I. Introduction
A. Objectives
1. Explain why inflation is a PROBLEM.
2. Explain how increasing aggregate demand generates a price-wage inflation spiral
3. Explain how decreasing aggregate supply generates a cost-price inflation spiral
4. Explain why it pays to anticipate inflation accurately
5. Explain how inflation expectations are made.
6. Explain how inflation expectations affect actual inflation.
7. Explain the relation between inflation and interest rates.
8. Explain the relation between inflation and unemployment.
B. Topics to be covered
1. Why is inflation a problem?
2. Expectations about inflation rates.
3. A rational expectations equilibrium
4. Interest rates and inflation
5. Inflation and unemployment
I. Why Inflation is a Problem
A. The inflation rate (INFRTE) is the percentage change in the price level (P);
1. The inflation rate equals:
INFRTE = % DELTA P = (P1 - P0) / (P0) * 100
where:
a. P1 is the current price level and
b. P0 is last year's price level.
2. The inflation rate is a measure of the rate at which money is losing its value.
B. The consequences of inflation will depend upon:
1. Whether the inflation was:
a. Anticipated or
b. Unanticipated
2. Whether the inflation was caused by
a. Increasing aggregate demand
b. Reductions in aggregate supply
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A. The impact of inflation depends on whether it is:
1. anticipated inflation or
2. unanticipated inflation.
B. High anticipated inflation rates encourage people to shift their activities:
1. toward forecasting the inflation rate and
2. away from producing goods and services.
3. in rapid inflation money may not function well as a medium of exchange.
a. because it is a bad store of value
b. may use another country's currency
Spanish dollar in US
US dollar in Viet Nam
c. Increase in barter transactions
d. costly in time and resources
C. Even low unanticipated inflation is a problem:
It redistributes:
1. wealth between borrowers and lenders, and
2. income between employers and employees.
3. It also produces fluctuations in:
a. real GDP,
b. employment, and
c. unemployment.
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A. Demand-pull inflation is caused by an increase in aggregate demand (AD).
1. This may result from any factor that raises aggregate demand (AD).
2. Two factors that are controlled by the government are:
a. increases in the money supply (M) and
b. increases and increases in government purchases (G).
B. Initially, an increase in the money supply (M) causes the AD curve to shift right,
1. This results in higher output (Y) and a higher price level (P).
2. The movement to the higher price level (P) creates inflation.
3. The higher level of output (Y) means that economy is above full-employment real GDP (Y*).
Y > Y*
(Unemployment Rate < Natural Rate)
a. Wages increase and
W2 > W1
b. the SAS curve shifts to the left.
c. This lowers real GDP (Y) back to the full- employment level (Y*) and
Y = Y*
(Unemployment Rate = Natural Rate)
d. creates another round of inflation as the price level moves higher.
P2 > P1
4. If this was a one-time increase in the money supply,
a. the process stops;
INFRTE = 0
b. The price level is higher and
P2 > P0
c. there is no change in real GDP (Y).
Y2 = Y*
5. If this is an ongoing process,
(M or G continues to increase)
AD curve shifts to the right again
Prices and wages go up
a. A wage-price spiral results,
b. with the price level (P) constantly moving higher
c. so that inflation persists.
INFRTE > 0
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A. Cost-push inflation results from decreases in the aggregate supply.
1. There are two main origins of cost-push inflation. They are:
a. an increase in wage rates and
b. an increase in the price of essential raw materials.
2. Initially, an increase in the price of oil shifts the SAS curve to the left,
a. lowering real GDP (Y) and
Y < Y*
b. raising the price level (P).
P1 > P0
c. This creates inflation and rising unemployment,
d. a situation called "stagflation".
3. The Central Bank (e.g. the Fed) may respond to the unemployment equilibrium by increasing the money supply (M),
a. That would shift the AD curve to the right.
b. This raises real GDP (Y) and
Y2 > Y1
c. the price level (P), creating more inflation.
