U7: Inflation

what is inflation? what is it caused by?

increase in overall price levels; caused by too much money in circulation and market issues

what is deflation and what does it mean for prices and income?

decrease in overall price levels; lower prices = lower incomes = lower price of labor

what can inflation measure?

the value of individuals and the value of money itself

what is money supply and who is controlled by?

a fixed quantity in circulation at any given point in time (vertical supply curve), controlled by the Fed

what is the demand for money based on?

personal preference, interest rates, current price levels

what are the short and long run differences in monetary equilibrium?

short run (weeks/months): interest rates are biggest influence in balancing money S/D

long run (several years): prices naturally adjust to equilibrium level of money S/D

why would debtors “win” and creditors “lose” in some cases?

inflation makes dollars less valuable (so, debtors pay back an original amount of debt with less valuable dollars)

why would people who save money “lose”?

the value of each dollar earned through interest is not very high, so more dollars but less wealth

how do homeowners benefit during inflation?

• homeowners because they are already debtors (mortgage repaid with less valuable dollars) and home values tend to increase greater than inflation rates

• can take out home equity loans for other purposes

• can sell homes for increased profit when inflation occurs

do nominal variables (money) affect real variables (like the amount of things/stuff) in the long run?

no, money by itself doesn’t affect the ability to produce goods/services since money is neutral in the long run

what does output depend on?

real variables like education, technological advances, raw materials/resources

what are short term economic problems often caused by? what can be defined as a short term economic problems?

short term economic problems like lower production or unemployment are often caused by monetary/price changes

what are the four negative costs of inflation?

shoe leather costs, menu costs, relative price changes and the misallocation of resources, and a general sense of confusion and inconvenience

what is shoe leather costs?

when people choose to keep their money in their banks rather than carry it all and this causes more frequent trips to the bank or ATM to get cash. it explains the time spent and wear-and-tear on shoes/cars

what are menu costs?

when changing the price level requires businesses to print new price lists and catalogs, print new ads, mail new prices to consumers, and make adjustments to their websites

what do we mean by relative prices in terms of negative costs of inflation? how does this impact unemployment

when people think that if the price of one or a few things rise, that ALL prices are rising

if a consumer’s spending decreases = businesses cut back on production and this leads to greater unemployment

what do we mean by confusion/inconvenience in terms of negative affects of inflation?

since money/prices are a measure of value, inflation can cause incorrect perception of firms’ earnings and expenses. a company might make $100 million in profit a year, but inflation can make the real value of that money less

what are the three types of inflation?

demand pull: caused by demand for goods and services

cost-push: caused by supplier’ choices

built-in inflation: caused laborers and suppliers (when cost of living inc, pay raise is demanded, makes inflation worse)

describe demand-pull inflation

excess demand for finite amount of producs

explain the first stage of demand-pull inflation

• likely a recessionary period

• production is not maxed out, unemployment is higher than usual

• output increases but prices don’t rise

explain the second stage of demand-pull inflation

• economy moves towards full employment and maximizing production

• price levels start to rise as output rises because the cost of production increases

• each additional worker contributes less overall productivity (diminishing marginal returns)

explain stage three of demand-pull inflation

• resources are maximized and output is maxed out

• more products demanded but none available

• the only solution is to increase prices and determine who gets the finite amount of products available

what is cost-push inflation usually due to? explain it.

• usually due to rising input costs for suppliers

• higher costs of production = not only will firms raise prices to accommodate, they typically sell less

what are supply shocks?

sudden, often unexpected, increases in production costs

which is more serious: demand-pull or cost-push inflation?

cost-push

what does a small amount of inflation (usually 1-3%) a sign of?

a healthy economy, reflects good spending and a desire for more material welfare (which keeps people in business and employs workers