final eco ppt (1)
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Inflation Inflation is a persistent increase in the price level over
time.
Inflation erodes the purchasing power of a currency.
If it accelerates unchecked, inflation ultimately candestroy a country's monetary system, forcingindividuals and businesses to adopt foreign money or
revert to bartering physical goods
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Types of Inflation
The two types of inflation are demand-pull and cost-push. Demand-pull inflation results from all increaseill aggregate demand. while cost-push inflation resultsfrom a decrease in aggregate supply.
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Demand-Pull Inflation
y Demand-pull inflation can result from an increase inthe money supply, increased government spending, or
any other cause that increases aggregate demand.
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Cost-Push inflation
y Inflation can also result from an initial decrease inaggregate supply caused by an increase in the realprice of an important factor of production. such as
wages or energy.
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Built-in Inflationy It is induced by adaptive expectations, often linked to
the "price/wage spiral" because it involves workers
trying to keeptheir wages up.
y It reflects events in the past, and so might be seen ashangover inflation.
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Keynesian Inflationary-Gap Analysis
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Types of Cost-Push inflation
y W age push inflation
y Profit- Push Inflation
y Material- Cost Push Inflation
y Income- shares Inflation
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Inertia in AD-AS
y In t e - S fra e rinflati n inertia isc aracterize y
ersistent ar s iftsf t and S.
P
Q
S
ggregate s ly s ifts eca sef ex ected inflati n.
M st ften t e ard s ifting aggregate de and
c rve is ca sed y ersistentgr t in t e ney s ly.
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Inertia in AD-AS
(1/ )( )e P P Y Y E!
P
Y
A
AD
If prices have been rising quickly, people will expect them to continue to do so.
Because A depends on expected inflationthe A curve will continue to shift upward.
It will continue to shift upward until someevent, such as a recession or a supply shock, changes inflation and thereby
changes expectations of inflation.
If for example the central banktightened the money supply, AD
would shift back.
This would cause a recession. Highunemployment would reduce
inflation and expected inflation,causing inflation inertia to subside.
uppose the central bank is pursuing an
expansionary monetary policy causing ADto shift out.
A would stopshifting up.
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Two Causes of Rising and Falling Inflation
1 ( )n
u u vT T F
!
The second term shows that
cyclical unemployment exertsupward or downward pressureon inflation. Low
unemployment pulls inflationup. This is called demand-pull inflation because high
AD is the cause.
The third term shows that
inflation also rises and falls with supply shocks. Anadverse supply shock
would push productionprices up. This type of inflation is called cost-
push inflation.
Building the Phillips Curve
The Phillips curve statesthat inflation dependson expected inflation
( )e n
u u vT T F!
the deviation of unemployment from the
natural rate (cyclicalunemployment)
and supply shocks.
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Phillips Curvey Phillips curve the relationship between the rate of
change of money wages( W) and rate of
unemployment(U). W ª%
P
P
U%
0
P`
3
5PHILLIPS CURVE
0 1 2 3 4 5
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y Original Phillips curve was a relation between U and W, it can be used to show relation between U and
P( rate of inflation)
y P= W- X
Average value of x =3%
W here x= increasing productivity of a worker at a
certain time.
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Cost of living influence on wages
y W hen P(rate of inflation) increases, cost of living of workers also increases as a result workers demandincrease in W in order to maintain their real wages.
Thus, both the inflation and wages are inter-related.
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Phillips Curve Contd..y Professor A. W .Phillips
y The curve sloped down from left to right and seemed
to offer policy makers with a simple choice - you haveto accept inflation or unemployment. You can't lowerboth.
y However, in the 1970s the curve appeared to break
down as the economy suffered from unemploymentand inflation rising together (stagflation).
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y Milton Friedman - a monetarist economist. Hedeveloped a variation on the original Phillips Curvecalled the expectations-augmented Phillips Curve.
y Friedman argued that there were a series of different
Phillips curves for each level of expected inflation. If people expected inflation to occur then they wouldanticipate and expect a correspondingly higher wagerise. Friedman was therefore assuming no 'moneyillusion' - people would anticipate inflation andaccount for it. W e therefore got the situation shownbelow:
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Expectations-Augmented Phillips
Curve.
