Download Chapter 5 MONEY AND INFLATION

Chapter 5
MONEY AND INFLATION
DEFINITION OF INFLATION
— Inflation is a process of continuous (persistent) increase in the price level.
Inflation results in a decrease of the value of money.
— In the definition of inflation we have to observe that:
o Inflation is an increase in the prices of all goods and services not
only of a particular good or service. An increase in the price of one
good is not inflation.
o Inflation is an ongoing process, not a one-time jump in the price
level.
— Milton Friedman proposed that "inflation is always and everywhere a
monetary phenomenon". The source of inflation is the high growth rate of
money supply with too much money chasing too few goods.
— A quick and simple solution to fighting inflation is reducing the growth rate
of the money supply
— The proposition that inflation is the result of a high rate of money growth is
supported by evidence from inflationary episodes throughout the world.
— The German hyperinflation of the 1921-23 supports the proposition that
excessive monetary growth causes inflation and not the other way around
since the increase in monetary growth appears to have been exogenous, the
government expands the money supply to finance its expenditures.
— Evidence for Latin American countries over the ten-year period 1989-1999
indicates that in every case in which a country's inflation rate is extremely
high for any sustained period of time, its rate of money growth is extremely
high
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INFLATION RATE:
— To measure the inflation rate, we calculate the annual percentage change in
the price level.
Inflation Rate =
Pthis year - Plast year
Plast year
× 100
— we measure the price level (P) of a country using GDP Deflator or CPI.
Inflation Rate =
GDP Deflator
this year
- GDP Deflator
GDP Deflator
last year
× 100
last year
OR
Inflation Rate =
CPI
this year
- CPI
CPI
last year
last year
× 100
— These two equations show the connection between the inflation rate and the
price level. If the price level in the current year is higher than that of the last
year, the inflation rate will be positive meaning higher inflation rate Ö the
lower is the value of money.
VIEWS OF INFLATION
— According to aggregate demand and supply analysis, inflation is caused by
expansionary monetary policies. A continually increasing money supply
causes a continual increase in aggregate demand, everything else held
constant.
— Fiscal policy alone cannot produce inflation. There is a limit on the total
amount of possible government expenditure. Decreasing taxes also has a
limit.
— Negative supply shocks increase the price level, but cannot increase the
inflation rate. Suppose that the economy is at the natural rate of output. In
the absence of accommodating policy and everything else held constant, the
net result of a negative supply shock is that the economy returns to full
employment at the initial price level.
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SOURCES OF INFLATION
— Inflation usually occurs as a result of expansionary monetary policy. These
government policies are the most common sources of inflation.
(1) Cost-Push Inflation and High Employment Targets
— Cost-push inflation arises due to a decrease in supply as a result of the rise
in the per-unit cost of production. The
— negative supply shocks mainly occur because of
1. the push by workers to get higher wages
2. the increase in the prices of key raw materials (e.g. oil price)
— At a given price level, cost-push inflation starts as the rise in the cost of
production as a result of an increase in the money wage rate or an increase
in the prices of raw material ⇒ firms are willing to produce less amount of
the output ⇒ SAS decreases ⇒ SAS shifts leftward ⇒ an increase in prices
and unemployment and a decrease in RGDP ⇒ stagflation
.
LAS
P
SAS3
SAS2
P4
E
P3
SAS1
D
P2
C
P1
AD3
B
A
P0
AD2
AD1
Y
Y1
Y0
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— Suppose that the price level was P0 and PGDP is Y0, where AD0, SAS0 and
LAS intersect at point A, the LR FE equilibrium.
— Then, nominal wages or prices of other factors of production increase ⇒
production cost increases ⇒ firms reduce production ⇒ SAS ⇒ SAS
curve shifts leftward to SAS1 to point B.
— At point B, price level increases to P1 and RGDP decreases to Y1 and
therefore unemployment increases above its natural rate (below FE)
— If government fiscal and monetary policies remain unchanged, the economy
would move back to point A
— However, as a response to the increase in P and unemployment, and a
decrease in RGDP, the government increases Qm ⇒ AD increases ⇒ AD
curve starts to shift rightward until it reaches AD1 at point C, where AD1
intersects with SAS1 and LAS.
