L10-13: Inflation and the Phillips Curve Flashcards

Inflation: What's the Big Deal?

• What it is: Inflation is simply the rate at which prices for goods and services are rising. If your coffee cost 5 last year and costs 5.50 this year, there’s been inflation.

• Why it matters: A little inflation is normal and even good for the economy. Too much, and your money doesn't buy as much as it used to, which can cause problems.

Market Crashes and the Economy: A Roller Coaster

• Stock Market's ups and downs: The stock market's performance reflects overall economic health. Major events like wars, economic policies, and global crises (like COVID-19) can cause big swings.

• Visualizing wealth: Graphs showing cumulative real wealth help illustrate how different events impact economic growth over long periods.

Taylor Rule: Setting Interest Rates

• What it is: The Taylor Rule is like a guideline for central banks (like the Federal Reserve in the U.S.) on setting interest rates.

• How it works:

  • If inflation is higher than desired, raise interest rates to cool down the economy.

  • If the economy is underperforming, lower interest rates to encourage spending and investment.

• The formula: The rule uses a formula: r – r* = a(\pi - \pi) + b(Y – Y), a, b > 0

  • r = real interest rate

  • \pi = inflation rate

  • Y = real output

  • '*' denotes ideal levels

• In simple terms: If inflation is too high by 1%, the central bank increases interest rates by more than 1% to combat it.

Quantity Theory of Money: Money Supply and Inflation

• What it is: This theory explains the relationship between money supply, velocity of money, price levels, and economic output.

• The equation: MV = PY

  • M = money supply

  • V = velocity of money (how often money changes hands)

  • P = price level

  • Y = real output (goods and services produced)

• In simple terms: If the amount of money in the economy increases faster than the amount of goods and services, prices will rise (inflation).

Is the Velocity of Money Stable?

• The assumption that the velocity of money is stable is crucial for the quantity theory of money to hold true. However, this stability is often debated.

Fisher Hypothesis: Real vs. Nominal Interest Rates

• What it says: Real interest rate (what you actually earn after inflation) equals nominal interest rate (the stated rate) minus expected inflation.

• In simple terms: Real\ Interest\ Rate = Nominal\ Interest\ Rate – Expected\ Inflation

• Why it matters: Real interest rates don't change much because nominal rates adjust to offset inflation.

The Phillips Curve: Inflation vs. Unemployment

• What it is: This curve shows the relationship between inflation and unemployment.

• The trade-off:

  • High unemployment tends to lead to lower inflation.

  • Low unemployment can lead to higher inflation.

• Why this happens: When lots of people are employed, they have more money to spend, driving up demand and prices.

• Digging deeper: The Phillips curve suggests that during economic booms, companies are eager to hire, leading to lower unemployment. With more people working and earning, they demand higher wages. Companies often pass these increased labor costs onto consumers in the form of higher prices, thus fueling inflation.

Long Run Phillips Curve: No Trade-Off

• The catch: The Phillips Curve relationship doesn't hold in the long run.

• Natural rate of unemployment: There's a natural level of unemployment that exists even when the economy is healthy.

  • Types of Unemployment:

    • Cyclical Unemployment: This is unemployment that rises during economic downturns and falls when the economy improves. It's tied to the business cycle.

    • Frictional Unemployment: This occurs when people are in between jobs, searching for new opportunities. It's a natural part of a dynamic economy.

    • Structural Unemployment: This happens when there's a mismatch between the skills workers have and the skills employers need. This can be due to changes in technology or industry shifts.

• Long-term view: In the long run, the Phillips curve is vertical, meaning there's no trade-off between inflation and unemployment. The economy will always return to the natural rate of unemployment regardless of inflation rates.

Phillips Curve and Aggregate Supply

• Short-term vs. Long-term: In the short term, surprise inflation can lower unemployment. But eventually, wages and prices adjust, and the economy returns to its natural state.

• Expectations matter: If people expect higher inflation, they'll demand higher wages, which cancels out any short-term benefits.

Phillips Curve Adjustment Speed

• Flexibility is key: How quickly wages and prices adjust affects how fast the economy moves along the Phillips curve.

• Monetary policy: How the central bank manages interest rates also plays a role.

Supply Shocks and the Phillips Curve

• What are supply shocks: These are unexpected events that affect the supply of goods and services (e.g., a natural disaster or sudden increase in oil prices).

• Stagflation: A negative supply shock can lead to stagflation: higher unemployment and higher inflation at the same time.

Why Relationship Between Unemployment and Inflation Is Weaker Today

• Central bank credibility: Central banks are more transparent and predictable, influencing expectations.

• Globalization: Global competition limits how much companies can raise prices.

• Gig economy: Flexible work arrangements impact wage negotiations.

The Costs of Inflation

• Price signals get muddled: Inflation makes it harder for businesses and consumers to make informed decisions.

• Savings erode: Your savings lose value if inflation is higher than your interest rate.

• Lending and borrowing: Unexpected inflation can shift wealth between borrowers and lenders.

How Bad Is Moderate Inflation?

• While hyperinflation is clearly damaging, there's less agreement on the impact of moderate inflation. Some argue it doesn't significantly harm the economy.

In summary:

• This note covers key macroeconomic concepts like inflation, the Phillips curve, the Taylor rule, and the quantity theory of money.

• It explains these concepts in simple terms, using real-world examples and analogies.

• It also discusses the limitations and nuances of these concepts,