Question

Answer the following questions about inflation: a) What is the generic inflation equation? b) What does Friedman add to it? c) Who is inflation good for? Who is it bad for? d) Suppose inflation expectations are 3%, the employment gap is 2%, and supply shocks are 3%. What would the inflation rate be?

Answer 1

Answer

a) Inflation is the change in price of a basket of goods from one period to another. Thus, inflation is calculated based on Consumer Price Index.

So the equation to calculate inflation : CPI (current year) - CPI (Base Year) / CPI (Base Year) * 100

b)Friedman added more significance to monetary policy and stated it to be as important as fiscal policy in terms of inflation. He mentioned that in the long run, increased flow of money raises the price of the commodity but does not bring about any change in the output.

c) Inflation is not good for the individuals or the economy as it reduce the value of money and thus the products or commodities become expensive for them to purchase.

It is good for the borrowers, because as there is rise in price, the wages also increase. And thus the repaid amount becomes a small portion of their income and thus is easy to repay.

d) Higher employment gap leads to lower inflation as the demand of commodity would be low in the market.

High supply shock leads to higher inflation, as the scarcity of supply would always lead to rise in price.

As supply shock (3%) is more than employment gap (2%) so the overall inflation rate would be higher than the expected.