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Economic Effects of High Inflation
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Economic Effects of High Inflation

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Questions and Answers

What is a consequence of high inflation on producers?

  • They can distinguish between changes in relative prices and inflation.
  • They can reduce their production costs.
  • They find it harder to distinguish between changes in relative prices and inflation. (correct)
  • They need to update their prices less frequently.

    • Why do the poor suffer more from inflation?

  • They have a higher income to absorb price increases.
  • They are more likely to be unemployed.
  • They have more savings to invest.
  • They have a lower capacity to substitute out of products. (correct)

    • What happens to consumption when prices are falling?

  • Households postpone their consumption. (correct)
  • Households increase their consumption.
  • Households reduce their consumption.
  • Households maintain their current level of consumption.

    • What is a consequence of deflation?

    <p>Real debt burden increases.</p> Signup and view all the answers

    What is a characteristic of the labour market equilibrium?

    <p>All parties are doing the best they can, given what everyone else is doing.</p> Signup and view all the answers

    What is true about the labour market equilibrium?

    <p>Those who have jobs cannot improve their situation by asking for higher pay or working less hard.</p> Signup and view all the answers

    What is a characteristic of the labour market equilibrium?

    <p>There is no reason for the wage and price level to change.</p> Signup and view all the answers

    What is a consequence of high inflation?

    <p>Menu costs increase as firms must update their prices more frequently.</p> Signup and view all the answers

    What is the result of a positive bargaining gap in a boom economy?

    <p>Inflation</p> Signup and view all the answers

    What determines the feasible trade-offs between inflation and unemployment?

    <p>Phillips Curve</p> Signup and view all the answers

    What is the result of a negative bargaining gap in a recession?

    <p>Deflation</p> Signup and view all the answers

    What is used to map the preferences of the economy?

    <p>Indifference Curve</p> Signup and view all the answers

    What is shown in Figure 15.4d?

    <p>The business cycle</p> Signup and view all the answers

    What does each level of aggregate demand cost?

    <p>A certain level of unemployment</p> Signup and view all the answers

    What is the relationship between unemployment and output in a recession?

    <p>Higher unemployment, lower output</p> Signup and view all the answers

    What is the name of the curve that shows the relationship between inflation and unemployment?

    <p>Phillips Curve</p> Signup and view all the answers

    What occurs when the unemployment level is below the labor market equilibrium unemployment level?

    <p>An upward pressure on wages and prices</p> Signup and view all the answers

    What is the result of a labour market equilibrium?

    <p>Stable price level</p> Signup and view all the answers

    What happens when the labour market is not in equilibrium and unemployment is above the equilibrium level?

    <p>Downward pressure on wages and prices</p> Signup and view all the answers

    What is the bargaining gap?

    <p>The difference between the real wage required to incentivize effort and the real wage that gives firms enough profits to stay in business</p> Signup and view all the answers

    What is the result of a positive bargaining gap?

    <p>Inflation</p> Signup and view all the answers

    What is the relationship between extra output and inflation?

    <p>A tradeoff</p> Signup and view all the answers

    What is the result of a labour market not in equilibrium with unemployment below the equilibrium level?

    <p>A positive bargaining gap</p> Signup and view all the answers

    What is the only way to stop a wage-price spiral?

    <p>Decrease the unemployment level to the labor market equilibrium unemployment level</p> Signup and view all the answers

    What is the effect of an increase in the level of employment on the labour market equilibrium diagram?

    <p>An upward movement along the wage-setting curve</p> Signup and view all the answers

    Who benefits from inflation?

    <p>Borrowers and flexible-income recipients</p> Signup and view all the answers

    What type of products contribute significantly to inflation year on year?

    <p>Alcohol, electricity, and cigarettes</p> Signup and view all the answers

    Who loses from inflation?

    <p>Creditors and fixed-income recipients</p> Signup and view all the answers

    Why do fixed-income recipients lose from inflation?

    <p>Their income is not adjusted for inflation</p> Signup and view all the answers

    What happens to savers if the rate of return from their investments is less than the annual inflation rate?

    <p>They lose money</p> Signup and view all the answers

    What is the relationship between employment and inflation according to the Phillips Curve?

    <p>Higher employment results in higher inflation</p> Signup and view all the answers

    Who else may benefit from inflation?

