Inflation Study Guide
Name two causes of inflation. Explain how they work.
Demand-pull inflation: As the name suggests, demand-pull inflation occurs as a result of increasing aggregate demand in the economy. Cost-push inflation: Cost-push inflation occurs as a result of an increase in the costs of production.
How can inflation be caused by excess monetary growth?
If there is more money in the economy, then there will be more spending, thus higher aggregate demand. Increases in the money supply result in higher aggregate demand from AD1 to AD2. Because the economy rests at the full employment level of output in the long run, such increases in aggregate demand due to increases in the money supply are purely inflationary, with the price level rising from P1 to P2.
Name 2 costs of inflation. Explain.
The answer could be two of the following:
• Loss of purchasing power: If the rate of inflation is 2%, then this means that the average price of all goods and services in the economy has risen by 2%.
• Effect on saving: If you save $1,000 in the bank at 4% annual interest, then in one year's time you will have $1,040. If the inflation rate is 6% then the real rate of interest (the interest rate adjusted for inflation) will be negative and your savings will not be able to buy as much as they could have in the previous year.
• Effect on interest rates: Commercial banks make their money from charging interest to people who borrow money from them
• Effect on international competitiveness: If a country has a higher rate of inflation than that of its trading partners then this will make its exports less competitive and will make imports from lower-inflation trading partners more attractive.
• Uncertainty: Not only might there be reduced investment due to a fall in the availability of savings and higher nominal interest rates, but firms may be discouraged from investing due to the uncertainty associated with inflation
• Labor unrest: This may occur if workers do not feel that
Demand-pull inflation: As the name suggests, demand-pull inflation occurs as a result of increasing aggregate demand in the economy. Cost-push inflation: Cost-push inflation occurs as a result of an increase in the costs of production.
How can inflation be caused by excess monetary growth?
If there is more money in the economy, then there will be more spending, thus higher aggregate demand. Increases in the money supply result in higher aggregate demand from AD1 to AD2. Because the economy rests at the full employment level of output in the long run, such increases in aggregate demand due to increases in the money supply are purely inflationary, with the price level rising from P1 to P2.
Name 2 costs of inflation. Explain.
The answer could be two of the following:
• Loss of purchasing power: If the rate of inflation is 2%, then this means that the average price of all goods and services in the economy has risen by 2%.
• Effect on saving: If you save $1,000 in the bank at 4% annual interest, then in one year's time you will have $1,040. If the inflation rate is 6% then the real rate of interest (the interest rate adjusted for inflation) will be negative and your savings will not be able to buy as much as they could have in the previous year.
• Effect on interest rates: Commercial banks make their money from charging interest to people who borrow money from them
• Effect on international competitiveness: If a country has a higher rate of inflation than that of its trading partners then this will make its exports less competitive and will make imports from lower-inflation trading partners more attractive.
• Uncertainty: Not only might there be reduced investment due to a fall in the availability of savings and higher nominal interest rates, but firms may be discouraged from investing due to the uncertainty associated with inflation
• Labor unrest: This may occur if workers do not feel that