V. INFLATION

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V. INFLATION

• EC21B INTERMEDIATE MACROECONOMICS II

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INTRODUCTION

• Inflation can be defined as a sustained upward
  movement in the aggregate price level that is
  shared by most products. It can also be viewed as
  a fall in the purchasing power of money.
• The opposite of inflation is deflation.

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INTRODUCTION

• The expected rate of inflation is the level of
  inflation people expect to occur in the future.
• There are 3 main types of inflation
• Demand-pull inflation due to high GDP and low
  unemployment
• Supply shock inflation due to adverse changes
  in prices of raw materials (e.g. oil)
• Built in inflation induced by expectations based
  on previous inflation levels.

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THE INFLATION PROBLEM

• Whats wrong with Inflation?
• Inflation is undesirable as it imposes costs on
  the society. The areas of economic costs include
  the following
• Shoe Leather cost of holding money
• Tax distortions
• Unfair gains and losses
• Non adapting economic institutions.

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THE INFLATION PROBLEM

• Shoe Leather costs of holding money when
  inflation is high, currency and non-interest
  bearing accounts are undesirable because they are
  constantly declining in purchasing power. It is
  termed a shoe leather cost as people wear out
  their shoes making trips to the banks in order to
  avoid holding money.

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THE INFLATION PROBLEM

• Tax distortions personal income tax increases
  with the consumer price index. When inflation
  increases, the actual value of the tax deductions
  is much less than it should be due to declining
  purchasing power.

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THE INFLATION PROBLEM

• Unfair gains and losses inflation results in
  gains to some individuals and losses to others.
  Retired individuals with a fixed pension lose
  while homeowners gain as they are able to pay off
  their mortgages in less valuable dollars.
• Total losses from inflation is equal to the total
  gains.
• The Social cost to inflation is that it makes
  long-term transactions more unreliable.

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THE INFLATION PROBLEM

• Unexpected inflation redistributes wealth among
  individuals. If inflation is higher than expected
  the debtor wins and the creditor loses as the
  debtor repays loan with less valuable dollars.
• If inflation is lower than expected, the creditor
  wins and the debtor loses because repayment is
  now worth more than the two parties anticipated.

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THE INFLATION PROBLEM

• Inflation as a Monetary Phenomenon
• Friedman wrote that Inflation is always and
  everywhere a monetary phenomenon.
• This statement means that the growth in the
  quantity of money is the primary determinant of
  the inflation rate.
• And since the central banks control the money
  supply they have ultimate control over the
  inflation rate.

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THE INFLATION PROBLEM

• An analysis of historical data from the US as
  well as Internationally show a positive
  correlation between average money growth and the
  average rate of inflation.
• This theory however works best in the long run.

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THE INFLATION MODEL

• Aggregate Demand in terms of Inflation
• A positive shock to the aggregate demand (AD)
  curve has the effect of sending the economy into
  a recession.
• An increase in aggregate demand shifts the AD
  curve upwards increasing prices due to the upward
  pressure on nominal wages and the supply curve
  shift upwards.
• This increase in the price level leads to
  inflation.

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THE INFLATION MODEL

• It is therefore safe to say that any change in
  the growth rate of aggregate demand would change
  the inflation rate.

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THE INFLATION MODEL

• Price Adjustment
• The theory of price adjustments state that
  Inflation rises when demand conditions are tight,
  when expectations of inflation rise, or when they
  are price shocks.
• A simple algebraic summary of this can be
  written as Equation 1

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THE INFLATION MODEL

• Y-1 represents the percentage deviation of real
  GDP from potential GDP
• The subscript -1 indicates that current inflation
  is related to market pressure in the previous
  period.
• ?e represents individuals expectation of
  inflation
• Z represents price shocks, it describes the
  upward or downward effect of a change in world
  oil prices or other factors.

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THE INFLATION MODEL

• The price adjustment equation highlights that
  there is no long-run trade-off between inflation
  and the level of GDP. Therefore in the long run
  the effect of a price shock would be zero and
  expected inflation would be equal to actual
  inflation and actual output would be equal to
  potential.

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THE INFLATION MODEL

• Price Adjustment Line

?
Price adjustment line
Output Gap (Y Y) / Y
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THE INFLATION MODEL

• The Inflation Line
• We now need to describe the impact of monetary
  policy on aggregate demand. But since we are
  focusing on the inflation rate we derive a new
  curve that relates aggregate demand to inflation
  called the Aggregate Demand - Inflation Curve.
• The curve shows a downward sloping relation
  between inflation and the GDP gap. When inflation
  rises above target it leads to a reduction in the
  GDP gap

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THE INFLATION MODEL

• This curve is obtained by combining the IS curve
  and the monetary policy rule.
• This gives us the algebraic expression equation
  2

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THE INFLATION MODEL

• The Inflation Line

?
Inflation curve
0
Output Gap (Y Y) / Y
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THE INFLATION MODEL

• Equilibrium with Persistent Inflation
• The intersection of the inflation curve and price
  adjustment line determines the equilibrium level
  of inflation and output.

?
Price adjustment line
Inflation curve
0
Output Gap (Y Y) / Y
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THE INFLATION MODEL

• Adjustment in the Inflation Model
• Since from equation 1 inflation is not dependent
  on current GDP so the price adjustment line will
  shift up if
• Real GDP was above potential last year
• The expected rate of inflation rises
• There is a positive price shock

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THE INFLATION MODEL

• From equation 2 inflation is negatively related
  to the GDP so the inflation line will
• Shift if there is a change in the target rate of
  inflation or if there are shocks to the IS curve.
• A change in the inflation level in the economy
  will lead to change sin the real GDP and cause
  movements along the curve.

