Sunday, June 1, 2008

Embedded vs. non-embedded inflation--scale issue?

Krugman explained why Fed considers only "core" inflation where commodities with volatile prices, e.g. oil and grain were excluded. But isn't it only a matter of time before high oil prices is embedded in the economy? In fact we have already seen examples of rippling effects, e.g. US airlines have started charging checked-in bags.

Update: High oil prices in fact can cause inflation or deflation. In a simple example, if the demand is inelastic (upper left diagram) then higher production costs cannot be passed to consumers and that can result in a deflation/recession (as in 1973 and 1979). On the other hand, if the demand is elastic (upper right diagram) then everything might get more expensive as oil price increases and we have a bigger chance for embedded inflation.

So I was right when saying it was a scale issue but for the wrong reason ;)

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