Sunday, September 19, 2010

"We need Inflation like we need a hole in the head!!" Don't think of it as a hole, think of it as AC for the mind---It could be a good thing! (inflation, not the hole)

   I am covering the basics of supply and demand right now in my AP and "regular" economics classes.  One of the determinants of demand is "consumer expectations".  A common example is to suggest today that we have complete knowledge that the price of a good is going to increase in the near future.  How do consumers respond to this information? Well, even high school students know you go out and buy the good TODAY!  That increases the demand for the good (shifts the demand curve to the right).  Ceterus Paribus (holding all other variables constant), this will cause the market quantity to increase, as well as the price. See graph below:
    Economic logic/theory suggests that the more a producer produces, the more workers they will need to produce the good. So far so good, but this is only ONE industry/business that hired some workers because the price of the good they produce increased.  So, what is good for one industry (in a Micro sense) MIGHT be good for all industries (in a Macro sense), right? How do we get ALL prices to rise simultaneously so the above process can play out and we have LESS UNemployment nationwide but at the cost of some inflation? Gahh! There is that "inflation" word! BUT is it really a bad word given our present circumstances?
   Currently there is a clog in the process. Business and banks are sitting on piles of money right now and are not spending or lending, repectively. Consumers are hesitant to spend because of an uncertain economy and, to a lesser extent, deflation (one puts off buying today in anticipation of lower prices in the future). All these things contribute to a stagnant economy. 
    The worry that DEFLATION is the problem of the day. We need to induce a little inflation (by increasing the money supply) AND have the Federal Reserve publicly TELEGRAPH that they are pursuing a moderate (3%?) inflationary policy. The thinking is this will prompt consumers to do just what I illustrated at the beginning of this post, but on an economy-wide basis.  Anticipation of higher prices of homes, cars, other consumer goods will incentivize people to go buy today.  Consumers and businesses will want to spend dollars that are worth more TODAY than they will be worth in the future.The result will be an increase in the aggregate level of demand for goods/services, a movement to Full-Employment ("FE RGDP") and an increase in the price level, as one would expect. See graph below.

   There is lots of controversy about this in the economic blogosphere, and since I am just a simple-minded  high school teacher, this is as easy an explanation as I can make.  Hey, it gets me through the day...What do you think---Inflation, deflation, leave alone?? Would love to hear from you...
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