Download Inflation is

Inflation is ...
• Inflation is a rise in the price level.
• Pure inflation is when goods and input prices
rise at the same rate.
• One of the first acts of the Labour
government in 1997 was to make the Bank of
England independent
– with a mandate to achieve low inflation.
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Some questions about
inflation
• What are the causes of inflation?
• What are the effects and hence costs of
inflation?
• What can be done about it?
• These are the questions we seek to
answer in what follows.
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Inflation in the UK, 1950-2000
30
25
% p.a.
20
15
10
5
0
2000
1990
1980
1970
1960
1950
Source: Economic Trends Annual Supplement, Labour Market Trends
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The quantity theory (1)
• The quantity theory of money says:
• “Changes in the nominal money supply lead
to equivalent changes in the price level (and
money wages) but do not have effects on
output and employment.”
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The quantity theory (2)
• We can state it algebraically as:
– MV = PY
– where V = velocity of circulation
Y = potential level of real GDP
P = the price level
M = nominal money supply
– Given constant velocity, if prices adjust to maintain
real income at the potential level
– an increase in nominal money supply leads to an
equivalent increase in prices.
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Money, prices and inflation (1)
• Milton Friedman famously claimed
“Inflation is always and everywhere a
monetary phenomenon.”
– i.e. it results when money supply grows more
rapidly than real output.
• But notice that the quantity theory equation
does not tell us whether prices determine
quantity or vice versa.
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Money, prices and causation (a)
• In money market equilibrium, the supply of
real money equals the demand for money i.e.
– M/P = Y/V
• If the demand for real money is constant,
M/P is constant.
• Monetary policy can fix M, in which case M
 P
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Money, prices and causation (b)
• OR monetary policy can try and fix P over
time, in which case P  M
• This latter approach is known as inflation
targeting
• in contrast to the former approach which
indirectly targets the money supply.
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Money, prices and inflation (2)
• In any case, in the long run, potential real
GDP and interest rates will significantly alter
real money demand
• Therefore, in the long-run there may not be a
perfect correspondence between excess
monetary growth and inflation.
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Money, prices and inflation (3)
• Also, in the short run, the link between
money and prices may be broken if:
– the velocity of circulation is variable
– prices are sluggish.
• For all the above reasons, we must therefore
interpret the quantity theory with care.
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Inflation and interest rates
• FISHER HYPOTHESIS
– a 1% increase in inflation will be accompanied by
a 1% increase in interest rates
• REAL INTEREST RATE
– Nominal interest rate minus inflation rate
– i.e. the Fisher hypothesis says that real interest
rates do not change much
– but the nominal interest rate is the opportunity
cost of holding money
– so a change in nominal interest rates affects real
money demand.
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Hyperinflation
• Hyperinflations are periods when inflation
rates are very large
• During such periods there tends to be a ‘flight
from cash’, i.e. people hold as little cash as
possible
– e.g. Germany in 1922-23, Hungary 1945-46, Brazil
in the late 1980s.
• Large government budget deficits help to
explain such periods
– persistent inflation must be accompanied by
continuing money supply growth
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The Phillips curve (1)
• In 1958, Prof. A W Phillips demonstrated a
statistical relationship between annual
inflation and unemployment in the UK.
• The Phillips curve relates higher
unemployment to lower inflation.
• It implies we can trade-off higher inflation
for lower unemployment and vice versa.
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Inflation rate (%)
The Phillips curve
Phillips curve
U*
Unemployment rate (%)
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The long-run Phillips curve (1)
• The vertical long-run Phillips curve
implies that sooner or later, the
economy will return to U* whatever the
inflation rate.
• The position of the short-run Phillips
curve depends on expected inflation.
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The long-run Phillips curve (2)
• The long-run and short-run curves
intersect when actual and expected
inflation are equalised.
• The long run Phillips curve shows that
in the long-run there is no trade-off
between unemployment and inflation.
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The long-run Phillips curve and an
increase in aggregate demand (1)
Inflation
Suppose the economy begins
at E, with unemployment
at the natural rate U*, and
inflation at 1
2
1
A
E
U1 U*
Unemployment
PC1
An increase in government
spending funded by an
expansion in money supply
takes the economy to A,
with lower unemployment
(U1) but inflation at 2.
… but what happens
next?
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The Long-run Phillips curve and an
increase in aggregate demand (2)
Inflation
LRPC
2 A
B
1
E
U1 U*
Unemployment
PC1 PC2
If the nominal money supply
continues to expand at the same
rate thereafter, the economy will
eventually move to B on PC2.
At B, inflation expectations
coincide with actual inflation
and nominal wages have
been renegotiated so that
the real wage and hence,
employment are the same as
before the monetary
expansion,
i.e. there is no trade-off between
unemployment and inflation
in the long-run
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The long-run Phillips curve and an
increase in aggregate demand (3)
Inflation
LRPC
2
1
A
Effectively, the long-run
Phillips curve is vertical,
as the economy always
adjusts back to U*.
The short-run Phillips curve
shows just a short-run
trade-off:
its position may depend
upon expectations about
inflation.
B
E
U1 U*
PC1 PC2
Unemployment
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Expectations and credibility
LRPC
1
2
E
A
PC1
F
PC2
U*
Suppose the economy begins
at E, with a newly-elected
government pledged to
reduce inflation.
Monetary growth is cut to 2.
In the short run, the economy
moves to A along the shortrun Phillips curve.
Unemployment rises to U1
As expectations adjust,
the short-run Phillips curve
shifts to PC2, and U*
is restored at F.
U1
Unemployment
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Inflation and unemployment
in the UK 1978-2000
20
1980
Inflation
15
1990
10
1978
5
2000
1986
1993
0
3
5
7
9
11
13
Unemployment
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Inflation illusion
• People have inflation illusion when they
confuse nominal and real changes.
• Welfare depends upon real variables, not
nominal variables.
• If all nominal variables (prices and incomes)
increase at the same rate, real income does
not change.
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The costs of inflation (1)
• Fully anticipated inflation:
• Institutions adapt to known inflation:
– nominal interest rates
– tax rates
– transfer payments
• there is no inflation illusion
• Some costs remain:
– shoe-leather
• people economise on money holdings
– menu costs
• firms need to alter price lists etc.
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The costs of inflation (2)
• Even if inflation is fully anticipated, the
economy may not fully adapt
– interest rates may not fully reflect inflation
– taxes may become distorted
• fiscal drag may have unintended effects on tax
liabilities
• capital and profits taxes may be distorted
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The costs of unanticipated inflation
• Unintended redistribution of income
– from lenders to borrowers
– from private to public sector
– from old to young
• Uncertainty
– firms find planning more difficult under inflation,
which may discourage investment
• This has been seen as the most important
cost of inflation
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Defeating inflation
• In the long run, inflation will be low if the
rate of money growth is low.
• The transition from high to low inflation may
be painful if expectations are slow to adjust.
• Policy credibility may speed the adjustment
process.
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The Monetary Policy Committee
• Central Bank Independence may improve the
credibility of anti-inflation policy.
• Since 1997 UK monetary policy has been set
by the Bank of England’s Monetary Policy
Committee
– which has the responsibility of meeting the
(underlying) inflation target
– via interest rates
– which are set according to inflation forecasts.
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Why inflation targeting?
• Unpredictable changes in real money demand
undermined attempts to use a nominal
money target.
• Setting inflation targets involves an element
of forward-looking.
• MPC performance so far has been creditable.
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