Advanced Economics Essay Example

Exercise 4, Chapter 19

Exercise 4, Chapter 19

05, 05, 2014

Exercise 4, Chapter 19

Question 1

Why it is socially desirable to stabilize the rate of inflation around some constant target value

First, it is socially desirable in order to reduce recession implying a decrease in the number of unemployed people. Second, stabilizing the rate of inflation ensures that there is creation of employment opportunities to the people. Finally, there is an increase in the number of goods and services produced (output) thus ensuring a stable economy

The costs of a fluctuating rate of inflation

First, there may be a decrease in the output of a product, which may be caused by firms diverting their workers (labour) from production of the product due to the losses the firm has been experiencing by producing that product. Second, there may be a decrease in the output of a product, which may be caused by diverting resources from the firm involved in the production of that product so as to produce a product that will maximise profits. Third, there may be increase in taxes (amendments in tax laws) which may lead to a reduction in the net income of an employee. Fourth, the debtors may fail to benefit from the money borrowed since the value of money is less that leads to unfair loss to the debtor but results to unfair gain to the creditor. Finally, many people might change the ways through which they invest their money for instance many people may withdraw money from banks to buy assets that are appreciating.

Question 2

The arguments for avoiding fluctuations in output and employment

Decreased output implies that there is a reduction in the number of people involved during the production process. This results to an increase in the number of unemployed people. Thus decreased output results to recession that in turn leads to decreased aggregate market worth of goods and services manufactured by employees and resources in a nation in a specified time (GDP). Thus, output fluctuations should be avoided in order to ensure that GDP does not drop by high margins within a short period.

Increased unemployment leads to people experiencing tough economic times as they struggle to get the basic needs. This may also lead to a decrease in salaries and prompts the employed people to try their best, as the probability of losing a job is very high.

Factors determining the magnitude of the welfare costs of output and employment


First, the amount of time allocated to the employees during the production of goods and services. Second, the number of employees involved in the production of goods and services. Finally, the amount of effort that the employees contribute towards the production of goods and services (the force of employees available)

Question 3

Explanation on why even a constant rate of inflation generates welfare costs

A constant rate of inflation is not efficient with the rate at which the employee spends the salary paid during the production of goods and services per the amount of time the employee spends to produce the goods and services. That is in a constant rate of inflation the employee spends a higher amount as compared to a changing rate of inflation while the amount of time spent by the employee is lower in a constant rate of inflation as compared to a changing rate of inflation. This shows that welfare costs are lower in a changing rate inflation economy as compared to a constant rate inflation economy.

My consideration as to whether these costs are large or small

I consider these costs to be either large or small that is the costs can be large if the price friction is appropriately big.

Factors that policy makers should take into account when they choose the target inflation rate

First, they should consider all the elements or variables and understand the behaviour of these variables. Second, they should come up with a clear objective that leads to the set inflation rate. Third, they should inform people so that they can give suggestions to increase the efficiency of the attained target inflation rate that also leads to people having confidence on these target inflation rate. Finally, they should ensure that the target inflation rate reduces risks.

Optimal inflation target

Zero inflation is the optimal inflation target because nominal interest rates are usually positive.

Question 4

The factors that should be considered when policy makers choose the target level of output

  1. The quality of being measurable

The policy makers should consider whether a given product could be calculated in order to set the target level

  1. The ability of being manageable

The policy makers should ensure that the output is controllable and after taking this into consideration, they are very likely to come up with an efficient target level.

  1. Ability to probably influence objectives

Policy makers should ensure that they have deep knowledge on how the output affects the goals of firms and individuals consuming it in order to come up with an effective target level.

Whether policy makers should choose either the ‘efficient’ level of output or the ‘trend’ level of output

From my own point of view, policy makers should choose the ‘efficient’ level of output because I find it more dependable.

Difference between the ‘efficient’ level of output and the ‘trend’ level of output

In the ‘efficient’ level of output the policy makers normally have to really search the models or functions from the firms that are involved in the production process and then come up with a target level of output after evidently understanding the models.

In the ‘trend’, level of output the policy makers normally check for patterns during a given period of time after which they come up with a target level of output.


Stabilisation Policy Chapter 14, 2007. Available from:

<>. (05 May 2014)

The New Normative Macroeconomics Chapter 17, n.d. Available from:

<>. (05 May 2014)