect net exports

A higher real rate reduces net capital outflows increasing real exchange rate - exports more expensive , imports cheaper so net exports decreases

Show a shift in interest rates

What is a credit crunch

A reduction in bank lending

Show an expenditure shock with real interest on a graph

How can the central bank keep output constant after a supply shock

Show ts on a graph

After an supply shock if real interest rate is unchanged then output remains constant but inflation rises

Show what occurs after a supply shock if the central bank allows real interest rate to change

PC = phillips curve

Draw a phillips curve (Maybe this is uni one not 100)

What is the long run monetary neutrality

That monetary policy can only effect inflation and thus real output.ect and not actual output

And because monetary policy it cannot affect unemployment because when output is at the potential then unemployment has to be at its natural rate

What would occur if a central bank tried to create a permanent boom

Output would be pushed above output and so this would cause inflation to rise quickly