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Transcript
Macroeconomic Theory and Policy Lecture 32 Theories of Inflation and Deflation 1 Learning Objectives • • • • • • 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 2 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? 3 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 4 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. 5 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 10 Germany Aug. 1922 Nov. 1923 1.0x10 322 314 6 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 5 Russia Dec. 1921 Jan. 1924 1.2x10 57 49 nd Source: Blanchard text, 2 ed. p. 447. Tanzi-Olivera Effect: Higher inflation creates large deficits because real values of 6 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: ( ) 7 Policies used to control Hyperinflation • • • • • • • • 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. 8 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 9 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 10 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 11 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) ⎭ 12 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 13 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 14 • • • • 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. 15 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 16 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 17 References • • • • • • • • • • • • • • • • • • • • • • • • • • • Aghevli B B (1977), Inflationary Finance and Growth, Journal of Political Economy, vol. 85, no.6 pp. 1295-1307. Bailey M J. (1956) The Welfare Cost of Inflationary Finance, Journal of Political Economy, vol.LXIV no. 2, April, pp. 93-110. Ball Laurence (1999) Aggregate Demand and Long-Run Unemployment, Brookings Paper on Economic Activity, 2. Ball Laurence and Romer David (1990) Real Rigidities and the Non-Neutrality of Money, Review of Economic Studies, 1990 57 183-203. Barro R.J. (1995) Inflation and Economic Growth, Bank of England Quarterly Bulletine, vol. 35, no. 2, May, pp. 166-175. Blanchard O.J. and L.H. Summers (1986) Hysterisis and the European Unemployment Problem in S.Fischer ed. Macroeconomic Annual. 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Nickeel (1990) Is Unemployment Lower if Unions Bargain Over Employment?, Quarterly Journal of Economics, 3, 773-87. Mankiw Gregory N. 1985: Small Menu Costs and large Business Cycles: A macroeconomic Model of Monopoly, QJE, 1985, pp.529-537. Manning, Alan (1995) Development in Labour Market Theory and their implications for macroeconomic Policy, Scottish Journal of Political Economy, vol.42, no. 3, August 1995. Monetary Policy Committee Bank of England ( ) The Transmission Mechanism of Monetary Policy, www.bankofengland.co.uk. Nickel Stephen (1990) Unemployment Survey, Economic Journal, June, pp 391-439. Nickell, S. (1990), “Inflation and the UK Labor Market,” Oxford Review of Economic Policy; 6(4) Winter. Phelps, Edmund S. (1968), Money-Wage Dynamics and Labor-market equilibrium, Journal of Political Economy, vol. 76, pp. 678-710. Phelps E. S. and J.B. Taylor (1977) Stabilisation Powers of Monetary Policy under Rational Expectations, Journal of Political Economy, vol.85 no. 1, pp. 163-190. Phillips, A. W., (1958) The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957, Economica, pp.283-299. Taylor J B (1972) Staggered Wage Setting in a Macro Model, American Economic Review, 62, pages 1-18. Yellen J. L (1984) Efficiency wage models of unemployment, AEA papers and proceedings vol.74 No.2, May, pp. 199-205. 18