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Chapter 29
INFLATION AND ITS
RELATIONSHIP TO
UNEMPLOYMENT AND GROWTH
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29-2
Today’s lecture will:
• Discuss some of the distributional effects of
•
•
•
•
•
inflation.
Explain how inflation expectations are formed.
Outline the quantity theory of money and its
theory of inflation.
Discuss the institutionalist theory of inflation.
Differentiate between long-run and short-run
Phillips curves.
Explain the different views on the relationship
between inflation and growth.
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29-3
Some Basics About Inflation
• Inflation is a continuous rise in the
•
•
price level.
People who can’t raise their prices or
wages are hurt by inflation.
If people can raise their wages or
prices and still keep their jobs or sell
their goods, inflation doesn’t hurt
them.
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29-4
The Distributional
Effects of Inflation
• Unexpected inflation redistributes income
from lenders to borrowers.
 If lenders charge a nominal rate of 5% and
expect inflation to be 2%, their real rate is 3%.
 If inflation is actually 4%, their real rate is
only 1%.
• People who do not expect inflation and
who are tied to fixed nominal contracts
are likely to lose in inflation.
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29-5
Expectations of Inflation
• Expectations play a key role in the
inflationary process.
 Rational expectations – the
expectations that the economists’
models predict.
 Adaptive expectations – those based on
what has been in the past.
 Extrapolative expectations – those that
assume a trend will continue.
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29-6
Productivity, Inflation,
and Wages
• Changes in productivity and changes
•
in wages determine whether inflation
may be coming.
There will be no inflationary
pressures if wages and productivity
increase at the same rate.
Inflation = Nominal wage increases
- Productivity growth
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29-7
Deflation
• Deflation – a sustained fall in the price
•
•
•
level.
Deflation is the opposite of inflation and is
associated with a number of problems in
the economy.
Deflation limits how low the Fed can push
the real interest rate.
Deflation is often associated with large
falls in stock and real estate prices.
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29-8
Theories of Inflation
• The two theories of inflation are the
quantity theory and the institutional
theory.
 The quantity theory emphasizes the
connection between money and inflation;
if the money supply rises, the price level
rises.
 The institutional theory emphasizes
market structure and price-setting
institutions and inflation.
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29-9
The Equation of Exchange
MV = PQ
M = Quantity of money
V = Velocity of money
PQ = Nominal output
Q = Real output
P = Price level
Nominal GDP
Velocity 
Money supply
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29-10
Velocity is Constant
• Velocity of money – the number of times
•
•
per year, on average, a dollar goes around
to generate a dollar’s worth of income.
The quantity theory assumes that velocity
is constant.
If velocity is constant, nominal GDP will
grow by the same percent as the money
supply grows.
%M  %P
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29-11
Real Output is Independent
of the Money Supply
• The second assumption of the quantity theory
•
•
•
is that real output (Q) is independent of the
money supply.
Q is autonomous, determined by forces
outside those in the quantity theory.
The third assumption is that causation goes
from money to prices.
The quantity theory says that the price level
varies in response to changes in the quantity
of money.
%M  %P
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29-12
Examples of Money’s
Role in Inflation
• The quantity theory lost favor in the late
•
1980s and early 1990s.
The formerly stable relationship between
measurements of money and inflation
appeared to break down because:
 Technological changes and changing
regulations in financial institutions.
 Increasing global interdependence of
financial markets.
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29-13
U.S. Price Level and Money
Relative to Real Income
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29-14
Inflation and Money Growth
• The empirical evidence that supports the
•
•
quantity theory of money is most convincing
in Argentina and Chile.
Central banks in these nations are not as
politically independent as those in developed
countries.
Their central banks sometimes increase the
money supply to keep the economy running.
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29-15
Inflation and Money Growth
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29-16
The Inflation Tax
• If the central bank must buy government bonds
•
•
to finance a government deficit, the money
supply increases and inflation may occur.
This inflation works as a kind of tax on
individuals, and is often called an inflation tax
because it reduces the value of cash.
Central banks have to make a policy choice:
 Ignite inflation by bailing out their governments with

an expansionary monetary policy.
Do nothing and risk recession or economic
breakdown.
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29-17
Policy Implications
of the Quantity Theory
• Supporters of the quantity theory oppose an
•
•
activist monetary policy because it is
unpredictable in the short-run.
Quantity theorists favor a monetary policy set
by rules, rather than a discretionary monetary
policy.
A monetary rule takes money supply decisions
out of the hands of politicians, who almost
always advocate an expansionary policy.