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Short run Phillips C
urvey Say the economy starts at point U with expected
inflation at 0%
y To decrease unemployment ,govt. Boost demand by
5%->shift in AD curve and hence unemployment fallto V .
y However , it lead to demand pull inflation->price rise.The increase in these prices leads people to seek wage
demands that give them a 'real' increase, i.e. is aboveinflation. Since inflation has risen people couldreasonably be expected to build an anticipatedinflation rate into their wage demands
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y R ise in wage->increase in cost for business->A S curveto shift left-> unemployment would be at W .
y Firms would either increase price or shed labour to
maintain their profit margin. Hence, economy wouldbe back to same unemployment level but at higherinflation i.e. 5%
y If the government insist on trying again to reduce the
unemployment the economy will do the same thing( W to X to Y ), but this time at a higher level of inflation.
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y As a result , people will push for higher wage push(5%+ x%) to have real increase. They might think thatgiven that inflation had risen by 5% last year it might
rise by 8%
next and so put in for a wage rise of 11%
toensure they get a real pay increase plus coverthemselves for any anticipated inflation.
y Therefore ,any attempt to reduce inflation below the
level U will simply be inflationary. For this reason therate U is often known as the Natural Rate of Unemployment.
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Long run Phillips
Curve
y W hat shifts the LONG R UN PHILLIPS CURVE?
y Changes in government benefits to the
unemployed/underemployedy Changes in the composition of the Labor force
y Changes in Supply-Side policies
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Phillips Curve
Inflation
Unemployment
SRPC
LRPC
NRU
Changes in Govt. Benefits towards the UNEMPLOYED and the UNDEREMPLOYED
If the Govt. INCREASES the benefits they pay to the unemployed/underemployed in
general this produces a higher level of FRICTIONAL unemployment. People tend to stay
Unemployed for longer periods of time because the replacement income they receive
from the govt. is closer to their lost incomeIn other words, the incentive to look for a
Job is diminished and the tendency to stay unemployed increases..
The LONG RUN PHILLIPS CURVE SHIFTS TO THE RIGHT
(5%)
0%10%
10%
NRU1
(7%)
LRPC1
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Phillips Curve
Inflation
Unemployment
SRPC
LRPC
NRU
Changes in Govt. Benefits towards the UNEMPLOYED and the UNDEREMPLOYED
If the Govt. DECREASES the benefits they pay to the unemployed/underemployed in
general this produces a lower level of FRICTIONAL unemployment. People tend to stay
Unemployed for shorter periods of time because the replacement income they receive
from the govt. is much LESS then their original incomeIn other words, the incentive to
look for a job is INCREASES and the tendency to stay unemployed DECREASES...
The LONG RUN PHILLIPS CURVE SHIFTS TO THE LEFT
(5%)
0%10%
10%
NRU1
(3%)
LRPC1
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Structural Inflation in LDCs
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Least developed country (LDC) is the name given to
a country which, according to the United Nations, exhibitsthe lowest indicators of socioeconomic development, withthe lowest Human Development Index ratings of allcountries in the world. A country is classified as a Least Developed Country if itmeets three criteria based on:
y Low-income (three-year average GNI per capita of less thanUS $905, which must exceed $1,086 to leave the list)
y Human resource weakness (based on indicatorsof nutrition, health, education and adult literacy) and
y Economic vulnerability (based on instability of agriculturalproduction, instability of exports of goods and services,economic importance of non-traditional activities,merchandise export concentration, handicap of economicsmallness, and the percentage of population displaced by natural disasters)
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The gaps and Bottlenecksy R esource Gap
y Food Bottleneck
y Foreign Exchange Bottlenecky Infrastructural (physical) Bottlenecks
y Other Structural Factors
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Money and Inflation
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What Does Rational Expectations
Theory Mean?y It means that the people in the economy make choices
based on their rational outlook, available
information and past experiences.y The theory suggests that the current expectations in
the economy are equivalent to what the future state of the economy will be.
y This contrasts the idea that government policy influences the decisions of people in the economy.
