Chapter 28Inflation

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

6th Edition, McGraw-Hill, 2000

Power Point presentation by Peter Smith

28.2

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.

28.3

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?

28.4

Inflation in the UK, 1950-99

0

5

10

15

20

25

30

% p

.a.

Source: Economic Trends Annual Supplement, Labour Market Trends

28.5

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.

28.6

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.

28.7

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.

28.8

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

28.9

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

28.10

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

28.11

The Phillips curve

It suggests we can trade-off more inflation forless unemployment orvice versa.

Prof. A W Phillips demonstrated a statistical relationshipbetween annual inflation and unemployment in the UK

Unemployment rate (%)

Infla

tion

rate

(%

)

The Phillips curve showsthat a higher inflation rateis accompanied by a lower unemployment rate.

Phillips curve

28.12

The Phillips curve and an increase in aggregate demand

Unemployment

Infla

tion

PC0U*

Suppose the economy begins at E, with zeroinflation, unemploymentat the natural rate U*...

U1

1

An increase in governmentspending funded by an expansion in money supplytakes the economy to A,with lower unemploymentbut inflation at 1.

A

… but what happens next?

28.13

The Phillips curve and an increase in aggregate demand

Unemployment

Infla

tion

PC0U*U1

1

A

If nominal money supply is fixed in the long run,and prices and wageseventually adjust, theeconomy moves back to E.

E

But nominal money supplyneed not be constant in thelong run

so we may find the economy finds its way back to the natural rate, but with continuing inflation at C.

C

28.14

The vertical Phillips curve

Unemployment

Infla

tion

PC0U*U1

1

A

E

C

Effectively, the long-run Phillips curve is vertical, as the economy always adjusts back to U*.

LRPC

The short-run Phillips curveshows just a short-run trade-off –

its position may dependupon expectations aboutinflation.

PC1

28.15

Expectations and credibility

Unemployment

Infla

tion

PC2

PC1

1

U*

Unemployment rises to U1

U1

Suppose the economy beginsat E, with a newly-elected government pledged toreduce inflation.

E

LRPC

Monetary growth is cut to 2.

2

In the short run, the economymoves to A along the short-run Phillips curve.A

As expectations adjust, the short-run Phillips curveshifts to PC2, and U*is restored at F.

F

28.16

Inflation and unemploymentin the UK 1978-99

02468

101214161820

4 6 8 10 12

Unemployment

Infl

atio

n

1978

1980

1986

1990

1999 1993

28.17

Inflation illusion

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

People’s 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.

28.18

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.

28.19

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

28.20

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

28.21

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

28.22

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 England’s Monetary Policy

Committee– which has the responsibility of meeting the inflation

target

– via interest rates

– which are set according to inflation forecasts.