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Inflation

Inflation. Inflation versus price level Determinants of Irish inflation: 1. Euro price of foreign goods Foreign prices (in foreign currency) Nominal exchange rate 2. Economic slack Aggregate spending relative to potential output. Euro price of foreign goods.

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Inflation

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  1. Inflation • Inflation versus price level • Determinants of Irish inflation: 1. Euro price of foreign goods • Foreign prices (in foreign currency) • Nominal exchange rate 2. Economic slack • Aggregate spending relative to potential output

  2. Euro price of foreign goods • Traded goods (Internationally) • Law of one price (LOOP) Pi = 1/e × Pi* where Pi = domestic price of good i e = nominal exchange rate Pi* = foreign price of good i

  3. Purchasing Power Parity (PPP) P = 1/e × P* where P = domestic price of traded goods e = nominal exchange rate P* = foreign price of traded goods

  4. Economic slack • Non-traded goods • e.g. services YP = A Ka L(1-a) • If aggregate spending (demand) greater than YP then rate of inflation increases • If aggregate spending (demand) less than YP then rate of inflation decreases

  5. Slack in Ireland • Ireland’s potential output growth estimated to be between 4-5 percent • Depends critically on assumptions about number of immigrants • Ireland’s level of actual output estimated to be close to potential output level • i.e. close to zero slack

  6. Labour market slack • Non-accelerating inflation rate of unemployment (NAIRU) • If actual unemployment rate below NAIRU then wage inflation picks up • If actual unemployment rate above NAIRU then wage inflation eases

  7. Labour market slack • Ireland’s NAIRU estimated at about 4.5 percent • Ireland actual unemployment rate is about 4.5 percent

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