— At point C, the economy is at higher price level (P2) and RGDP goes back
to PGDP (Y0) at full employment
— With the new higher price, money wage rate and prices of other productive
resources start to increase again which leads to increase in the cost of
production ⇒ SAS curve will shift leftward from SAS1 to SAS2 ⇒
stagflation ⇒ the process will be repeated ⇒ higher price level (inflation)
— This is an ongoing process of rising price level.
— Note that a one-time increase in the price of one resource without any
following change in AD produces stagflation but not inflation.
— The combination of a successful wage push by workers and the
government's commitment to high employment leads to cost-push inflation.
— Cost-push inflation is a monetary phenomenon because it cannot occur
without the monetary authorities pursuing an accommodating policy of a
higher rate of money growth.
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— Accommodating policy (usually monetary policy) occurs when
government pursue active, discretionary policy to eliminate high
unemployment that developed after a successful wage push by workers.
— Monetary expansion increases AD repeatedly, and wages continue to adjust
upward. This recipe leads to inflation
— In the absence of an accommodating monetary policy and everything else
held constant, a push by workers to get higher wages will cause higher
unemployment and higher prices, and the net result of a negative supply
shock is that the economy returns to full employment at the initial price
level.
(2) Demand-Pull Inflation
— Demand-pull inflation occurs when policy makers pursue policies that
raise AD and shift the aggregate demand curve to the right
— Demand-pull inflation is a result of the increase in spending faster than the
increase in production of output.
— An increase in aggregate demand is caused mainly by
1. the increase in quantity of money (Qm),
2. the increase in any of C, I, G, or X
— Suppose the economy is at LR full employment equilibrium point A, where
LAS, AD0 and SAS0 intersect with each other. At this point, RGDP =
PGDP = Y0 and P = P0.
— Then, because government goal is to achieve high level of employment
(high level of output), government may increase Qm, C, I, G, or X, which
leads to an increase in AD ⇒ AD curve shifts rightward from AD0 to AD1
⇒ the new SR equilibrium is at point B,
— At B, RGDP is greater than PGDP, price level increases from P0 to P1, ⇒
real wage rate has decreased and unemployment falls below its natural rate
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(above FE) ⇒ there is a shortage of labor ⇒ money wage rate starts to
increase to attract more labor ⇒ SAS starts to decrease ⇒ SAS curve starts
to shift leftward ⇒ P starts to increase and RGDP starts to decrease until
SAS curve shifted to SAS1 where it intersects AD1 and LAS at point C
P
LAS
P4
SAS3
SAS2
E
D
P3
P2
SAS1
C
P1
AD3
B
P0
A
AD2
AD1
Y
Y0
Y1
— At point C, RGDP goes back to its potential LR and FE level (Y0) and the
price level increase further to P2.
— This process is only a one-time rise in P. For inflation to proceed, AD must
persistently increase.
— At this stage two actions may occur simultaneously: (1) Government wants
to achieve a specific target of high employment (and high production) so it
will increase G, Qm or decrease taxes, and (2) Since now the money wage
is higher which means people can spend more and as a result P is higher
(P2), the result is the increase in Qm
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— In either case ⇒ increase in AD ⇒ AD curve will shift from AD1 to AD2
⇒ the process will continue ⇒ higher price level (inflation)
— This is an ongoing process of rising price level.
— From the discussion above, according to aggregate demand and supply
analysis, it is evidenced that high inflation cannot be driven by fiscal policy
alone. High money growth produces high inflation. Inflation is caused by
expansionary monetary policies.
— Theoretically, one can distinguish a demand-pull inflation from a cost-push
inflation by comparing the unemployment rate with its natural rate level.
(3) Budget Deficit and Inflation
— High government budget deficit relative to GDP can be a source of
sustained inflation only if
a. it is persistent rather than temporary and
b. if the government finances it by creating money rather than by
issuing bonds to the public
ACTIVIST / NONACTIVIST POLICY DEBATE
— Activist is an economist who views the self-correcting mechanism through
wage and price adjustment to be very slow and hence sees the need for the
government to pursue active, discretionary policy to eliminate high
unemployment whenever it develops.
