1 CHAPTERS 33, 35, 17

CHAPTER 33 Inflation, Disinflation, and Deflation

3 Money and Inflation Between 1985 and 1995 Brazil had serious inflation—up to almost 3,000% per year. In 1992, Brazilians were demanding new leadership.

4 Money and Prices Growth in the money supply is usually seen as a problem because it will likely cause inflation. Examples – Brazil, Germany in 1920s.

5 Money Supply Growth and Inflation in Brazil

6 The Inflation Tax  The inflation tax is the reduction in the real value of money held by the public.  Inflation tax = inflation rate X money supply  Example: Assume 6% inflation. After 1 year, a dollar only buys $.94. .06 X money supply = lost value of money

7 The Logic of Hyperinflation  In order to avoid paying the inflation tax, people reduce their real money holdings (by using commodities as money) and force the government to increase inflation to capture the same amount of real inflation tax.  In some cases, this leads to a vicious circle of a shrinking real money supply and a rising rate of inflation, leading to hyperinflation and a fiscal crisis.

8 Effects of Inflation  Winners and losers from unexpected inflation: The nominal interest rate is the interest rate in money terms. (assume 0% inflation; no expected future inflation) The real interest rate adjusted for inflation. Inflation that is higher than expected benefits borrowers and hurts lenders Inflation that is lower than expected benefits lenders and hurts borrowers.

9 Effects of Inflation  Expected inflation and interest rates: According to the Fisher effect, expected inflation raises the nominal interest rate one-for- one so that the real interest rate remains unchanged.

10 The Fisher Effect

11 The Costs of Inflation  Shoe-leather costs are the increased costs of transactions that arise from the public’s efforts to avoid the inflation tax. (because no one wants to hold money) (Using gold, cigarettes, or gasoline instead of money)  Menu costs are the costs of changing prices;  Unit-of-account costs are costs that arise because money ceases to be a reliable measure of value. (harder to compare prices)

12 Inflation and Nominal Interest Rates in the US

Although there are arguments for a negative rate of inflation (deflation), in practice policy makers tend to aim for low but positive rates of inflation. In deflation, people are reluctant to buy, because prices are constantly decreasing. Disinflation = the process of reducing inflation that has become embedded in expectations. 13

14 Moderate Inflation and Disinflation When moderate inflation happens, getting it back down can be difficult because disinflation can be very costly, requiring the sacrifice of large amounts of potential output and imposing high levels of unemployment. (contractionary policy)

15 Supply Shocks Another factor that contributed to the rise of U.S. inflation in the 1970s and its decline in the 1980s was a series of supply shocks, first negative (Arab oil embargo) and then positive (oil prices fall).

16 The Great Disinflation of the 1980s

17 The End of Chapter 33 Start of Chapter 35

18 Capital Flows And The Balance Of Payments  A country’s balance of payments accounts summarize its transactions with the rest of the world.  The balance of payments on current account includes the balance of payments on goods and services together with balances on factor income and transfers.  The balance of payments on financial account measures capital flows. (Capital account) By definition, sum of the balance of payments on current account plus the balance of payments on financial account is zero.

19 The Balance of Payments (Must = 0) Green = current account Red = capital account

20 The Role Of The Exchange Rate  Currencies are traded in the foreign exchange market.  The prices at which currencies trade are known as exchange rates.  When a currency becomes more valuable in terms of other currencies, it appreciates.  When a currency becomes less valuable in terms of other currencies, it depreciates.

21 The Foreign Exchange Market

22 An Increase in the Demand for U.S. Dollars

23 Exchange Rate Policy  A country has a fixed exchange rate when the government keeps the exchange rate against some other currency at or near a particular target.  A country has a floating exchange rate when the government lets the exchange rate go wherever the market takes it.

24 Exchange Rates And Macroeconomic Policy  A devaluation is a reduction in the value of a currency that previously had a fixed exchange rate.  A revaluation is an increase in the value of a currency that previously had a fixed exchange rate.

