Download Chapter27 - Web.UVic.ca

Inflation
Copyright © 2006 Pearson Education Canada
27
CHAPTER
Objectives
After studying this chapter, you will able to
 Distinguish between inflation and a change in the price
level and between demand-pull inflation and cost-push
inflation
 Explain the quantity theory of money
 Explain the short-run and long-run relationships between
inflation and unemployment
 Explain the short-run and long-run relationships between
inflation and interest rates
Copyright © 2006 Pearson Education Canada
From Rome to Rio de Janeiro
Inflation is a very old problem and some countries even in
recent times have experienced rates as high as 40 percent
a month.
Today, the Bank of Canada targets the inflation rate and
keeps it low. But during the 1970s, the price level in
Canada doubled.
Why does inflation occur and do our expectations of
inflation influence the economy?
In targeting inflation, does the Bank of Canada face a
tradeoff between inflation and unemployment? And how
does inflation affect the interest rate?
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
Inflation is a process in which the price level is rising and
money is losing value.
Inflation is a rise in the price level, not in the price of a
particular commodity.
And inflation is an ongoing process, not a one-time jump in
the price level.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
Figure 27.1 illustrates the
distinction between
inflation and a one-time
rise in the price level.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
The inflation rate is the percentage change in the price
level.
That is, where P1 is the current price level and P0 is last
year’s price level, the inflation rate is
[(P1 – P0)/P0]  100
Inflation can result from either an increase in aggregate
demand or a decrease in aggregate supply and be
 Demand-pull inflation
 Cost-push inflation
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
Demand-Pull Inflation
Demand-pull inflation is an inflation that results from an
initial increase in aggregate demand.
Demand-pull inflation may begin with any factor that
increases aggregate demand.
Two factors controlled by the government are increases in
the quantity of money and increases in government
purchases.
A third possibility is an increase in exports.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
Initial Effect of an
Increase in Aggregate
Demand
Figure 27.2(a) illustrates
the start of a demand-pull
inflation.
Starting from full
employment, an increase
in aggregate demand
shifts the AD curve
rightward.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
The price level rises, real
GDP increases, and an
inflationary gap arises.
The rising price level is
the first step in the
demand-pull inflation.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
Money Wage Rate
Response
Figure 27.2(b) illustrates
the money wage response.
The money wages rises
and the SAS curve shifts
leftward.
Real GDP decreases back
to potential GDP but the
price level rises further.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
A Demand-Pull Inflation
Process
Figure 27.3 illustrates a
demand-pull inflation
spiral.
Aggregate demand keeps
increases and the process
just described repeats
indefinitely.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
Although any of several
factors can increase
aggregate demand to start
a demand-pull inflation,
only an ongoing increase
in the quantity of money
can sustain it.
Demand-pull inflation
occurred in Canada
during the late 1960s and
early 1970s.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
Cost-Push Inflation
Cost-push inflation is an inflation that results from an
initial increase in costs.
There are two main sources of increased costs:
1. An increase in the money wage rate
2. An increase in the money price of raw materials, such
as oil.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
Initial Effect of a
Decrease in Aggregate
Supply
Figure 27.4 illustrates the
start of cost-push inflation.
A rise in the price of oil
decreases short-run
aggregate supply and
shifts the SAS curve
leftward.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
Real GDP decreases and
the price level rises—a
combination called
stagflation.
The rising price level is the
start of the cost-push
inflation.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
Aggregate Demand Response
The initial increase in costs creates a one-time rise in the
price level, not inflation.
To create inflation, aggregate demand must increase.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
Figure 27.5 illustrates an
aggregate demand
response to stagflation,
which might arise because
the Bank of Canada
stimulates demand to
counter the higher
unemployment rate and
lower level of real GDP.
Real GDP increases and
the price level rises again.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
A Cost-Push Inflation
Process
Figure 27.6 illustrates a
cost-push inflation spiral.
