Unit 10 Study Guide
Workshop 10.1
1. Which of the following are wholesale and which are retail?
(a) Large-scale deposits made by firms at negotiated rates of interest. (b) Loans made by high street banks at published rates of interest. (c) Deposits in savings accounts in high street banks. (d) Deposits in savings accounts in building societies (e) Large-scale loans to industry syndicated through several banks.
wholesale retail retail retail wholesale
Workshop 10.1
A building society is a financial institution owned by its members. In the UK today, building societies actively compete with banks for most consumer banking services, especially mortgage lending and deposits.
the phrase "high street banks" has been widely used to refer to the retail banking sector in the …show more content…
United Kingdom.
Retail banking refers to banking in which banking institutions execute transactions directly with consumers, rather than corporations or other banks. Services offered include: savings and transactional accounts, mortgages, personal loans, debit cards, credit cards, and so forth.
Wholesale banking is the provision of services by banks to the likes of large corporate clients, mid-sized companies, real estate developers and investors, international trade finance businesses, institutional customers (such as pension funds and government entities/agencies), and services offered to other banks or other financial institutions. In essence, wholesale banking services usually involve high value transactions.
Workshop 10.1
2. Rank the following assets of a commercial banks in order of decreasing liquidity.
High liquidity Cash
Reserves with the Bank of England
Market loans (Short term page 308) Sale and repurchase agreements (repos) (Short term page 308) Government bonds (of from one to five years to maturity) (long-term page 309) Personal loans (=advances = long-term page 309) Mortgages (long-term . Least liquid. page 310) Low liquidity
Workshop 10.1
3. Consider the items in the following table, selected from a Bank A’s balance sheet
LIABILITIES Sight deposits Time deposits Certificates of deposit in Bank A Repos £bn ASSETS £bn 2 1 77 20 100 Notes and coin 110 Reserve balances with B of E 40 Market loans 20 Bill of Exchange
Loans from other financial institutions 30 Investments
Advances 300 Total
30
170 300
Total
See page 308-310 for long versus short term loans and liquidity (b) (c) (d) What is the cash ratio? What is the total of liquid assets What is the liquidity ratio? 3/300 = 1/100 or 0.01 or 1% £100bn 100/300 = 1/3 or 0.33 or 33%
Workshop 10.1
4. Assuming that banks choose to maintain a liquidity ratio of 20 per cent and assuming that new cash deposits of £100m are made in the banking system:
Banks receive
£m 100 80
Hold Lend Hold Lend Hold Lend Hold Lend Hold Lend
£m 20
80 16 64 12.8 51.2 10.24 40.96 8.19 32.77
Second round deposits rise by
Third round deposits rise by
64
Fourth round deposits rise by
51.2
Fifth round deposits rise by
40.96
Total deposits after five rounds
336.16
Workshop 10.1
4. Assuming that banks choose to maintain a liquidity ratio of 20 per cent and assuming that new cash deposits of £100m are made in the banking system: (b) How much credit will have been created after five rounds? £336.16 – £100 = £236.16
(c)
(d)
To what level will total deposits eventually increase?
£500
Define the bank deposits multiplier The number of times greater the expansion of bank deposits is than the additional liquidity in banks that caused it: 1/L (the inverse of the liquidity ratio) What is the bank multiplier in this case? How is it related to the liquidity ratio? 5 The inverse. 1/5
(e) (f)
Workshop 10.1
6. Which of the following will cause the UK money supply to rise; which will cause it to fall; and which will cause no direct change?
A balance of payments surplus (under a fixed rate of exchange)
The government finances the public-sector net cash requirement (PSNCR) by selling securities to the Bank of England.
(p. 327) The government decides to increase the proportion of the national debt financed by bonds rather than by Treasury bills. (p. 327f) The Bank of England purchases government bonds from the banking sector. (p. 317)
Rise
Rise
No change
Rise
Workshop 10.1
6. Which of the following will cause the UK money supply to rise; which will cause it to fall; and which will cause no direct change?
No (e) The government finances its budget deficit by selling bonds and bills to change the general public and non-bank private sector. (p. 328)
(f) The government finances its budget deficit by selling Treasury bills to the banking sector. (p. 328) (g) The Bank of England imposes a statutory liquidity ratio on banks higher than their current ratio. (h) With the increased use of debit and credit cards, the general public decides to hold less cash as a proportion of income. (page 325 – banks hold less cash over time because of credit cards. Extra cash allows banks to create more money)
Rise
Fall
Rise
worksheet
12.1
1. 2. Cash is the monetary base; the money supply is the monetary base plus deposits at the bank. Under the asset motive for holding money, as the price of bonds fall, individuals demand more money. False. As the price of a bond falls, its effective interest rate increases. Individuals will therefore prefer to hold bonds rather than money - the asset motive. 3. The precautionary motive for holding money reflects the unpredictability of transactions and the need to hold liquid funds in order to meet these payments. True. Under the precautionary motive for holding money, we demand money because we are uncertain about the timing of the transaction. 4. M4 is a broader measure of money than M0 True. M4 takes M0 and adds easy access savings accounts at banks, time deposits at banks, and deposits at building societies. M4 is, therefore, a broad measure of money. 5. The Bank of England is not independent False. The Bank of England is independent since 1997. False True/ True True False
worksheet 12.1
Which of the following is necessary for an asset
to function as a medium of exchange?
