Lecture10 inflation

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10Causes of Inflation

and the Philips Curve

Causes of Inflation

Definition and Measurement

� Definition: Inflation is a continuous increase

in the general price level.

� Measurement: Percentage change in the

general price level.

ππππt = [( Pt - Pt-1)/ Pt-1].100 (%)

� General price level: measured by either

Consumer Price Index (CPI) or GDP deflator

(DGDP).

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Category of Inflation

� Mild inflation

� High inflation:

� Hyper inflation: According to Philip

Cagan, inflation rate being from 50% per

month to 13.000% per year.

0

2

4

6

8

10

12

14

16

1960 1965 1970 1975 1980 1985 1990 1995 2000

% per year

inflation rate inflation rate trend

Figure 1 Inflation in the US, 1960-2002

6

Chỉ số giá tháng 10 năm 2008 so với (%) Chỉ số giá 10 tháng đầu năm

2008 so với cùng kỳ năm

2007

Kỳ gốc năm 2005

Tháng 10 năm 2007

Tháng 12 năm 2007

Tháng 9 năm 2008

CHỈ SỐ GIÁ TIÊU DÙNG 148,20 126,72 121,64 99,81 123,15

I. Hàng ăn và dịch vụ ăn uống 172,14 140,56 132,12 99,58 136,95

Trong đó: 1- Lương thực 201,99 160,06 151,41 98,09 149,58

2- Thực phẩm 161,16 132,82 124,44 100,01 133,05

3. Ăn uống ngoài gia đình 169,86 139,54 131,37 100,47 131,92

II. Đồ uống và thuốc lá 128,32 113,27 111,34 100,67 110,21

III. May mặc, mũ nón, giầy dép 126,05 112,55 110,82 100,70 109,81

IV. Nhà ở và vật liệu xây dựng (*) 148,40 122,84 116,76 98,92 122,39

V. Thiết bị và đồ dùng gia đình 125,94 111,99 111,26 100,73 108,36

VI. Dược phẩm, y tế 123,00 109,76 108,75 100,58 108,72

VII. Phương tiện đi lại, bưu điện 138,44 124,82 119,56 99,06 116,66

Trong đó: Bưu chính viễn thông 83,46 89,21 90,39 99,82 88,44

VIII. Giáo dục 115,02 106,71 106,56 100,69 103,63

IX. Văn hoá, thể thao, giải trí 115,74 109,50 109,30 100,38 105,03

X. Đồ dùng và dịch vụ khác 132,35 114,65 111,69 100,85 113,11

Vietnam’s CPI in 2008

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Typical Hyper inflation in the World

Germany Russia China Greece Hungary Bolivia Nicaragua

Begin 8/1922 12/1921 2/1947 11/1943 8/1945 4/1984 4/1987

End 11/1923 1/1924 3/1949 11/1944 7/1946 9/1985 3/1991

No. of months 16 26 26 13 12 18 48

Ratio of

begin/end price1,02(1010) 1,24(105) 4,15(106) 4,7(108) 3,81(1027) 1028,5 5,53(105)

Average inflation

rate per month (%)

322 57 79,7 365 19800 48,1 46,45

Highest inflation

rate per month (%)

32400 213 919,9 85,5(106) 41,9(1015) 182,8 261,15

Money growth and inflation in four typical inflation

Period Monthly Inflation rate

%

Money growth

%

GermanyGreeceHungaryPoland

8/1922 => 11/192311/1943 => 11/19448/1945 => 7/19461/1923 => 1/1924

322%365%

19,800%81.4%

314%220%

12,200%72.2%

Source: Philip Cagan: The Monetary Dynamics of Hyperinflation, in Milton Friedman, ed.,

Studies in the Quantity Theory of Money (Chicago: University of Chicago press, 1956), p.26

INTERNATIONAL COMPARISON OF MONEY AND PRICE INDICES (1990-2003)

CountryAnnual growth

of GDP deflator

Annual growth

of CPI

Annual growth

of food price

Vietnam 11.6 2.8 -

China 4.9 6.0 11.3

The Philippines 7.7 7.3 6.7

Indonesia 15.3 13.9 16.1

Malaysia 3.4 3.1 4.3

Thailand 3.4 4.1 4.6

South Korea 4.8 4.5 4.8

Singapore 0.6 1.3 1.4

Source: WDI 2005

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10

Theories of Inflation

A. Causes of inflation1. Demand-pull inflation: An increase in

aggregate demand

2. Cost-push inflation: An increase in prices of factors of production. Examples:• An increase in wage level.

• An increase in input prices

3. Inertial inflation

11

Fig.2 Demand-pull inflation

Fig.3 Cost-push inflation

P

P1

P0

AS0

E0

E1

AS1

Y1 Y* Y

AD0AD1

AS1P

P2

P1

AD2

Y* Y2 Y

AD0

12

Figure 4 Inertial inflation

P

P3

P2

P1

Y* Y

AS2

AD1

AD2

AD3

AS1

AS3

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B. Monetary approach to inflation• Central insight: Changes in money supply is the

root cause of changes in the general price level.