Copyright © 2006 Pearson Education Canada
Inflation: Demand-Pull and Cost-Push
If the oil producers raise
the price of oil to try to
keep its relative price
higher,
and the Bank of Canada
responds with an increase
in aggregate demand,
a process of cost-push
inflation continues.
Cost-push inflation
occurred in Canada during
1974–1978.
Copyright © 2006 Pearson Education Canada
The Quantity Theory of Money
The quantity theory of money is the proposition that, in
the long run, an increase in the quantity of money brings
an equal percentage increase in the price level.
The quantity theory of money is based on the velocity of
circulation and the equation of exchange.
The velocity of circulation is the average number of
times in a year a dollar is used to purchase goods and
services in GDP.
Copyright © 2006 Pearson Education Canada
The Quantity Theory of Money
Calling the velocity of circulation V, the price level P, real
GDP Y, and the quantity of money M:
V = PY ÷ M
The equation of exchange states that
MV = PY
The equation of exchange becomes the quantity theory of
money by making two assumptions:
1. Velocity of circulation V is not influenced by M
2. Potential GDP is not influenced by M
Copyright © 2006 Pearson Education Canada
The Quantity Theory of Money
Given these two assumptions:
P = (V/Y)M
Because (V/Y) does not change when M changes, a
change in M brings a proportionate change in P.
Copyright © 2006 Pearson Education Canada
The Quantity Theory of Money
That is, the change in P, P, is related to the change in M,
M, by the equation:
P = (V/Y)M
Divide this equation by
P = (V/Y)M
and the term (V/Y) cancels to give
P/P = M/M
P/P is the inflation rate and = M/M is the growth rate of
the quantity of money.
Copyright © 2006 Pearson Education Canada
The Quantity Theory of Money
Evidence on the Quantity Theory
Canadian historical evidence is consistent with the
quantity theory.
1. On the average, the money growth rate exceeds the
inflation rate.
2. The money growth rate is correlated with the inflation
rate.
The next slide shows Figure 27.7, which summarizes
the Canadian data on inflation and money growth for the
years 1971-2001.
Copyright © 2006 Pearson Education Canada
The Quantity Theory of Money
Copyright © 2006 Pearson Education Canada
The Quantity Theory of Money
International evidence
shows a marked tendency
for high money growth rates
to be associated with high
inflation rates.
Figure 27.8(a) shows the
evidence for 134 countries
from 1990 to 2004.
Figure 27.8(b) shows the
evidence for 104 countries
from 1990 to 2004.
Copyright © 2006 Pearson Education Canada
The Quantity Theory of Money
Correlation, Causation, and Other Influences
Correlation is not causation; money growth and inflation
could be correlated because money growth causes
inflation, or because inflation causes money growth, or
because a third factor caused both.
But the combination of historical, international, and other
independent evidence gives us confidence that in the long
run, money growth causes inflation.
In the short run, the quantity theory is not correct; we need
the AS-AD model to understand the links between money
and inflation.
Copyright © 2006 Pearson Education Canada
Effects of Inflation
Failure to anticipate inflation correctly results in unintended
consequences that impose costs in both the labour market
and the capital market.
Unanticipated Inflation in the Labour Market
Unanticipated inflation has two main consequences in the
labour market:
 Redistribution of income
 Departure from full employment
Copyright © 2006 Pearson Education Canada
Effects of Inflation
Redistribution of Income
Higher than anticipated inflation lowers the real wage rate
and employers gain at the expense of workers.
Lower than anticipated inflation raises the real wage rate
and workers gain at the expense of employers.
Copyright © 2006 Pearson Education Canada
Effects of Inflation
Departure from Full Employment
Higher than anticipated inflation lowers the real wage rate,
increases the quantity of labour demanded, makes jobs
easier to find, and lowers the unemployment rate.
Lower than anticipated inflation raises the real wage rate,
decreases the quantity of labour demanded, and
increases the unemployment rate.