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29-18
Policy Implications of the
Quantity Theory
• Many central banks use monetary
•
•
regimes or feedback rules.
New Zealand has a legally mandated
monetary rule to keep inflation
between 0 and 3 percent.
The Fed does not have strict rules,
but it works hard to show that it is
serious about controlling inflation.
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29-19
Institutionalist
Theories of Inflation
• Both quantity theorists and institutionalists
•
•
agree that money and inflation are positively
related, but they have different causes and
effects.
Quantity theorists believe that increases in
money cause direct increases in prices.
Institutionalists believe that increases in prices
force government to increase the money
supply or cause unemployment.
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29-20
Institutionalist Theories of Inflation
• According to the quantity theory, changes
in money cause changes in prices.
MV  PQ
• According to the institutionalists, increases in
prices force the government to increase the
money supply.
MV  PQ
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29-21
Institutionalist Theories of Inflation
• The source of inflation is firms who pass on
•
•
higher wages, rents, taxes, or other costs on to
consumers in the form of higher prices.
If the government increases the money supply
so that demand is sufficient to buy the goods
at higher prices, inflation is the result.
If the government doesn’t increase the money
supply unemployment increases.
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29-22
The Insider/Outsider
Model and Inflation
• The insider-outsider model is an
•
•
institutionalist story of inflation where
insiders bid up wages and outsiders are
unemployed.
Insiders are business owner and workers
with good jobs and excellent long-run
prospects who receive above equilibrium
wages.
Outsiders are everyone else.
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29-23
The Insider/Outsider
Model and Inflation
• If markets were purely competitive,
•
•
wages, profits, and rents would be
pushed down to equilibrium levels.
Insiders develop sociological and
institutional barriers such as unions and
brand recognition to prevent outsider
competition.
Outsiders must take dead-end low
paying jobs.
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29-24
Policy Implications of
Institutionalists
• Institutionalists agree that contractionary
•
•
•
monetary policy will control inflation, but in an
inefficient and unfair way.
They favor combining contractionary monetary
policy with incomes policy.
Incomes policy – a policy that places direct
pressure on individuals to hold down their
nominal wages and prices.
Informal incomes policies exist in many
European countries.
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29-25
Demand-Pull and
Cost-Push Inflation
• Demand-pull inflation occurs when the
economy is at or above potential
output.
 It is generally characterized by shortages
of goods and workers.
• Cost-push inflation occurs when the
economy is below potential output.
 Significant proportions of market or one
very important market experience price
increases not related to demand pressure.
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29-26
The Phillips Curve
• The tradeoff between inflation and
•
•
unemployment in the AS/AD model can be
represented graphically in the short-run Phillips
curve.
Short-run Phillips curve – a downward sloping
curve showing the relationship between
inflation and unemployment when inflation
expectations are constant.
In the 1960s the Phillips curve was thought to
represent macroeconomic policy options.
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29-27
The Phillips Curve
•
5
A
Inflation
4
•
3
2
Republicans favored
contractionary policy that
meant high unemployment
and low inflation (point B).
Democrats generally favored
expansionary policy that
meant low unemployment
and high inflation (point A).
B
1
0
4
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5 6 7
Unemployment rate
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29-28
Inflation
rate
The Rise of the Phillips Curve
(1954-1968)
In the 1950s and 1960s
the tradeoff between
unemployment and
inflation seemed
relatively stable.
1968
1956
4
3
1966
1967
2
1
0
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1957
1955
1964
1965
1959
1954
1960
1963
1962
4
5
6
Unemployment rate
1958
1961
7
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Inflation
rate
29-29
The Fall of the Phillips Curve
(1969-1981)
1974
8
1979
6
1981
1969
1978
1977
1973
1971
1970
4
1980
1976
1972
1975
In the 1970s the
economy
experienced
stagflation – the
combination of
high inflation and
high
unemployment
2
0
4
5
6
7
Unemployment rate
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29-30
Questions About the
Phillips Curve (1981-2004)
A Phillips
curve
type
relationship
began to
reappear in
1986.
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29-31
The Importance of
Inflation Expectations
• Expectations of inflation – the rise in the price
level that the average person expects.
 Expectations of inflation do not change along a
short-run Phillips curve.
• Long-run Phillips curve – a vertical curve at
the unemployment rate consistent with
potential output.
 It shows the trade-off between inflation and
unemployment when expectations of inflation equal
actual inflation.
