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Macroeconomic Theory and Policy
Lecture 32
Theories of Inflation and Deflation
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Learning Objectives
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Inflation in the classical model
Deficit financing and inflation
Cagan’s model of hyper inflation
Policies to control hyper inflation
Demand pull and cost push inflations
Views on the role of economic policy
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Inflation in the Classical Theory
Friedman: Inflation is every time and everywhere a
monetary phenomenon.
Quantity Theory of money: M t V
M = money supply, V = velocity,
P = price level, Y = output
Take log of both sides:
ln (Pt ) = ln (M
)+
t
= Pt Y t
ln (V ) − ln (Y t
)
differentiate with respect to time(V is constant):
P&t
M&
=
Pt
M
t
t
V&t
Y&t
+
−
Vt
Yt
In usual notations:
π
t
= g m ,t − g
y ,t
Thus the inflation is directly the result of excess of rate
of growth of money supply growth over that of output.
Why does money supply grow more than output?
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Seigniorage (inflation tax) Model of Inflation
Suppose the deficit is financed by money creation
⎛ G −T ⎞
M
Δ
⎟
ΔB =
= ⎜⎜
P ⎜⎝ P ⎟⎟⎠ (1)
Seigniorage (inflation tax) can be defined as
⎛ G −T ⎞
⎛ G −T ⎞
M
⎟
M
M
Δ
⎜
⎟
S = gm = ⎜⎜
S=
=⎜
⎟ or
P ⎜⎝ P ⎟⎟⎠ (2)
M P ⎜⎝ P ⎟⎠
Demand for money is inversely related with the growth rate of
money supply
M
= β − α g m (3)
P
Using (3) in (2) we get seigniorage as
S = gm ⎛⎜⎝ β −αgm ⎞⎟⎠ = βgm −α (gm )2
Optimal growth that maximizes S is
g m =
β
2α
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Cagan’s Model of Inflation and Money Supply
mt − pt = −γ (Pt +1 − Pt )
pt = mt + γ (Pt +1 − Pt )
or rearranging this we get
or
pt =
1
γ
mt +
Pt +1 .
1+ γ
1+ γ
Now using an iterative
procedure:
⎛ γ
γ
1 ⎡
pt =
mt +1 + ⎜⎜
⎢ mt +
1+ γ ⎢
1+ γ
⎝1+ γ
⎣
2
⎞
⎛ γ
⎟⎟ mt + 2 + ⎜⎜
⎠
⎝1+ γ
3
⎤
⎞
⎟⎟ mt + 3 + .... + ...⎥
⎥⎦
⎠
or by simply
taking expectations of future money supply.
⎛ γ
γ
1 ⎡
pt =
Em t +1 + ⎜⎜
⎢ Em t +
1+ γ ⎢
1+ γ
⎝1+ γ
⎣
2
⎞
⎛ γ
⎟⎟ Em t + 2 + ⎜⎜
⎠
⎝1+ γ
3
⎤
⎞
⎟⎟ Em t + 3 + .... + ...⎥
⎥⎦
⎠
Inflation rate depends upon series of expected money
supply.
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Seigniorage and Hyperinflation
Seven Hyperinflation of the 1920s and 1940s
Average Monthly Average Monthly
PT/PO inflation rate (%) MoneyGrowth (%)
Country
Beginning
End
Austria
Oct. 1921
Aug. 1922
70
47
31
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Germany
Aug. 1922
Nov. 1923
1.0x10
322
314
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Greece
Nov. 1943
Nov. 1944
4.7x10
365
220
Hungary I
Mar. 1923
Feb. 1924
44
46
33
27
Hungary II
Aug. 1945
Jul. 1946
2.8x10
19,800
12,200
Poland
Jan. 1923
Jan. 1924
699
82
72
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Russia
Dec. 1921
Jan. 1924
1.2x10 57
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nd
Source: Blanchard text, 2 ed. p. 447.
Tanzi-Olivera Effect: Higher inflation creates large deficits because real values of
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Determination of the Natural Rate of Unemployment: Wage and Price
Setting and Inflation Example from Blanchard (2002; pp.179)
Price Setting:
Pt = W t (1 + μ )
(1)
W t = Pt e (1 − au t + z ) (2)
Wage setting:
Aggregate supply From (1) and (2):
Pt = Pt e (1 + μ )( 1 − au t + z ) (3)
Dividing both sides by Pt-1 :
Pt
Pt e
(1 + μ )(1 − au t + z t ) (4)
=
Pt − 1
Pt − 1
Pt
P − Pt − 1 + Pt − 1
= t
= 1 + π t (5)
Pt − 1
Pt − 1
Pt e
Pt e − Pt e− 1 + Pt e− 1
e
=
=
1
+
π
t
(6)
Pt e− 1
Pt e− 1
Substituting (5) and (6) in (4)
1 + π t = 1 + π te (1 − au t + z ) (7)
Using the approximation rule of multiplication
π t = π te − au t + z
Phillips Curve:
(
)
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Policies used to control Hyperinflation
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Fiscal reform and credible deficit reduction programme.