Copyright © 2006 Pearson Education Canada
Effects of Inflation
Unanticipated Inflation in the Market for Financial
Capital
Unanticipated inflation has two main consequences in the
market for financial capital:
 Redistribution of income
 Too much or too little lending and borrowing
Copyright © 2006 Pearson Education Canada
Effects of Inflation
Redistribution of Income
If the inflation rate is unexpectedly high, borrowers gain
but lenders lose.
If the inflation rate is unexpectedly low, lenders gain but
borrowers lose.
Copyright © 2006 Pearson Education Canada
Effects of Inflation
Too Much or Too Little Lending and Borrowing
When the inflation rate is higher than anticipated, the real
interest rate is lower than anticipated, and borrowers want
to have borrowed more and lenders want to have loaned
less.
When the inflation rate is lower than anticipated, the real
interest rate is higher than anticipated, and borrowers
want to have borrowed less and lenders want to have
loaned more.
Copyright © 2006 Pearson Education Canada
Effects of Inflation
Forecasting Inflation
To minimize the costs of incorrectly anticipating inflation,
people form rational expectations about the inflation rate.
A rational expectation is one based on all relevant
information and is the most accurate forecast possible,
although that does not mean it is always right; to the
contrary, it will often be wrong.
Copyright © 2006 Pearson Education Canada
Effects of Inflation
Anticipated Inflation
Figure 27.9 illustrates an
anticipated inflation.
Aggregate demand
increases, but the increase
is anticipated, so its effect
on the price level is
anticipated.
Copyright © 2006 Pearson Education Canada
Effects of Inflation
The money wage rate
rises in line with the
anticipated rise in the price
level.
The AD curve shifts
rightward and the SAS
curve shifts leftward so
that the price level rises as
anticipated and real GDP
remains at potential GDP.
Copyright © 2006 Pearson Education Canada
Effects of Inflation
Unanticipated Inflation
If aggregate demand increases by more than expected,
inflation is higher than expected.
Money wages do not adjust enough, and the SAS curve
does not shift leftward enough to keep the economy at full
employment.
Real GDP exceeds potential GDP.
Wages eventually rise, which leads to a decrease in the
short-run aggregate supply
Copyright © 2006 Pearson Education Canada
Effects of Inflation
The economy experiences more inflation as it returns to
full employment.
This inflation is like a demand-pull inflation.
Copyright © 2006 Pearson Education Canada
Effects of Inflation
If aggregate demand increases by less than expected,
inflation is less than expected.
Money wages rise too much and the SAS curve shifts
leftward more than the AD curve shifts rightward.
Real GDP is less than potential GDP.
This inflation is like a cost-push inflation.
Copyright © 2006 Pearson Education Canada
Effects of Inflation
The Costs of Anticipated Inflation
Anticipated inflation occurs at full employment with real
GDP equal to potential GDP.
But anticipated inflation, particularly high anticipated
inflation, inflicts three costs:
 Transactions costs
 Tax effects
 Increased uncertainty
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
A Phillips curve is a curve that shows the relationship
between the inflation rate and the unemployment rate.
There are two time frames for Phillips curves:
 The short-run Phillips curve
 The long-run Phillips curve
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
The Short-Run Phillips Curve
The short-run Phillips curve shows the tradeoff between
the inflation rate and unemployment rate, holding constant
1. The expected inflation rate
2. The natural unemployment rate
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
Figure 27.10 illustrates a
short-run Phillips curve
(SRPC)—a downwardsloping curve.
If the unemployment rate
falls, the inflation rate
rises.
And if the unemployment
rate rises, the inflation rate
falls.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
The negative relationship
between the inflation rate
and unemployment rate
is explained by the ASAD model.
Figure 27.11 shows how.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
Aggregate demand is
expected to increase to AD1
so the money wage rate
rises and the short-run
aggregate supply curve
shifts to SAS1.
If this outcome occurs, the
inflation rate is 10 percent
and unemployment is at the
natural rate.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
An unexpectedly large
increase in aggregate
demand raises the inflation
rate and increases real
GDP, which lowers the
unemployment rate.
