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Inflation, deflation and discretionary fiscal policy

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Questions:

1.Explain the various types of inflation and its consequences. Suppose you borrow $1000 from a bank at 5% interest for one year and the inflation rate that year is 10%. Was this loan advantageous to you or to the bank?

2.Explain two limitations of the discretionary fiscal policy.

3.Describe the difference between inflationary gap and deflationary gap.

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Solution Preview

Explain the various types of inflation and its consequences.

There are three different kinds of inflation. They are called, cost plus inflation, demand pull inflation and spiraling inflation. These together with the laws of supply and demand allow economists to predict future economic behavior. Then too, there are people who support a supply side economy as opposed to a demand side economic environment.
Within a stable economy, cost plus inflation is a normal occurrence as a result of cost increases of wages and natural resources. The plus part of the equation is the businesses' expected return on investment. Also, when demand exceeds the supply of certain products this kind of inflation is called demand pull. That is also the second worst kind of inflation and is generally a short term condition within an otherwise healthy economy.

The worst kind of inflation is spiraling, or run away, inflation and that is the result of rising costs that cause rising prices which again raise costs of production. Greed and future expectations, for the most part, causes this kind of inflation.
The last time that our economy suffered the effects of spiraling inflation was after the 1973 Arab oil embargo. The result of that unfortunate situation caused the failure of thousands of businesses and a prolonged record rate of unemployment within our society.

The Republicans called it a recession, since they were in power. The Democrats called it a depression because they wanted to gain power. The end result was lasting price increases of as much as 1,000%, or ten times the cost for the same product. Gasoline was thirty cents per gallon and now the price is over $3.00 per gallon and rising.

Well, we have reached the level of demand pull inflation and will most likely reach the level of ...

Solution Summary

This solution discussed the various types of inflation and its consequences. Limitations of the discretionary fiscal policy, and the difference between inflationary gap and deflationary gap are also mentioned.

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