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INFLATION AND TREND OUTPUT: USA 1960-2005

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THE ORIGINAL PHILLPS CURVE The original Phillips Curve (A W Phillips, Economica, 1958) was about the relation between Money Wage changes and Inflation UK: 1861-1957: for % P = 0, % W can be > 0 %U %W%W +

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A MODIFIED “PHILLIPS” CURVE Instead of dW/W we have inflation (dP/P) on the vertical axis Instead of %U we have (Y/Y*) on the horizontal axis For simplicity the relation (SP) is linear…. (plausible?) dP/P Y/Y* 0 SP 0

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THE PHILLIPS CURVE AND SHIFTS IN AD Y/Y* = 1 where Y = Yn, U = Un Y/Y* 0 SP 0 0 Y/Y* P P0P0 AD 0 AS 0 0 Initially = 0 11 AD 1 AD shift increased P and 1 In long run, AS shifts, we have LAS AS 1 SP 1 LAS This implies no long run tradeoff between and U 1 SP is conditional on e

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ORIGINAL SR, LR PHILLPS CURVES The short and long-run responses to AD when U < U n %U + SP 0 00 U0U0 11 U1U1 SP 1 SP 2 22 LP AD stimulus: U 0 U 1 e e 1 : SP SP 1 In long run LP vertical at U 0 = U n Wage behaviour and SP adjustment

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US INFLATION AND SUPPLY SHOCKS: 1970-2007

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US INFLATION AND UNEMPLOYMENT: 1960-2007

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INFLATION and Money Supply Up to now we have looked at the impact of (one-off) AS and AD shocks on the price level Inflation is a sustained increase in the general price level: it is a dynamic process continuing through time. A Supply or Demand shock might initiate a price change, but it is difficult to see such as shock as an explanation of a sustained inflation process A simple preliminary monetary explanation: Let MV PY Over time: % (MV) % (PY) And as % V 0 this reduces to % Ms = % (PY) How the change in PY is divided between real and nominal components can vary in SR, but in LR the > % Ms, the > % P

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MONEY AND INFLATION: DATA

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LR Ms GROWTH AND INFLATION MsV PY In terms of rates of change: % Ms + % V % P + % Y In LR if % V 0, this reduces to: % Ms = % P + % Y This is in nominal terms: money growth = nominal GDP growth In real terms: % Ms – % P = % (Ms/P) = % Y i.e. growth of real Ms = growth of real GDP (V constant) If real growth is a low positive number (from 2% to 6% per annum), prolonged rapid growth of Ms will produce high inflation. Two issues: –why worry about inflation? What are its costs? –why would high grow of Ms occur?

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THE COSTS OF INFLATION Money is a store of value, and inflation erodes the real value of money In principle a fully-anticipated inflation would not impose real welfare costs: –all money-denominated assets would pay an interest rate which incorporated an inflation premium –alternatively capital and interest would be index-linked –tax on interest income would allow for inflation In practice these conditions are very difficult if not impossible In addition the sheer convenience of money as a medium of exchange breaks down when inflation is very high: the welfare costs of hyperinflation are fairly clear.

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INTEREST RATE AND INFLATION The Fisher Effect: nominal interest rates reflects expectations of inflation, and also the implied expected real interest rate: i = r e + e If you have €100 to invest and expect to get a real rate of return of 3%, you need to get €103 in a year’s time if there is zero inflation. If you expect inflation to be 5%, then a real return of 3% means you need a nominal rate of return of about 8% (5% to compensate for the inflation leaving a net real 3%) This is an approximation: the correct relation is: i = r e + e + e r e The e r e term is very small (0.0015 where i = 0.05 and r = 0.03), but in a very high inflation, say 1000% p.a., e r e = 0.3

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THE FISHER EFFECT: ( i = r + e ) US 10-yr T-bond rate, v 3-year GDP deflator (expected ?) Note apparently unexpected in mid-70s (1 st oil shock) The inflation rate below is arguably actual, not expected

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INDEXED ASSETS Some governments issue index-linked bonds; however these are the exception rather than the rule (which index to use?) What about other financial assets and liabilities? It is possible to index bank liabilities (deposits) and assets (loans): Brazil in the 1960s, which learned to live with chronic high inflation? However currency is another matter: Brazilian indexation (“monetary correction”) benefited the better off, i.e. those with bank accounts. It is widely accepted that poorer people were big gainers when Brazil made the transition to low inflation in the 1990s

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TAX DISTORTIONS Where inflation = 0, a nominal interest rate of 5% is also a real of 5%, and tax on interest income at say 40% reduces the real return to 3% Suppose inflation = 3%, nominal interest rate = 8% and real rate = 5%. Tax at 40% on nominal interest means post-tax nominal rate = 4.8%, and post-tax real rate = 1.8% Suppose inflation = 20%, nominal interest rate = 25%, tax on interest income = 40%: post-tax real rate = minus 5%. Capital Gains tax can also be distortionary if the basis is nominal rather than real gains This can be especially severe on long-term gains: e.g. inflation = 3% p.a, capital asset sold after 10 years with 50% nominal gain, tax at 40%, leaving net gain of 30% nominal, but inflation over 10 years is (1.03) 10, i.e. 34%, so there is a post-tax real loss

