Chapter 28 Inflation

1
Chapter 28Inflation

• David Begg, Stanley Fischer and Rudiger
  Dornbusch, Economics,
• 6th Edition, McGraw-Hill, 2000
• Power Point presentation by Peter Smith

2
Inflation is ...

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

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?

4
Inflation in the UK, 1950-99
Source Economic Trends Annual Supplement, Labour
Market Trends
5
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.

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.

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.

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

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

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

11
The Phillips curve
It suggests we can trade-off more inflation
for less unemployment or vice versa.
12
The Phillips curve and an increase in aggregate
demand
Inflation
but what happens next?
PC0
Unemployment
13
The Phillips curve and an increase in aggregate
demand
If nominal money supply is fixed in the long
run, and prices and wages eventually adjust,
the economy moves back to E.
Inflation
But nominal money supply need not be constant in
the long run
A
?1
E
U1
PC0
U
Unemployment
14
The vertical Phillips curve
Inflation
The short-run Phillips curve shows just a
short-run trade-off
A
C
?1
E
U1
PC0
U
Unemployment
15
Expectations and credibility
LRPC
Inflation
?1
PC1
PC2
U
Unemployment
16
Inflation and unemploymentin the UK 1978-99
1980
1990
1978
1986
1993
1999
17
Inflation illusion

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

18
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
• people economize on money holdings
• menu costs
• firms need to alter price lists etc.

19
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

20
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

21
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

22
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 Englands Monetary Policy Committee
• which has the responsibility of meeting the
  inflation target
• via interest rates
• which are set according to inflation forecasts.