Backed by a precious metal Accepted as legal tender by the authorities Accepted by everyone as legal tender Holds its value into the future
worksheet 12.1
In what way would you expect each of the following
items to affect the demand for real money balances?
i) ii) iii) iv) v) vi) An increase in real income An increase in confidence about the future An increase in the opportunity cost of holding money A fall in nominal interest rates An increase in uncertainty concerning future transactions An increase in the monetary base brought about by the Central Bank interventions in the money market. Increase Increase Decrease Increase Increase Increase supply
Inflation and Unemployment
INFLATION
DEFINITION OF INFLATION the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.
DEFINITION OF INFLATION
Inflation Rising price levels Deflation Falling price levels Rise in the rate of inflation Faster increse in prices Fall in the rate of inflation Slower increase in prices (not a fall of prices unless the rate is negative)
TYPES OF INFLATION
Inflation
How fast are prices rising?
Types
Demand Pull Cost Push
Inflationary Expectations
This
is mainly why a target of 2 per cent are set!
Q Suppose that the CPI in a country increases from 150 to 153 over a period of a year. What is the annual rate of inflation?
A. 3% B. 2% C. 1.02%
D. 0.03%
E. 0.02%
TYPES OF INFLATION
Demand pull
Continuing rises in AD causing inflation to rise (AD increase, firms will increase production & prices) how much prices will change depends on the resulting cost rise. The less slack in the economy, the more will firms respond to a rise in demand by raising prices (the steeper the AS curve; the greater the price increase)
Cost push
Demand-pull inflation
AS
Price level P1
AD1
O Q1 National output
Demand-pull inflation
AS
Price level
P2 P1
AD2 AD1
O Q1 Q2 National output
TYPES OF INFLATION
Demand pull Cost push
Continuing rises in costs and hence continuing leftward
(upward) shift of the AS curve
Occurs when costs of production rise independently of AD firms respond to a rise in costs by raising prices and decreasing output
How much depends on the shape of the AD curve
Q Which one of the following would be the cause of cost-push inflation?
A. A cut in the rate of income tax. B. A cut in the rate of VAT C. A cut in interest rates
D. A rise in the exchange rate
E. A rise in the price of oil
Cost-push inflation
AS1
Price level P1
AD
O Q1 National output
Cost-push inflation
AS2 AS1
Price level
P2 P1
AD
O Q2 Q1 National output
Q In a period of rapid inflation which of the following would be the least desirable store of wealth?
A. Vintage wine. B. Property C. Money
D. Land
E. Stocks and shares
COSTS OF INFLATION
CASE WORK 11.5
Inflationary Illusion (confuse nominal and real) Menu costs Price competitiveness Assets and liabilities (value of property loans)
INFLATION TARGET REDUCES UNCERTAINTY STABILITY
Money Supply, Aggregate Demand and Inflation
The quantity theory of money The equation of exchange: MV = PY
M money supply (M4) V velocity of circulation (times/year the money is spend)
P price level (number of times greater than in base year)
Y real value of output at base-year prices
The link between money and prices
quantity theory holds if V and Y are determined independently of M
Page 344-346
Money Supply, Aggregate Demand and Inflation
Inflation and changes in aggregate demand
the short-run aggregate supply curve
relatively
elastic in short run
Short run stickiness of wages and prices Positive confidence
the long-run aggregate supply curve
Short-run aggregate supply curve
AS
Price level
O
National output
Short-run aggregate supply curve
AS
Price level
P1
AD1
O Y1
National output
Short-run aggregate supply curve
AS
Price level
P2 P1
As full-capacity output is approached, so aggregate supply is less and less able to respond to an increase in aggregate demand.
AD2 AD1
O Y1 Y2
National output
Money Supply, Aggregate Demand and Inflation
Inflation and changes in aggregate demand
the short-run aggregate supply curve
relatively
elastic in short run
stickiness of wages and prices confidence
the long-run aggregate supply curve
relatively
inelastic
the flexibility of prices
potential level of output
Supply-side policy (Long-run growth chapter 9)
The long-run aggregate supply curve when firms are interdependent
AS1(short run)
Price level
P2 P1 a
b
AD2
AD1
O Y1
Y2 Real GDP (Y)
The long-run aggregate supply curve when firms are interdependent
AS(long run) AS2 (short run)
AS1(short run)
Price level c P3 P2 P1 a b
Prices rise more in the long run as price increases are passed from firm to firm.