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y
The idea is that rational expectations of the players inan economy will partially affect what happens to theeconomy in the future.
y If a company believes that the price for its product will
be higher in the future, it will stop or slow productionuntil the price rises.
y In sum, the producer believes that the price will rise inthe future, makes a rational decision to slow
production and this decision partially affects whathappens in the future.
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a ona xpec a ons re
Unbiased
A ccuracy and bias in target shooting
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Rational Expectations and Aggregate
Supply
Long A nd Short Run A ggregateSupply with Irrational Expectations
Long A nd Short Run A ggregateSupply with Rational Expectations
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Policy Ineff ectiveness Proposition
y The Policy Ineffectiveness Proposition (PIP) is a theory proposed in 1976 by Thomas J. Sargent and Neil W allacebased upon the theory of rational expectations.
y Any consistent set of government policies will be learned
and anticipated by a population with R ationalExpectations. Since they are anticipated, they will not comeas a surprise.
y Instead, people will shift their short-run aggregate supply curves in such a way that production will be back at the
NA IR GDP and unemployment at the NA IR U.y If the policies are designed to move the economy away from
the NA IR GDP, then they will be ineffective -- regardless what mix of fiscal and monetary policies they are.
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y This leads to the general Policy
IneffectivenessProposition :
y Policy Ineffectiveness Proposition :
y Any consistent government policies designed toinfluence the economy to a level of production otherthan the NA IR GDP will be ineffective if the population
have rational expectations.
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Rational Expectationy W hile rational expectations is often thought of as a school
of economic thought, it is better regarded as a ubiquitousmodeling technique used widely throughout economics.
y First proposed by John F. Muth of Indiana University in the
early 1960s.y He used the term to describe the many economic
situations in which the outcome depends partly on whatpeople expect to happen.
y Many earlier economists, including A. C. PIGOU, JOHN
M AYNA R D KE YNES, and JOHN R . HICKS, assigned a centralrole in the determination of the business cycle to peoplesexpectations about the future. Keynes referred to this aswaves of optimism and pessimism that helped determinethe level of economic activity.
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Rational Expectation & Outcome
y The influences between expectations and outcomes flow both waysy In forming their expectations, people try to forecast what will
actually occur. They have strong incentives to use forecastingrules that work well because higher profits accrue to someone
who acts on the basis of better forecasts, whether that someoneis a trader in the stock market or someone considering thepurchase of a new car.
y And when people have to forecast a particular price over andover again, they tend to adjust their forecasting rules toeliminate avoidable errors. Thus, there is continual feedbackfrom past outcomes to current expectations.
y Thus, in recurrent situations the way the future unfolds fromthe past tends to be stable, and people adjust their forecasts toconform to this stable pattern.
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Applications of Rational Expectationy R andom W alk-A sequence of observations on a variable
(such as daily stock prices) is said to follow a random walkif the current value gives the best possible prediction of future values.
y In their efforts to forecast prices, investors comb allsources of information, including patterns that they canspot in past price movements.
y Friedmans Permanent Income Theory - personsconsumption ought not depend on current income alone,but also on prospects of income in the future.
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y R obert Lucass policy ineffectiveness proposition.- If people have rational expectations, policies that try tomanipulate the economy by inducing people intohaving false expectations may introduce more noiseinto the economy but cannot, on average, improve theeconomy s performance.
y The idea of rational expectations has been usedextensively in such contexts to study the design of
monetary, fiscal, and regulatory policies to promotegood economic performance.
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Inflationary Expectations
y During the 1960s and 1970s, Milton Friedman helped changeattitudes to Monetary policy and inf lation with his theory of adaptive expectations.
y However, a limitation of the model was that it assumed thatpeople's expectations were always based on the past, leaving noroom for future trends.
