08 Inflation

8/10/2019 08 Inflation

1/48

0

Chapter 8

Inflation


2/48

1

8.1 Introduction

In this chapter, we learn: What inflation is, and how costly it can be.

How the quantity theory of money and the

classical dichotomy help us understand

inflation.

The relationship of interest rates and inflation

through the Fisher equation.

The important link between fiscal policy andhigh inflation.


3/48

2

Inflation

The percentage change in the overall price level

Hyperinflation

an episode of extremely high inflation

Greater than 500 percent per year (Mankiw: 50

percent per month) Example: Post World War I Germany

The inflation rate is computed as the annual percentage

change in the price level in period t(Pt):

The Consumer Price Index (CPI)

Price index for a bundle of consumer goods


4/48

3


5/48

4

Case Study: How Much Is That?

We can use the CPI to evaluate the value of a

good in 1950 in todays dollars.


6/48

5


7/48

6

Multiply the price of the good in 1950 times

the ratio of the CPI in todays dollars to the

CPI in 1950 dollars.

Its not as large of a difference as the raw

numbers may lead you to believe.

Other price indexes

The CPI excluding food and energy prices

The GDP deflator


8/48

7

8.2 The Quantity Theory of Money

We often think of money as paper currency.

Historically

Money was backed by gold or silver

Today

Currency is fiat money.

Currency is paper that the government simplydeclares is worth a certain price.

Money has value because we expect others will

value it.


9/48

8

Measures of the Money Supply

The monetary base includes currency and

accounts, called reserves.

Private banks hold accounts with the economys

central bank, which pay no interest. These banks ensure that they have sufficient cash

on hand in case of money withdrawals.

Other measures of currency: M1: adds demand deposits to the money base

M2: adds savings accounts and money market

account balances to M1


10/48

9


11/48

10

Case Study: Digital Cash

Electronic forms of currency

Debit cards, PayPal, travelers checks

Makes up most money in advanced economies


12/48

11

The Quantity Equation

The quantity theory of money allows us to

make the connection between money andinflation.

Price

level

Real

GDP

Money

supply

Velocity

of money


13/48

12

Velocity of money

The average number of times per year that

each piece of paper currency is used in a

transaction

The equation implies that the amount of money

used in purchases is equal to nominal GDP.


14/48

13

The Classical Dichotomy, Constant

Velocity, and the Central Bank

The classical dichotomy

States that, in the long run, the real and nominal

sides of the economy are completely separate.

In the quantity theory of money

Real GDP is assumed as exogenously given

Determined by real forces.

In other words:

Bar over the Y

means exogenous.


15/48

14

The velocity of money

Exogenously given constant

Assumed to be constant over time

In other words:

The money supply

Determined by the central bank

Monetary policy is exogenously given

In other words:

No timesubscript


16/48

15


17/48

16


18/48

17

The Quantity Theory for the Price Level

To solve the model Plug all the exogenous variables

Solve for the price level

Prices will rise as a result of

Increases in the money supply

Decreases in real GDP

In the long run, the key determinant of the price

level is the money supply.


19/48

18

The Quantity Theory for Inflation

We can express the quantity equation interms of growth rates.

Using gas growth rate

Constant = 0 Rate of inflation,

represented as


20/48

19

Rate of

inflation

Growth

rate in

money

supply

Growth

rate in

GDP

Thus:

Quantity Theory of Money

Changes in the growth rate of money lead one-for-

one to changes in the inflation rate.

Empirically, this holds up both in U.S. and worldwidedata.

Deflation

Occurs when inflation rates are negative


21/48

20


22/48

21


23/48

22

Revisiting the Classical

Dichotomy

When allprices in the economy double,

relative prices are unchanged.

When the relative prices of goods are

unchanged, nothing real is affected.


24/48

23

The neutrality of moneysays that changes in the

money supply

Have no real effects on the economy Only affect prices

Empirically

Holds in the long run

Does not hold in the short run:

nominal prices do not respond immediately to

changes in the money supply


25/48

24

8.3 Real and Nominal Interest Rates

The real interest rate

Is equal to the marginal product of capital

Is paid in goods

The nominal interest rate

Is the interest rate on a savings account

Is paid in dollars


26/48

25

The Fisher equation

The nominal interest rate is generally high when

inflation is high.

Empirically The real interest rate has been negative

This implies that in the short run the real

interest rate need not equal the MPK.

