Chapter 28 Inflation: Causes and Consequences. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-2 Figure 28.1 Consumer Price Level in

Chapter 28

Inflation: Causes and Consequences

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-2

Figure 28.1 Consumer Price Level in the U.S., 1939-2002


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.


Figure 28.2 Price Level Effects of an Increase in the Money Supply


Figure 28.3 Price Level Effects of an Oil Price Increase


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.


Figure 28.4 Persistent Money Supply Growth and Inflation


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.


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.


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.


Figure 28.5 Demand-Pull Inflation


Figure 28.6 Cost-Push Inflation


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.


Figure 28.7 New Classical Suggestion: Cold Turkey Disinflation


Figure 28.8 New Keynesian Suggestion: Gradual Disinflation


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.


Figure 28.9 Strategies for Changing the Economy’s Equilibrium


Figure 28.10 Payoffs from Alternative Actions

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Chapter 28 Inflation: Causes and Consequences. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28-2 Figure 28.1 Consumer Price Level in