The Beast Known as Inflation

http://www.economist.com/blogs/freeexchange/2013/04/monetary-policy-2

In class we started to learn and understand the purpose of the fisher effect. The fisher effect states that nominal interest rates are equal to inflation plus real interest rates. The fisher effect also helps explain expected inflation which states nominal interest rates are equal to the ex post inflation (or expected inflation) plus real interest rates. This indicates that expectations of the inflation rate has a direct impact on what the actual nominal and real interest rates will be. The International Monetary fund (IMF) states that because the federal reserve would insure inflation rates in the future would be generally low and stable. Due to this inflation expectations became so stable that not even the worst few months of economic performance since the 1930s could produce deflation.

In 2008 America hit a demand vague. Basically this means firms and household perceived the future economy to be bad because of talks of recession. Firms and households decided that holding onto their money by saving instead of investing would be the wise decision. This ultimately made the economy worse and led to the ultimate recession.  Equity prices fell close to 50%. Commodity prices also harshly fell. Crude oil prices fell about 60% from the beginning of the year. From 2008 to 2009 wheat prices dropped by 33%, coal prices dropped nearly 50%, and most industrial metals prices fell by 25%. However wages did not fall by the expected 40%.

Expectations of inflation defiantly do not solely dictate what is to happen to the economy. This was seen through the recent recession where households forgot to think about broad price and wage shifts. Other variables such as nominal output, nominal incomes , or unemployment became worrying numbers during the economic crisis that low inflation could not fix. Luckily because the federal reserve declared short run prices to be sticky and that inflation would be kept relativity low, so there was very little risk that aggressive monetary stimulus leads to rapid inflation.

In conclusion if the Federal reserve believes that its credibility is the reason inflation has been stable during the recovery, then they will do nothing so unemployment will eventually settle at a higher natural rate. If wage rigidities are responsible for stable inflation, then the Federal reserve must set a higher inflation rate expectation in order to increase employment growth.