• M. Friedman: “Inflation is always and

everywhere a monetary phenomenon... and it occurs only when money grows faster than does

output”

• Quantity theory of money:

MV = PY

V = V

So: % change in P (π) =

= % change in M - % change in Y

Monetary approach to inflation

• Policy implications:

�Tightening money supply is a core

solution to control inflation.

�Tightening fiscal policy, too.

Fig.5 International data on money growth and inflation

Inflation rate(percent, logarithmicscale)

1,000

10,000

100

10

1

0.1

Money supply growth (percent, logarithmic scale)0.1 1 10 100 1,000 10,000

Nicaragua

Angola

Brazil

Bulgaria

Georgia

Kuwait

USA

JapanCanada

Germany

Oman

Democratic Republicof Congo

Data for more than 100 countries in 1990s: Average growth of M1 and π

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16

1

10

100

1000

10000

percent growth

Israel

1983-85

Poland

1989-90

Brazil

1987-94

Argentina

1988-90

Peru

1988-90

Nicaragua

1987-91

Bolivia

1984-85

inflation growth of money supply

Fig.6 Money growth and inflation in typical hyper inflation cases

Inflation in Vietnam, 1987-2004

1987-1989

1990-1994

1995-1999

2000-2004

1987-2004

Growth of CU 286.9 44.8 25.9 27.3 78.9

Growth of M1 286.9 44.8 25.9 27.3 78.9

Growth of M2 318.3 43.5 27.2 22.7 84.3

Openness degree 44.9 57.2 75.3 104.9 71.6

GDP growth rate 4.77 7.30 7.51 7.23 6.90

Inflation rate by CPI 217.2 34.3 6.02 4.33 48.3

Inflation rate by DGDP 281.1 36.4 9.38 3.76 63.9

Fig.7 Inflation rate and money growth rate in Vietnam,

1988-2004

-100

0

100

200

300

400

500

600

700

800

900

1987

1989

1991

1993

1995

1997

1999

2001

2003

Lạm phát M2

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Inflation Tax (IT) and Seiniorage (SE)

• Seiniorage is the revenue earned by

government from printing money.

• Inflation tax: Inflation reduces purchasing power of money in circulation.

PP

P

P

M

P

P

PPP

PPPM

PP

M

P

M

∆+

∆=

∆+

−∆+=

∆+−

)(

PP

P

P

M

M

M

PP

M

∆+

∆=

∆+

∆

20

ThuÕ ®óc tiÒn ë mét sè n−íc, 1975-90*

N−íc % so víi nguån thu ngoµithuÕ ®óc tiÒn

% GDP

Mü 6,02 1,17Canada 6,61 1,26Anh 5,31 1,91Italia 28,00 6,60Ph¸p 7,19 2,73§øc 3,85 1,08Bolivia** 139,5 5,00Brazil 18,36 4,13Chile 7,48 2,39Ên ®é 14,30 1,81Hµn quèc 10,70 1,84Mªhic« 18,70 2,71Philippines 7,79 0,99Thai lan 7,06 0,94Thæ nhÜ kú 24,40 5,09Vªnzuela 10,76 3,05Peru 29,71 4,92Israel 24,55 2,99

*TÝnh trung b×nh n¨m**cña giai ®o¹n 1977-1985

Nguån : J. D. Sachs and F. Larrain, Macroeconomics in the Global Economy, trang 341.

Inflation and economic growth relation

�T. Killick (1981): U-turn shape relation between inflation and economic growth:− Inflation has positive impacts on economic growth at

a low level, while it has negative impacts on econ. growth at high level.

