Published on April 9, 2008
V. INFLATION: V. INFLATION EC21B – INTERMEDIATE MACROECONOMICS II INTRODUCTION: INTRODUCTION Inflation can be defined as a sustained upward movement in the aggregate price level that is shared by most products. It can also be viewed as a fall in the purchasing power of money. The opposite of inflation is deflation. INTRODUCTION: INTRODUCTION The expected rate of inflation is the level of inflation people expect to occur in the future. There are 3 main types of inflation Demand-pull inflation – due to high GDP and low unemployment Supply shock inflation – due to adverse changes in prices of raw materials (e.g. oil) Built in inflation –induced by expectations based on previous inflation levels. THE INFLATION PROBLEM: THE INFLATION PROBLEM What’s wrong with Inflation? Inflation is undesirable as it imposes costs on the society. The areas of economic costs include the following: “Shoe Leather cost” of holding money Tax distortions Unfair gains and losses Non adapting economic institutions. THE INFLATION PROBLEM: THE INFLATION PROBLEM Shoe Leather costs of holding money – when inflation is high, currency and non-interest bearing accounts are undesirable because they are constantly declining in purchasing power. It is termed a shoe leather cost as people wear out their shoes making trips to the banks in order to avoid holding money. THE INFLATION PROBLEM: THE INFLATION PROBLEM Tax distortions – personal income tax increases with the consumer price index. When inflation increases, the actual value of the tax deductions is much less than it should be due to declining purchasing power. THE INFLATION PROBLEM: THE INFLATION PROBLEM Unfair gains and losses – inflation results in gains to some individuals and losses to others. Retired individuals with a fixed pension lose while homeowners gain as they are able to pay off their mortgages in less valuable dollars. Total losses from inflation is equal to the total gains. The Social cost to inflation is that it makes long-term transactions more unreliable. THE INFLATION PROBLEM: THE INFLATION PROBLEM Unexpected inflation redistributes wealth among individuals. If inflation is higher than expected the debtor wins and the creditor loses as the debtor repays loan with less valuable dollars. If inflation is lower than expected, the creditor wins and the debtor loses because repayment is now worth more than the two parties anticipated. THE INFLATION PROBLEM: THE INFLATION PROBLEM “Inflation as a Monetary Phenomenon” Friedman wrote that “Inflation is always and everywhere a monetary phenomenon.” This statement means that the growth in the quantity of money is the primary determinant of the inflation rate. And since the central banks control the money supply they have ultimate control over the inflation rate. THE INFLATION PROBLEM: THE INFLATION PROBLEM An analysis of historical data from the US as well as Internationally show a positive correlation between average money growth and the average rate of inflation. This theory however works best in the long run. THE INFLATION MODEL: THE INFLATION MODEL Aggregate Demand in terms of Inflation A positive shock to the aggregate demand (AD) curve has the effect of sending the economy into a recession. An increase in aggregate demand shifts the AD curve upwards increasing prices due to the upward pressure on nominal wages and the supply curve shift upwards. This increase in the price level leads to inflation. THE INFLATION MODEL: THE INFLATION MODEL It is therefore safe to say that any change in the growth rate of aggregate demand would change the inflation rate. THE INFLATION MODEL: THE INFLATION MODEL Price Adjustment The theory of price adjustments state that Inflation rises when demand conditions are tight, when expectations of inflation rise, or when they are price shocks. A simple algebraic summary of this can be written as Equation 1: THE INFLATION MODEL: THE INFLATION MODEL Y-1 – represents the percentage deviation of real GDP from potential GDP The subscript -1 indicates that current inflation is related to market pressure in the previous period. Пe – represents individuals expectation of inflation Z – represents price shocks, it describes the upward or downward effect of a change in world oil prices or other factors. THE INFLATION MODEL: THE INFLATION MODEL The price adjustment equation highlights that there is no long-run trade-off between inflation and the level of GDP. Therefore in the long run the effect of a price shock would be zero and expected inflation would be equal to actual inflation and actual output would be equal to potential. THE INFLATION MODEL: THE INFLATION MODEL Price Adjustment Line Output Gap = (Y – Y*) / Y* Price adjustment line п THE INFLATION MODEL: THE INFLATION MODEL The Inflation Line We now need to describe the impact of monetary policy on aggregate demand. But since we are focusing on the inflation rate we derive a new curve that relates aggregate demand to inflation called the Aggregate Demand - Inflation Curve. The curve shows a downward sloping relation between inflation and the GDP gap. When inflation rises above target it leads to a reduction in the GDP gap THE INFLATION MODEL: THE INFLATION MODEL This curve is obtained by combining the IS curve and the monetary policy rule. This gives us the algebraic expression equation 2: THE INFLATION MODEL: THE INFLATION MODEL The Inflation Line Output Gap = (Y – Y*) / Y* Inflation curve п 0 THE INFLATION MODEL: THE INFLATION MODEL Equilibrium with Persistent Inflation The intersection of the inflation curve and price adjustment line determines the equilibrium level of inflation and output. Price adjustment line Inflation curve Output Gap = (Y – Y*) / Y* п 0 THE INFLATION MODEL: THE INFLATION MODEL Adjustment in the Inflation Model Since from equation 1 inflation is not dependent on current GDP so the price adjustment line will shift up if : Real GDP was above potential last year The expected rate of inflation rises There is a positive price shock THE INFLATION MODEL: THE INFLATION MODEL From equation 2 inflation is negatively related to the GDP so the inflation line will: Shift if there is a change in the target rate of inflation or if there are shocks to the IS curve. A change in the inflation level in the economy will