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

2. ©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

3. 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

4. ©McGraw-Hill Companies, 2010
Inflation in the UK,
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

5. ©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

6. ©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

7. ©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

8. ©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

9. ©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

10. ©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

11. 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

12. 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

13. ©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 , Hungary , 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

14. ©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

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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. ©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

23. 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

24. 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

25. 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

26. ©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

27. 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

28. ©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