Inflation

1
CHAPTER 16 Inflation
2
In this Chapter we will . . .

• Distinguish between inflation and a one-time rise
  in the price level.
• Explain two ways in which inflation can be
  generated.
• Look at the effects of inflation.
• Ask -- Is there a relationship between inflation
  and unemployment? -- and note the link between
  inflation and interest rates.

3

• Inflation is defined as a continuous increase in
  the price level (two or more periods).

• The inflation rate is calculated as

• A one-time jump in the price level is not
  inflation.

4
An Example
Price Level
Inflation Rate
1994
120
1995
120
0
1996
126
5
1997
126
0
5
5
Remember the difference between the
inflation rate and inflation.

• In 1996 the inflation rate was 5.
• In 1997 the inflation rate was 0.
• Thus there was a one time price increase
  there was no inflation.

Price Level
Inflation Rate
1994
120
1995
120
0
1996
126
5
1997
126
0
6
Inflation Versus a One-TimeRise in the Price
Level
160
150
140
Price level (1992 100)
130
120
110
100
90
1992
1993
1994
1995
1996
1997
7
Causes of Inflation

• Demand-pull inflation is inflation that is
  started by an initial increase in aggregate
  demand.

• If an event leads to an increase in aggregate
  demand when the economy is in long-run
  equilibrium, both GDP and the price level will
  increase.

8
A Demand-Pull Exercise

• We begin in long run equilibrium . . .

Pricelevel
LAS
130
SAS0
121
113
110

• As wage costs begin to rise ...

100
AD0
RealGDP
6.0
7.0
7.5
8.5
6.5
8.0
9
A Demand-Pull Exercise

• Eventually, with the upward wage pressure
  upon the system . . .

Pricelevel
LAS
130
SAS0
121
113
113
110
110
AD1
100
AD0
RealGDP
7.0
6.0
8.5
6.5
8.0
7.5
10

• What was the change in prices from the initial
  long-run equilibrium (LR) to the final LR
  equilibrium?

110
121
10

• Once in LR equilibrium, the price increases will
  stop.
• For inflation, aggregate demand must increase
  repeatedly or continuously. Here we had only a
  one time increase in prices.

11
A Demand-Pull Inflation Spiral Exercise

• We begin in long run equilibrium . . .

Pricelevel
LAS
133
125
121
SAS0
113
110
100
AD0

• Repeated increases in AD create a
  price-wage spiral.

RealGDP
6.0
7.0
7.5
8.5
6.5
8.0
12

• What was the change in prices from the initial
  long-run equilibrium (LR) to the final LR
  equilibrium?

Price Level
Inflation Rate
1st LR
110
121
10
2nd LR
3rd LR
131
10

• For inflation to continue, aggregate demand must
  increase repeatedly or continuously.
• Here we had continuing increases in prices, thus
  we had inflation.

13

• Milton Friedman says the only way for aggregate
  demand to repeatedly increase is by repeated
  increases in the money supply. He is a
  monetarist, he says that inflation is solely a
  monetary phenomenon.

• Example of Demand-Pull Inflation in the US -
  late 1960s.

14
Causes of Inflation

• Cost-push inflation is inflation that begins with
  shifts in the aggregate supply curve.

• Suppose the costs of production increase. The
  aggregate supply curve will shift to the left.

15
A Cost-Push Exercise

• We begin in long run equilibrium . . .

Pricelevel
LAS
130
SAS0
121
117
110
110
110
100
AD0
RealGDP
6.0
7.0
7.5
8.5
6.5
8.0
16

• Initial Effect of a decrease in aggregate supply

• stagflation- note this one time event is
  not inflation.
• Other things must occur for this to be converted
  into ongoing inflation.

17
A Cost-Push Exercise What happens next (1)

• If the government does not respond, wage
  costs will fall because of slackness in
  the labor market.

Pricelevel
LAS
130
SAS1
SAS0
121
117
110
110
100
AD0
RealGDP
6.5
7.0
6.0
7.5
8.5
8.0
18
What happens next?

• The drop in wages and prices that moves AS back
  down so that the economy returns to full
  employment may take a long time, during which we
  lose output a cost and we have excess
  unemployment, because output is less than
  potential GDP
• If government is not willing to wait, because it
  believes voters are unhappy about waiting, it may
  act to increase AD .

19
A Cost-Push Exercise What happens next (2)

• The government may respond to the rising
  unemployment in the labor market by . . .

Pricelevel
LAS
130
SAS1
SAS0
121
117
110
100

• At the new long run equilibrium, the output
  level is back to7.0 and a new higher price
  level 121

AD0
RealGDP
6.5
7.0
6.0
7.5
8.5
8.0
20

• For inflation to occur from a cost-push event,
  repeated supply shocks must occur, and be
  accommodated by expansionary demand policy.

