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Chapter 31: Problem 11

The economy of Brittania has been suffering from high inflation with an unemployment rate equal to its natural rate. Policy makers would like to disinflate the economy with the lowest economic cost possible. Assume that the state of the economy is not the result of a negative supply shock. How can they try to minimize the unemployment cost of disinflation? Is it possible for there to be no cost of disinflation?

Short Answer

Expert verified
Can there be no cost of disinflation? Answer: Policy makers can minimize the unemployment costs of disinflation by pursuing a gradual and steady reduction in inflation. This can be achieved through gradual tightening of monetary policy or carefully implementing fiscal policies. While it is unlikely to have no cost of disinflation in a real-world situation, the goal is to minimize those costs to the extent possible.

Step by step solution

01

Understanding Inflation and Unemployment

Inflation can be caused by excessive demand in the economy, known as demand-pull inflation, or by increases in input costs and production, known as cost-push inflation. Since the economy is not experiencing a negative supply shock, we can assume the inflation is likely caused by excess demand. Unemployment is at its natural rate, meaning that it is caused by frictional and structural factors, not cyclical unemployment.
02

Monetary and Fiscal Policy Options

Policy makers have several tools to deal with high inflation, including monetary policy (such as raising interest rates) and fiscal policy (such as increasing taxes or decreasing government spending).
03

Minimizing Unemployment Costs of Disinflation

To minimize the unemployment cost of disinflation, policy makers should aim for a gradual and steady reduction in inflation rather than a sudden and drastic reduction. This can be achieved through gradual tightening of monetary policy by raising interest rates slowly or carefully implementing fiscal policies that reduce aggregate demand over time without affecting labor market equilibrium.
04

No Cost of Disinflation

In reality, there is likely to be some cost associated with disinflation due to policy implementation lags and the time it takes for economic agents to adjust to changes in government policy. However, by pursuing a gradual and steady disinflation strategy, the costs can be minimized and reduced to as low a level as possible. The possibility of having no cost of disinflation in a real-world situation is unlikely, but the goal is to minimize those costs to the extent possible.

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Most popular questions from this chapter

Due to historical differences, countries often differ in how quickly a change in actual inflation is incorporated into a change in expected inflation. In a country such as Japan, which has had very little inflation in recent memory, it will take longer for a change in the actual inflation rate to be reflected in a corresponding change in the expected inflation rate. In contrast, in a country such as Zimbabwe, which has recently had very high inflation, a change in the actual inflation rate will immediately be reflected in a corresponding change in the expected inflation rate. What does this imply about the short- run and long-run Phillips curves in these two types of countries? What does this imply about the effectiveness of monetary and fiscal policy to reduce the unemployment rate?

Who are the winners and losers when a mortgage company lends \(\$ 100,000\) to the Miller family to buy a house worth \(\$ 105,000\) and during the first year prices unexpectedly fall by \(10 \%\) ? What would you expect to happen if the deflation continued over the next few years? How would continuing deflation affect borrowers and lenders throughout the economy as a whole?

In the following examples, would the classical model of the price level be relevant? a. There is a great deal of unemployment in the economy and no history of inflation. b. The economy has just experienced five years of hyperinflation. c. Although the economy experienced inflation in the \(10 \%\) to \(20 \%\) range three years ago, prices have recently been stable and the unemployment rate has approximated the natural rate of unemployment.

After experiencing a recession for the past two years, the residents of Albernia were looking forward to a decrease in the unemployment rate. Yet after six months of strong positive economic growth, the unemployment rate has fallen only slightly below what it was at the end of the recession. How can you explain why the unemployment rate did not fall as much although the economy was experiencing strong economic growth?

Concerned about the crowding-out effects of government borrowing on private investment spending, a candidate for president argues that the United States should just print money to cover the government's budget deficit. What are the advantages and disadvantages of such a plan?
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