Post on 21-Dec-2015
28.2
1. Inflation is ...
Inflation is a rise in the average price of goods over time
Too much money chasing too few goods
One of the first acts of the Labour government in 1997 was to make the Bank of England independent– with a mandate to achieve low inflation.
28.3
2. Measuring Inflation
Price level A measure of the average prices of goods and services in the economy.
Inflation rate The percentage increase in the price level from one year to the next.
Consumer price index (CPI) An average of the prices of the goods and services purchased by the typical urban family of four.
Deflation A decline in the price level.
28.4
3. Some questions about inflation
Why is inflation bad?– Inflation does have bad effects, but
some popular criticisms are based on
spurious reasoning
What are the causes of inflation?
What can be done about it?
28.5
4. Causes of Inflation
Cost-push inflation occurs when
businesses respond to rising production
costs, by raising prices in order to
maintain their profit margins (rising
imported raw materials costs, rising labour costs,
higher indirect taxes imposed by the
government)
28.6
4. Causes of Inflation
Demand-pull inflation is likely when there
is full employment of resources and when
SRAS is inelastic. In these circumstances
an increase in AD will lead to an increase
in prices. AD might rise for a number of
reasons – some of which occur together at
the same moment of the economic cycle
28.7
4. Causes of Inflation
Demand-pull inflation (A depreciation
of the exchange rate: increase price of
imports and decrease price of exports, A
reduction in direct or indirect taxation, The
rapid growth of the money supply , faster
economic growth in other countries)
28.9
6. The quantity theory of money
The quantity theory of money says
that changes in the nominal money
supply lead to equivalent changes in
the price level (and money wages)
but do not have effects on output
and employment.
28.10
6. The quantity theory (2) The quantity theory of money says: M V = P Y
– where V = velocity of circulation
If prices adjust to maintain real income (Y) at the potential level and if velocity stays constant
then an increase in nominal money supply leads to an equivalent increase in prices
but if velocity is variable or prices are sluggish, this link is broken.
28.11
7. Money and prices
Milton Friedman famously claimed
‘Inflation is always and everywhere a monetary
phenomenon.’– i.e. it results when money supply grows more rapidly
than real output.
But this does not prove that causation is
always from money to prices– e.g. if the government adopts an accommodating
monetary policy.
28.12
8. Money and inflation (2)
…but in the long run, changes in real income and interest rates significantly alter real money demand
so there may not be a perfect correspondence between excess monetary growth and inflation.
And in the short run, the link between money and prices may be broken if– velocity of circulation is variable– prices are sluggish
28.13
9. Inflation and interest rates
FISHER HYPOTHESIS– a 1% increase in inflation will be accompanied by a
1% increase in interest rates REAL INTEREST RATE
– Nominal interest rate – inflation rate– i.e. the Fisher hypothesis says that real interest
rates do not change much– but the nominal interest rate is the opportunity cost
of holding money– so a change in nominal interest rates affects real
money demand
28.14
10. Hyperinflation
… periods when inflation rates are very large in such periods there tends to be a ‘flight
from money’– people hold as little money as possible
e.g. Germany in 1922-23, Hungary 1945-46, Brazil in the late 1980s.
Large government budget deficits help to explain such periods– persistent inflation must be accompanied by
continuing money growth
28.15
11. The Phillips curve
It suggests we can trade-off more inflation forless unemployment orvice versa.
Prof. A W Phillips demonstrated a statistical relationshipbetween annual inflation and unemployment in the UK
Unemployment rate (%)
Infla
tion
rate
(%
)
The Phillips curve showsthat a higher inflation rateis accompanied by a lower unemployment rate.
Phillips curve
28.16
11. The Phillips curve and an increase in aggregate demand
Unemployment
Infla
tion
PC0U*
Suppose the economy begins at E, with zeroinflation, unemploymentat the natural rate U*...
U1
1
An increase in governmentspending funded by an expansion in money supplytakes the economy to A,with lower unemploymentbut inflation at 1.
A
… but what happens next?
28.17
12. The Phillips curve and an increase in aggregate demand
If nominal money supply is fixed in the long run,and prices and wageseventually adjust, theeconomy moves back to E.
Unemployment
Infla
tion
PC0U*U1
1
A
E
But nominal money supplyneed not be constant in thelong run
so we may find the economy finds its way back to the natural rate, but with continuing inflation at C.
C
28.18
13. The vertical Phillips curve
Unemployment
Infla
tion
PC0U*U1
1
A
E
C
Effectively, the long-run Phillips curve is vertical, as the economy always adjusts back to U*.
LRPC
The short-run Phillips curveshows just a short-run trade-off –
its position may dependupon expectations aboutinflation.
PC1
28.19
14. Expectations and credibility
Unemployment
Infla
tion
PC2
PC1
1
U*
Unemployment rises to U1
U1
Suppose the economy beginsat E, with a newly-elected government pledged toreduce inflation.
E
LRPC
Monetary growth is cut to 2.
2
In the short run, the economymoves to A along the short-run Phillips curve.A
As expectations adjust, the short-run Phillips curveshifts to PC2, and U*is restored at F.
F
28.20
Inflation and unemploymentin the UK 1978-99
02468
101214161820
4 6 8 10 12
Unemployment
Infl
atio
n
1978
1980
1986
1990
1999 1993
28.21
15. Inflation illusion
People have inflation illusion when they confuse nominal and real changes.
People’s welfare depends upon real variables, not nominal variables.
If all nominal variables (prices and incomes) increase at the same rate, real income does not change.
28.22
16. The costs of inflation
Fully anticipated inflation: Institutions adapt to known inflation:
– nominal interest rates– tax rates– transfer payments
no inflation illusion Some costs remain:
– shoe-leather the extra time and effort in transacting when we
economize on holding real money– menu costs
The physical resources needed for adjustments to keep real things constant when inflation occurs
28.23
16. The costs of inflation (2)
Even if inflation is fully anticipated, the economy may not fully adapt– interest rates may not fully reflect
inflation– taxes may be distorted
fiscal drag may have unintended effects on tax liabilities
capital and profits taxes may be distorted
28.24
17. The costs of unanticipated inflation
Unintended redistribution of income– from lenders to borrowers– from private to public sector– from young to old
Uncertainty– firms find planning more difficult under
inflation, which may discourage investment This has been seen as the most
important cost of inflation
28.25
19. Defeating inflation
In the long run, inflation will be low if the rate of money growth is low.
The transition from high to low inflation may be painful if expectations are slow to adjust.
Policy credibility may speed the adjustment process
Income Policy; Institutional Reform; Central Bank Independence
28.26
20. The Monetary Policy Committee Central Bank Independence may improve the
credibility of anti-inflation policy
Since 1997 UK monetary policy has been set by
the Bank of England’s Monetary Policy
Committee– which has the responsibility of meeting the inflation
target
– via interest rates
– which are set according to inflation forecasts.