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Chapter 32
Inflation
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What will you learn in this chapter?
• How to explain the neutrality of money.
• What the classical theory of inflation is.
• What relationship exists between the quantity
theory of money and inflation (and deflation).
• What the role of monetary policy is in creating
inflation and deflation, and what their economic
consequences are.
• What relationship exists between inflation, the
output gap, and monetary policy.
• How the Phillips curve models the relationship
between inflation and unemployment.
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Changing price levels
• The price level, and especially changes in it, is
one of the most important concepts in
macroeconomics.
• Inflation is an overall rise in prices in the
economy.
• Deflation is an overall fall in prices in the
economy.
• Core inflation excludes goods with historically
volatile price changes.
• Headline inflation includes all of the goods that
the average consumer buys.
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Changing price levels
To understand the underlying rate of inflation in the economy,
headline inflation and core inflation are often differentiated.
Percentage %
6
CPI
Core CPI
5
4
3
2
1
0
Jan-02
Jan-04
Jan-06
Jan-08
Jan-10
Jan-12
-1
-2
• Core CPI represents core inflation.
• Core CPI is much more stable than headline inflation.
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The neutrality of money
• A country’s GDP is simply an accounting of all of
the purchases and sales that take place over a
given period.
• Measuring output in terms of money can be
problematic.
• The aggregate price level is a measure of the
average price level for GDP.
– Price indices, such as the CPI or GDP deflator, convert
nominal values into real values.
• The neutrality of money is the idea that real
outcomes in the economy are not affected by
aggregate price levels.
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The classical theory of inflation
• The classical theory of inflation states that in the long run,
increases in the money supply will lead to an increase in prices
only.
• This theory can be illustrated using the aggregate demand and
aggregate supply model.
Price level
LRAS
SRAS 2
SRAS1
P3
P2
E3
P1
E1
– Increases prices and output, E2.
E2
AD 2
AD1
Y1,3 Y2
Real GDP (trillions of dollars)
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• Suppose the economy is in longrun equilibrium, E1.
• In the short run, increases in
money supply shift AD outward.
• Eventually, prices will rise in
proportion with the increase in the
money supply, shifting the SR
aggregate supply curve.
• In the long run, only prices
increase, E3.
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2
The quantity theory of money
• The quantity theory of money states that the value
of money is determined by the money supply.
– The aggregate price level is also determined this way,
as it is tied directly to the value of money.
• The quantity theory of money can be seen
mathematically through the quantity equation:
M × V = P × Y
– The velocity of money, V, is the number of times that
the entire money supply turns over in a given period.
– The quantity theory of money depends on V being
relatively constant.
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Active Learning: Velocity of money
Use the quantity equation to fill in the blanks in
the following table.
Price level (P)
Real output (Y)
Money supply (M)
$1
$10,000
$5,000
$1
Velocity of money (V)
$15,000
$2
3
$25,000
5
$8,000
$32,000
1
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The quantity theory of money
• To establish a relationship between money and prices requires a
stable velocity.
• The data suggests that the U.S. velocity of money has been relatively
stable.
Velocity of M1 in the United States
Ratio to nominal GDP
12
10
M1 velocity
8
6
4
2
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
• The recent crisis has temporarily caused some significant changes.
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Why do we care about changing price levels?
• The quantity equation implies that increasing the
money supply leads to inflation and decreasing the
money supply leads to deflation.
– The economy adjusts to a different nominal price level
when the money supply changes.
• Leads to the conclusion that the price level is
immaterial.
– Changes in the price level can have a big effect on
economic behavior.
– A modest and predictable level of inflation can be a good
thing.
– High inflation, unpredictable inflation, and deflation are bad
for economies.
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Inflation
Over the last forty years, inflation has generally decreased.
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Inflation
• There are costs of predictable inflation.
– Menu costs are the money, time, and
opportunity costs of changing prices to keep up
with inflation.
– Shoe-leather costs are the time, money, and
effort costs of managing cash in the face of
inflation.
– Tax distortion refers to the fact that tax laws only
take into consideration nominal income, not
what you can buy with it.
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Inflation
• There are also problems with unpredictable
inflation.
– Changing prices affects interest rates.
– The nominal interest rate is the reported interest
rate that is not adjusted for the effects of inflation.
– The real interest rate is adjusted for the effects of
inflation.
• Mathematically, this relationship can be
established as:
Real interest rate = Nominal interest rate – Inflation rate
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Active Learning: Inflation
Use the equation relating inflation and interest rates to
fill in the blanks in the following table.
Real interest rate (%)
Nominal interest rate (%)
Inflation rate (%)
6
1
2.75
0
2.5
4.5
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Inflation
The effects of inflation rates are easily observed.
Value
in 2010 ($)
Nominal
interest
rate ($)
Inflation
Real interest
Nominal
Value in 2015
rate (%)
rate (%)
2015 value
($)
(2010 dollars)
1,000
4
0
4
1,217
1,217
1,000
4
3
1
1,217
1,051
1,000
4
5
-1
1,217
951
• Without inflation, the real and nominal interest rates are the same.
• With inflation, the real interest rate is less than the nominal rate.
• If inflation is greater than the nominal rate, investment is worth less in real
value.
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Inflation
• The analysis suggests that savers are worse off,
while borrowers are better off, from inflation.
• If inflation is predictable, then this
redistributive effect need not happen.
– Even if inflation is high, savers will not lose out as
long as banks offer nominal interest rates above
inflation.
• Changes in the inflation rate often come as a
surprise, and it can take time for nominal
interest rates to adjust.
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Active Learning: Interest rates and inflation
• You deposit $100 in a savings account with an
annual interest rate of 5%.
• The inflation rate over the next year is 2%.
1. How much more do you have in the bank account
at the end of one year?