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EXERCISES WITH THE INFLATION MODEL

• Increase in Money Growth
• Money growth speaks to an increase in the stock
  of money.
• More money simply raises prices. The central bank
  can target any level of inflation it desires by
  simply raising the money supply by that
  percentage each year.
• For price and inflation stability the money
  supply would have to remain constant from year to
  year.
• If money supply increased by 5 inflation would
  increase by 5

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EXERCISES WITH THE INFLATION MODEL

• In a growing economy, the rate of inflation will
  be less than the rate of money growth. If
  potential output is growing over time, some money
  growth is needed just to keep price level from
  falling from one year to the next.

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EXERCISES WITH THE INFLATION MODEL

• An Export Boom
• An export boom is a demand shock. It would
  increase the aggregate expenditure in the
  economy.
• This would shift out the IS curve as well as the
  inflation curve.
• If the export boom was a one off occurrence the
  economy would eventually get back to equilibrium
  with an output equal to potential and inflation
  at a higher level.

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EXERCISES WITH THE INFLATION MODEL

• Inflation and Export Boom

2. PA line shifts up
?
PA1
4
1. Boom caused by shift in inflation line
PA0
2
ADI1
ADI0
Output Gap (Y Y) / Y
0
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EXERCISES WITH THE INFLATION MODEL

• An Oil Price Shock
• An adverse supply shock such as an increase in
  oil prices would increase inflation, lower real
  GDP and increase unemployment.
• If it is a one time shock as inflation subsides
  aggregate demand would recover and the economy
  would gradually return to potential GDP and to
  the original inflation level.
• The only impact of the oil price shock in the
  long run would be a higher price level with no
  effect on real GDP or the inflation rate

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EXERCISES WITH THE INFLATION MODEL

• Inflation and Oil Price Shock

Price shock causes PA line to shift up, then
gradually shift done
?
4
2
PA0
ADI
0
Output Gap (Y Y) / Y
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DISINFLATING AN ECONOMY

• Disinflation refers to the slowing of the rate of
  inflation, prices are still rising but at a
  slower rate. Developing a disinflation policy
  requires close attention to the role of
  expectations in the Phillips curve.
• Why is it so hard to reduce inflation?
• The main sources of inflation is due to an
  increase in consumption and investment spending,
  an expansionary fiscal policy and an adverse
  supply shock.
• Since inflation is viewed as a monetary
  phenomenon the logical way to stop inflation is
  to reduce the rate of money growth.

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DISINFLATING AN ECONOMY

• The reduction in money growth acts to disinflate
  the economy but this might lead to recession and
  an increase in unemployment if actual inflation
  falls below expected inflation.
• It is this difficulty to reduce peoples
  inflationary expectations that makes it difficult
  to reduce inflation.
• It is also hard to reduce money growth when
  government prints money to finance its budget
  deficit.

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DISINFLATING AN ECONOMY

• Alternative Disinflating Paths
• The most challenging problem of disinflating
  occurs in the case where the expected rate of
  inflation equals last periods inflation rate.
  The only way that inflation can be reduced is by
  allowing output to drop below potential.
• So when disinflating policy makers more concerned
  with how long and how deep the recession should
  be.

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DISINFLATING AN ECONOMY

• We will examine three alternative paths for the
  deviation of GDP from potential GDP and
  corresponding paths for the inflation rate.
• 1. Neutral Policy under a neutral policy the aim
  is to maintain nominal GDP growth so allowing a
  decline in the output ratio equal to the increase
  in the inflation level.

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DISINFLATING AN ECONOMY

• 2. Accommodating Policy an accommodating policy
  aims to maintain the original output ratio. In
  order to do this an increase in inflation results
  in an increase in nominal GDP. This policy holds
  GDP at its potential level and so avoids a
  recession but inflation remains permanently high.

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DISINFLATING AN ECONOMY

• 3. Extinguishing Policy an extinguishing policy
  aims to reduce nominal inflation GDP growth so as
  to maintain the original inflation rate. In this
  case the government wishes to remove the extra
  inflation so depresses real GDP below potential

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DISINFLATING AN ECONOMY

• Implications for Unemployment
• Okuns law shows the relation between GDP gap
  and the rate of unemployment. For each change
  of GDP gap, there is a 1/3 point extra
  unemployment.
• Path 1 and 3 would result in an increase in
  unemployment rate.
• Path 2 unemployment remains at natural level.
• The more unemployment chosen the faster
  disinflation will occur.

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DISINFLATING AN ECONOMY

• The Importance of Credibility
• The question has often been asked about why
  inflation is tempting to the government?
• The government gains revenue from printing money
  and hence inflation.
• This revenue is called seinorage.
• The printing of money to finance government
  expenditure is also viewed as imposing an
  inflation tax on consumers.
• The holders of money pay the inflation tax due to
  a fall in the purchasing power of their money.

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DISINFLATING AN ECONOMY

• Now if the government announces a disinflation
  policy their credibility comes into question.
• Credibility refers to the extent to which
  households and firms believe that an announced
  monetary or fiscal policy will actually be
  implemented and maintained.
• In order for the disinflation policy to be
  effective the public has to believe that the
  government will reduce budget deficit and contain
  monetary growth.
• If there is a lack of credibility people will
  expect inflation to remain at its high level so
  the government disinflation policy would fail to
  achieve its goal.

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SUMMARY

• Low inflation that proceeds at a moderate and
  fairly predictable rates year after year carries
  far lower social costs than high or variable
  inflation. But even low steady inflation entails
  a cost.