AD2
AD1
O YP
Y2 Real GDP (Y)
Long-run Aggregate Supply
Output GDP is at a constant level. We are also at the
natural employment level
LRAS can only increase if productivity increases
and/or because of technological improvement
Money Supply, Aggregate Demand and Inflation
Inflation and changes in aggregate demand
the short-run aggregate supply curve
relatively
elastic in short run
stickiness of wages and prices confidence
the long-run aggregate supply curve
relatively
inelastic
the interdependence of markets the flexibility of prices
the
effects of investment on aggregate supply
Page 351-352
Effect of investment on the long-run AS curve
AS1 (short run) AS2 (short run)
Price level b d a
Increased potential output in the long run from higher investment
AS (long run)
AD2
AD1
Page 351-352
National output
UNEMPLOYMENT
Unemployment
Unemployment measure ILO´s definition
Available to work Want to work Jobless Actively seeking unemployment
-
-
Divided into Region Time Age
Unemployment
frictional (search) unemployment structural unemployment
cyclical
(demand deficient / changing pattern of demand
technological regional
(mobility)
seasonal
classical unemployment (real wages above market clearing
price)
Unemployment
The costs of unemployment
Unemployment – wasted resource Would like but can´t find work Increased stress and poor health
BOX 11.2 Page 354
Q If there are 3 million people unemployed and 24 million people employed, the rate of unemployment will be:
A. 3 per cent B. 8 per cent C. 9 per cent
D. 11.1 per cent
E. 12.5 per cent
Unemployment
Unemployment and the labour market
the aggregate demand and supply of labour equilibrium in the model
disequilibrium equilibrium
unemployment
unemployment
Equilibrium unemployment
ASL
Average (real) wage rate
e We
ADL
O Qe No. of workers
Equilibrium unemployment
ASL
Average (real) wage rate
N (total number of labor force
e We
d
ADL
O Qe Q2
No. of workers
Equilibrium and disequilibrium unemployment
ASL
Average (real) wage rate
e We
ADL
O Qe No. of workers
Equilibrium and disequilibrium unemployment
ASL
Average (real) wage rate
Disequilibrium unemployment
b W2 e We
a
ADL
O No. of workers
Equilibrium and disequilibrium unemployment
ASL
Average (real) wage rate
Disequilibrium unemployment
N
b W2 e We
a
c Equilibrium unemployment
ADL
O No. of workers
Q Which of the following defines real-wage unemployment?
A. Real wages being set above the equilibrium level by trade unions, or minimum wage legislation.
B. Inflation causing an erosion of real wages and hence a rise in unemployment. C. Increased aggregate demand in the economy driving up equilibrium real wages.
D. Increased aggregate demand in the economy causing money wages to rise faster than real wages. E. Real wages falling below the equilibrium level as a result of deficiency of demand.
INFLATION & UNEMPLOYMENT
Unemployment
In long run the economy operates at the Production Possibility Frontier (chapter 1).
At any point of the PPF:
1.Full employment is achieved 2.Potential (natural) GDP is reached.
-Vs
actual GDP (in SR) -Vs Output Gap So there is no need for fiscal or monetary policy to intervene!
Inflation & Unemployment: Short-run
'Gap' analysis
the recessionary (deflationary) gap
Equilibrium
level of national income (Ye) below full employment
level (YF)
the inflationary gap
Equilibrium
level of national income (Ye) above full employment
level (YF)
W, J, E
The recessionary gap
Recessionary gap The amount by which national income exceeds aggregate expenditure at the full-employment level of national income
Y E a b Recessionary gap
O
Ye
YF
Y
W, J, E
The recessionary gap
Y E a b Recessionary gap
W c d O Ye YF
J
Y
Q An economy currently has a recessionary gap of £20bn and an equilibrium level of national income £60bn below the full-employment level of national income. This means that it must have an mpcd of:
A. 3
B. 3/2 C. 2/3 D. 1/3
E. 1/6
Inflation & Unemployment: Short-run
'Full-employment' national income 'Gap' analysis
the recessionary gap the inflationary gap
W, J, E
The inflationary gap
Y E e Inflationary gap (excess demand) f
Inflationary gap The amount by which aggregate expenditure exceeds national income at the full-employment level of national income
O
YF
Ye
Y
Inflation & Unemployment: Short-run
The Phillips curve
the shape of the original curve
π (%)
A PHILLIPS CURVE
π
2
b
π1
a
O
U2
U1
U (%)
The breakdown of the Phillips curve
26 24 22 20 18
75
Possible Phillips curves?
