L10-13: Inflation and the Phillips Curve Flashcards

Flashcards on Inflation and the Phillips Curve

What is the Taylor Rule?

Central banks set interest rates based on deviations of both inflation and output from their target long-run equilibrium levels.

What is the formula for the Taylor rule

The formula is typically expressed as: i = r* + π + 0.5(π - π) + 0.5(Y - Y), where i is the target interest rate, r* is the equilibrium real interest rate, π is the current rate of inflation, π* is the target inflation rate, and Y is the actual output while Y* is the potential output.

According to the Taylor Rule, how do central banks respond to inflation exceeding its target?

When inflation exceeds its target, nominal interest rates increase by more than 1% to raise real interest rates and lower inflation.

How can the Taylor rule be interpreted regarding the central bank's concerns?

It represents the central bank’s concern for both current and future inflation.

What is the equation for the Quantity Theory of Money?

MV = PY, where M is nominal money supply, V is the velocity of money, Y is real output, and P is prices.

What is the velocity of money?

The number of times a unit of money changes hands through transactions in a year.

According to the Quantity Theory of Money, what primarily causes sustained inflation?

Sustained inflation is largely a monetary phenomenon caused by growth in money supply.

What is the Fisher Hypothesis formula?

[Real Interest rate] = [Nominal interest rate] – E[Inflation rate]

What does the Fisher Hypothesis state about the relationship between real and nominal interest rates?

Real interest rates do not change much; higher inflation rates are offset by changes in nominal interest rates.

What relationship did Professor Phillips find in 1958?

A strong negative statistical relationship between annual inflation and annual unemployment rates.

How does the Phillips Curve explain the relationship between inflation and unemployment during economic booms?

The Phillips Curve illustrates that during economic booms, inflation tends to rise as unemployment falls, suggesting an inverse relationship between the two. This occurs because increased demand for goods and services leads to higher prices and lower unemployment.

Given the trade-off between inflation and unemployment, how can policymakers utilize the Phillips Curve?

Policymakers can manipulate aggregate demand through fiscal/monetary policies to choose a point on the curve.

What are the three types of unemployment in the economy?

Cyclical, frictional, and structural unemployment.

What causes cyclical unemployment?

Changes in economic activity over the business cycle.

What causes frictional unemployment?

People moving between jobs in the labor market.

What causes structural unemployment?

Mismatch between the skills workers have and those that employers demand.

What is the natural rate of unemployment?

The level of unemployment when the economy is at the potential output level or at its long-run equilibrium.

What does the long-run Phillips Curve show?

No trade-off between inflation and unemployment; the curve is vertical. It illustrates that in the long run, the economy tends to achieve natural unemployment regardless of inflation rate.

Why is there no long-run trade-off between inflation and unemployment?

In the long run, any increase in inflation only leads to an increase in prices, not a decrease in unemployment, as expectations adjust.

Why is there a short-run trade-off between inflation and unemployment?

This occurs because, in the short run, unexpected inflation can lead to lower real wages, prompting firms to increase hiring and output, which temporarily reduces unemployment.

What happens once inflationary expectations are revised upwards?

Itleads to a shift of the short-run Phillips Curve to the right, resulting in higher inflation with the same levels of unemployment.

This shift indicates that inflation expectations have increased, causing policymakers to struggle in maintaining low unemployment without contributing to rising inflation, demonstrating the trade-off between inflation and unemployment.

What creates the short-run trade-off between inflation and unemployment?

Nominal wage rigidities.

What is a crucial determinant of inflation tomorrow?

Inflationary expectations.

What is important for the success of monetary policy?

The credibility of a central bank.

What are some reasons why the relationship between unemployment and inflation is weaker today?

Central bank credibility, globalization, and gig economy/zero-hour contracts.

Why is inflation costly?

Inflation can erode purchasing power, lead to uncertainty in investment decisions, and create income redistribution effects, disproportionately affecting low-income individuals.

It can also result in increased costs for businesses and hinder economic growth.

What happens when inflation is higher than expected?

It transfers purchasing power from lenders to borrowers.

What happens when inflation is lower than expected?

When inflation is lower than expected, it can lead to increased unemployment as businesses may reduce hiring or lay off workers due to lower demand. Additionally, consumers may delay purchases, expecting prices to fall further, which can slow economic growth.

What role do prices play in a market economy?

Prices in a market economy provide signals that guide the allocation of resources.