Nominal

interest

rate

Real

interest

rate

Rate of

inflation


27/48

26


28/48

27

8.4 Costs of Inflation

Individuals who are hurt during inflation:An individual who has a pension that is not

indexed to inflation

A bank that issues loans at fixed rates but

that pays interest rates that move with the

market

An individual with a variable rate mortgage


29/48

28

Large surprise inflations can lead to largedistributions in wealth.

People with debts can pay back their loans with

new cheaper dollars.

Creditors wind up losers.


30/48

29

Taxes Based on nominal incomes

Economic decisions

Based on real variables

Tax distortions are more severe when inflation is

high.


31/48

30

Inflation also distorts relative prices.

Some prices are faster at adjusting to inflationthan other prices are.

Shoe leather costs of inflation

People want to hold less money when inflation

is high.

Menu costs

The costs to firms of changing prices frequently.


32/48

31

Case Study: The Wage-Price Spiral

and President Nixons Price Controls

At the time, the view was: Strong unions pushed for high wages

Strong corporations translated rising costs to

rising prices

Strong unions demanded even higher wages.

Wage-price spiral, resulting in inflation


33/48

32

Nixon froze wages and prices for 90 days to

break the spiral.

High unemployment resulted from an

expansionary policy that brought the return of

inflation.

Price controls also distort economic decisions.


34/48

33

8.5 The Fiscal Causes of High Inflation

The government budget constraint

Government

funds

Tax revenue

Borrowing

Changes in

the stock of

money


35/48

34

The Inflation Tax

Seignorage and the inflation tax

Names for the revenue that the government

obtains from printing more money (M) The inflation tax

Shows up as a rise in the price level

Is paid by people holding currency


36/48

35

If a government runs large budget deficits, as debt

rises

Lenders may worry the government will havetrouble paying back loans

They may stop lending to the government

altogether.

Debt solution: Raising taxes?

May not be politically feasible

The government may resort to printing currency tofinance its budget.

Lenders to the government will be paid back in

currency that is worth less than the dollars lent.


37/48

36

Central Bank Independence

Monetary Policy

Conducted by Federal Reserve

Fiscal Policy

President and Congress

Central Bank Independence

An attempt to prevent fiscal considerations

from leading to excessive inflation


38/48

37

Case Study: Episodes of High Inflation

Episodes of high inflation tend to recur.

Hyperinflations can stop just as quickly as they

start. Countries experiencing hyperinflation typically

raise about 5 percent of GDP from the inflationtax.

Argentina raised 10 percent of GDP this way.


39/48

38


40/48

39


41/48

40

Hyperinflation

Ends when the rate of money growth falls

rapidly

The government gets its finances in order

through lower spending, higher taxes, and new

loans The coordination problem

People build their expectations into the prices

they set.


42/48

41

8.6 The Great Inflation of the 1970s

During the Great Inflation,

The rate peaked below 15 percent

Yet the inflation tax was a small fraction of

government spending

Inflation rose in the 1970s for the following reasons:

OPEC coordinated increases in oil prices that

spurred inflation.

The Federal Reserve grew the money supply toorapidly.

Policymakers pursued such a policy because of the

productivity slowdown.


43/48

42

Summary

Inflation The annual percentage change in the overall

price level in an economy

A dollar today is worth much less than it was a

decade ago.

Th tit th f i b i d l


44/48

43

The quantity theory of money is our basic model

for understanding the long-run determinants of

the price level and therefore of inflation. There

are two ways to express the solution.

For the price level

For the rate of inflation


45/48

44

The classical dichotomy

The real and nominal sides of the economy are

largely separate. Real economic variables, like real GDP, are

determined only by real forceslike the

investment rate and TFP.

They are not influenced by nominal changes,

such as a change in the money supply.

Classical dichotomy holds in the long run but

not necessarily in the short run.


46/48

45

The nominal interest rate

Paid in units of currency

Real interest rate

Paid in goods

Related by the Fisher equation

Nominal

interest

rate

Real

interest

rate

Rate of

inflation

I fl ti


47/48

46

Inflation

Can be very costly to an economy

Generally transfers resources from lenders and

savers to borrowers

Can cause

high effective tax rates

distortions to relative prices

shoe-leather costs

menu costs

Th t b d t t i t th t th


48/48

The government budget constraint says that the

government has three basic ways to finance its

spending.

Taxes

Borrowing

Printing money

If none of those methods work, the government

may be forced to print money to satisfy the

budget constraint.

Hyperinflations are generally a reflection of such

fiscal problems.

Documents

08 Inflation