Chapter 22 Inflation, expectations and credibility ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Inflation 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. ©McGraw-Hill Companies, 2010 2

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. ©McGraw-Hill Companies, 2010 3

©McGraw-Hill Companies, 2010 Inflation in the UK, 1920-2010 The UK price level fell sharply in some interwar years when inflation was negative. Since 1950, the price level has risen 20-fold, more than its rise over the previous three centuries. This story applies in most advanced economies. Sources: R. B. Mitchell, European Historical Statistics 1750–1970, Macmillan, 1975; OECD, Economic Outlook. Source: Economic Trends Annual Supplement, Labour Market Trends ©McGraw-Hill Companies, 2010 4

©McGraw-Hill Companies, 2010 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.” ©McGraw-Hill Companies, 2010 5

©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 6

©McGraw-Hill Companies, 2010 The quantity theory (3) MV = PY The quantity theory equation implies M/P = Y/V The left-hand side is the real money supply. The right-hand side must be real money demand. ©McGraw-Hill Companies, 2010 7

©McGraw-Hill Companies, 2010 M/P = Y/V If the demand for real money is constant, M/P is constant. Monetary policy can control M, in which case M  P But if nominal wages and prices adjust slowly in the short run, higher nominal money supply M leads initially to a higher real money stock M/P since prices P have not yet adjusted. The excess supply of real money bids down interest rates. This boosts the demand for goods. Gradually this bids up goods prices. ©McGraw-Hill Companies, 2010 8

©McGraw-Hill Companies, 2010 M/P = Y/V OR monetary policy can try and fix P over time, in which case P  M The equation says prices and money are correlated, but is agnostic on which causes which. With an intermediate target for nominal money, the causation flows from money to prices. With a target for prices or inflation, the causation flows the other way. ©McGraw-Hill Companies, 2010 9

©McGraw-Hill Companies, 2010 The short run 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. ©McGraw-Hill Companies, 2010 10

High interest rates & high inflation Nominal interest and inflation rates 2008 (%) -5 5 10 15 20 interest inflation Source: OECD Economic Outlook. Turkey Iceland Hungary Australia UK Mexico Euro Switz- erland USA Japan An extra percentage point of inflation is accompanied on average by a nominal interest rate nearly one percentage point higher. ©McGraw-Hill Companies, 2010 11

Inflation and interest rates Fisher hypothesis The Fisher hypothesis is that a 1% rise in inflation leads to a similar rise in nominal interest rates so real interest rates change little. Real interest rate Nominal interest rate minus inflation rate but the nominal interest rate is the opportunity cost of holding money, so a change in nominal interest rates affects real money demand. ©McGraw-Hill Companies, 2010 12

©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 13

©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 14

©McGraw-Hill Companies, 2010 The Phillips curve (2) Phillips curve Inflation rate (%) Unemployment rate (%) U* ©McGraw-Hill Companies, 2010 15

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. ©McGraw-Hill Companies, 2010 16

The long-run Phillips curve (2) The long-run and short-run curves intersect when actual and expected inflation are equalized. The long-run Phillips curve shows that in the long run there is no trade-off between unemployment and inflation. ©McGraw-Hill Companies, 2010 17

The long-run Phillips curve and an increase in aggregate demand (1) Suppose the economy begins at E, with unemployment at U*, and inflation at 1 E 1 Inflation U1 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. A 2 U* PC1 Unemployment … but what happens next? ©McGraw-Hill Companies, 2010 18

The long-run Phillips curve and an increase in aggregate demand (2) LRPC If the nominal money supply continues to expand at the same rate thereafter, the economy will eventually move to B on PC2. Inflation 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, A 2 B 1 E PC2 U1 U* PC1 Unemployment i.e. there is no trade-off between unemployment and inflation in the long run. ©McGraw-Hill Companies, 2010 19

The long-run Phillips curve and an increase in aggregate demand (3) LRPC Effectively, the long-run Phillips curve is vertical, as the economy always adjusts back to U*. Inflation The height of the short-run Phillips curve reflects expected inflation. A B 2 The short-run Phillips curve shows just a short-run trade-off: 1 E PC2 U1 U* PC1 Unemployment U* is known as the natural rate of unemployment. ©McGraw-Hill Companies, 2010 20

Expectations and credibility Suppose the economy begins at E, with a newly-elected government pledged to reduce inflation. E LRPC PC2 As expectations adjust, the short-run Phillips curve shifts to PC2, and U* is restored at F. F Inflation Monetary growth is cut to 2. 2 1 In the short run, the economy moves to A along the short- run Phillips curve. A Unemployment rises to U1 U1 PC1 U* Unemployment ©McGraw-Hill Companies, 2010 21

©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 22

The costs of inflation (1) Fully anticipated inflation: Limited costs if institutions adapt to known inflation: nominal interest rates tax rates transfer payments there is no inflation illusion Some costs remain: shoe-leather people economize on money holdings menu costs firms need to alter price lists, etc. ©McGraw-Hill Companies, 2010 23

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 ©McGraw-Hill Companies, 2010 24

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. ©McGraw-Hill Companies, 2010 25

©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 26

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 (MPC) which has the responsibility of meeting the (underlying) inflation target via interest rates which are set according to inflation forecasts. ©McGraw-Hill Companies, 2010 27

©McGraw-Hill Companies, 2010 The MPC The MPC successfully maintained UK inflation within a much narrower range than previously accomplished. The Bank was prepared to change interest rates even when this was unpopular. But low levels of inflation led to low nominal interest rates, which encouraged more reckless private sector behaviour. Regulatory failure was perhaps more to blame for the crisis. Good monetary policy cannot be held responsible for inadequate financial regulation. ©McGraw-Hill Companies, 2010 28