lead to change sin the real GDP and cause movements along the curve. EXERCISES WITH THE INFLATION MODEL: EXERCISES WITH THE INFLATION MODEL Increase in Money Growth Money growth speaks to an increase in the stock of money. More money simply raises prices. The central bank can target any level of inflation it desires by simply raising the money supply by that percentage each year. For price and inflation stability the money supply would have to remain constant from year to year. If money supply increased by 5% inflation would increase by 5% EXERCISES WITH THE INFLATION MODEL: EXERCISES WITH THE INFLATION MODEL In a growing economy, the rate of inflation will be less than the rate of money growth. If potential output is growing over time, some money growth is needed just to keep price level from falling from one year to the next. EXERCISES WITH THE INFLATION MODEL: EXERCISES WITH THE INFLATION MODEL An Export Boom An export boom is a demand shock. It would increase the aggregate expenditure in the economy. This would shift out the IS curve as well as the inflation curve. If the export boom was a one off occurrence the economy would eventually get back to equilibrium with an output equal to potential and inflation at a higher level. EXERCISES WITH THE INFLATION MODEL: EXERCISES WITH THE INFLATION MODEL Inflation and Export Boom Output Gap = (Y – Y*) / Y* PA0 PA1 п ADI1 ADI0 0 2 4 1. Boom caused by shift in inflation line 2. PA line shifts up EXERCISES WITH THE INFLATION MODEL: EXERCISES WITH THE INFLATION MODEL An Oil Price Shock An adverse supply shock such as an increase in oil prices would increase inflation, lower real GDP and increase unemployment. If it is a one time shock as inflation subsides aggregate demand would recover and the economy would gradually return to potential GDP and to the original inflation level. The only impact of the oil price shock in the long run would be a higher price level with no effect on real GDP or the inflation rate EXERCISES WITH THE INFLATION MODEL: EXERCISES WITH THE INFLATION MODEL Inflation and Oil Price Shock Output Gap = (Y – Y*) / Y* п PA0 ADI 0 2 4 Price shock causes PA line to shift up, then gradually shift done DISINFLATING AN ECONOMY: DISINFLATING AN ECONOMY Disinflation refers to the slowing of the rate of inflation, prices are still rising but at a slower rate. Developing a disinflation policy requires close attention to the role of expectations in the Phillips curve. Why is it so hard to reduce inflation? The main sources of inflation is due to an increase in consumption and investment spending, an expansionary fiscal policy and an adverse supply shock. Since inflation is viewed as a monetary phenomenon the logical way to stop inflation is to reduce the rate of money growth. DISINFLATING AN ECONOMY: DISINFLATING AN ECONOMY The reduction in money growth acts to disinflate the economy but this might lead to recession and an increase in unemployment if actual inflation falls below expected inflation. It is this difficulty to reduce people’s inflationary expectations that makes it difficult to reduce inflation. It is also hard to reduce money growth when government prints money to finance its budget deficit. DISINFLATING AN ECONOMY: DISINFLATING AN ECONOMY Alternative Disinflating Paths The most challenging problem of disinflating occurs in the case where the expected rate of inflation equal’s last period’s inflation rate. The only way that inflation can be reduced is by allowing output to drop below potential. So when disinflating policy makers more concerned with how long and how deep the recession should be. DISINFLATING AN ECONOMY: DISINFLATING AN ECONOMY We will examine three alternative paths for the deviation of GDP from potential GDP and corresponding paths for the inflation rate. 1. Neutral Policy –under a neutral policy the aim is to maintain nominal GDP growth so allowing a decline in the output ratio equal to the increase in the inflation level. DISINFLATING AN ECONOMY: DISINFLATING AN ECONOMY 2. Accommodating Policy – an accommodating policy aims to maintain the original output ratio. In order to do this an increase in inflation results in an increase in nominal GDP. This policy holds GDP at its potential level and so avoids a recession but inflation remains permanently high. DISINFLATING AN ECONOMY: DISINFLATING AN ECONOMY 3. Extinguishing Policy – an extinguishing policy aims to reduce nominal inflation GDP growth so as to maintain the original inflation rate. In this case the government wishes to remove the extra inflation so depresses real GDP below potential DISINFLATING AN ECONOMY: DISINFLATING AN ECONOMY Implications for Unemployment Okun’s law – shows the relation between GDP gap and the rate of unemployment. For each % change of GDP gap, there is a 1/3% point extra unemployment. Path 1 and 3 would result in an increase in unemployment rate. Path 2 unemployment remains at natural level. The more unemployment chosen the faster disinflation will occur. DISINFLATING AN ECONOMY: DISINFLATING AN ECONOMY The Importance of Credibility The question has often been asked about why inflation is tempting to the government? The government gains revenue from printing money and hence inflation. This revenue is called seinorage. The printing of money to finance government expenditure is also viewed as imposing an inflation tax on consumers. The holders of money pay the inflation tax due to a fall in the purchasing power of their money. DISINFLATING AN ECONOMY: DISINFLATING AN ECONOMY Now if the government announces a disinflation policy their credibility comes into question. Credibility refers to the extent to which households and firms believe that an announced monetary or fiscal policy will actually be implemented and maintained. In order for the disinflation policy to be effective the public has to believe that the government will reduce budget deficit and contain monetary growth. If there is a lack of credibility people will expect inflation to remain at its high level so the government disinflation policy would fail to achieve its goal. SUMMARY: SUMMARY Low inflation that proceeds at a moderate and fairly predictable rates year after year carries far lower social costs than high or variable inflation. But even low steady inflation entails a cost.