— Activists argue that monetary and fiscal policies should be deliberately used
to smooth out the business cycle.
— They are in favor of economic fine-tuning, which is the frequent use of
monetary and fiscal policies to counteract even small undesirable
movements in economic activity.
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— According to activists, the economy does not always equilibrate quickly
enough at natural real GDP.
— They believe that activist monetary policy works; it is effective at
smoothing out the business cycle.
— Nonactivist is an economist who believes that the performance of the
economy would be improved if the government avoided active policy to
eliminate unemployment
— Nonactivists argue against the use of deliberate fiscal and monetary
policies.
— They believe the discretionary policies should be replaced by a stable and
permanent monetary and fiscal framework and the rules should be
established in place of activist policies.
— According to nonactivists, in modern economies, wages and prices are
sufficiently flexible to allow the economy to equilibrate at reasonable speed
at natural real GDP.
— They believe activist monetary policies may not work, and may be more
destabilizing rather than stabilizing, and are likely to make matters worse
rather than better.
— If aggregate output is below the natural rate level, advocates of activist
policy would recommend that the government try to eliminate the high
unemployment by attempting to shift the aggregate demand curve to the
right while advocates of nonactivist policy would recommend that the
government to do nothing.
— Activists usually view fiscal policy as having a shorter effectiveness lag
than monetary policy, but there is substantial uncertainty about how long
this lag is.
— According to activist, the wage and price adjustment process being
extremely slow, and a nonactivist policy results in a large loss of output
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— Nonactivists usually view fiscal policy as having a longer implementation
lag than monetary policy, but there is substantial uncertainty about how
long this lag is
— Nonactivists contend that an activist policy of shifting the aggregate
demand curve will be costly because it produces more volatility in both the
price level and output
— There are five time lags that prevent an activist policy from returning
aggregate output to full employment instantaneously
1. The data lag is the time it takes for policymakers to obtain the data that
tell them what is happening to the economy,
2. The recognition lag is the time it takes for policymakers to be sure of
what the data are signaling about the future course of the economy.
3. The legislative lag represents the time it takes to pass legislation to
implement a particular (fiscal) policy
4. The implementation lag is the time it takes for policymakers to change
policy instruments once they have decided on a new policy.
5. The effectiveness lag is the time that it takes for an activist policy to
actually influence economic activity.
— The existence of lags prevents the instantaneous adjustment of the economy
to policies changing aggregate demand, thereby strengthening the case for
nonactivist policy.
— However, activist respond that even with time lags, activist policy moves
the economy to full employment before the economy's self-correcting
mechanism would
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EFFECTS OF INFLATION
— Inflation may be anticipated (expected) or unanticipated (unexpected)
— A moderate anticipated (expected) has a small cost, but a rapid anticipated
inflation is costly because it decreases potential GDP and slow growth.
— Unanticipated (unexpected) inflation has two main consequences in the
labor market. It redistributes income and results in the departure from full
employment
1. Higher than anticipated inflation (unexpectedly high) ⇒ lowers the real
wage rate ⇒ employers gain at the expense of workers ⇒ increases the
quantity of labor demanded, makes jobs easier to find, and lowers the
unemployment rate.
2. Lower than anticipated inflation (unexpectedly low) ⇒ raises the real
wage rate ⇒ workers gain at the expense of employers ⇒ decreases the
quantity of labor demanded, and increases the unemployment rate.
3. If workers and employers base their wages on an inflation forecast that
turns out to be correct, neither workers nor employers gain or lose from
the inflation.
— Unanticipated inflation has two main consequences in the market for
financial capital: it redistributes income and results in too much or too little
lending and borrowing.
1. When the inflation rate is higher than anticipated (unexpectedly high)
⇒ the real interest rate is lower than anticipated ⇒ borrowers gain but
lenders lose ⇒ borrowers want to have borrowed more and lenders want
to have loaned less.
