Inflation

1
Chapter 13

• Part 1
• Inflation
• Equation of exchange

2
Laugher Curve

• Economics is the only field in which two people
  can share a Nobel Prize for saying opposing
  things.
• Specifically, Gunnar Myrdahl and Friedrich S.
  Hayek shared one.

3
Some Basics about Inflation

• Inflation is a continuous rise in the price
  level.
• It is measured using a price index.

4
The Distributional Effects of Inflation

• There are individual winners and losers in an
  inflation.
• On average, winners and losers balance out.

5
The Distributional Effects of Inflation

• The winners are those who can raise their prices
  or wages and still keep their jobs or sell their
  goods.

• The losers in an inflation are those who cannot
  raise their wages or prices.

6
The Distributional Effects of Inflation

• Unexpected inflation redistributes income from
  lenders to borrowers.

• People who do not expect inflation and who are
  tied to fixed nominal contracts are likely lose
  in an inflation.

7
Expectations of Inflation

• Expectations play a key role in the inflationary
  process.
• Rational expectations are the expectations that
  the economists' model predicts.
• Adaptive expectations are those based, in some
  way, on what has been in the past.
• Extrapolative expectations are those that assume
  a trend will continue.

8
Productivity, Inflation, and Wages

• Changes in productivity and changes in wages
  determine whether inflation may be coming.
• There will be no inflationary pressures if wages
  and productivity increase at the same rate.

9
Productivity, Inflation, and Wages

• The basic rule of thumb

Inflation Nominal wage increases Productivity
growth
10
Deflation

• Deflation is the opposite of inflation and is
  associated with a number of problems in the
  economy.
• Deflation a sustained fall in the price level.

11
Deflation

• Deflation places a limit on how low the Fed can
  push the real interest rate.
• Deflation is often associated with large falls in
  stock and real estate prices.

12
Theories of Inflation

• The two theories of inflation are the quantity
  theory and the institutional theory.
• The quantity theory emphasizes the connection
  between money and inflation.
• The institutional theory emphasizes market
  structure and price-setting institutions and
  inflation.

13
The Quantity Theory of Money and Inflation

• The quantity theory of money is summarized by the
  sentence
• Inflation is always and everywhere a monetary
  phenomenon.

14
The Equation of Exchange

• Equation of exchange the quantity of money
  times velocity of money equals price level times
  the quantity of real goods sold.

MV PQ

• M Quantity of money
• V velocity of money
• P price level

• Q real output
• PQ the economys nominal output

15
The Equation of Exchange

• Velocity of money the number of times per year,
  on average, a dollar goes around to generate a
  dollars worth of income.

16
Velocity Is Constant

• The first assumption of the quantity theory is
  that velocity is constant.
• Its rate is determined by the economys
  institutional structure.

17
Velocity Is Constant

• If velocity remains constant, the quantity theory
  can be used to predict how much nominal GDP will
  grow.

• Nominal GDP will grow by the same percent as the
  money supply grows.

18
Real Output Is Independent of the Money Supply

• The second assumption of the quantity theory is
  that real output (Q) is independent of the money
  supply.
• Q is autonomous real output is determined by
  forces outside those in the quantity theory.

19
Real Output Is Independent of the Money Supply

• The quantity theory of money says that the price
  level varies in response to changes in the
  quantity of money.

• With both V and Q unaffected by changes in M, the
  only thing that can change is P.
• ?M ? ?P

20
Examples of Money's Role in Inflation

• The quantity theory lost favor in the late 1980s
  and early 1990s.
• The formerly stable relationships between
  measurements of money and inflation appeared to
  break down.

21
Examples of Money's Role in Inflation

• The relationship between money and inflation
  broke down because

• Technological changes and changing regulations in
  financial institutions.
• Increasing global interdependence of financial
  markets.

22
U.S. Price Level and Money Relative to Real Income
Price level
Money
23
Inflation and Money Growth

• The empirical evidence that supports the quantity
  theory of money is most convincing in Brazil and
  Chile.

24
Inflation and Money Growth
Argentina
Poland
Annual percent change in inflation ()
Nicaragua
Chile
Zaire
Indonesia
U.S.
10
20
Annual percent change in the money supply ()
25
The Inflation Tax

• Central banks in nations such as Argentina and
  Chile are not a politically independent as in
  developed countries.
• Their central banks sometimes increase the money
  supply to keep the economy running.

26
The Inflation Tax

• The increase in money supply is caused by the
  government deficit.

• The central bank must buy the government bonds or
  the government will default.

27
The Inflation Tax

• Financing the deficit by expansionary monetary
  policy causes inflation.

28
The Inflation Tax

• The inflation works as a kind of tax on
  individuals, and is often called an inflation tax.

• It is an implicit tax on the holders of cash and
  the holders of any obligations specified in
  nominal terms.

29
The Inflation Tax

• Central banks have to make a monetary policy
  choice

• Ignite inflation by bailing out their governments
  with an expansionary monetary policy.
• Do nothing and risk recession or even a breakdown
  of the entire economy.

30
Policy Implications of the Quantity Theory

• Supporters of the quantity theory oppose an
  activist monetary policy.
• Monetary policy is powerful, but unpredictable in
  the short run.
• Because of its unpredictability, monetary policy
  should not be used to control the level of output
  in an economy.

31
Policy Implications of the Quantity Theory

• Quantity theorists favor a monetary policy set by
  rules not by discretionary monetary policy.

• A monetary rule takes money supply decisions out
  of the hands of politicians.

32
Policy Implications of the Quantity Theory

• Many central banks use monetary regimes or
  feedback rules.

• New Zealand has a legally mandated monetary rule
  based on inflation.
• The Fed does not have strict rules governing
  money supply, but it works hard to establish
  credibility that it is serious about fighting
  inflation.