Inflation rate (%)
76
74 79 77
80
16 14 12 10 8 6 4 2 0 0 1 2
81 73 70 69 65 68 66 62 61 64 67 63 60
3 4
71 72 08 05 06 07 01 02 04 03 00
5
90 78 89 91 88 98 97 09 82 85 92 87 93
10 11 12 13
84
83
95
96 10
94 11
86
99
6 7 8
9
Note: 2010 and 2011 based on forecasts
Unemployment rate (%)
Introducing Expectations
Expectations augmented Phillips curve
adaptive expectations
The position of the curve (shifts) depends on non-demand factors causing inflation and unemployment
Frictional
and structural unemployment
Cost
push and expectations-generated inflation
Resent years – target inflation rate.
Q Adaptive expectations models assume that:
A. people never make the same mistake twice.
B. people adapt their expectations according to the policies the government is currently pursuing.
C. expectations are formed on the basis of information from the past. D. expectations are based upon forecasts made about the future performance of the economy. E. government economic policy will always be predicted and hence people will adapt to it before it takes effect.
Introducing Expectations
Expectations augmented Phillips curve
adaptive expectations
The accelerationist theory
accelerating inflation
when
unemployment is kept below the ‘natural’ level
π (%)
20
The accelerationist theory of inflation
16
12
Assume that the government wants to reduce unemployment to 6% and thus expands aggregate demand.
8
4
b a
0
0
6
8
I
(πe
= 0)
U (%)
π (%)
20
The accelerationist theory of inflation
Year Point on π graph a 0 b 4 c 4 d 8 e 12 f 16 = f(1/U) + π = = = = = = 0 4 0 4 4 4 e f
16
12
e d
1 2 3 4 5 6
+ 0 + 0 + 4 + 4 + 8 + 12
8
IV (πe = 12%)
4
b
c
III (πe = 8%)
0 0
a
6 8 I (πe
II (πe = 4%) = 0)
U (%)
Introducing Expectations
Expectations augmented Phillips curve
adaptive expectations
The accelerationist theory
accelerating inflation
when
unemployment is kept below the ‘natural’ level
the long-run Phillips curve
π (%)
20
The long-run Phillips curve
16
12
8
4
0 0
6
8 Un
U (%)
Introducing Expectations
Expectations augmented Phillips curve
adaptive expectations
The accelerationist theory
accelerating inflation
when
unemployment is kept below the ‘natural’ level
the long-run Phillips curve effects of deflationary policies
π (%)
24 22 20 18 16 14 12 10 8 6 4 2 0 0
The effects of contractionary policy
J
k
X (πe = 20%)
Now assume that the government wants to reduce inflation and thus reduces real aggregate demand.
8
13
U (%)
π (%)
24 22 20 18 16 14 12 10 8 6 4 2 0 0
The effects of contractionary policy
J
k l m X (πe = 20%) XI (πe = 18%) XII (πe = 16%)
8
13
U (%)
π (%)
24 22 20 18 16 14 12 10 8 6 4 2 0 0
The effects of contractionary policy
J
k l m
a 8
13
U (%)
Inflation Targeting and Unemployment
Inflation targeting
inflation targeting in the UK
2
per cent CPI inflation of Monetary Policy Committee (MPC)
role
importance of influencing expectations
Introducing Expectations
Expectations augmented Phillips curve
adaptive expectations
The accelerationist theory
accelerating inflation
when
unemployment is kept below the ‘natural’ level
the long-run Phillips curve effects of deflationary policies
Phillips loops
The path of inflation and unemployment in the UK?
28 26
Inflation (% increase in GDP deflator) .
1975
24 22 20 18 16 14 12 10 8 6 4 2 0 0 2 4 6 8
1967 2004 2010 1972 1978 1990 1980
1967-79 1979-93 1993-2010
1984 1993
10
12
Unemployment rate (%)
Source: Data from National Statistics time series Note: 2010 based on forecasts
Inflation Targeting and Unemployment
Why have both inflation and unemployment been
lower in recent years? Long-term changes in unemployment
experience of the 1970s and 1980s
changes
in technology competition from abroad shift away from older labour-intensive products
increasing labour market flexibility in recent years hysteresis
persistence
of unemployment after recessions of early 1980s and early 1990s reductions in unemployment from protracted period of expansion after 1992
Inflation Targeting and Unemployment
Inflation targeting
inflation targeting in the UK
2
per cent CPI inflation of Monetary Policy Committee (MPC)
role
importance of influencing expectations
Inflation Targeting and Unemployment
Inflation targeting
inflation targeting in the UK
2
per cent CPI inflation of Monetary Policy Committee (MPC)
role
importance of influencing expectations inflation targeting in other countries effect on inflation/unemployment relationship
a
horizontal Phillips curve? if inflation targeting were abandoned? re-emergence of a downward sloping short-run Phillips curve?
what
Q An apparently horizontal Phillips curve is the result of:
A. the adaptive expectations being wrong.
B. expectations being formed rationally.
C. shifts in equilibrium unemployment combined with inflation targeting. D. the ending of the business cycle.
E. a reduction over time in demand-deficient unemployment and reduced demand-pull inflation offsetting increased cost-push pressures from commodity prices.
