InflationInflation is defined as the

percentage increase in the average price level in a given period of time.

When we talk about inflation of a country, we indicate the increase in the general price level, not increase in the price of specific commodities.

2

Deflation vs. DisinflationThe opposite scenario of inflation is called deflation.Deflation is defined as the percentage decrease in the

average price level in a given period of time.Inflation is generally considered bad if it is high.Deflation is also considered bad if decrease in the price

level is considerable.If the rate of inflation falls then we call it disinflation.Example: if the general price level is 100 in year 1 and

it is 90 in year 2 then we call it deflation.Example: If the general price level is 100 at the end of

year 1 and at the end of year 2 it is 110, then the rate of inflation in year 2 is 10%. In year 3 if the price level is 120 then the rate of inflation is 9.09%. In this case the inflation rate falls from year 2 to year 3 and will be called disinflation.

3

Sources of inflationDemand-pull inflation: occurs when demand

increases exceeding available supply.Cost-push inflation: occurs when cost of production

increases and as a result producers increase price.Fiscal inflation: occurs when there is excess

government spending. This may also be considered as another version of demand-pull inflation.

Monetary inflation: occurs when the government increases money supply.

Pricing power inflation: occurs when firms increase price to maximize their profit.

Protective measure: occurs when a country, for example increases tariff to protect domestic industries.

4

Effects of inflationNegative effects:

Hurts fixed income groupEncourages hoardingSocial unrestMenu costAutomatic tax increase (Bracket creep)Money illusionCreates pressure on the exchange rateHurts lenders

Positive effectsEmployment increasesBeneficial for the borrowers and therefore

encourages investment

5

Degree of inflationOpinions about the acceptable degree of inflation

varies. A general thumb rule is: if the rate of inflation is

below 5% it is tolerable. It is very good when around 2%. Policy makers should be cautious when the rate is more than 5% but less than 10%. Policy makers should declare war against inflation if the rate is more than 10%.

Usually an inflation rate without a time dimension indicates annual inflation.

But, if the rate is monthly or quarterly then situation gets much worse.

Hyperinflation is the extreme scenario when the rate of inflation increases abnormally, may be even on a daily basis.

6

Measurement of inflationConsumer Price Index (CPI): an index that

depicts changes in prices of selected consumer goods.

Wholesale Price Index (WPI): This is also know as Producer Price Index (PPI). It indicates changes in the price of selected wholesale goods.

GDP Deflator = (nominal GDP / real GDP) X 100Core price index: an index that indicates price

changes of selected items (excluding items prices of which are volatile).

7

8

Construction of CPIFirst we calculate price index of all the goods and services considered for CPI.Suppose we have two goods, x and y, to be considered for CPI.For the first good:

For the second good:

Where, C indicates current year price and B indicates base year price.CPI is then calculated by using the following formula:

Where “w” stands for weights assigned to the goods x and y.8

100B

CCPI

x

xx

100B

CCPI

y

yy

j

yx

w

ww

yx,jyx,i

i

yx

CPICPI

)(CPI)(CPICPI

Unemployment Is defined by

the International Labor Organization (ILO) as a situation in which people are without jobs and they have actively looked for a job for the past four weeks.

According to this definition, people who do not look for a job will not be considered unemployed.

9

Productive population

In the labor force

Not in the labor force

Employed Unemployed

Employment dynamics

10

Employed labor force

UnemployedNew hire/ recall

Lay off/ quits

Out of the labor force

Retiring/ temporarily leaving

Taking a job

Discouraged workers

New entrants willing to work but not yet found one

Some useful conceptFrictional unemployment: caused by temporary job

loss. For example: when workers switch jobs they might be unemployed for a short period as long as they find a suitable job.

Structural unemployment: caused by a permanent shift of events. For example: if a country shuts down its jute factories and starts readymade garments industries then workers of the jute industry may find it very difficult to find a job in the readymade garments industry as the skills set does not match.

Natural rate of unemployment: it is the level of unemployment when the economy is at the full employment level. The natural rate of unemployment is a combination of both frictional and structural unemployment.

Cyclical unemployment: it is the deviation of natural rate of unemployment form the actual employment. 11

Are the two related? There is a common perception that inflation and

unemployment are related was proposed by A. W. Phillips in 1958.

Phillips explained 97 years of British data on unemployment and nominal wage growth and found that, historically, unemployment tended to be low in years when nominal wages grew rapidly and high in years when nominal wages grew slowly.

Economists later modified Phillips’s linkage between wage growth and unemployment and plotted the relationship between unemployment and growth of price level.

