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In economics, inflation is considered a tax. There are also various costs of inflation.

What is the inflation tax, and how might it explain the creation of inflation by a central bank? Explain how inflation affects savings and investment.

Inflation distorts relative prices. What does this mean and why does it impose a cost on society?

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Darryn D'Souza
Darryn D'SouzaLv10
28 Sep 2019

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Related questions

5. Current annualized yields on 1 year US treasury securities are only .28%....while current annualized yields on 2 year US treasury securities are .69% (note you may assume that both 1 and 2 year securities in this example are “0” coupon securities with no payment other than the maturity value on the maturity date.

What does this data suggest about financial market expectations of 1 year yields, 1 year from now? Explain…. (Assume investors are risk neutral in these short time horizons with default free treasuries.)

6. Here’s a quote from Fed head Janet Yellen on at a meeting in Cleveland on July 10 this year. (see www.federalreserve.gov then click news and events…

Regarding inflation, as I mentioned earlier, the recent effects of lower prices for crude oil and for imports on overall inflation are expected to wane during this year. Combined with further tightening in labor and product markets, I expect inflation will move toward the FOMC's 2 percent objective over the next few years. Importantly, a number of different surveys indicate that longer-term inflation expectations have remained stable even as recent readings on inflation have fallen. If inflation expectations had not remained stable, I would be more concerned because consumer and business expectations about inflation can become self-fulfilling.

Explain why the FOMC is concerned not only about actual recent inflation rates as measured by the CPI, but also about longer term inflation expectations remaining “stable” In particular, what is the problem if inflation expectations start to converge to an opinion that inflation will fall to “0” or less?

6. Fed Sees both unemployment and prices on the rise.

The federal reserve sees worse economic problems ahead. But even so, the Fed may be reluctant to cut interest rates any further than it already has. The Fed lowered its economic growth forecast for the year. At the same time, it raised its projections for inflation and unemployment. The Fed raised its unemployment forecast to between 5.5 percent and 5.7 percent and now expects personal consumption expenditures to rise between 3.1 percent and 3.4 percent in 2008 and expects steeper "core" inflation. In an effort to keep the country from falling into recession and to deal with the credit crisis, the Fed has cut its key federal funds rate seven times since September. This short-term interest rate is now 2 percent, down from 5.25percent at the start of the Fed's easing campaign. Some believe the Fed cuts since last September helped fuel inflation, especially the sharp run-up in oil prices because the rate cuts have led to a weakening of the dollar. Along those lines, the two Fed members who voted against the last rate cut argued during the meeting that the Fed cuts were hurting the economy more than helping it. CNN, May 21, 2008.

a. Explain the intended effect of the Fed cutting the target federal funds rate from 5.25 percent to 2 percent and illustrate your explanation with appropriate graphical analysis.

b. Explain how this monetary policy may have "helped fuel inflation, especially the sharp run-up in oil prices".

c. What is core inflation and why does the Fed tend to focus on that measurement of inflation more heavily than overall inflation?

d. Explain the dilemma that the Fed is facing when making decisions in the face of rising unemployment and rising inflation.

1. You’ve learned about money, its connection to inflation, money supply and the monetary multiplier, banking and money creation. Try to apply your understanding of these concepts in analyzing our current situation: During the crisis and until now, the Fed bought a lot of securities from banks and other financial institutions. This made some people fear that the Fed’s actions would spark inflation. Yet, inflation hasn’t really shown up in our economy (and the Fed has been doing this for five years now). Explain why, by answering the following questions:

a. Discuss briefly the connection between money supply and inflation.

b. When the Fed buys securities in the open market, what happens to banks’ reserves? What tends to happen to money supply, as a consequence? Explain briefly your answer to the last question. Let’s now look at the facts (data). FRED (Links to an external site.)is a good source of economic data, especially about money. Click on the “popular series” tab in the FRED homepage.

c. Look at the “CPI for all urban consumers” series first. Remember that inflation is the rate of increase in CPI. Eyeballing the graph, would you say that the CPI accelerated since 2008 or not?

d. Next, look at the “M2 money stock” series (make sure that you’re still in the “popular series” page). Has M2 increased faster since 2008?

e. Let’s try to understand why M2 is showing the pattern that it is. What might be the explanation for it? To see facts about the answer, type “excess reserves of depository institutions” in the FRED searchbox, and briefly discuss the pattern you see for this series, starting around 2008.

f. Look at the “Velocity of M2” series. What happened to it since 2008? Does this pattern support the idea that inflation should rise, or not? Explain briefly. [If you forgot what “velocity of money” means, please review the “Chapter 17 Highlights” and focus on the Equation of Exchange.

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