Explain why even a constant rate of inflation generates welfare costs. Do you consider these costs to be large or small? Discuss the factors which policy makers should take into account when they choose the target inflation rate. Is zero inflation an optimal inflation target?
Welfare cost here mean changes in welfare due to inflation. Even a constant rate of inflation will generate welfare costs. The reason is due to constant inflation the poor suffer as prices of necessities increase. Other effects on welfare of individuals like lenders also are there. These costs are smaller than under an increasing rate of inflation. The policymakers should take into consideration welfare effects of inflation and growth effects of inflation. Also its effect on employment etc should also be taken into consideration since higher inflation reduces unemployment. Zero inflation is not optimal target because inflation upto 2% is considered good for growth as it raises demand for goods and expectations of investors. Further zero inflation will result in unemployment
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