Spending reform: suspension of debt payments.
Taxation: change the structure of the tax system.
Central Bank must make a credible commitment not to monazite
the government debt.
Incomes Policies: Wage and price guidelines (heterodox
program, indexing).
Stabilisation programme may fail if people believe that they are
going to fail (think of unions demand for high wage rate in
expectations of price increase, higher prices by producers in
anticipation of higher wage demands).
Cost of disinflation: recession and unemployment.
Restoring credibility or ending confidence crisis.
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Price and Output Response to Aggregate Demand Shock
Y = Yn :Classical supply
AS
Neoclassical supply
(
)
(
Y = Yn + 10 P − P e = Yn + 10 π − π e
c
)
P1
b
a
P
Keynesian Supply
d
P=P
Y = AD
AD1
LAS
0 shock
Reply to a demand
Adaptive Expectation: a to b to c
Rational expectation: a to c
Keynesian response a to d
AD0
Y = yn
Y1
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Aggregate Demand, Productive Capacity and the Price Level
Higher Wage Rate Translates into Higher Prices
AS
Price Level
New
Classical
P5
P4
P3
P1
c
AD3
b
Keynesian
AD2
a
AD1
AD4
Y0
Y1
AD0
Y3
Yc
Output Gap
New
Keynes
part
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Inflation, Output and Unemployment in the Short Run
LAS
π >π
e
π =π
π <π
e
AS=f(w,pe)
⎧ a( y − y ) ⎫
⎪
⎪
π t = π e + ⎨ or ⎬ + s
⎪− b(u − u )⎪
⎭
⎩
e
AD =f(M,G, T)
o
y= y y>y
u> un u = un u< un
y< y
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Wage Price Spiral Aggregate Supply and Inflation
Mark up by firms and unions
Wt = 1+γ Pte
Pt = 1+θ Wt
(1)
⎛
⎜⎜
⎝
⎞
⎟⎟
⎠
θ +γ = a⎛⎜⎜⎝ y − y ⎞⎟⎟⎠ = −b⎛⎜⎜⎝u − u ⎞⎟⎟⎠
π t = π + a⎛⎜⎝ y − y ⎞⎟⎠
⎛
⎜⎜
⎝
⎞
⎟⎟
⎠
π t = π − b⎛⎜⎝u − u ⎞⎟⎠
(2)
The actual inflation depends both on
expectations as well as the cyclical
components.
Now include the supply shock to
represent all non-labour costs
a⎛⎜⎝ y − y ⎞⎟⎠ ⎫⎪
⎪
π t =π +
or ⎪⎬ + s
⎪
− b⎛⎜⎝u − u ⎞⎟⎠⎪⎪
⎧
⎪
⎪
⎪
⎨
⎪
⎪
⎪
⎩
(3)
⎭
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Adaptive and Rational Expectation Views on the Demand
Pull Inflation
LAS
SAS
c
P2
b
P1
P
P0
a
AD1
AD0
0
Reply to a demand shock
Adaptive Expectation: a to b to c
Rational expectation: a to c
Yn
Y
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Demand pull and Cost Push Inflation:
Movement of Aggregate Demand and Supply Around the Natural Rate
AS1
AS2 SA3
P2
Price Level
d
e
AS0
P3
P1
c
f
b
P0
AD3
a
AD1
AD0
0
YL Yn
YH
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Should Policy be Active or Passive?
Classical Economists on Economic Policy
Economy left itself will do better than with
an active intervention.
Perfectly flexible prices of goods, labour
and capital guarantee full employment
equilibrium consistent with maximisation of
welfare.
Supply creates its own demand in a free
market economy (general equilibrium model
as we discussed in micro foundation part
describe the frictionless economy).
Classical economists believed that active
policy may do more harm than good.
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Lags in Economic Policy
• Recognition lag:
turning points of business cycle difficult to
recognise
• Decision lag:
parliamentary process,
dispute among political parties
• Implementation lag:
It takes time for policy to reach to grassroot
level
• Impact lag:
institutional and technological inertial and
persistent habits
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Classical, Keynesian and Monetarist Approaches to Economic Policy
Classical economists suggest
“do-nothing” or “do minimum” policy to
be better than an active policy.
- Well-intentioned policy makers do more
harm than good.
- The self interest of the policy makers
may not be in the best interest of the
country.
- Money is neutral.
Monetarist argue for a money supply
rule such as the interest rate rule
Keynesian favour active policy
New-classical like classical argue for
minimum role of the government
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References
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