Trade Off Between Inflation And Other Macroeconomic Aims

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Trade Off Between Inflation And Other Macroeconomic Aims

Keeping inflation as low as possible can be undesirable especially when we consider the short run trade-off between inflation and other macroeconomic factors such as output and employment. This can be seen from the AD-AS curve drawn below. Assume that the country is initially at and is the natural level of output in Figure 4. In order to move to a higher level of output, reduce the output gap and unemployment, inflation is inevitable as the general price level must increase to . This is known as demand pull inflation, as the increase in output implies that more factors of production are being employed to produce this increase, and this increases the cost of production which
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Oil is used in the production of many goods and services and countries dependant on oil would face cost push inflation which is denoted by an upwards shift of the AS curve in Figure 5 from to as shown in the figure below. We see that prices have increased from to and we will have a negative output gap as output has decreased from to . If the Central Bank is forced to set inflation as low as possible, they could go about it by reducing aggregate demand from to but output has to fall even further to . The cost to output and employment by forcing a low inflation is greater when it comes from a supply shock, and this already assumes that the Central Bank knows perfectly what is happening in the economy. In the past, the Federal Reserve placed a greater priority on reducing the output gap and unemployment and they eased its monetary policy in response to these oil shocks (Clarida, Gal´ı, and Gertler, 2000) . Once again, the trade-off between employment and inflation is highlighted, as they were willing to accept a much higher level of inflation while placing a greater emphasis on other macroeconomic priorities. Yet, if the Central Bank is forced to set inflation to as low as possible, we will have to tolerate a very high (negative) output gap, unless they are able to use other methods to reduce inflation, which will be discussed later in this essay. Dealing with Cost Push Inflation
Hence, when dealing
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