ParkinBade Chapter 28

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CHAPTER
Inflation Ratna K. Shrestha
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From Rome to Rio de Janeiro

• Inflation is a very old problem and some
  countries even in recent times have experienced
  rates as high as 40 a month.
• Today, the BOC targets to keep the inflation rate
  low between 1 and 3. But during the 1970s, the
  price level in Canada doubled.
• Why does inflation occur?
• In targeting inflation, does the BOC face a trade
  off between inflation and unemployment? And how
  does inflation affect the interest rate?

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• Inflation rate in Zimbabwe topped 2.2 million
  percent in 2008.

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Inflation Demand-Pull and Cost-Push

• Inflation is a process in which the average price
  level rises and money loses its value.
• The inflation rate is the percentage change in
  the price level. The inflation rate is
• (P1 P0)/P0 ? 100

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Inflation Demand-Pull and Cost-Push

• Inflation can result from either an increase in
  AD or a decrease in AS and so can be
• Demand-pull inflation
• Cost-push inflation
• Demand-pull inflation results from an initial
  increase in AD. Demand-pull inflation may begin
  with any factor that increases (shift) AD such as
  increases in the quantity of money, increases in
  government purchases and an increase in exports.

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Inflation Demand-Pull and Cost-Push

• Initial Effect of an Increase in AD
• Starting from full employment, when AD shifts
  rightward, the price level rises, real GDP
  increases, and an inflationary gap arises.
• The rising price level is the first step in the
  demand-pull inflation.

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Inflation Demand-Pull and Cost-Push

• Money Wage Rate Response
• The inflationary gap will lead to an increase in
  money wage rates and the SAS curve shifts
  leftward.

Real GDP decreases back to potential GDP but the
price level rises further.
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Inflation Demand-Pull and Cost-Push

• A Demand-Pull Inflation Process
• Figure 27.3 illustrates a demand-pull inflation
  spiral.

As AD keeps increasing, the process just
described repeats indefinitely.
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Inflation Demand-Pull and Cost-Push

• Although any of several factors can increase AD
  to start a demand-pull inflation, only an ongoing
  increase in the quantity of money can sustain it.
• Demand-pull inflation occurred in Canada during
  the late 1960s and early 1970s.

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Inflation Demand-Pull and Cost-Push

• Cost-Push Inflation
• Cost-push inflation results from an initial
  increase in costs of production.
• There are two main sources of increased costs
• 1. An increase in the money wage rate
• 2. An increase in the money price of raw
  materials, such as oil.

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Inflation Demand-Pull and Cost-Push

• Initial Effect of a Decrease in AS
• A rise in the price of oil shifts the SAS curve
  leftward.
• Real GDP decreases and the price level risesa
  combination called stagflation.

The rising price level is the start of the
cost-push inflation.
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Inflation Demand-Pull and Cost-Push

• AD Response
• The initial increase in costs creates a one-time
  rise in price level, not inflation.
• To create inflation, AD must increase, which
  might arise because the BOC stimulates demand to
  counter the higher unemployment rate and lower
  level of real GDP.

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Inflation Demand-Pull and Cost-Push

• A Cost-Push Inflation Process
• If the oil producers raise the price of oil, and
  the BOC responds with an increase in AD, a
  process of cost-push inflation continues.
• Cost-push inflation occurred in Canada during
  19741978.

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The Quantity Theory of Money

• The quantity theory of money is the proposition
  that, in the long run, an increase in the
  quantity of money brings an equal percentage
  increase in the price level.
• The quantity theory of money is based on the
  velocity of circulation and the equation of
  exchange.
• The velocity of circulation is the average number
  of times in a year a dollar is used to purchase
  goods and services.

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The Quantity Theory of Money

• Calling the velocity of circulation V, the price
  level P, real GDP Y, and the quantity of money M
• V PY/ M
• The equation of exchange states that
• MV PY
• The equation of exchange becomes the quantity
  theory of money by making two assumptions
• Velocity of circulation V is not influenced by M
• Potential GDP, Y, is not influenced by M

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The Quantity Theory of Money

• Given the assumption that V/Y does not change,
  the change in P, ?P, is related to the change in
  M, ?M, by the equation
• ?P (V/Y)?M
• Divide this equation by
• P (V/Y)M
• ?P/P ?M/M
• ?P/P is the inflation rate and ?M/M is the growth
  rate of the quantity of money.

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The Quantity Theory of Money

• Evidence on the Quantity Theory
• Canadian historical evidence is consistent with
  the quantity theory.
• On the average, the money growth rate exceeds the
  inflation rate. One explanation behind this is
  the increase in potential GDP. Inflation occurs
  when money grows faster than real GDP.
• The money growth rate is correlated with the
  inflation rate.

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The Quantity Theory of Money
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The Quantity Theory of Money

• International evidence shows a marked tendency
  for high money growth rates to be associated with
  high inflation rates.
• Figure 27.8(a) shows the evidence for 134
  countries from 1990 to 2004.

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The Quantity Theory of Money
Figure 27.8(b) shows the evidence for 104
countries from 1990 to 2004.
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The Quantity Theory of Money

• Correlation, Causation, and Other Influences
• A combination of historical, international, and
  other independent evidence suggest that in the
  long run, money growth causes inflation.
• In the short run, the quantity theory is not
  correct we need the AS-AD model to understand
  the links between money and inflation.

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Effects of Inflation

• Failure to anticipate inflation correctly results
  in unintended consequences that impose costs in
  both the labour market and the capital market.
• Unanticipated Inflation in the Labour Market
• Unanticipated inflation has two main consequences
  in the labour market
• Redistribution of income
• Departure from full employment

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Effects of Inflation

• Redistribution of Income
• Higher than anticipated inflation lowers the real
  wage rate and employers gain at the expense of
  workers. The reverse is true when Inflation is
  lower than anticipated.
• Departure from Full Employment
• Higher than anticipated inflation lowers the real
  wage rate, increases the quantity of labour
  demanded, makes jobs easier to find, and lowers
  the unemployment rate.
• Just the reverse happens in the case of lower
  than anticipated inflation.