�M. Khan and A. Senhadji (2000), with data on 140 countries in the period 1960-1998: Inflation has an influence on the threshold of economic growth. The range of optimal inflation rate is:− 1-3% per year for industrial countries, and

− 7-11% per year for developing countries

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Fig.8 U-turn shape relation between inflation and economic growth

gY

ππππππππ*

gYmax

Controlling inflation

• Tightened fiscal policy• Reducing G or

increasing T results in

a reduction in Y and P.• Costs of reducing

inflation is lower Y and

higher UP1

Y1 Y

P

SAS

AD1

Eo

Po

Y0

E1

ADo

LAS

Controlling inflation

P1

Y1 Y

P

SAS

AD1

Eo

Po

Y0

E1

ADo

LAS

• Tightened monetary

policy• Contractionary

monetary policy results in higher interest rate,

which in turn reduces investment, and thus Y.

• Costs of reducing

inflation is lower Y and higher U

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The Short-Run Tradeoff between Inflation and

Unemployment : Philips Curve

Unemployment and Inflation

• The natural rate of unemployment depends on

various features of the labor market.

• Examples include minimum-wage laws, the

market power of unions, the role of efficiency wages, and the effectiveness of job search.

• The inflation rate depends primarily on growth in the quantity of money, controlled by the

Fed.

Unemployment and Inflation

• Society faces a short-run tradeoff between

unemployment and inflation.

• If policymakers expand aggregate demand,

they can lower unemployment, but only at the cost of higher inflation.

• If they contract aggregate demand, they can lower inflation, but at the cost of temporarily

higher unemployment.

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THE PHILLIPS CURVE

• The Phillips curve illustrates the

short-run relationship between inflation and unemployment.

Figure 9 The Phillips Curve

UnemploymentRate (percent)

0

InflationRate

(percentper year)

Phillips curve

4

B6

7

A2

Aggregate Demand, Aggregate Supply, and the Phillips Curve

• The Phillips curve shows the short-

run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the

economy along the short-run aggregate supply curve.

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Aggregate Demand, Aggregate Supply, and the Phillips Curve

• The greater the aggregate demand for

goods and services, the greater is the

economy’s output, and the higher is the

overall price level.

• A higher level of output results in a lower

level of unemployment.

Figure 8 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply

Quantityof Output

0

Short-run

aggregate

supply

(a) The Model of Aggregate Demand and Aggregate Supply


0

InflationRate

(percentper year)

PriceLevel

(b) The Phillips Curve

Phillips curveLow aggregate

demand

High

aggregate demand

(output is

8,000)

B

4

6

(output is

7,500)

A

7

2

8,000

(unemployment

is 4%)

106 B

(unemployment

is 7%)

7,500

102 A

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF EXPECTATIONS

• The Phillips curve seems to offer

policy-makers a menu of possible inflation and unemployment outcomes.

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The Long-Run Phillips Curve

• In the 1960s, Friedman and Phelps

concluded that inflation and

unemployment are unrelated in the long

run.

• As a result, the long-run Phillips curve is vertical at the natural rate of unemployment.

• Monetary policy could be effective in the short run but not in the long run.

Figure 9 The Long-Run Phillips Curve

UnemploymentRate

0 Natural rate of

unemployment

InflationRate Long-run

Phillips curve

BHigh

inflation

Low

inflation

A

2. . . . but unemployment

remains at its natural rate

in the long run.

1. When the

Fed increases

the growth rate

of the money

supply, the

rate of inflation

increases . . .

Figure 10 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply

Quantityof Output

Natural rate

of output

Natural rate of

unemployment

0

PriceLevel

P

Aggregate

demand, AD

Long-run aggregate

supply

Long-run Phillips

curve


UnemploymentRate

0

InflationRate


2. . . . raises

the price

level . . .

1. An increase in

the money supply

increases aggregate

demand . . .

A

AD2

B

A

4. . . . but leaves output and unemployment

at their natural rates.

3. . . . and

increases the

inflation rate . . .

P2B

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Expectations and the Short-Run Phillips Curve

• Expected inflation measures how much

people expect the overall price level to

change.

• In the long run, expected inflation adjusts to changes in actual inflation.

• The Fed’s ability to create unexpected inflation exists only in the short run.

• Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate.

• This equation relates the unemployment

rate to the natural rate of

unemployment, actual inflation, and

expected inflation.

Expectations and the Short-Run Phillips Curve

( )Natural rate of unemployment - a Actual inflation

Expected inflation−

Unemployment Rate =

Figure 11 How Expected Inflation Shifts the Short-Run Phillips Curve

UnemploymentRate

0 Natural rate of

unemployment

InflationRate Long-run

Phillips curve

Short-run Phillips curve

with high expected

inflation


with low expected

inflation

1. Expansionary policy moves

the economy up along the

short-run Phillips curve . . .