    <p>Those who rent out homes they own</p> Signup and view all the answers

    What is the preferred outcome for policymakers in terms of inflation and unemployment?

    <p>5% inflation with 3% unemployment</p> Signup and view all the answers

    What happens to the Phillips Curve over time?

    <p>It shifts upwards</p> Signup and view all the answers

    Why does keeping unemployment 'too low' lead to higher prices and rising inflation?

    <p>Because people are forward-looking and anticipate future prices</p> Signup and view all the answers

    What is the key factor that causes the Phillips Curve to shift?

    <p>Expected inflation</p> Signup and view all the answers

    What is the primary reason why people ask for raises in anticipation of future prices?

    <p>Because they expect higher prices in the future</p> Signup and view all the answers

    What happens when policymakers keep unemployment 'too low'?

    <p>Inflation increases</p> Signup and view all the answers

    What is the implication of people being forward-looking?

    <p>They consider current and future prices</p> Signup and view all the answers

    What is the result of the Phillips Curve shifting upwards over time?

    <p>Higher inflation and lower unemployment</p> Signup and view all the answers

    Study Notes

    Consequences of High Inflation

    • High inflation is often volatile, leading to uncertainty
    • It is harder for producers to distinguish between changes in relative prices and inflation
    • Menu costs arise as firms must update their prices more frequently
    • The inflation experience is not always even across the income distribution, with the poor more affected by price increases of essential goods

    Consequences of Deflation

    • Deflation could have even more dramatic consequences than high inflation
    • When prices are falling, households may postpone consumption, particularly of durables, expecting goods to be cheaper in the future
    • Deflation increases the real debt burden, leading households to cut consumption to return to their target wealth

    Labour Market Equilibrium

    • In the labour market equilibrium, all parties are doing the best they can, given what everyone else is doing
    • The labour market equilibrium is characterized by:
      • Firms offering a wage that ensures workers' effort at the lowest possible cost
      • Employment being the highest it can be, given the wage offered
      • No reason for the wage and price level to change, resulting in no inflation pressure

    Consequences of Inflation: The Distributive Nature

    • Who wins from inflation:
      • Borrowers, as they pay back money with less purchasing power
      • Flexible-income recipients, who may experience lower personal inflation rates
      • Those who rent out homes, as rental income grows with inflation
    • Who loses from inflation:
      • Creditors, as they may receive money back from debtors that has less purchasing power
      • Fixed-recipients, such as those with private pensions that are not adjusted for inflation
      • Savers, if the rate of return from their investments is less than the annual inflation rate

    The Phillips Curve

    • The Phillips Curve shows that higher employment may result in inflation, leading to a wage-price spiral
    • The only way to stop this cycle is for the unemployment level to decrease to the level associated with the labour market equilibrium
    • Prices are stable (inflation is 0) when the labour market is in (Nash) equilibrium

    What Happens if Labour Market is NOT in Equilibrium?

    • Unemployment below equilibrium: workers' claims to real wages + firms' claims to real profits > total productivity, leading to upward pressure on wages and prices
    • Unemployment above equilibrium: workers' claims to real wages + firms' claims to real profits < total productivity, leading to downward pressure on wages and prices

    The Bargaining Gap

    • The bargaining gap is the difference between the real wage required to incentivize effort and the real wage that gives firms enough profits to stay in business
    • Unemployment is below equilibrium: a positive bargaining gap and inflation
    • Unemployment is above equilibrium: a negative bargaining gap and deflation
    • Labour market equilibrium: the bargaining gap is zero, and the price level is constant

    The Phillips Curve and the Business Cycle

    • A positive bargaining gap in a boom → inflation
    • A negative bargaining gap in a recession → deflation

    The Phillips Curve Over Time

    • The trade-off between inflation and unemployment is not stable: the Phillips Curve shifts over time
    • Keeping unemployment "too low" leads to higher prices and rising inflation
    • People are forward-looking, taking actions now in anticipation of things they expect to happen, making expected inflation key

    The Role of Expectations and the Phillips Curve

    • Expectations of future prices can cause the Phillips Curve to shift
    • If people expect inflation to be 5% next year, they will ask for a raise of at least 5% for next year

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    Description

    This quiz discusses the negative effects of high inflation on the economy, including uncertainty, menu costs, and unequal impact on different income groups.

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