1. Which of the following are wholesale and which are retail?
(a) Large-scale deposits made by firms at negotiated rates of interest. (b) Loans made by high street banks at published rates of interest. (c) Deposits in savings accounts in high street banks. (d) Deposits in savings accounts in building societies (e) Large-scale loans to industry syndicated through several banks.
wholesale retail retail retail wholesale
Workshop 10.1
A building society is a financial institution owned by its members. In the UK today, building societies actively compete with banks for most consumer banking services, especially mortgage lending and deposits.
the phrase "high street banks" has been widely used to refer to the retail banking sector in the …show more content…
United Kingdom.
Retail banking refers to banking in which banking institutions execute transactions directly with consumers, rather than corporations or other banks. Services offered include: savings and transactional accounts, mortgages, personal loans, debit cards, credit cards, and so forth.
Wholesale banking is the provision of services by banks to the likes of large corporate clients, mid-sized companies, real estate developers and investors, international trade finance businesses, institutional customers (such as pension funds and government entities/agencies), and services offered to other banks or other financial institutions. In essence, wholesale banking services usually involve high value transactions.
Workshop 10.1
2. Rank the following assets of a commercial banks in order of decreasing liquidity.
High liquidity Cash
Reserves with the Bank of England
Market loans (Short term page 308) Sale and repurchase agreements (repos) (Short term page 308) Government bonds (of from one to five years to maturity) (long-term page 309) Personal loans (=advances = long-term page 309) Mortgages (long-term . Least liquid. page 310) Low liquidity
Workshop 10.1
3. Consider the items in the following table, selected from a Bank A’s balance sheet
LIABILITIES Sight deposits Time deposits Certificates of deposit in Bank A Repos £bn ASSETS £bn 2 1 77 20 100 Notes and coin 110 Reserve balances with B of E 40 Market loans 20 Bill of Exchange
Loans from other financial institutions 30 Investments
Advances 300 Total
30
170 300
Total
See page 308-310 for long versus short term loans and liquidity (b) (c) (d) What is the cash ratio? What is the total of liquid assets What is the liquidity ratio? 3/300 = 1/100 or 0.01 or 1% £100bn 100/300 = 1/3 or 0.33 or 33%
Workshop 10.1
4. Assuming that banks choose to maintain a liquidity ratio of 20 per cent and assuming that new cash deposits of £100m are made in the banking system:
Banks receive
£m 100 80
Hold Lend Hold Lend Hold Lend Hold Lend Hold Lend
£m 20
80 16 64 12.8 51.2 10.24 40.96 8.19 32.77
Second round deposits rise by
Third round deposits rise by
64
Fourth round deposits rise by
51.2
Fifth round deposits rise by
40.96
Total deposits after five rounds
336.16
Workshop 10.1
4. Assuming that banks choose to maintain a liquidity ratio of 20 per cent and assuming that new cash deposits of £100m are made in the banking system: (b) How much credit will have been created after five rounds? £336.16 – £100 = £236.16
(c)
(d)
To what level will total deposits eventually increase?
£500
Define the bank deposits multiplier The number of times greater the expansion of bank deposits is than the additional liquidity in banks that caused it: 1/L (the inverse of the liquidity ratio) What is the bank multiplier in this case? How is it related to the liquidity ratio? 5 The inverse. 1/5
(e) (f)
Workshop 10.1
6. Which of the following will cause the UK money supply to rise; which will cause it to fall; and which will cause no direct change?
A balance of payments surplus (under a fixed rate of exchange)
The government finances the public-sector net cash requirement (PSNCR) by selling securities to the Bank of England.
(p. 327) The government decides to increase the proportion of the national debt financed by bonds rather than by Treasury bills. (p. 327f) The Bank of England purchases government bonds from the banking sector. (p. 317)
Rise
Rise
No change
Rise
Workshop 10.1
6. Which of the following will cause the UK money supply to rise; which will cause it to fall; and which will cause no direct change?
No (e) The government finances its budget deficit by selling bonds and bills to change the general public and non-bank private sector. (p. 328)
(f) The government finances its budget deficit by selling Treasury bills to the banking sector. (p. 328) (g) The Bank of England imposes a statutory liquidity ratio on banks higher than their current ratio. (h) With the increased use of debit and credit cards, the general public decides to hold less cash as a proportion of income. (page 325 – banks hold less cash over time because of credit cards. Extra cash allows banks to create more money)
Rise
Fall
Rise
worksheet
12.1
1. 2. Cash is the monetary base; the money supply is the monetary base plus deposits at the bank. Under the asset motive for holding money, as the price of bonds fall, individuals demand more money. False. As the price of a bond falls, its effective interest rate increases. Individuals will therefore prefer to hold bonds rather than money - the asset motive. 3. The precautionary motive for holding money reflects the unpredictability of transactions and the need to hold liquid funds in order to meet these payments. True. Under the precautionary motive for holding money, we demand money because we are uncertain about the timing of the transaction. 4. M4 is a broader measure of money than M0 True. M4 takes M0 and adds easy access savings accounts at banks, time deposits at banks, and deposits at building societies. M4 is, therefore, a broad measure of money. 5. The Bank of England is not independent False. The Bank of England is independent since 1997. False True/ True True False
worksheet 12.1
Which of the following is necessary for an asset
to function as a medium of exchange?
