Question

Neoclassical economists believe that only unanticipated inflation has real effects. Explain this using the AS/AD-framework. In light of this discuss the desirability and feasibility of government stabilization policy.

Answer 1

Unanticipated inflation:

This is rise of inflation above the anticipated rate; suppose a 2% inflation rate is anticipated but in actual it becomes 5%.

In this case borrowers are benefited, since compare to actual market inflation they are paying less amount of interest. This actually hurts lenders, since they are actually receiving money that has less purchasing power.

Therefore, the unanticipated inflation reduces the real interest rate because the nominal rate doesn’t change.

Since the Real rate decreases, it increases purchasing power of consumers, and creates investment opportunity. Consumption and investment are elements of Real GDP – both these increase and make a shift of the AD curve to the right.

The shift of AD increases the price level of whole economy, since the equilibrium with AS would be at the higher point.

Therefore, an unanticipated inflation increases overall inflation in the economy.

The graph is as below:

The initial equilibrium is E0, where AD and AS meet. The corresponding Price level is P0 and Real GDP is Q0.

Now, there is unanticipated inflation. It shifts the AD curve to the right as AD1. The new equilibrium becomes E1, where the price level increases (overall inflation) from P0 to P1; this happens at real GDP of Q1.

Government policy:

In order to control such inflation the government needs to take a Contractionary fiscal policy. It includes the increase in taxes rates, or sale of government bonds in the open market, or both. Stabilization of the economy could be done quickly if the second option is chosen – sale of government bonds. This is desirable and feasible since this is the direct interference for taking money and decreasing money supply in the economy. Once the money supply decreases, the unanticipated inflation will be gone.