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Economics
TENTH EDITION
by David Begg, Gianluigi Vernasca, Stanley
Fischer & Rudiger Dornbusch
Chapter 22
Inflation, expectations
and credibility
©McGraw-Hill Companies, 2010
Inflation
• Inflation is a rise in the price level.
• Pure inflation is when goods and
input prices rise at the same rate.
• 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.
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Some questions about inflation
• What are the causes of inflation?
• What are the effects and hence costs of
inflation?
• What can be done about it?
These are the questions we seek to answer in
what follows.
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Inflation in the UK, 1920-2010
The UK price level fell
sharply in some interwar
years when inflation
was negative.
Since 1950, the price
level has risen 20-fold,
more than its rise over
the previous three
centuries. This story
applies in most
advanced economies.
Sources: R. B. Mitchell,
European Historical
Statistics 1750–1970,
Source: Economic Trends Annual Supplement, Labour Market Trends
Macmillan, 1975; OECD,
Economic Outlook.
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The quantity theory (1)
• The quantity theory of money says:
• “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.”
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The quantity theory (2)
• We can state it algebraically as:
MV = PY
where V = velocity of circulation
Y = potential level of real GDP
P = the price level
M = nominal money supply
– Given constant velocity, if prices adjust to
maintain real income at the potential level,
– an increase in nominal money supply leads to
an equivalent increase in prices.
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The quantity theory (3)
• MV = PY
• The quantity theory equation implies
M/P = Y/V
• The left-hand side is the real money supply.
• The right-hand side must be real money
demand.
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M/P = Y/V
• If the demand for real money is constant, M/P is
constant.
• Monetary policy can control M, in which case M
 P
• But if nominal wages and prices adjust slowly in the
short run, higher nominal money supply M leads
initially to a higher real money stock M/P since
prices P have not yet adjusted.
• The excess supply of real money bids down interest
rates. This boosts the demand for goods.
• Gradually this bids up goods prices.
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M/P = Y/V
• OR monetary policy can try and fix P over
time, in which case P  M
• The equation says prices and money are
correlated, but is agnostic on which
causes which.
• With an intermediate target for nominal
money, the causation flows from money to
prices.
• With a target for prices or inflation, the
causation flows the other way.
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The short run
• Also, in the short run, the link between
money and prices may be broken if:
– the velocity of circulation is variable
– prices are sluggish
• For all the above reasons, we must
therefore interpret the quantity theory with
care.
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High interest rates & high
inflation
Nominal interest and inflation rates 2008 (%)
Source: OECD
Economic Outlook.
interest
inflation
Turkey
20
Iceland
15
Hungary
10
5
Japan
USA
Switz- Euro
erland
UK
Mexico
Australia
0
-5
An extra percentage point of inflation is accompanied on average by a
nominal interest rate nearly one percentage point higher.
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Inflation and interest rates
• Fisher hypothesis
– The Fisher hypothesis is that a 1% rise in
inflation leads to a similar rise in nominal
interest rates so real interest rates change
little.
• Real interest rate
– Nominal interest rate minus inflation rate
– but the nominal interest rate is the opportunity
cost of holding money,
– so a change in nominal interest rates affects
real money demand.
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Hyperinflation
• Hyperinflations are periods when inflation rates
are very large.
• During such periods there tends to be a ‘flight
from cash’, i.e. people hold as little cash 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 supply growth.
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The Phillips curve (1)
• In 1958, Prof. A W Phillips demonstrated a
statistical relationship between annual
inflation and unemployment in the UK.
• The Phillips curve relates higher
unemployment to lower inflation.
• It implies we can trade-off higher inflation
for lower unemployment and vice versa.
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Inflation rate (%)
The Phillips curve (2)
Phillips curve
U*
Unemployment rate (%)
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The long-run Phillips curve (1)
• The vertical long-run Phillips curve
implies that sooner or later, the
economy will return to U*, whatever
the inflation rate.
• The position of the short-run Phillips
curve depends on expected inflation.
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The long-run Phillips curve (2)
• The long-run and short-run curves
intersect when actual and expected
inflation are equalized.
• The long-run Phillips curve shows that
in the long run there is no trade-off
between unemployment and
inflation.
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Inflation
The long-run Phillips curve and an
increase in aggregate demand (1)
2
Suppose the economy begins
at E, with unemployment at
U*, and inflation at 1
A
E
1
U1
U*
Unemployment
PC1
An increase in government
spending funded by an
expansion in money supply
takes the economy to A, with
lower unemployment (U1) but
inflation at 2.
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… but what happens
next?
The long-run Phillips curve and an
increase in aggregate demand (2)
Inflation
2
1
If the nominal money supply
continues to expand at the same
rate thereafter, the economy will
eventually move to B on PC2.
LRPC
A
B
E
U1 U*
PC1 PC2
Unemployment
At B, inflation expectations
coincide with actual inflation
and nominal wages have been
renegotiated so that the real
wage and hence, employment
are the same as before the
monetary expansion,
i.e. there is no trade-off
between unemployment and
inflation in the long run.
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The long-run Phillips curve and an
increase in aggregate demand (3)
Inflation
LRPC
2
1
A
Effectively, the long-run
Phillips curve is vertical,
as the economy always
adjusts back to U*.
B
The short-run Phillips curve
shows just a short-run
trade-off:
E
U1 U*
PC1 PC2
Unemployment
The height of the short-run
Phillips curve reflects
expected inflation.
U* is known as the natural
rate of unemployment.
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Expectations and credibility
Suppose the economy begins
at E, with a newly-elected
government pledged to
reduce inflation.
LRPC
Monetary growth is cut to 2.
E
1
2
A
F
In the short run, the economy
moves to A along the shortrun Phillips curve.
PC1
PC2
U*
U1
Unemployment
Unemployment rises to
U1
As expectations adjust,
the short-run Phillips
curve shifts to PC2, and
U* is restored at F.
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Inflation illusion
• People have inflation illusion when they
confuse nominal and real changes.
• 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.
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The costs of inflation (1)
• Fully anticipated inflation:
• Limited costs if institutions adapt to known
inflation:
– nominal interest rates
– tax rates
– transfer payments
• there is no inflation illusion
• Some costs remain:
– shoe-leather
• people economize on money holdings
– menu costs
• firms need to alter price lists, etc.
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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 become distorted
•fiscal drag may have unintended
effects on tax liabilities
•capital and profits taxes may be
distorted
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The costs of unanticipated
inflation
• Unintended redistribution of income
– from lenders to borrowers
– from private to public sector
– from old to young
• Uncertainty
– firms find planning more difficult under
inflation, which may discourage investment
• This has been seen as the most important cost of
inflation.
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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.
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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 (MPC)
– which has the responsibility of meeting the
(underlying) inflation target
– via interest rates
– which are set according to inflation forecasts.
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The MPC
• The MPC successfully maintained UK inflation within
a much narrower range than previously
accomplished.
• The Bank was prepared to change interest rates
even when this was unpopular.
• But low levels of inflation led to low nominal interest
rates, which encouraged more reckless private
sector behaviour.
• Regulatory failure was perhaps more to blame for
the crisis.
• Good monetary policy cannot be held responsible
for inadequate financial regulation.
©McGraw-Hill Companies, 2010