This negative relationship when showed in a graph is called the Phillips Curve.

Unfortunately, there is no credible data of unemployment rate in Bangladesh. Therefore, it is very difficult to plot and see the relationship in the context of Bangladesh.

12

The Phillips curveInflation

Unemployment

If the negative relationship truly exists then it can be an important source of choices for the policy makers.

13

Empirical evidence of Phillips curveDuring 1960s in the USA unemployment rate and

inflation were found to be negatively related supporting the Phillips curve.

However, for the 1970-2002 period there was no clear negative relationship between inflation and unemployment

The non-existence of the negative relationship between inflation and unemployment after 1970 raised three questions-Why was negative relationship observed before

1970?Why did the relationship vanish after 1970?Does the Phillips Curve provide choices for the

policymakers?

14

The expectation-augmented Phillips curve

15

Natural rate of unemployment

Expectation-augmented Phillips curve

Suppose, an economy is at full-employment with steady, full anticipated inflation.

In this economy both unanticipated inflation and cyclical employment are zero.

For some reason, aggregate demand growth increases unexpectedly and as a result unanticipated inflation increases and cyclical unemployment reduces.

If this is the case, then it shows the negative relationship between unanticipated inflation and cyclical unemployment.

The following two figures depict this. In these figures we consider an unexpected increase

in money supply as the cause of increase in demand growth.

16

When price level changes according to expectations

LRAS

SRAS2

SRAS1

AD2

AD1

100

110

P

Y

E

F

2. Therefore, expected price level increases by 10% each year.

1. Money supply grows by 10% each year.

3. Output remain unchanged

17

When price level does not change according to expectations

LRAS

SRAS2

SRAS1

AD2

AD1

100

110

P

Y

E

F

AD3

113G

Y1

1. A more than expected increase in the money supply raise the AD curve from AD1 to Ad3.

2. By this, producers are allured and supply more than the full-employment level in year 2.

3. But in the long run, price adjusts and equilibrium reached at point H.

H

4. In this example, unanticipated inflation in year 2 is equal to 3% and cyclical unemployment will reduce (because actual unemployment will be lower than the structural unemployment level.)

115

5. This shows that when price increase is more than expectation unemployment may reduce.

18

Expectation-augmented Phillips curve

19

Shift of the Phillips curveEquation 1 states

that if expected inflation does not remain constant then the negative relationship will fluctuate and will not show a smooth negative trend.

Example: for any constant natural rate of unemployment level, if the expected inflation increases then the whole Phillips curve will shift upward.

20

3%

9%

A

B

Inflation

u

Phillips curve will also shift if the natural rate of unemployment changes.

Example: For any constant level of inflation, if the natural rate of unemployment changes from 6% to 7% then the Phillips curve will shift to the right.

21

3%A B

Inflation

u7%6%

Shift of the Phillips curve

Answering the questions on slide 4Why was negative relationship observed between

inflation and unemployment in USA before 1970? Because both natural rate of unemployment and expected

inflation were fairly constant.Why didn’t the relationship hold after 1970?

There were several shocks in the economy including 1973 oil shock, 1979 oil shock, Iraqi invasion in Kuwait in 1990, east Asian currency crisis in 1997, attack on Twin Tower in 2001, USA’s preemptive strike on Iraq in 2004. Because of these shocks, the usual relationship stated by the Phillips curve did not hold. However, plotting unexpected inflation on the vertical axis and cyclical unemployment on the horizontal axis proves that Friedman-Phelps theory was correct- there was negative relationship between cyclical unemployment and unexpected inflation.

22

Does the Phillips Curve provide choices for the policymakers?

Classical and Keynesian economists differ on this issue. Classical economists believe in rapid adjustment of

economic variables, and therefore, suggest that temporary surprises will not have any effect. In this context, the classical economists think that Phillips curve does not represent any policy choice for the policy makers.

On the other hand, Keynesians believe that the policy makers have choices, at least in the short run, to manipulate expected inflation to change natural rate of unemployment.

However, both the classical and the Keynesian economists agree that such use of Phillips curve is not possible in the long run, as in the long-run everything will be adjusted to reach equilibrium.

23

Answering the questions on slide 4

What should the policymakers choose? Governments and policymakers try to reduce

unemployment as much as possible to reduce cost of unemployment.

Cost of unemployment includes- loss of productive activities, frustration among workers, cost on the part of the government in terms of social safety net expenses.

On the other hand, unemployment forces workers to develop skills using which they can be employed in future with increased productivity and thus increasing output, which is beneficial for the economy in the long run.

24