Backed by a precious metal Accepted as legal tender by the authorities Accepted by everyone as legal tender Holds its value into the future
worksheet 12.1
In what way would you expect each of the following
items to affect the demand for real money balances?
i) ii) iii) iv) v) vi) An increase in real income An increase in confidence about the future An increase in the opportunity cost of holding money A fall in nominal interest rates An increase in uncertainty concerning future transactions An increase in the monetary base brought about by the Central Bank interventions in the money market. Increase Increase Decrease Increase Increase Increase supply
Inflation and Unemployment
INFLATION
DEFINITION OF INFLATION the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.
DEFINITION OF INFLATION
Inflation Rising price levels Deflation Falling price levels Rise in the rate of inflation Faster increse in prices Fall in the rate of inflation Slower increase in prices (not a fall of prices unless the rate is negative)
TYPES OF INFLATION
Inflation
How fast are prices rising?
Types
Demand Pull Cost Push
Inflationary Expectations
This
is mainly why a target of 2 per cent are set!
Q Suppose that the CPI in a country increases from 150 to 153 over a period of a year. What is the annual rate of inflation?
A. 3% B. 2% C. 1.02%
D. 0.03%
E. 0.02%
TYPES OF INFLATION
Demand pull
Continuing rises in AD causing inflation to rise (AD increase, firms will increase production & prices) how much prices will change depends on the resulting cost rise. The less slack in the economy, the more will firms respond to a rise in demand by raising prices (the steeper the AS curve; the greater the price increase)
Cost push
Demand-pull inflation
AS
Price level P1
AD1
O Q1 National output
Demand-pull inflation
AS
Price level
P2 P1
AD2 AD1
O Q1 Q2 National output
TYPES OF INFLATION
Demand pull Cost push
Continuing rises in costs and hence continuing leftward
(upward) shift of the AS curve
Occurs when costs of production rise independently of AD firms respond to a rise in costs by raising prices and decreasing output
How much depends on the shape of the AD curve
Q Which one of the following would be the cause of cost-push inflation?
A. A cut in the rate of income tax. B. A cut in the rate of VAT C. A cut in interest rates
D. A rise in the exchange rate
E. A rise in the price of oil
Cost-push inflation
AS1
Price level P1
AD
O Q1 National output
Cost-push inflation
AS2 AS1
Price level
P2 P1
AD
O Q2 Q1 National output
Q In a period of rapid inflation which of the following would be the least desirable store of wealth?
A. Vintage wine. B. Property C. Money
D. Land
E. Stocks and shares
COSTS OF INFLATION
CASE WORK 11.5
Inflationary Illusion (confuse nominal and real) Menu costs Price competitiveness Assets and liabilities (value of property loans)
INFLATION TARGET REDUCES UNCERTAINTY STABILITY
Money Supply, Aggregate Demand and Inflation
The quantity theory of money The equation of exchange: MV = PY
M money supply (M4) V velocity of circulation (times/year the money is spend)
P price level (number of times greater than in base year)
Y real value of output at base-year prices
The link between money and prices
quantity theory holds if V and Y are determined independently of M
Page 344-346
Money Supply, Aggregate Demand and Inflation
Inflation and changes in aggregate demand
the short-run aggregate supply curve
relatively
elastic in short run
Short run stickiness of wages and prices Positive confidence
the long-run aggregate supply curve
Short-run aggregate supply curve
AS
Price level
O
National output
Short-run aggregate supply curve
AS
Price level
P1
AD1
O Y1
National output
Short-run aggregate supply curve
AS
Price level
P2 P1
As full-capacity output is approached, so aggregate supply is less and less able to respond to an increase in aggregate demand.
AD2 AD1
O Y1 Y2
National output
Money Supply, Aggregate Demand and Inflation
Inflation and changes in aggregate demand
the short-run aggregate supply curve
relatively
elastic in short run
stickiness of wages and prices confidence
the long-run aggregate supply curve
relatively
inelastic
the flexibility of prices
potential level of output
Supply-side policy (Long-run growth chapter 9)
The long-run aggregate supply curve when firms are interdependent
AS1(short run)
Price level
P2 P1 a
b
AD2
AD1
O Y1
Y2 Real GDP (Y)
The long-run aggregate supply curve when firms are interdependent
AS(long run) AS2 (short run)
AS1(short run)
Price level c P3 P2 P1 a b
Prices rise more in the long run as price increases are passed from firm to firm.