• If the system is left alone to self-correct, no
  inflation will occur, only wage adjustment and a
  maybe short period of higher than
  full-employment unemployment.

21
Anticipated inflation

• Suppose you expect the money supply to increase.
  If as a result you expect the price level to
  increase, you will ask for a nominal wage
  increase to offset the price increase.
• What will happen?

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Anticipated Inflation

• If you anticipate the govt.'s increase in
  MS, you anticipate the resultant increase
  in AD to be followed by a period of rising
  prices and thus lower relative wages.

Pricelevel
LAS
130

• Before the anticipated action actually occurs,
  you ask for a nominal wage increase to
  offset the expected increase of prices. The
  increase in wage levels that accompanies
  the anticipated increase in the MS will
  shift the SAS curve up.

121
SAS0
117
117
110
100
AD0

• These shifts occur simultaneously.

RealGDP
6.5
7.0
6.0
7.5
8.5
8.0
6.5
7.0
23
Anticipated Inflation

• The new equilibrium will be at the long
  run level, where the LAS crosses SAS1
  and AD1 . . .

Pricelevel
LAS
130
SAS1
121
SAS0
117
117

• Also note, as output does not increase
  beyond full- employment, there is no change
  in the level of unemployment, just
  inflation.

110
AD1
100
AD0
RealGDP
6.5
7.0
6.0
7.5
8.5
8.0
6.5
7.0
24
The Costs of Anticipated Inflation

• Transactions costs -

• people spend time and resources in the attempt to
  avoid increasing losses from the decline in the
  value of money.
• boot leather costs are estimated to be as much
  as 2 percent of GDP for a 10 bout of inflation.

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The Costs of Anticipated Inflation
4
8
4
4
50
50
2
4
2
0

• With a low after-tax real interest rate, the
  incentive to save may be weakened and saving may
  fall. However, because inflation may make people
  uncertain about the future, they may save more.

26
The Costs of Anticipated Inflation

• Increased Uncertainty-

• This increased uncertainty makes long-term
  planning difficult and may give people a
  shorter-term focus. Investment may fall, and the
  growth rate slow.

27
Unanticipated inflation

• Unanticipated inflation occurs when you under- or
  over- forecast the inflation -- i.e. you estimate
  the future wrong.
• What will happen?

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Unanticipated Inflation

• If you anticipate the govt.'s increase in
  MS, you anticipate the resultant increase
  in AD.

Pricelevel
LAS
130

• Before the anticipated action actually occurs,
  you ask for a nominal wage increase to
  offset the expected increase of prices. The
  increase in wage levels shift the SAS curve
  up.

123
SAS0
119
110

• If you underestimate the amount of the
  change, SAS will not shift far enough.

100
AD0
RealGDP
6.5
7.0
6.0
8.5
8.0
6.5
7.0
7.3
29
Unanticipated Inflation

• The new short-run equilibrium will be
  where SAS1 crosses AD1 . . .

Pricelevel
LAS
130
SAS1
123

• In the long run, inflation will be
  recognized and wages will be renegotiated
  upward, shifting SAS the rest of the way up
  to where the market is in long- run
  equilibrium and output is at the full-
  employment level.

SAS0
119
110
110
AD1
100
AD0
RealGDP
6.5
7.0
6.0
7.3
8.5
8.0
6.5
7.0
7.0
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The Costs of Unanticipated Inflation
(1) The redistribution of income to
employers from workers
10.00
10.00
Nominal wages
100
Expected price level
10.00
Expected real wage
110
Actual price
Actual real wage
9.09

• Here we see that workers earn a real wage less
  than they expected.

31
The Costs of Unanticipated Inflation
(2) The redistribution of income from borrowers
to lenders as lenders get to repay with
cheaper dollars.
No Inflation
5 Inflation
100
100
Loan
5
5
Nominal interest rate
Nominal payment after a year
105
105
Real value of paymentafter a year
100
105

• Unanticipated inflation means lenders are paid
  105. However, the 105 dollars will purchase
  only 100 worth of goods.

32
Costs of Unanticipated Inflation

• Losers are net nominal creditors and those who
  have incomes fixed in money terms
• Gainers are net monetary debtors, and those who
  own or are owed real assets.
• If inflation is less than expected, the reverse
  is true -- monetary debtors lose, creditors gain.

33
The Phillips Curve

• Phillips in the mid-1950s noted a relationship
  between the rate of change of money wages and the
  unemployment rate.
• Now, the Phillips Curve is the name for a graph
  which shows the relationship between inflation
  and unemployment.