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Effects of Inflation

• Unanticipated Inflation in the Market for
  Financial Capital
• Unanticipated inflation has two main consequences
  in the market for financial capital
• Redistribution of income
• Too much or too little lending and borrowing
• Redistribution of Income
• If the inflation rate is unexpectedly high,
  borrowers gain but lenders lose. On the other
  hand, if the inflation rate is unexpectedly low,
  lenders gain but borrowers lose.

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Effects of Inflation

• Too Much or Too Little Lending and Borrowing
• When the inflation rate is higher than
  anticipated, the real interest rate is lower than
  anticipated, and borrowers want to have borrowed
  more and lenders want to have loaned less.
• When the inflation rate is lower than
  anticipated, we have just the reverse result.

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Effects of Inflation

• Forecasting Inflation
• To minimize the costs of incorrectly anticipating
  inflation, people form rational expectations
  about the inflation rate.
• A rational expectation is one based on all
  relevant information and is the most accurate
  forecast possible, although that does not mean it
  is always right to the contrary, it will often
  be wrong.

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Effects of Inflation

• Anticipated Inflation
• Figure 27.9 illustrates an anticipated inflation.
• If the shift in AD is as anticipated, then money
  wage rate and hence SAS curve shift to the right
  as anticipated. As a result we have increase in
  price level as anticipated.

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Effects of Inflation

• Unanticipated Inflation
• If AD increases by more than expected, inflation
  is higher than expected.
• Money wages do not adjust enough, and the SAS
  curve does not shift leftward enough to keep the
  economy at full employment. Real GDP exceeds
  potential GDP.
• Wages eventually rise, which leads to a decrease
  in the short-run AS.
• The economy experiences more inflation as it
  returns to full employment. This inflation is
  like a demand-pull inflation.

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Effects of Inflation

• If AD increases by less than expected, inflation
  is less than expected.
• Money wages rise too much and the SAS curve
  shifts leftward more than the AD curve shifts
  rightward.
• As a result Real GDP is less than potential GDP.
• This inflation is like a cost-push inflation.
• Note the shift in AS is in line with anticipated
  shift in AD.

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Effects of Inflation

• The Costs of Anticipated Inflation
• Anticipated inflation occurs at full employment
  with real GDP equal to potential GDP.
• But anticipated inflation, particularly high
  anticipated inflation, inflicts three costs
• Transactions costs
• Tax effects
• Increased uncertainty

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Effects of Inflation

• Transaction Costs
• With spiraling inflation, people spend their
  income as soon as they receive their pay cheques.
  Firms also pay out incomeswages and dividendsas
  soon as they receive revenue from their sales.
• During 1990s, when inflation in Brazil was around
  80 a year, people spent their money as soon as
  they received it.
• People also would convert their earnings right
  away (before it losses the value) to the US
  dollar in the underground market.

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Effects of Inflation

• Tax Effects
• Inflation increases the nominal interest rate,
  and because income taxes are paid on nominal
  interest income, the true income tax rate rises
  with inflation.
• The inflation tax revenue in Canada is about 3
  of total tax revenue. During the American
  Revolution, inflation tax was the major source of
  revenue to fund wars.
• In 1998 Russian government also found this
  temptation of funding deficit by printing more
  money irresistible and as a result inflation rate
  rose to 100 a year.

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Inflation Tax An Example

• Suppose real interest rate 4. With no
  inflation, nominal interest rate 4. If income
  tax rate 50, then after tax real interest rate
  earned 2.
• Now suppose inflation rate 4. Then nominal
  interest rate 8. At 50 tax rate, the nominal
  interest rate earned 4.
• Thus,
• Real interest rate earned nominal rate
  inflation
• 4 - 4 0.
• The after tax real interest rate earned 0,
  that means the effective income tax rate 100.

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Effects of Inflation

• Uncertainty Costs
• A high inflation rate brings increased
  uncertainty about the long-term inflation rate.
• Increased uncertainty also misallocates
  resources. Instead of concentrating on the
  activities at which they have a comparative
  advantage, people find it more profitable to
  search for ways of avoiding the losses that
  inflation inflicts.

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Interest Rates and Inflation

• Interest rates and inflation rates are
  correlated, although they differ around the
  world.
• Figure 27.15(a) shows a positive correlation
  between the inflation rate and the nominal
  interest rate over time in Canada.

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Interest Rates and Inflation

• Figure 27.15(b) shows a positive correlation
  between the inflation rate and the nominal
  interest rate across countries.

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Interest Rates and Inflation

• How Interest Rates are Determined
• The real interest rate is determined by
  investment demand and saving supply in the global
  capital market.
• The real interest rate adjusts to make the
  quantity of investment equal the quantity of
  saving.
• National real rates vary because of differences
  in risk.
• The nominal interest rate is determined by the
  demand for money and the supply of money in each
  nations money market.

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Interest Rates and Inflation

• Why Inflation Influences the Nominal Interest
  Rate
• On the average, and other things remaining the
  same, a 1 rise in the inflation rate leads to a
  1 rise in the nominal interest rate. Why?
• The answer is that the financial capital market
  and the money market are closely interconnected.
• The investment, saving, and demand for money
  decisions that people make are connected and the
  result is that equilibrium nominal interest rate
  approximately equals the real interest rate plus
  the expected inflation rate.
• That is, inflation influences the nominal
  interest rate to maintain an equilibrium real
  interest rate.

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Ways to Control Inflation