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INFLATION AND UNEMPLOYMENT AGAIN We looked at the costs of inflation because of the inflation- unemployment tradeoff If it is necessary to endure higher unemployment to secure lower inflation, then perhaps this can only be welfare- enhancing if unemployment has a low cost Unemployment has welfare costs: these are so obvious that we need not day any more…… Note that the unemployment-inflation tradeoff is a short-tem one: in the long-term there appears to be no trade-off between the inflation rate and the “Natural” rate of unemployment The Natural rate of unemployment is better described as a long- run equilibrium rate, depending on structural features of the labour market The natural rate can be influenced by labour-market policies

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THE NATURAL RATE OF UNEMPLOYMENT This shows U and Un for USA, 1980-2007

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HIGH AND HYPER-INFLATION Why have some countries experienced bouts of very high inflation? How can hyperinflation be cured? An essential part of the answer is the role of Fiscal deficits which are financed by printing money (or the same thing, by the central bank creating government deposits) A Fiscal Deficit must be financed either: (a) by monetary creation via the central bank (b) or by borrowing on bond markets The former is inflationary because is leads directly to the creation of high-powered money (H), increased bank reserves and eventually a multiple expansion of the broad money supply. (NB: Eurozone governments may not borrow from ECB) The latter need not be inflationary, but may be limited by the willingness to lend, i.e. credit-worthiness of Government.

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THE GOVERNMENT BUDGET CONSTRAINT Define: –G = non-interest Govt Exp –T = Tax revenue –I = nominal int rate –D = stock of public debt –H = stock of High-powered money (currency + banks’ reserves) (G + iD) – T = H + D i.e. (G – T) = H + D – iD NB all the above are in nominal terms, unlike the textbook where G and T are (confusingly) in real terms. Here (G – T) is termed the Basic Deficit, probably better termed the Primary Deficit, i.e. the non-interest deficit, which we will encounter later We can look at the constraint in real terms or in relation to Y (later)

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CAUSES OF HYPERINFLATION Sometimes a negative Supply Shock can start a process: normally real Y falls and P increases If Wages are indexed to prices this can lead to further increases in P A falling exchange rate can be a further channel for transmitting inflation The same process can cause the Fiscal Deficit to increase: if this is financed by H, there is further impetus to inflation Two key points: –the dependence on monetary financing requires a compliant Central Bank –lack of credibility on bond markets may increase recourse to monetary financing

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EXTREME HYPERINFALTIONS CountryPeak Annual RateDaily Rate Time to double HungaryJuly 1946 1.30(10 16 ) %195 % 15.6 hours ZimbabweNov 2008 7.96(10 10 ) %98 % 24.7 hours YugoslaviaJan 1994 3.13(10 8 ) %64.6 % 1.4 days GermanyNov 1923 29,500 %20.9 % 3.7 days GreeceNov 1944 11,300 %17.1 % 4.5 days China May 1949 4,210 %13.4 % 5.6 days Source: Prof. Steve H. Hanke, (Johns Hopkins University) Note circumstances: wars, civil disruption.

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STOPPING HYPERINFLATIONS Reduce the (real) Budget deficit: –Expenditure –Tax revenues Reduce/abandon indexation Establish central bank independence Link to external currency ($ ?): Currency board with 100 reserve backing Establish credibility – a political issue In some extreme cases a currency is abandoned de facto in response to hyperinflation (Zimbabwe?) Many Latin American hyperinflations have been tamed only after several false starts: the effects may linger for a long time.

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THE AFTER-EFFECTS OF HYPERINFLATIONS Often we can assess credibility by looking at Government bond yields: compared with benchmark German Bunds and US Treasury bonds (approx 3.4% and 3.7% for 10-years as of July 2009) Argentina: Stabilized in 92; Currency board 1Peso = 1$; breakdown indluding default in 2001 due to continuing fiscal deficits, inflation back up to 10-15%; 3-month int rate 14.63%; 25 year indexed Arg Peso bonds 16.7% Brazil: stabilization in 94 (Real plan): in 2001 currency peg to $ abandoned, fiscal deficit controlled, inflation now 5.5%; 3- month int rate 9.16%; 1 year bond rate 8.97%; 10 yr $ bond yield 6.16% Chile: Inflation of 1,300% by 1973; stabilization under military rule in late ’70s; subsequent banking crisis; inflation now 4%; 3-month int rate 1.32%; 10-year indexed Cl.Peso bond yield 2.83%; 10 yr $ bond yield 3.07%

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