34
A Short-Run Phillips Curve
20
15
Inflation rate (percent per year)
a
10
SRPC
5
3
6
9
12
0
Unemployment rate (percentage of labor force)
35
AS-AD and the Short-Run Phillips Curve
LAS
113
SAS0
Price level (GDP deflator, 1992 100)
110
107
100
AD0
6.0
7.0
7.5
8.5
6.5
8.0
Real GDP (trillions of 1992 dollars)
36
PriceLevel
Phillips CurveDerivation
LAS0
SAS0

• If last periods price index was 100, and the
  natural rate of unemployment is 6, then at
  the initial equilibrium (as shown) . . .

the inflation rate
is 10 and the unemployment rate is 6.
AD0
Inflationrate
GDP

• Let aggregate demand increase to AD1.

• The new equilibrium here represents another
  point on the unemployment / inflation
  graph, where an inflation rate of 13
  associates with an unemployment rate of 5

Unemploymentrate
37

• For a few years, policy makers thought the
  short-run Phillips curve was an unchanging
  relationship that policymakers could use -- they
  could trade off lower unemployment for higher
  inflation.

• What happened was that workers learnt to expect
  higher prices, which resulted in higher wages
  costs, shifting the curve up.
• Higher wage costs correspond to the short run
  aggregate supply curve SAS1.

38
PriceLevel
Phillips CurveDerivation
LAS0
SAS0

• So instead of the economy actually moving
  beyond full- employment, workers expect the
  coming inflation, and demand higher nominal
  wages before hand . . .

113
110
AD1
the
SAS0 curve shifts up to SAS1, moving the
economy back to the long-run equlibrm, at
full-employment.
AD0
7.5
7.0
Inflationrate
GDP
13

• The new equilibrium here represents another
  point on the unemployment / inflation
  graph, where an inflation rate of 16 is
  associated with the natural rate of
  unemployment, 6.

10
SPC0
Unemploymentrate
6
5
39
PriceLevel
Phillips CurveDerivation
LAS0
SAS1
SAS0
116

• The new point on the unemployment/inflation
  graph is not on the SPC0 curve.

113
110
AD1
AD0
7.5
7.0
Inflationrate
GDP

• Thus, a move in the short-run aggregate
  supply curve causes the Phillips curve to
  shift.

16
13
10
SPC0
Unemploymentrate
6
5
40
Inflation and UnemploymentThe Phillips Curve

• The Long-Run Phillips Curve
• The long-run Phillips curve is a curve that
  shows the relationship between inflation and
  unemployment when the actual inflation rate
  equals the expected inflation rate.

41

• So the Long Run Phillips Curve is a curve that
  shows the relationship between inflation
  and unemployment when the AD/AS relationship
  is in long-run equilibrium.

42
Inflation and UnemploymentThe Phillips Curve

• The Long-Run Phillips Curve
• It shows that any anticipated inflation rate is
  possible at the natural unemployment rate.
• Therefore, when inflation is anticipated, real
  GDP equals potential GDP.
• In other words, the Long-Run Phillips Curve is
  just like the LAS, Long-Run Aggregate Supply,
  except now we have inflation rather than price
  level on the vertical axis.

43
PriceLevel
Long-RunPhillips CurveDerivation
LAS0

• In the long run, either a supply shock or a
  demand fluctuation will result in an
  equilibrium in long-run equilibrium, on LAS.

7.0
Inflationrate
GDP

• The long-run Phillips curve is vertical
  which tells us that any anticipated inflation
  rate is possible at the natural rate of
  unemployment.

Unemploymentrate
6
44
Short-Run and Long Run Phillips Curves
LRPC
20
Decreases in expected inflation shifts
short-run Phillips curve downward
15
Inflation rate (percent per year)
a
10
c
7
SRPC0
5
3
6
9
12
0
Unemployment rate (percentage of labor force)
45
Inflation and UnemploymentThe Phillips Curve

• Changes in the Natural Unemployment Rate
• As studied earlier, the natural unemployment rate
  -- full employment, and therefore potential GDP,
  the LAS -- may change for several reasons --
  changing population structure, structural change
  in the economy, etc.
• This shifts both the short-run and long-run
  Phillips curves.

46
A Change in theNatural Unemployment Rate
LRPC0
20
Increase in natural unemployment rate shifts
LRPC and SRPC rightward
15
Inflation rate (percent per year)
a
10
SRPC0
5
3
6
9
12
0
Unemployment rate (percentage of labor force)
47
Phillips Curves in the United States
48
Phillips Curves in the United States
49
Interest Rates and Inflation

• When inflation is fully anticipated, the nominal
  interest rate increases by an amount equal to the
  expected inflation rate.
• The real interest rate should remain constant, if
  ceteris paribus.
• Nominal real inflation rate

50
Interest Rates and Inflation

• Inflation and Interest Rates in the United
  States
• A positive relationship has existed between
  inflation rates and interest rates.
• However, the real interest rate has not been
  constant because ceteris has not been paribus --
  other things changed too.

51
Inflation and the Interest Rate