2. . . . but in the long run, expected

inflation rises, and the short-run

Phillips curve shifts to the right.

CB

A

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The Natural Experiment for the Natural-Rate Hypothesis

• The view that unemployment

eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis.

• Historical observations support the

natural-rate hypothesis.

The Natural Experiment for the Natural Rate Hypothesis

• The concept of a stable Phillips curve

broke down in the in the early ’70s.

• During the 1970’s and 1980’s, the economy experienced high inflation and high unemployment

simultaneously.

Figure 12 The Phillips Curve in the 1960s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10


Inflation Rate(percent per year)

1968

1966

19611962

1963

1967

1965

1964

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Figure 13 The Breakdown of the Phillips Curve

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1973

1966

1972

1971

19611962

1963

1967

1968

1969 1970

19651964

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS

• Historical events have shown that the short-run

Phillips curve can shift due to changes in expectations.

• The short-run Phillips curve also shifts because of shocks to aggregate supply.

• Major adverse changes in aggregate supply can worsen the short-run tradeoff between unemployment and inflation.

• An adverse supply shock gives policymakers a less favorable tradeoff between inflation and

unemployment.


• A supply shock is an event that directly

alters the firms’ costs, and, as a result, the

prices they charge.

• This shifts the economy’s aggregate

supply curve. . .

• . . . and as a result, the Phillips curve.

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Figure 14 An Adverse Shock to Aggregate Supply

Quantityof Output

0

PriceLevel

Aggregate

demand


UnemploymentRate

0

InflationRate


3. . . . and

raises

the price

level . . .

AS2 Aggregate

supply, AS

A

1. An adverse

shift in aggregate

supply . . .

4. . . . giving policymakers

a less favorable tradeoff

between unemployment

and inflation.

BP2

Y2

PA

Y

Phillips curve, PC

2. . . . lowers output . . .

PC2

B


• In the 1970s, policymakers faced two

choices when OPEC cut output and raised

worldwide prices of petroleum.

• Fight the unemployment battle by expanding aggregate demand and

accelerate inflation.

• Fight inflation by contracting aggregate

demand and endure even higher

unemployment.

Figure 15 The Supply Shocks of the 1970s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1972

19751981

1976

1978

1979

1980

1973

1974

1977

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THE COST OF REDUCING INFLATION

• To reduce inflation, the Fed has to pursue

contractionary monetary policy.

• When the Fed slows the rate of money

growth, it contracts aggregate demand.

• This reduces the quantity of goods and

services that firms produce.

• This leads to a rise in unemployment.

Figure 16 Disinflationary Monetary Policy in the Short Run and the Long Run

UnemploymentRate

0 Natural rate of

unemployment

InflationRate

Long-run

Phillips curve


with high expected

inflation


with low expected

inflation

1. Contractionary policy moves

the economy down along the

short-run Phillips curve . . .

2. . . . but in the long run, expected

inflation falls, and the short-run

Phillips curve shifts to the left.

BC

A


• To reduce inflation, an economy must endure

a period of high unemployment and low output.

• When the Fed combats inflation, the economy moves down the short-run Phillips curve.

• The economy experiences lower inflation but at the cost of higher unemployment.

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• The sacrifice ratio is the number of

percentage points of annual output that

is lost in the process of reducing inflation

by one percentage point.

• An estimate of the sacrifice ratio is five.

• To reduce inflation from about 10% in 1979-

1981 to 4% would have required an estimated sacrifice of 30% of annual output!

Summary

• The Phillips curve describes a negative

relationship between inflation and unemployment.

• By expanding aggregate demand, policymakers can choose a point on the Phillips curve with

higher inflation and lower unemployment.

• By contracting aggregate demand, policymakers

can choose a point on the Phillips curve with

lower inflation and higher unemployment.

Summary

• The tradeoff between inflation and

unemployment described by the Phillips

curve holds only in the short run.

• The long-run Phillips curve is vertical at

the natural rate of unemployment.

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Summary

• The short-run Phillips curve also shifts

because of shocks to aggregate supply.

• An adverse supply shock gives

policymakers a less favorable tradeoff

between inflation and unemployment.

Summary

• When the Fed contracts growth in the

money supply to reduce inflation, it

moves the economy along the short-run

Phillips curve.

• This results in temporarily high

unemployment.

• The cost of disinflation depends on how

quickly expectations of inflation fall.

Lecture10 inflation

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