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y One of the most misunderstood causes of inflation is infact inflationary expectations. W hen people believe thatthere is going to be inflation, inflation itself tends to grow.This is not in any way a new concept. John M. Keynes cameup with a theory, no longer widely accepted, whichnonetheless deals with this issue. It's called the sticky wage theorem. Here's how it works. Suppose I am a worker. I believe that there is going to be inflation. To methis means that I cam going to be able to buy fewer goods.
In response to this threat, I will go to my employer anddemand higher wages. My demand of higher wages will inturn force employers to raise prices. In this way, because I feared inflation, I created it.
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y W hat inflation does do, especially when it is unexpected, isto hurt productivity. W hen firms cannot make correct andaccurate decisions because they are hampered by orunwary of inflation, they tend to delay investment andgrowth in productivity will generally slow. Currently,inflationary expectations have many important impactsdealing with the financial markets, which can causeinflation.
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What Determines Inflation
Expectations?
y Current Inflation
yPerceived Inflation
y Cost Push or Demand Pull Inflation.
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y Difference Between Nominal Bond Y ields and IndexBond Y ields: One gauge of measuring inflation is thedifference between the yield on index linked bonds andordinary nominal bonds. The theory is that if people expect
inflation to rise, they will need a higher yield on nominalbonds to compensate for the threat of inflation. However,there are limitations of this method, as the market forindex linked bonds is relatively small and other factors can
affect bond yields as well as inflation expectations.
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How Inflation Expectations Influence Inflation and
Monetary Policyy If people expect low inflation, monetary policy is more effective.
A quarter point rise may be sufficient to reduce inflation. If people have high inflationary expectations, the Central Bank
may need to increase interest rates by a much bigger%
to have asimilar effect.
For example, in 1990, interest rates in the UK needed to rise to12% to reduce the inflation of the Lawson boom. In the US,
interest rates were 10%
, when inflation was only 4%
.
Central banks definitely have much benefit from keepinginflationary expectations low. The only problem is that reducinginflation with rising oil prices, could push the economy into
recession; it is certainly a difficult dilemma.
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Q . Discuss Reasons for Low Inflation in the UK? (30)
Despite recent increases in inflation, by historical standards,inflation in the UK is very low (3% as opposed to 10% in
1990). Since independence of the B of England, in 1997,inflation has remained close to the governments target of 2% Many feel the MPC has played a pivotal role in keepinginflation low. However, there are also other reasons toconsider such as; globalization, commodity prices and supply
side reforms.
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yFactors explaining Low Inflation in UK
1. Independent Bank of England - MPC
The MPC has sought to maintain low inflation and
sustainable economic growth. It has managed interest ratesto avoid inflationary growth. If the economy wasexpanding too quickly interest rates were increased toprevent future inflation. This is known as pre-emptivemonetary policy, interest rates increased BEFORE inflation
becomes a problem. As a consequence of this policy,growth has been close to the long run trend rate, and thishas been a significant factor in maintaining low inflation.(AD increasing at same rate as A S)
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2. Lower Inflation Expectations
R elated to the independence of the MPC, is the fall ininflation expectations. Because people expect low inflation itis easier to create low inflation. For example, workers do notbargain for high wage increases. Firms don't expect to be ableto pass price increases on. It is a virtuous circle.
3. International Price trends.
It is not just in the UK that inflation has fallen. Other OECD
countries have seen low inf lation. For example, the process of globalization has seen falling prices of manufactured goods,often produced in China. Several commodity prices have alsobeen increasing at low rates, although recently they havestarted to increased.
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4. New Technology.
New technology has helped to reduce the costs of firms. Therefore,the A S curve will shift to the right. For example, the internet andimprovements in microchip computers have helped to reduce costsfor firms.
5. Supply side reforms in the UK.
Supply side policies implemented since the 1980s have helped toreduce cost push inflation. For example, privatization has seen
public companies become more efficient, leading to lower prices.Privatization was often accompanied by deregulation, which seeksto increase competition and therefore reduce prices. It is hard toquantify the contribution of supply side reforms to reducinginflation, but, they have had a benefit.
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