Chapter 32: Inflation

11© 2014 by McGraw-Hill Education Chapter 32 Inflation 2© 2014 by McGraw-Hill Education • 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. What will you learn in this chapter? 3© 2014 by McGraw-Hill Education • 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. Changing price levels 24© 2014 by McGraw-Hill Education To understand the underlying rate of inflation in the economy, headline inflation and core inflation are often differentiated. Changing price levels CPI Core CPI Percentage % 6 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. 5© 2014 by McGraw-Hill Education • 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. The neutrality of money 6© 2014 by McGraw-Hill Education LRAS AD1 P1 Y1,3 SRAS1 E1 • 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. The classical theory of inflation AD2 P2 Y2 E2 Price level Real GDP (trillions of dollars) • Suppose the economy is in long- run equilibrium, E1. • In the short run, increases in money supply shift AD outward. – Increases prices and output, E2. • 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. SRAS2 P3 E3 37© 2014 by McGraw-Hill Education • 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. The quantity theory of money 8© 2014 by McGraw-Hill Education Use the quantity equation to fill in the blanks in the following table. Active Learning: Velocity of money Price level (P) Real output (Y) Money supply (M) Velocity of money (V) $1 $10,000 $5,000 $1 $15,000 3 $2 $25,000 5 $8,000 $32,000 1 9© 2014 by McGraw-Hill Education • 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. The quantity theory of money 0 2 4 6 8 10 12 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 M1 velocity Ratio to nominal GDP Velocity of M1 in the United States • The recent crisis has temporarily caused some significant changes. 410© 2014 by McGraw-Hill Education • 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. Why do we care about changing price levels? 11© 2014 by McGraw-Hill Education Inflation Over the last forty years, inflation has generally decreased. 12© 2014 by McGraw-Hill Education • 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. Inflation 513© 2014 by McGraw-Hill Education • 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 Inflation 14© 2014 by McGraw-Hill Education Use the equation relating inflation and interest rates to fill in the blanks in the following table. Active Learning: Inflation Real interest rate (%) Nominal interest rate (%) Inflation rate (%) 6 1 2.75 0 2.5 4.5 15© 2014 by McGraw-Hill Education The effects of inflation rates are easily observed. Inflation • 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. Value in 2010 ($) Nominal interest rate ($) Inflation rate (%) Real interest rate (%) Nominal 2015 value ($) Value in 2015 (2010 dollars) 1,000 4 5 - 1 1,217 951 1,000 4 0 4 1,217 1,217 1,000 4 3 1 1,217 1,051 616© 2014 by McGraw-Hill Education • 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. Inflation 17© 2014 by McGraw-Hill Education • 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? Active Learning: Interest rates and inflation 18© 2014 by McGraw-Hill Education • 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. Deflation 719© 2014 by McGraw-Hill Education • 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 long- lasting and painful increases in the price level. – This can leave currency completely valueless or close to it. Disinflation and hyperinflation: Controlling inflation, or not 20© 2014 by McGraw-Hill Education • 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. Inflation as a buffer against deflation 21© 2014 by McGraw-Hill Education • 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. Inflation and monetary policy 822© 2014 by McGraw-Hill Education The difference between potential and actual output in an economy is the output gap. Inflation and monetary policy 2010 2 8 2 6 2 4 2 2 0 2 4 1985 1990 1995 2000 2005 Percent of total GDP (%) 1980 • For the most part, actual output in the U.S. has stayed below potential output since 1980. 23© 2014 by McGraw-Hill Education • 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. Inflation and monetary policy 24© 2014 by McGraw-Hill Education The Phillips curve models the connection between inflation and unemployment in the short run. The Phillips curve -2 -1 3 2 1 0 4 5 6 7 1 2 3 4 5 6 7 8 Inflation rate (%) Unemployment rate Phillips curve 0 Hypothetical short-run Phillips curve for an economy • In strong economies, prices increase at a faster rate and unemployment is low. • When unemployment increases, prices increase more slowly. 925© 2014 by McGraw-Hill Education • 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. The Phillips curve Unemployment rate E2 E1 Inflation rate (%) P Phillips curve 0 1 2 3 4 5 6 7 8 6 5 4 3 2 1 -1 Price level Real GDP (trillions of dollars) SRAS AD1 E1 Y1 Aggregate demand and supply 103 Y2 104 E2 AD2 26© 2014 by McGraw-Hill Education In the long run, output returns to its earlier equilibrium, and so do levels of employment. The Phillips curve A -2 -1 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 Inflation rate (%) Unemployment rate P1 C P2 1. When the central bank increases short-run aggregate demand, unemployment initially falls (A→B). 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). • Individuals expect higher price levels, causing inflation to be permanently higher. • Connecting the two long-run equilibrium points yields the long-run Phillips curve. 27© 2014 by McGraw-Hill Education • The long-run Phillips curve is also called the non- accelerating 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 Phillips curve NAIRU -2 -1 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 Inflation rate (%) Unemployment rate P1 P2 The long-run Phillips curve • 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. – If unemployment is below the NAIRU, inflation generally accelerates. – If involuntary unemployment rises, unemployment is above the NAIRU. 10 28© 2014 by McGraw-Hill Education • 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 and NAIRU in practice P2 1979 1974 1975 1978 1977 1976 1973 1970 1971 1972 1980 1981 1982 1983 1984 1985 P3 Inflation rate (%) Unemployment rate P1 0 2 4 6 8 10 12 2 4 6 8 10 The Phillips curve winds upwards Inflation rate (%) Unemployment rate P2 0 2 4 6 8 10 12 14 16 2 4 6 8 10 12 The Phillips curve adjusts downwards 29© 2014 by McGraw-Hill Education • 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. Summary 30© 2014 by McGraw-Hill Education • 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. Summary 11 31© 2014 by McGraw-Hill Education • 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). Summary