AD2
AD1
O YP
Y2 Real GDP (Y)
Long-run Aggregate Supply
Output GDP is at a constant level. We are also at the
natural employment level
LRAS can only increase if productivity increases
and/or because of technological improvement
Money Supply, Aggregate Demand and Inflation
Inflation and changes in aggregate demand
the short-run aggregate supply curve
relatively
elastic in short run
stickiness of wages and prices confidence
the long-run aggregate supply curve
relatively
inelastic
the interdependence of markets the flexibility of prices
the
effects of investment on aggregate supply
Page 351-352
Effect of investment on the long-run AS curve
AS1 (short run) AS2 (short run)
Price level b d a
Increased potential output in the long run from higher investment
AS (long run)
AD2
AD1
Page 351-352
National output
UNEMPLOYMENT
Unemployment
Unemployment measure ILO´s definition
Available to work Want to work Jobless Actively seeking unemployment
-
-
Divided into Region Time Age
Unemployment
frictional (search) unemployment structural unemployment
cyclical
(demand deficient / changing pattern of demand
technological regional
(mobility)
seasonal
classical unemployment (real wages above market clearing
price)
Unemployment
The costs of unemployment
Unemployment – wasted resource Would like but can´t find work Increased stress and poor health
BOX 11.2 Page 354
Q If there are 3 million people unemployed and 24 million people employed, the rate of unemployment will be:
A. 3 per cent B. 8 per cent C. 9 per cent
D. 11.1 per cent
E. 12.5 per cent
Unemployment
Unemployment and the labour market
the aggregate demand and supply of labour equilibrium in the model
disequilibrium equilibrium
unemployment
unemployment
Equilibrium unemployment
ASL
Average (real) wage rate
e We
ADL
O Qe No. of workers
Equilibrium unemployment
ASL
Average (real) wage rate
N (total number of labor force
e We
d
ADL
O Qe Q2
No. of workers
Equilibrium and disequilibrium unemployment
ASL
Average (real) wage rate
e We
ADL
O Qe No. of workers
Equilibrium and disequilibrium unemployment
ASL
Average (real) wage rate
Disequilibrium unemployment
b W2 e We
a
ADL
O No. of workers
Equilibrium and disequilibrium unemployment
ASL
Average (real) wage rate
Disequilibrium unemployment
N
b W2 e We
a
c Equilibrium unemployment
ADL
O No. of workers
Q Which of the following defines real-wage unemployment?
A. Real wages being set above the equilibrium level by trade unions, or minimum wage legislation.
B. Inflation causing an erosion of real wages and hence a rise in unemployment. C. Increased aggregate demand in the economy driving up equilibrium real wages.
D. Increased aggregate demand in the economy causing money wages to rise faster than real wages. E. Real wages falling below the equilibrium level as a result of deficiency of demand.
INFLATION & UNEMPLOYMENT
Unemployment
In long run the economy operates at the Production Possibility Frontier (chapter 1).
At any point of the PPF:
1.Full employment is achieved 2.Potential (natural) GDP is reached.
-Vs
actual GDP (in SR) -Vs Output Gap So there is no need for fiscal or monetary policy to intervene!
Inflation & Unemployment: Short-run
'Gap' analysis
the recessionary (deflationary) gap
Equilibrium
level of national income (Ye) below full employment
level (YF)
the inflationary gap
Equilibrium
level of national income (Ye) above full employment
level (YF)
W, J, E
The recessionary gap
Recessionary gap The amount by which national income exceeds aggregate expenditure at the full-employment level of national income
Y E a b Recessionary gap
O
Ye
YF
Y
W, J, E
The recessionary gap
Y E a b Recessionary gap
W c d O Ye YF
J
Y
Q An economy currently has a recessionary gap of £20bn and an equilibrium level of national income £60bn below the full-employment level of national income. This means that it must have an mpcd of:
A. 3
B. 3/2 C. 2/3 D. 1/3
E. 1/6
Inflation & Unemployment: Short-run
'Full-employment' national income 'Gap' analysis
the recessionary gap the inflationary gap
W, J, E
The inflationary gap
Y E e Inflationary gap (excess demand) f
Inflationary gap The amount by which aggregate expenditure exceeds national income at the full-employment level of national income
O
YF
Ye
Y
Inflation & Unemployment: Short-run
The Phillips curve
the shape of the original curve
π (%)
A PHILLIPS CURVE
π
2
b
π1
a
O
U2
U1
U (%)
The breakdown of the Phillips curve
26 24 22 20 18
75
Possible Phillips curves?