A higher inflation is
associated with a lower
unemployment, as shown
by a movement along a
short-run Phillips curve.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
An unexpectedly small
increase in aggregate
demand lowers the inflation
rate and decreases real
GDP, which raises the
unemployment rate.
A lower inflation is
associated with a higher
unemployment, as shown
by a movement along a
short-run Phillips curve.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
The Long-Run Phillips Curve
The long-run Phillips curve shows the relationship
between inflation and unemployment when the actual
inflation rate equals the expected inflation rate.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
Figure 27.12 illustrates the
long-run Phillips curve
(LRPC) which is vertical at
the natural rate of
unemployment.
Along the long-run Phillips
curve, because a change
in the inflation rate is
anticipated, it has no effect
on the unemployment rate.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
Figure 27.12 also shows
how the short-run Phillips
curve shifts when the
expected inflation rate
changes.
When expected inflation
falls from 10 percent to 7
percent, the short-run
Phillips curve shifts
downward by an amount
equal to the fall in the
expected inflation rate.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
But with an expected
inflation rate of 10 percent
a year, a fall in the actual
inflation rate to 7 percent a
year would increase the
unemployment rate to 9
percent at point C.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
Changes in the Natural
Unemployment Rate
A change in the natural
unemployment rate shifts
both the long-run and
short-run Phillips curves.
Figure 27.13 illustrates.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
The Canadian Phillips
Curve
Each dot represents
the combination of
inflation and
unemployment in a
particular year in
Canada.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
Figure 27.14 (a)
shows the actual path
traced out in inflation
rate-unemployment
rate space.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
Figure 27.14(b)
interprets the data
with shifting short-run
and long-run Phillips
curves.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
In the 1960s, the
natural rate of
unemployment was
5 percent, so the
long-run Phillips
curve was LRPC1.
With an expected
inflation rate of 3
percent a year, the
short-run Phillips
curve was SRPC1.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
During the 1970s and
through 1982, the
natural rate of
unemployment
increased to 10
percent. The long-run
Phillips curve shifted to
LRPC2.
The expected inflation
increased to 9 percent
a year, and the shortrun Phillips curve
shifted to SRPC2.
Copyright © 2006 Pearson Education Canada
Inflation and Unemployment:
The Phillips Curve
During the 1980s and
1990s, the natural
rate of unemployment
decreased to 7
percent. The long-run
Phillips curve shifted
to LRPC3.
The expected
inflation rate fell to 2
percent a year and
the short-run Phillips
curve shifted back to
SRPC1.
Copyright © 2006 Pearson Education Canada
Interest Rates and Inflation
Interest rates and
inflation rates are
correlated, although
they differ around the
world.
Figure 27.15(a) shows a
positive correlation
between the inflation
rate and the nominal
interest rate over time in
Canada.
Copyright © 2006 Pearson Education Canada
Interest Rates and Inflation
Figure 27.15(b) shows
a positive correlation
between the inflation
rate and the nominal
interest rate across
countries.
Copyright © 2006 Pearson Education Canada
Interest Rates and Inflation
How Interest Rates are Determined
The real interest rate is determined by investment demand
and saving supply in the global capital market.
The real interest rate adjusts to make the quantity of
investment equal the quantity of saving.
National real rates vary because of differences in risk.
The nominal interest rate is determined by the demand for
money and the supply of money in each nation’s money
market.
Copyright © 2006 Pearson Education Canada
Interest Rates and Inflation
Why Inflation Influences the Nominal Interest Rate
On the average, and other things remaining the same, a 1
percentage point rise in the inflation rate leads to a 1
percentage point rise in the nominal interest rate. Why?
The answer is that the financial capital market and the
money market are closely interconnected.
The investment, saving, and demand for money decisions
that people make are connected and the result is that
equilibrium nominal interest rate approximately equals the
real interest rate plus the expected inflation rate.
That is, inflation influences the nominal interest rate to
maintain an equilibrium real interest rate.
Copyright © 2006 Pearson Education Canada
Copyright © 2006 Pearson Education Canada