25 End of Chapter 35 Start of Chapter 17

26 The basis for international trade Remember comparative advantage? A country has a comparative advantage in producing a good if the opportunity cost of producing the good is lower for that country than for other countries.

27 David Ricardo – trade will make individuals and nations better off. Autarky is a situation in which a country cannot trade with other countries.

28 The Colombian opportunity cost of a box of roses in terms of a computer is only 0.5: 0.5 computer must be forgone for every additional box of roses produced. The U.S. opportunity cost of a box of roses in terms of a computer is 2: 2 computers must be forgone for every additional box of roses produced. Comparative Advantage and the Production Possibility Frontier Therefore, Colombia has a comparative advantage in roses and the United States has a comparative advantage in computers. In autarky, CUS is the U.S. production and consumption bundle and CCO is the Colombian production and consumption bundle.

29 The Gains from International Trade The Ricardian model of international trade shows that trade between two countries makes both countries better off. The following figure illustrates that specialization has the effect of increasing total world production of both goods and that each country can consume more of both goods than it did under autarky.

30 The Gains from International Trade Trade increases world production of both goods, allowing both countries to consume more. Here, each country specializes its production as a result of trade: the United States produces at QUS and Colombia produces at QCO. Total world production of computers has risen from 1,500 to 2,000 and of roses from 1,500 boxes to 2,000 boxes. The United States can now consume bundle C'US, and Colombia can now consume bundle C'CO — consumption bundles that were unattainable without trade.

31 The Effects of Imports The domestic demand curve shows how the quantity of a good demanded by domestic consumers depends on the price of that good. The domestic supply curve shows how the quantity of a good supplied by domestic producers depends on the price of that good. The world price of a good is the price at which that good can be bought or sold abroad.

32 The Effects of Imports When a market is opened to trade, competition among importers or exporters drives the domestic price to equality with the world price. If the world price is higher than the autarky price, trade leads to exports and arise in the domestic price compared to the world price.

33 Effects of Trade Protection An economy has free trade when the government does not attempt either to reduce or to increase the levels of exports and imports that occur naturally as a result of supply and demand. Policies that limit imports are known as trade protection or simply as protection. Most economists advocate free trade, although many governments engage in trade protection of import- competing industries. The two most common protectionist policies are tariffs and import quotas. In rare instances, governments subsidize export industries.

34 Effects of a Tariff A tariff is a tax on imports. It raises the domestic price above the world price, leading to a fall in trade and total consumption and a rise in domestic production. Domestic producers and the government gain, but consumer lose because they pay higher prices.

35 Effects of an Import Quota An import quota is a legal quantity limit on imports. Its effect is like that of a tariff, except that revenues—the quota rents—accrue to the license-holder, not to the government.

36 The Political Economy of Trade Protection Arguments for Trade Protection Advocates of tariffs and import quotas offer a variety of arguments. Three common arguments are:  national security  job creation  the infant industry argument.

37 International Trade Agreements and the World Trade Organization To further trade liberalization, countries engage in international trade agreements. International trade agreements are treaties in which a country promises to engage in less trade protection against the exports of other countries in return for a promise by other countries to do the same for its own exports.

38 Some agreements are for only a small number of countries, such as the North American Free Trade Agreement. NAFTA 1994 US – Mexico - Canada The World Trade Organization (WTO) is a multinational organization that seeks to negotiate global trade agreements and settle trade disputes between members.

39 Declining Tariff Rates Tariffs reached a peak in the early 1930s. From then on, tariff rates have steadily ratcheted down, with U.S. moves matched in other advanced countries. At this point world trade in manufactured goods is subject to low tariffs and relatively few import quotas, with clothing the main exception. Agricultural products are subject to many more restrictions, reflecting the political power of farmers in advanced countries.

40 The End of Chapter 17