Question

1. List and briefly explain
   1. Four costs associated with expected inflation
   2. Suppose that Brazil is in a state of hyperinflation. If the goal of the Brazilian Central Bank is to stabilize the price level, explain carefully what path the money supply should follow. (Assume that money demand depends on the nominal interest rate). Assuming that the Central Bank’s policy is successful, show and briefly explain the path of the price level, the inflation rate, the nominal interest rate, the money supply, and the level of real balances both during and after the hyperinflation.

Answer 1

ANSWER:

a. Costs associated with inflation:

1. Menu cost: Menu Cost is the amount which is spent in changing the menu or the price list. When inflation (price rise) occurs, a cost is associated to update the price list with the new prices. This cost is known as menu cost.
2. Real income: There is a fall in real income during inflation. The prices rise while wages don’t rise proportionately, this leads to the fall in real income.
3. Income redistribution: The borrowers get better off while the lenders get worse off. Because the borrowers pay the amount as per the previous prices (lower). And due to the inflation the lenders get worse off by receiving the amount as per previous prices (lower).
4. Taxes: The amount we pay as taxes increase. Because the increase in prices (inflation) leads to the increase in wages. Higher wages push people to the high income tax brackets which in turn increase the government revenue. This concept is known as Fiscal Drag.

b. Hyperinflation is the extreme version of inflation. When prices rise to an extreme level it leads to hyperinflation. When Brazil is in a state of hyperinflation (higher price level), the money supply in the economy is higher. People around the country have a lot of money to spend; hence the aggregate demand is more than the aggregate supply. Due to this the Central Bank will aim at decreasing the money supply by increasing the interest rates. Because the rise in interest rates will attract people to deposit their money in banks and earn a higher interest amount from that. The real balances will decrease during inflation, as the prices and the wages will not change proportionately. Rate of inflation will be higher during hyperinflation, because as per the previous prices, there is a hyperinflation in the economy.

If the Central Bank’s policy is successful, it means the Central Bank is able to control the money supply by increasing the interest rates. The money supply is now lower than before and the people of the country have less amount of money in their hands to spend. Which means the price level is now lower. The real balances are now higher than before, as because the people now pay less than before. Rate of inflation is also lower than before because the prices were more previously than now.