2. When the inflation rate is lower than anticipated (unexpectedly low) ⇒
the real interest rate is higher than anticipated ⇒ lenders gain but
borrowers lose ⇒ borrowers want to have borrowed less and lenders
want to have loaned more
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— We can conclude from the above that Inflation that is higher than expected,
transfers resources from workers to employers and from lenders to
borrowers.
— The opposite is true
— High levels of unanticipated inflation have other negative impacts on
economies for a number of reasons.
1. They lead to distortions in the economy and give confusing price
signals to producers.
2. For individuals on fixed incomes, the rise in prices increases the
cost of living, eroding purchasing power.
3. For investors it erodes the value of saving, while effectively
reducing the real rate of borrowing for debtors.
4. It makes goods produced in the country more expensive relative to
goods produced abroad resulting in a decrease in exports and an
increase in imports.
5. People who hold a lot of money loose from inflation because
money value becomes less overtime.
6. Those who own “real” assets such as land, stocks, etc. gain from
inflation because the value of these assets goes up with inflation.
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SNAPSHOT ON THE CURRENT INFLATION IN GCC COUNTRIES
(2007- 08)
— The growth rate of money supply in Gulf countries has in some cases
exceeded 20 percent. Check the latest rates of inflation in GCC countries.
— With this double digit inflation nominal interest rates are way below the
inflation rate which has resulted in negative real rates of interests.
Factors Causing Inflation in GCC Stats
1. As a result of pegging GCC currencies - except the Kuwaiti dinar- to a
weakening dollar there has been an increase in the cost of goods that are
imported from countries whose currencies had appreciated against the
dollar, like the EU, Japan and China.
2. Rising food prices internationally due to the high demand for some
types of grains such as corn to use them as bio fuels in addition to the
increase in the price of oil, this added to the increase in the food prices.
3. Huge money supply and abundant liquidity, triggered by sharply higher
oil revenues, that is accompanied by a fixed supply of goods and
services.
4. The rise in demand for real estate, which increases real estate prices in
addition to sharp increase in the cost of housing due to shortage in
property supplies such as steel and cement.
5. The dollar peg forces GCC central banks to follow the US Federal
Reserve in setting interest rates. But while the US central bank
continues cutting rates to stimulate a sluggish economy, GCC central
banks are faced with expanding economies that were already
overheating at the higher rates. Cutting interest rate just fuel the
inflation more.
6. The increase in wages without controlling goods markets that just
increase prices to take advantage of the wage rise
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Solutions adopted by GCC.
— It is not necessary to adopt all solutions by all countries. Different countries
adopted different solutions
1. De-peg GCC Currencies from the tumbling dollar and track a currency
basket of their main trade partners, including the US dollar, euro,
sterling and yen. The European Union is now the main trading partner
of the GCC accounting for 35 per cent of their foreign trade, followed
by Asian countries 30 per cent and the US 10 per cent.
2. As a recommended basket, GCC states may link their currencies with
the International Monetary Fund's Special Drawing Rights (SDRs), a
mixed basket of currencies.
3. Revaluation: the link to the dollar should be revisited without
necessarily de-pegging the Gulf currencies,
4. Price should be controlled by governments, especially of the necessary
products.
5. Increase in interest rates should be implemented to reduce money
supply and liquidity in the hands of public.
6. Increase the reserve requirement for banks forcing lenders to keep more
customer deposits in their vaults.
7. Central banks should engage in open market operations to decrease the
abundant liquidity.
8. Create a suitable environment to invest the liquidity surplus in import
substitution products.
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The Current Global Financial Crises
— The current financial crisis hits the world in many ways and has its impact
on most countries around the world.
— There have been many debates, discussions, articles, meetings, interviews,
lectures, legislations, and summits that create a huge amount of literature
on this crisis.
— It is the assignment of every one of you to write an essay about this crisis
stating the following:
1. The causes of the crisis
2. The different impacts of the crisis on countries, consumers’ welfare, and
business strength
3. The impact of the crisis on Bahrain and other GCC countries
4. The actions that have been taken to reduce the impact of the crisis
5. The solutions to go out of this crisis
— The essay should be of at least five typed-pages (with 12 Times New
Roman and 1.5 space) and its due date is by the end of December.
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