2. How much has your purchasing power changed?
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Deflation
• Deflation is a sustained fall in the aggregate
price level.
• Periods of deflation occur less often than
inflation.
• Deflation causes aggregate demand to
decrease.
– Increases the burden of debt, which leads to a
decrease in consumption.
– Companies are less willing to borrow money,
which leads to a decrease in investment.
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Disinflation and hyperinflation:
Controlling inflation, or not
• Disinflation is a period where inflation rates
are falling, but still positive.
– This usually occurs when the central bank
aggressively tries to contain inflation via
contractionary monetary policy.
• Hyperinflation refers to extremely longlasting and painful increases in the price
level.
– This can leave currency completely valueless or
close to it.
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Inflation as a buffer against deflation
• Preferred monetary policy is to promote
modest positive inflation around 2-3% per
year.
• Inflation reduces the risk of deflation.
• Permits the central bank to implement
expansionary monetary policy.
• Makes it easier for firms to adjust real wages in
response to changes in the labor market.
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Inflation and monetary policy
• The Fed’s dual mandate is to maintain price
stability and ensure full employment.
– These goals are often incompatible.
• An economy’s potential output is the total
amount of output a country could produce
if all of its resources were fully engaged.
– This means that only frictional and structural
unemployment occur.
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Inflation and monetary policy
The difference between potential and actual output in
an economy is the output gap.
Percent of total GDP (%)
4
2
0
1980
1985
1990
1995
2000
2005
2010
22
24
26
28
• For the most part, actual output in the U.S. has
stayed below potential output since 1980.
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Inflation and monetary policy
• There is a strong positive relationship between
the output gap and inflation.
– During recessionary periods, there is typically little to
no threat of a rise in inflation.
– During expansionary periods, there is a higher threat
of rising prices as resources become more scarce.
• A central bank can engage in expansionary
monetary policy to increase employment.
– In the long-run, employment will decrease but prices
will remain higher.
• Central banks can affect prices with no lasting
impact on employment.
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The Phillips curve
The Phillips curve models the connection between
inflation and unemployment in the short run.
Hypothetical short-run Phillips curve for an economy
Inflation rate (%)
7
6
5
4
3
2
1
0
0
-1
-2
1
2
3
4
5
6
7
• In strong economies,
prices increase at a faster
rate and unemployment is
low.
• When unemployment
increases, prices increase
more slowly.
8
Phillips curve
Unemployment rate
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The Phillips curve
• An increase in aggregate demand results in an increase
in price and output in the short run.
• The Phillips curve shows that this is associated with
higher inflation and lower unemployment.
Phillips curve
Aggregate demand and supply
Inflation rate (%)
Price level
6
SRAS
5
104
103
E1
E1
3
AD2
2
1
AD1
Y1
E2
4
E2
Y2
0
1
2
-1
Real GDP (trillions of dollars)
3
4
5
6
7
8
Unemployment rate
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The Phillips curve
In the long run, output returns to its earlier
equilibrium, and so do levels of employment.
Inflation rate (%)
10
9
8
7
B
6
5
4
3
2
1
0
-1
-2
1. When the central bank increases short-run
aggregate demand, unemployment initially
falls (A→B).
2. However, once the economy returns to the long-run
equilibrium, unemployment returns to the same level
while inflation stays the same (B→C).
C
A
P2
1
2
3
4
5
6
Unemployment rate
7
8
9
P1
• Individuals expect higher price levels, causing inflation to be
permanently higher.
• Connecting the two long-run equilibrium points yields the long-run
Phillips curve.
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The Phillips curve
• The long-run Phillips curve is also called the nonaccelerating inflation rate of employment (NAIRU).
• The long-run Phillips curve shows that there is no tradeoff
between inflation and unemployment in the long run.
• The NAIRU can change over time
due to structural changes in
employment.
• It is difficult to know the exact
location of the NAIRU.
• It is easy to determine if the
economy is above or below it.
The long-run Phillips curve
Inflation rate (%)
NAIRU
10
9
8
7
6
5
4
3
2
1
0
1
2
3
4
5
6
-1
Unemployment rate
-2
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P2
7
8
9
P1
– If unemployment is below the NAIRU,
inflation generally accelerates.
– If involuntary unemployment rises,
unemployment is above the NAIRU.
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The Phillips curve and NAIRU in practice
• In the 1970s, the Fed attempted to fight high inflation by expanding the
money supply.
– Shifted the Phillips curve upward.
• In the 1980s, the Fed fought inflation by raising interest rate.
– Shifted the Phillips curve downward.
The Phillips curve winds upwards
The Phillips curve adjusts downwards
Inflation rate (%)
12
Inflation rate (%)
16
1979
1974
14
10
1980
12
1975
8
1973
1970
6
P2
1978
1977
4
8
1976
1971
6
2
4
6
8
Unemployment rate
10
0
2
P2
1982
1985
2
P1
0
1984
4
1972
2
1981
10
4
6
8
Unemployment rate
1983
P3
10
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Summary
• Inflation is an increase in the price level in an
economy.
– Unstable inflation rates introduce uncertainty into
the market.
• Deflation is a fall in the price level in an
economy.
– Considered more dangerous than inflation because
there is less borrowing and less spending.
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Summary
• Disinflation occurs when inflation rates are
positive but falling.
• Hyperinflation is when there are extreme rises
in price levels.
• The central bank can use monetary policy to
control inflation.
– Prefer to keep inflation low, but positive.
• The difference between potential and actual
output is the output gap.
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Summary
• When the output gap is positive, inflation
increases.
• The Phillips curve models the relationship
between employment and information.
– This relationship does not hold over the long run,
in part because of inflation expectations.
• The level of unemployment where inflation
remains stable is called the non-accelerating
inflation rate of unemployment (NAIRU).
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