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Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-2 The Costs of Inflation Inflation is widely viewed as a social evil, but the degree of seriousness is debated. – Arthur Okun considered inflation as serious a problem as unemployment and defined the “Misery Index:” Misery Index = Inflation + Unemployment rate – James Tobin wrote that “inflation is greatly exaggerated as a social evil.” Any debate about inflation must distinguish between moderate inflation and hyperinflation. – Hyperinflation is very rapid inflation, sometimes defined as p > 22% per month or p > 1,000% per year.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-3 Money and Inflation Recall the quantity equation: M S V = X = PY The quantity equation expressed in terms of growth rates: m s + v = x = p + y Rearranging to solve for the inflation rate yields: p = x – y = m s + v – y Conclusion: In the long run, inflation equals the excess growth of the money supply plus velocity over real GDP.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-5 Why Do Central Banks Allow Large m S ? There are four reasons why central banks may allow money supply to grow very rapidly: – Temptation of demand stimulation – Fear of recession and job loss – Adverse supply shocks that raise prices unless central banks introduce an extinguishing policy An accommodating policy calls for central banks to “print the extra money to pay for the inflation.” – Financing government deficits by printing money

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-6 Nominal vs. Real Interest Rates The Nominal Interest Rate (i) is the rate actually charged by banks and negotiated in financial markets. The Expected Real Interest Rate (r e ) is the rate that people expect to pay on their borrowings or earn on their savings after deducting expected inflation: r e = i – p e The actual Real Interest Rate is: r = i – p

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-7 When Is Inflation Harmless? There are four conditions necessary for inflation to be harmless: 1.Inflation is universally and accurately anticipated. 2.An increase in p e raises i for both saving and borrowing by the same number of percentage points. 3.All savings are held in bonds, stocks, or savings accounts earning i; no one holds money in accounts with an interest rate held below i. 4.Only real (not nominal) interest income is taxable, and only the real cost of borrowing is tax deductible.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-8 Violation of #1: Surprise Inflation Unanticipated Inflation occurs when the actual inflation rate (p) differs from the expected (or anticipated) inflation rate (p e ). Suppose savers are offered i = 3% and p e = 1. – The expected real return is: r e = i – p e = 2% If p = 7%, the actual real return is: r = i – p  r = 3 – 7 = - 4% Conclusion: Surprise inflation redistributes income from savers to debtors.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-9 Violation of #2: The Fisher Effect The Fisher Equation states: i = r e + p e The Fisher Effect predicts that a one percentage point increase in p e will raise i by one percentage point, leaving r e unaffected. – If the Fisher Effect holds, condition #2 is not violated. Problem: In the real world, the expected real interest rate often fluctuates dramatically (see Figure 9-1).

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-10 Figure 9-1 The 10-year Treasury Bond Rate and the Expected Rate of Inflation, 1970–2007 Sources: Federal Reserve Board, Selected Interest Rates, and Bureau of Economic Analysis NIPA Tables.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-11 Violation of #3: Money Does Not Pay i Why does money not pay the market rate of interest, i? – Currency does not pay interest – Banks earn no interest on reserves at the Fed, so banks cannot afford to pay i on deposits – Bank deposits are FDIC insured, so customers are willing to accept lower interest rates on deposits Higher inflation causes harm via: – The loss of convenience from holding less money – The “shoe leather” cost of inflation – Higher “menu costs” to display new prices

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-12 Violation of #4: Nominal Interest is Taxed Inflation reduces the after-tax real interest rate when nominal interest is taxed. – This is true even if i obeys the Fisher Effect! Suppose the tax rate is t = 0.3, p= 0 and i = 3% – Initial after-tax real rate = i(1 – t) – p = 3(1 – 0.3) = 2.1% Now suppose p = 10% and i = 13%. – New after-tax real rate = 13(1-0.3) – 10 = - 0.9% Result: High inflation encourages people to borrow more and save less.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-13 Reforms to Reduce the Cost of Inflation Decontrol of Financial Institutions – Since deregulation in the 1980s, checking, savings, and time-deposit accounts pay interest, which lowers the redistributive cost of inflation. Indexed Bonds – An Indexed Bond pays a fixed real interest rate plus the actual inflation rate. Example: Treasury Inflation-Protected Securities or TIPS Indexed Tax System – In 1985, the personal income tax system was partially indexed to inflation.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-15 The Government Budget Constraint The Government Budget Constraint relates government spending to the sources available to finance that spending: where… – (G – T) is the basic deficit – B is the dollar amount of outstanding government bonds – i is the interest paid on B – ∆B is the new amount of new bonds issued – H or High Powered Money = currency + bank reserves – ∆H is the issuance of new government monetary liabilities

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-17 3 Types of Unemployment Cyclical unemployment is the difference between actual unemployment and the natural rate of unemployment The Natural Rate of Unemployment has two components: – Turnover (or Frictional) unemployment occurs in the normal process of job search by individuals who have voluntarily quit their jobs are entering the labor force for the first time or are reentering the labor force. – Mismatch (or Structural) unemployment occurs when there is a mismatch between the skill or locations requirements of job vacancies and the present skills or location of the labor force.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-18 Figure 9-2 The Actual Unemployment Rate and the Natural Rate of Unemployment, 1980–2007 Sources: Bureau of Labour Statistics and research by Robert J. Gordon. Details in Appendix C-4.