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29-32
The Importance of
Inflation Expectations
10
Long-run
Phillips curve
•
Inflation
8
6
•
4
PC0 (expected
inflation = 4)
2
A
0
4.5
5.5
6.5
Unemployment rate
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When inflation
expectations rise,
the short-run
Phillips curve
shifts up.
The only
sustainable point
is where short and
long-run Phillips
curves intersect.
PC0 (expected
inflation = 0)
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29-33
Moving Off the Long-Run
Phillips Curve
• If government increases AD above potential
•
•
•
output, the demand for labor increases and
wages increase more than productivity.
Inflation wipes out wage gains and workers ask
for more money.
If unemployment is lower than the target level,
inflation and the expectation of inflation will
increase.
The short-run Phillips curve shifts up until
output is no longer above potential.
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29-34
Inflation Expectation
and the Phillips Curve
Price
level
Inflation PC PC1 (expected inflation = 4)
0
Potential
rate
output SAS
Long-run
2
Phillips
8
C
SAS1
curve
B
SAS0 6
A
AD1
AD0
Real output
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4
B
C
expected
inflation = 0
2
A
4.5 5.5
6.5 Unemployment
rate
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29-35
The Rise and Fall
of the New Economy
• Output expanded significantly during the late
1990s and early 2000s due to:
 Increased productivity from Internet growth and


investment
Increased competition from globalization
Workers were less concerned with real wages and
more concerned with protecting their jobs, so
wages did not increase
• Beginning in 2001, however, the high growth
and low unemployment ended.
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29-36
The Inflation/Growth Trade Off
Inflationary pressures
Deflationary
pressures
•
Inflationary
pressures
•
Low
High
potential
potential
output
output
Real output
McGraw-Hill/Irwin
•
Below low potential
output there is no
inflationary, and
possible some
deflationary,
pressure.
Above high potential
output there will be
significant
inflationary pressure .
The degree of
inflationary pressure
between the extremes
is ambiguous.
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29-37
Quantity Theory and the
Inflation/Growth Trade-Off
• Quantity theorists believe that low
•
inflation should be the priority of policy.
They believe that low inflation leads to
growth because:
 It reduces price uncertainty, making it easier
for businesses to invest in future
production.
 It encourages businesses to enter into longterm contracts.
 It makes using money much easier.
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29-38
Institutional Theory and the
Inflation/Growth Trade-Off
• Institutionalists are less sure about a
•
•
negative relationship between
inflation and growth.
They do not agree that all price level
increases start an inflation.
If inflation does get started, the
government has tools to get rid of it
relatively easily.
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29-39
Summary
• The winners in inflation are people who can
•
•
raise their wages or prices and still keep their
jobs or sell their goods.
The losers are people who can’t raise their
wages or prices.
Three types of inflationary expectations are:
 Rational – expectations based on economic models
 Adaptive – expectations based on the past
 Extrapolative – expectations that a trend will
continue
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29-40
Summary
• A basic rule to predict inflation is:
•
•
•
Inflation
equals nominal wage increases minus
productivity growth.
The equation of exchange is MV = PQ.
When velocity is constant it becomes the
quantity theory, and it predicts that the price
level varies in direct response to changes in
the quantity of money.
The inflation tax is an implicit tax on the
holders of cash and the holders of any
obligations specified in nominal terms.
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29-41
Summary
• Quantity theorists tend to favor a policy that
•
•
•
relies on rules rather than a discretionary
policy.
The institutional theory of inflation sees the
source of inflation in the wage-and-price
setting institutions.
Institutionalists see the direction of causation
going from price increases to money supply
increases.
They favor supplemental policies such as
incomes policies to supplement tight monetary
policy.
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29-42
Summary
• The long-run Phillips curve is vertical, and it
•
•
allows expectations of inflation to change.
The short-run Phillips curve is downward
sloping, holds expectations constant, and
shifts when expectations change.
Quantity theorists see a long-run trade-off
between inflation and growth, but
institutionalists are less sure about this tradeoff.
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29-43
Suppose that the velocity of money is constant at 5. Real output is
1500 and the money supply is $300.
Review Question 29-1 Use the equation of exchange to find the
price level.
Substituting in MV=PQ
$300 x 5 = P x 1500
P = $1500/1500 = $1
Review Question 29-2 Suppose the money supply increases to
$330 and real output is constant. Find the new price level.
$330 x 5 = P x 1500
P = $1650/1500 = $1.10
Review Question 29-3 What is the rate of inflation and the growth
rate of the money supply?
%ΔP (inflation) = (1.10-1.00)/1 = 10%
%ΔM = (330-300)/300 = 10%
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