Inflation rate (%)
76
74 79 77
80
16 14 12 10 8 6 4 2 0 0 1 2
81 73 70 69 65 68 66 62 61 64 67 63 60
3 4
71 72 08 05 06 07 01 02 04 03 00
5
90 78 89 91 88 98 97 09 82 85 92 87 93
10 11 12 13
84
83
95
96 10
94 11
86
99
6 7 8
9
Note: 2010 and 2011 based on forecasts
Unemployment rate (%)
Introducing Expectations
Expectations augmented Phillips curve
adaptive expectations
The position of the curve (shifts) depends on non-demand factors causing inflation and unemployment
Frictional
and structural unemployment
Cost
push and expectations-generated inflation
Resent years – target inflation rate.
Q Adaptive expectations models assume that:
A. people never make the same mistake twice.
B. people adapt their expectations according to the policies the government is currently pursuing.
C. expectations are formed on the basis of information from the past. D. expectations are based upon forecasts made about the future performance of the economy. E. government economic policy will always be predicted and hence people will adapt to it before it takes effect.
Introducing Expectations
Expectations augmented Phillips curve
adaptive expectations
The accelerationist theory
accelerating inflation
when
unemployment is kept below the ‘natural’ level
π (%)
20
The accelerationist theory of inflation
16
12
Assume that the government wants to reduce unemployment to 6% and thus expands aggregate demand.
8
4
b a
0
0
6
8
I
(πe
= 0)
U (%)
π (%)
20
The accelerationist theory of inflation
Year Point on π graph a 0 b 4 c 4 d 8 e 12 f 16 = f(1/U) + π = = = = = = 0 4 0 4 4 4 e f
16
12
e d
1 2 3 4 5 6
+ 0 + 0 + 4 + 4 + 8 + 12
8
IV (πe = 12%)
4
b
c
III (πe = 8%)
0 0
a
6 8 I (πe
II (πe = 4%) = 0)
U (%)
Introducing Expectations
Expectations augmented Phillips curve
adaptive expectations
The accelerationist theory
accelerating inflation
when
unemployment is kept below the ‘natural’ level
the long-run Phillips curve
π (%)
20
The long-run Phillips curve
16
12
8
4
0 0
6
8 Un
U (%)
Introducing Expectations
Expectations augmented Phillips curve
adaptive expectations
The accelerationist theory
accelerating inflation
when
unemployment is kept below the ‘natural’ level
the long-run Phillips curve effects of deflationary policies
π (%)
24 22 20 18 16 14 12 10 8 6 4 2 0 0
The effects of contractionary policy
J
k
X (πe = 20%)
Now assume that the government wants to reduce inflation and thus reduces real aggregate demand.
8
13
U (%)
π (%)
24 22 20 18 16 14 12 10 8 6 4 2 0 0
The effects of contractionary policy
J
k l m X (πe = 20%) XI (πe = 18%) XII (πe = 16%)
8
13
U (%)
π (%)
24 22 20 18 16 14 12 10 8 6 4 2 0 0
The effects of contractionary policy
J
k l m
a 8
13
U (%)
Inflation Targeting and Unemployment
Inflation targeting
inflation targeting in the UK
2
per cent CPI inflation of Monetary Policy Committee (MPC)
role
importance of influencing expectations
Introducing Expectations
Expectations augmented Phillips curve
adaptive expectations
The accelerationist theory
accelerating inflation
when
unemployment is kept below the ‘natural’ level
the long-run Phillips curve effects of deflationary policies
Phillips loops
The path of inflation and unemployment in the UK?
28 26
Inflation (% increase in GDP deflator) .
1975
24 22 20 18 16 14 12 10 8 6 4 2 0 0 2 4 6 8
1967 2004 2010 1972 1978 1990 1980
1967-79 1979-93 1993-2010
1984 1993
10
12
Unemployment rate (%)
Source: Data from National Statistics time series Note: 2010 based on forecasts
Inflation Targeting and Unemployment
Why have both inflation and unemployment been
lower in recent years? Long-term changes in unemployment
experience of the 1970s and 1980s
changes
in technology competition from abroad shift away from older labour-intensive products
increasing labour market flexibility in recent years hysteresis
persistence
of unemployment after recessions of early 1980s and early 1990s reductions in unemployment from protracted period of expansion after 1992
Inflation Targeting and Unemployment
Inflation targeting
inflation targeting in the UK
2
per cent CPI inflation of Monetary Policy Committee (MPC)
role
importance of influencing expectations
Inflation Targeting and Unemployment
Inflation targeting
inflation targeting in the UK
2
per cent CPI inflation of Monetary Policy Committee (MPC)
role
importance of influencing expectations inflation targeting in other countries effect on inflation/unemployment relationship
a
horizontal Phillips curve? if inflation targeting were abandoned? re-emergence of a downward sloping short-run Phillips curve?
what
Q An apparently horizontal Phillips curve is the result of:
A. the adaptive expectations being wrong.
B. expectations being formed rationally.
C. shifts in equilibrium unemployment combined with inflation targeting. D. the ending of the business cycle.
E. a reduction over time in demand-deficient unemployment and reduced demand-pull inflation offsetting increased cost-push pressures from commodity prices.