Chapter 28 Inflation David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

28.1 Inflation is... n Inflation is a rise in the average price of goods over time n 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.

28.2 Some questions about inflation n Why is inflation bad? – Inflation does have bad effects, but some popular criticisms are based on spurious reasoning n What are the causes of inflation? n What can be done about it?

28.3 Inflation in the UK, Source: Economic Trends Annual Supplement, Labour Market Trends

28.4 The quantity theory of money n The quantity theory of money says that 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.

28.5 The quantity theory (2) n The quantity theory of money says: n M V = P Y – where V = velocity of circulation n If prices adjust to maintain real income (Y) at the potential level and if velocity stays constant n then an increase in nominal money supply leads to an equivalent increase in prices n but if velocity is variable or prices are sluggish, this link is broken.

28.6 Money and prices n Milton Friedman famously claimed n ‘Inflation is always and everywhere a monetary phenomenon.’ – i.e. it results when money supply grows more rapidly than real output. n But this does not prove that causation is always from money to prices – e.g. if the government adopts an accommodating monetary policy.

28.7 Money and inflation (2) n …but in the long run, changes in real income and interest rates significantly alter real money demand n so there may not be a perfect correspondence between excess monetary growth and inflation. n And in the short run, the link between money and prices may be broken if – velocity of circulation is variable – prices are sluggish

28.8 Inflation and interest rates n FISHER HYPOTHESIS – a 1% increase in inflation will be accompanied by a 1% increase in interest rates n REAL INTEREST RATE – Nominal interest rate – inflation rate – i.e. the Fisher hypothesis says that real interest rates do not change much – but the nominal interest rate is the opportunity cost of holding money – so a change in nominal interest rates affects real money demand

28.9 Hyperinflation n … periods when inflation rates are very large n in such periods there tends to be a ‘flight from money’ – people hold as little money as possible n e.g. Germany in , Hungary , Brazil in the late 1980s. n Large government budget deficits help to explain such periods – persistent inflation must be accompanied by continuing money growth

28.10 The Phillips curve It suggests we can trade-off more inflation for less unemployment or vice versa. Prof. A W Phillips demonstrated a statistical relationship between annual inflation and unemployment in the UK Unemployment rate (%) Inflation rate (%) The Phillips curve shows that a higher inflation rate is accompanied by a lower unemployment rate. Phillips curve

28.11 The Phillips curve and an increase in aggregate demand Unemployment Inflation PC 0 U* Suppose the economy begins at E, with zero inflation, unemployment at the natural rate U*... U1U1 11 An increase in government spending funded by an expansion in money supply takes the economy to A, with lower unemployment but inflation at  1. A … but what happens next?

28.12 The Phillips curve and an increase in aggregate demand Unemployment Inflation PC 0 U* U1U1 11 A If nominal money supply is fixed in the long run, and prices and wages eventually adjust, the economy moves back to E. E But nominal money supply need not be constant in the long run so we may find the economy finds its way back to the natural rate, but with continuing inflation at C. C

28.13 The vertical Phillips curve Unemployment Inflation PC 0 U* U1U1 11 A E C Effectively, the long-run Phillips curve is vertical, as the economy always adjusts back to U*. LRPC The short-run Phillips curve shows just a short-run trade-off – its position may depend upon expectations about inflation. PC 1

28.14 Expectations and credibility Unemployment Inflation PC 2 PC 1 11 U* Unemployment rises to U 1 U1U1 Suppose the economy begins at E, with a newly-elected government pledged to reduce inflation. E LRPC Monetary growth is cut to  2. 22 In the short run, the economy moves to A along the short- run Phillips curve. A As expectations adjust, the short-run Phillips curve shifts to PC 2, and U* is restored at F. F

28.15 Inflation and unemployment in the UK

28.16 Inflation illusion n People have inflation illusion when they confuse nominal and real changes. n People’s welfare depends upon real variables, not nominal variables. n If all nominal variables (prices and incomes) increase at the same rate, real income does not change.

28.17 The costs of inflation n Fully anticipated inflation: n Institutions adapt to known inflation: – nominal interest rates – tax rates – transfer payments n no inflation illusion n Some costs remain: – shoe-leather n people economize on money holdings – menu costs n firms need to alter price lists etc.

28.18 The costs of inflation (2) n Even if inflation is fully anticipated, the economy may not fully adapt – interest rates may not fully reflect inflation – taxes may be distorted n fiscal drag may have unintended effects on tax liabilities n capital and profits taxes may be distorted

28.19 The costs of unanticipated inflation n Unintended redistribution of income – from lenders to borrowers – from private to public sector – from young to old n Uncertainty – firms find planning more difficult under inflation, which may discourage investment n This has been seen as the most important cost of inflation

28.20 Defeating inflation n In the long run, inflation will be low if the rate of money growth is low. n The transition from high to low inflation may be painful if expectations are slow to adjust. n Policy credibility may speed the adjustment process

28.21 The Monetary Policy Committee n Central Bank Independence may improve the credibility of anti-inflation policy n Since 1997 UK monetary policy has been set by the Bank of England’s Monetary Policy Committee – which has the responsibility of meeting the inflation target – via interest rates – which are set according to inflation forecasts.