Question

1. Define inflation and discuss the differing impacts of “expected” vs. “unexpected inflation.” Which do you believe is the more important type of inflation the government should work to reduce? Explain.

2. What action can the Federal Reserve take to reduce inflation?

3. Using one of the tools available to the Federal Reserve, explain how the Fed would accomplish the action you listed in response to No. 2.

4. Assume the economy is currently operating at the natural rate of unemployment, what affects will the action you listed in response to No. 2 have in the short run on output, price level, and interest rates? Please use the AS/AD and Money Market diagrams to illustrate your answer.

5. Again, assume the economy is currently operating at the natural rate of unemployment, what affects will the action you listed in response to No. 2 have in the long run on output, price level, and interest rates? Please use the AS/AD and Money Market diagrams to illustrate your answer.

Answer 1

1. Inflation can be defined as a general increase in the price of the commodities and fall in the purchasing value of money. It is generally measured with respect to a basket of goods. The tools used for measuring inflation are CPI, WPI and Cost of Living Index. expected inflation is the rate of inflation anticipated by economic agents, whereas unexpected inflation is the inflation above or below the expected rate of inflation. The expected inflation results in Menu costs and Shoe leather costs. On the other hand, inequality, information asymmetry and risk premium are due to unexpected inflation.

Government should work to reduce unexpected inflation as it more detrimental for the growth of the economy. Economists and RBI takes appropriate control measures and monetary tools to counter expected inflation, but unexpected inflation results in bigger loss for the economy as the economy is not prepared for the same.

2. Measures taken to reduce inflation :

Reduce demand : Monetary policy tools like increasing CRR and Repo Rate would left the banks with less cash to be given to public in the form of loans, which would reduce demand and thus the rate of inflation.

Reduced exports and increase imports : By reducing exports and increasing imports the domestic supply of goods increases, thereby reducing inflation.