DPBS1150 Global Business Environments
Global Business Environments
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DPBS1150
Global Business Environments
ECONOMIC LENS (III):
SHORT-RUN FLUCTUATIONS AND
POLICY RESPONSES (continued)
Unit 7: Lecture 7B
Lecture Overview
(Unit 7A and 7B)
• Develop a simple macroeconomic model of income and
expenditure with sticky prices.
• Analyse household consumption/savings decisions.
• Evaluate how household marginal propensity to consume
determines the aggregate expenditure multiplier
• Define the main forms and functions of money.
• Understand how prices depend on the supply of money.
• Explain how the central bank influences economic activity.
• Articulate key mechanisms and limitations of fiscal and monetary
policy
DPBS11502
The Role of Money and Monetary Policy
3
What is Money?
Many functions for money:
• Medium of exchange
• Used to exchange for goods and
services
• Unit of account
• Used to measure the economic
value of goods and services
• Store of value
• Used to hold wealth
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Many types of money:
• Commodity money
• Something with intrinsic value used
as money
• Gold, silver, rice, salt, beads,
feathers, cigarettes, shells, noodles
• Fiat money
• Money with no intrinsic value
Anything that is generally accepted in
exchange for goods or services.
What is Money?
• Money derives its value from the trust people place in it
• This trust can be lost if mismanaged
• For example: if too much paper money is printed and issued, value of
money will fall (high inflation/hyperinflation)
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Image: Reserve Bank of Australia Image: National Museum of American History, Smithsonian Institution
What is Inflation?
• An increase in the level of prices of the goods and services
that households typically buy over time.
• Measured as the rate of change of those prices
• Typically, prices rise over time
• Prices can also fall (called deflation)
DPBS11506 Source: RBA
Measuring Inflation
• Consumer Price Index (CPI) measures the changes in the
price of a typical basket of goods and services consumed
by households.
• Inflation rate is the percentage change in the price of this
basket over time.
• For example, if the inflation rate is 3%, a ‘basket’ of goods and
services that cost you $100 last year will cost you $103 this year.
DPBS11507
Inflation and the Business Cycle
DPBS11508
D
ur
in
g
an
e
xp
an
si
on
• consumers demand more
output (goods/services)
• businesses produce more
output to meet increased
demand,
• eventually reach productive
capacity (maximum level of
supply)
There will be more demand for
their output than output
available. This pulls prices up.
• consumers demand less
• businesses produce less
output
• businesses may lower
prices or offer discounts
to increase sales.
This leads to lower inflation
or deflation.
D
uring a contraction
Why is Inflation Important?
• A low, steady rate of inflation is good for the economy.
• It is important for the rate of inflation in an economy to be
managed.
• If inflation is too high, the currency loses its value.
• If inflation increases at a very rapid rate hyperinflation
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Costs of Inflation
Costs of expected inflation:
• Indexing costs: have to incorporate inflation expectations into
contracts; adjusting the terms of contracts
• Menu costs: have to change prices more often
• Shoe-leather costs: additional time and effort that consumers
must spend managing their cash holdings; consumers must go to
bank more to avoid losing purchasing power often
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Costs of Inflation
Costs of unexpected inflation:
• Inconvenience: hard to plan budgets/financial decisions when
prices keep changing
• Relative price distortions: not all prices adjust simultaneously;
prices of some goods adjust more rapidly than others
• Uncertainty: businesses face difficulties in accurately forecasting
costs, revenues, and profits, making investment decisions more
challenging; can distort investment
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Sticky Prices
• An important assumption of the Keynesian model is that prices tend to
adjust slowly in response to changes in supply and demand, a
phenomenon called sticky prices.
• Prices in the short run do not adjust quickly or fully in response to
changes in supply and demand conditions.
• Prices tend to remain relatively rigid or sticky.
• The following video describes some reasons why one particular and very
important price – a worker’s wage – tends to be sticky. (<5 mins)
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Redistributive Effects of Inflation
Unexpected inflation
Losers:
• fixed income earners
• If prices rise rapidly, the purchasing power of their fixed income diminishes because
they cannot easily adjust their income to keep up with inflation.
• Lenders
• Inflation erodes the value of money over time, the interest rates on loans may not
adequately compensate lenders for the decreased value of the loan repayment.
Winners:
• Borrowers
• If prices increase, the real value of the money they owe decreases over time.
• Asset holders
• Asset prices often rise during inflationary periods, as investors seek to protect their
wealth by investing in tangible assets that tend to retain value in inflationary
environments.
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“Headline” vs. “Underlying” Inflation
Headline inflation: % change in the CPI.
• What we usually mean when we just say “inflation”.
Underlying inflation: An inflation measure that excludes items that have particularly
large price changes.
• Intended to exclude price changes due to temporary factors.
• For example, supply disruptions due to weather events; energy prices due to geopolitical events
Provides a clearer signal of the overall inflationary pressures in the economy.
Make more informed decisions regarding monetary policy and other economic
measures.
• Many possible measures of underlying inflation, for example
• Core CPI: CPI excluding volatile items
• Trimmed mean: removing a certain percentage of the highest and lowest price changes from a set
of individual price changes
DPBS115014
Average Money Growth and
Inflation in Western Hemisphere Developing Countries