Name: Nayama ID: AIU20092072

Tutorial 3

1. Discuss using diagrams the main causes of inflation.

The main causes of inflation

Demand-pull inflation – Demand-pull inflation occurs when the overall demand for goods
and services in an economy increases more rapidly than the economy's production capacity. It
creates a demand-supply gap with higher demand and lower supply, which results in higher
prices. For instance, when the oil-producing nations decide to cut down on oil production, the
supply diminishes. It leads to higher demand, which results in price rises and contributes to
inflation.
Cost-push inflation – Cost-push inflation is a result of the increase in the prices of
production process inputs. Examples include an increase in labour costs to manufacture a
good or offer a service or an increase in the cost of raw material. These developments lead to
higher costs for the finished product or service and contribute to inflation.
Devaluation – increasing cost of imported goods, and also the boost to domestic demand.
Rising wages – higher wages increase firms costs and increase consumers’ disposable income
to spend more.
Expectations of inflation – High inflation expectations causes workers to demand wage
increases and firms to push up prices.
2. Discuss the social costs when the inflation is expected.
Costs of Expected Inflation:
Consider first the case of expected inflation. One cost of expected high inflation is the
distortion of the inflation tax on the amount of money people hold. A higher inflation rate
leads to a higher nominal interest rate which, in turn, leads to lower real balances. If people
are to hold lower money balances on average, they must make more frequent trips to the bank
to withdraw money. The inconvenience of reducing money holding is called the shoe-leather
cost of inflation.

The second cost of inflation arises because high inflation induces firms to change their prices
more often. Changing prices is sometimes costly: for example, it may require printing and
distribution of a new catalogue. These costs are called menu costs, because the higher the rate
of inflation, the more often restaurants have to print new menus.

The third cost of inflation arises because firms facing menu costs change prices infrequently:
thus, the higher the rate of inflation, the greater the variability in relative price. Since market
economics relies on relative prices to allocate resources efficiently, inflation leads to
microeconomic inefficiencies.

The fourth cost of inflation results from the tax laws. Many provisions of the tax code do not
take into account the effects of inflation. Inflation can alter an individual’s tax liability, often
in the ways that lawmakers did not intend.

The fifth cost of inflation is the inconvenience of living in a world with a changing price
level. Money is the yardstick with which we measure economic transactions. When there is
inflation, that yardstick is changing in length. For example, a changing price level
complicates personal financial planning.

Another important point is that money invested in the present age will yield fixed rate of
return but the value of money may fall to a greater level because of inflation.

3. What are the policy can be used to control the inflation?

1. Monetary policy – Higher interest rates reduce demand in the economy, leading to
lower economic growth and lower inflation.
 2. Control of money supply – Monetarists argue there is a close link between the money
supply and inflation, therefore controlling money supply can control inflation.
3. Supply-side policies – policies to increase the competitiveness and efficiency of the
economy, putting downward pressure on long-term costs.
4. Fiscal policy – a higher rate of income tax could reduce spending, demand and
inflationary pressures.
5. Wage controls – trying to control wages could, in theory, help to reduce inflationary
pressures. However, apart from the 1970s, it has been rarely used.

4. An investment analyst observes that the real interest rate has been stable at about 0.8% for
the past several years and doesn’t expect it to change, he can look at the prevailing yields on
Treasury securities with different maturities to calculate an estimate of the what the market is
expecting inflation to be:

Fisher Effect Worksheet

Maturity Yield on Treasury Bond Maturing in Year Real Interest Implied Average
Year (#) # (nominal Interest rate) Rate Yearly Inflation
1 1.31% 0.80% 0.51%
2 1.49% 0.80% 0.69%
3 1.63% 0.80% 0.83%
4 1.75% 0.80% 0.95%
5 1.94% 0.80% 1.14%

 Please fill in the blank (Calculate by using the Fisher Equation).

5. Assume an investor purchases a 12-month U.S. Treasury bill that offers a 3% rate of
return and that the real rate of interest is 1%.  Applying the Fisher effect, what is the
expected rate of inflation?

i−r =π
Where i is the nominal interest rate, r is the real interest rate, and π is the expected rate of
inflation.
*The expected rate of inflation = i−r
= 3% −¿ 1%
= 2%