InflationInflation

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Inflation is ...Inflation is ...

Inflation is a rise in the Inflation is a rise in the average price of goods average price of goods over timeover time

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Some questions about Some questions about inflationinflation

Why is inflation bad?Why is inflation bad?Inflation does have bad effects, but Inflation does have bad effects, but

some popular criticisms are based on some popular criticisms are based on

spurious reasoningspurious reasoning

What are the causes of inflation?What are the causes of inflation?

What can be done about it?What can be done about it?

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The quantity theory of The quantity theory of moneymoney

The quantity theory of money says The quantity theory of money says

that changes in the nominal money that changes in the nominal money

supply lead to equivalent changes in supply lead to equivalent changes in

the price level (and money wages) the price level (and money wages)

but do not have effects on output but do not have effects on output

and employment.and employment.

77

The quantity theory (2)The quantity theory (2)

The quantity theory of money says:The quantity theory of money says: M V = P YM V = P Y

where V = velocity of circulationwhere V = velocity of circulation If prices adjust to maintain real income (Y) at If prices adjust to maintain real income (Y) at

the potential level and if velocity stays the potential level and if velocity stays constantconstant

then an increase in nominal money supply then an increase in nominal money supply leads to an equivalent increase in pricesleads to an equivalent increase in prices

but if velocity is variable or prices are but if velocity is variable or prices are sluggish, this link is broken.sluggish, this link is broken.

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Money and pricesMoney and prices

Milton Friedman famously claimed Milton Friedman famously claimed

‘‘Inflation is always and everywhere a Inflation is always and everywhere a

monetary phenomenon.’monetary phenomenon.’ i.e. it results when money supply grows more i.e. it results when money supply grows more

rapidly than real output.rapidly than real output.

But this does not prove that causation is But this does not prove that causation is

always from money to pricesalways from money to prices e.g. if the government adopts an e.g. if the government adopts an accommodatingaccommodating

monetary policy.monetary policy.

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Money and inflation (2)Money and inflation (2)

……but in the long run, changes in real but in the long run, changes in real income and interest rates significantly income and interest rates significantly alter real money demandalter real money demand

so there may not be a perfect so there may not be a perfect correspondence between excess monetary correspondence between excess monetary growth and inflation.growth and inflation.

And in the short run, the link between And in the short run, the link between money and prices may be broken ifmoney and prices may be broken if velocity of circulation is variablevelocity of circulation is variable prices are sluggishprices are sluggish

1010

Inflation and interest Inflation and interest ratesrates

FISHER HYPOTHESISFISHER HYPOTHESIS a 1% increase in inflation will be accompanied by a 1% increase in inflation will be accompanied by

a 1% increase in interest ratesa 1% increase in interest rates REAL INTEREST RATEREAL INTEREST RATE

Nominal interest rate – inflation rateNominal interest rate – inflation rate i.e. the Fisher hypothesis says that i.e. the Fisher hypothesis says that realreal interest interest

rates do not change muchrates do not change much but the nominal interest rate is the opportunity but the nominal interest rate is the opportunity

cost of holding moneycost of holding money so a change in nominal interest rates affects so a change in nominal interest rates affects real real

money demandmoney demand

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HyperinflationHyperinflation

… … periods when inflation rates are very periods when inflation rates are very largelarge

in such periods there tends to be a ‘flight in such periods there tends to be a ‘flight from money’from money’ people hold as little money as possiblepeople hold as little money as possible

e.g. Germany in 1922-23, Hungary 1945-46, Brazil in the e.g. Germany in 1922-23, Hungary 1945-46, Brazil in the late 1980s.late 1980s.

Large government budget deficits help to Large government budget deficits help to explain such periodsexplain such periods persistent inflation must be accompanied by persistent inflation must be accompanied by

continuing money growthcontinuing money growth

1212

The Phillips curveThe 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

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The Phillips curve and an The Phillips curve and an increase in aggregate demandincrease 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?

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The Phillips curve and an The Phillips curve and an increase in aggregate demandincrease in aggregate demand

Unemployment

Infla

tion

PC0U*U1

1

A

If nominal money supply is fixed in the long run,and prices and wageseventually adjust, theeconomy moves back to E.

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

1515

The vertical Phillips curveThe 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

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Expectations and credibilityExpectations 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

1717

Inflation and unemploymentInflation and unemploymentin the UK 1978-99in the UK 1978-99

02468

1 01 21 41 61 82 0

4 6 8 1 0 1 2

U n e m p l o y m e n t

Infl

atio

n

1978

1980

1986

1990

1999 1993

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Inflation illusionInflation illusion

People have inflation illusion when People have inflation illusion when they confuse nominal and real they confuse nominal and real changes.changes.

People’s welfare depends upon real People’s welfare depends upon real variables, not nominal variables.variables, not nominal variables.

If all nominal variables (prices and If all nominal variables (prices and incomes) increase at the same rate, incomes) increase at the same rate, real income does not change.real income does not change.

1919

The costs of inflationThe costs of inflation

Fully anticipated inflation:Fully anticipated inflation: Institutions adapt to known inflation:Institutions adapt to known inflation:

nominal interest ratesnominal interest rates tax ratestax rates transfer paymentstransfer payments

no inflation illusionno inflation illusion

Some costs remain:Some costs remain: shoe-leathershoe-leather

people economize on money holdingspeople economize on money holdings menu costsmenu costs

firms need to alter price lists etc.firms need to alter price lists etc.

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The costs of inflation (2)The costs of inflation (2)

Even if inflation is fully anticipated, Even if inflation is fully anticipated, the economy may not fully adaptthe economy may not fully adaptinterest rates may not fully reflect interest rates may not fully reflect

inflationinflationtaxes may be distortedtaxes may be distorted

fiscal drag may have unintended effects on fiscal drag may have unintended effects on tax liabilitiestax liabilities

capital and profits taxes may be distortedcapital and profits taxes may be distorted

2121

The costs of unanticipated inflationThe costs of unanticipated inflation

Unintended redistribution of incomeUnintended redistribution of incomefrom lenders to borrowersfrom lenders to borrowersfrom private to public sectorfrom private to public sectorfrom young to oldfrom young to old

UncertaintyUncertaintyfirms find planning more difficult under firms find planning more difficult under

inflation, which may discourage inflation, which may discourage investmentinvestment

This has been seen as the most This has been seen as the most important cost of inflationimportant cost of inflation

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Defeating inflationDefeating inflation

In the long run, inflation will be low if In the long run, inflation will be low if the rate of money growth is low.the rate of money growth is low.

The transition from high to low The transition from high to low inflation may be painful if inflation may be painful if expectations are slow to adjust.expectations are slow to adjust.

Policy credibility may speed the Policy credibility may speed the adjustment processadjustment process

2323

JOIN KHALID AZIZJOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS,

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