P2 > P1
4. If no further rises in oil prices country moves to new equilibrium
GDP returns to full employment level
Y = Y*
Price level is permanently higher
P2 > P0
No further inflation
INFRTE = 0
3. If the oil producers again raise the price of oil to try to keep its relative price higher,
a. the process continues.
SAS shifts to the left again
Prices rise
output falls
Government shifts AD curve to the right
output rises
prices go up again
INFRTE > 0
4. This is a cost-price inflationary spiral.
III. Inflation Expectations
A. It pays to forecast inflation correctly.
A. Failure to anticipate inflation correctly imposes two types of costs on individuals.
1. One cost comes from "incorrect" wages and
2. the other cost comes from "incorrect" interest rates.
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B. Labor contracts that fail to anticipate inflation accurately cause wages to be set at the "wrong" level.
1. Unanticipated inflation lowers workers' real wages,(WR)
e.g.
a. expected 10% inflation
b. built 10% increase into annual contract
c. actual inflation was 20%
d. real wages fell below equilibrium levels
2. Causing some workers to quit in search of other jobs.
a. Forcing unwanted overtime or speedups to meet delivery contracts
b. quitting imposes costs on both workers and firms.
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C. Interest rates (r) that have incorrectly anticipated inflation impose a cost on either the borrower or lender.
1. If the inflation rate is unexpectedly high,
a. borrowers gain but
b. lenders lose, and
c. the loss to the lenders exceeds the gain the borrowers.
Borrowers wish they had borrowed more
Lenders wish that they had lent less
Both groups feel that they missed an opportunity
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A. To minimize the costs of incorrect inflation anticipations people may make "rational expectations" about the inflation rate.
1. A rational expectation is one based on all relevant information.
a. It has an expected error of zero and
b. the smallest range for the forecast error.
2. Rational expectations are correct on average;
a. They may never be right,
b. But they are equally likely to be too high or too low.
c. They are not biased either upward or downward.
B. In trying to figure out how people form their expectations of future prices, some economists adopt "the rational expectations hypothesis".
1. the rational expectations hypothesis states that:
a. the actual forecasts people make are the same as
b. the rational expectations obtained using the relevant economic model.
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A. A rational expectation of the inflation rate forecasts next period's price level (P) by predicting the position of:
1. the AD curve and
2. the short-run aggregate supply (SAS) curve.
B. The rational expectation of the AD curve,
1. Forecasting the expected aggregate demand (EAD)
C. The forecast of Expected Aggregate Demand (EAD) curve, depends on:
1. a forecast of all the factors that can affect aggregate demand, such as:
a. monetary policy or
b. fiscal policy.
D. The position of the expected short-run Aggregate Supply (ESAS) curve,
E. The forecast of the ESAS curve, depends on:
1. a forecast of the expected long-run aggregate supply (ELAS) curve and
2. the expected money wage rate (EWM).
F. The expected short-run AS curve (ESAS) intersects the expected long-run AS curve (ELAS) at the full-employment price level.
Y = Y*
1. The point on the expected long-run AS curve (ELAS) where the expected short-run AS curve (ESAS) crosses it is determined by:
a. the expected money wage rate (EWM).
2. With sticky money wages, (WM)
a. the position where the expected short-run AS curve (ESAS) crosses the expected long-run AS curve (ELAS) is determined by the known money wage rate.
EWM = WM
3. When money wages are flexible,
a. the expected money wage (EMW) depends on the (expected) price level (EP).
b. The expected price level (EP) will depend on the expected money wage (EWM).
c. The two are determined simultaneously.
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A. The rational expectations hypothesis does not assert that people actually form inflation expectations using expected AD and expected AS curves.
1. Instead it asserts that people's forecasts are, on average, the same as the forecasts an economist makes using the relevant economic theory.
B. Possible actual techniques for forming rational expectations
Hiring economic consultants,
reading business publications,
copying successful people
IV. Rational Expectations Equilibrium
A. A rational expectations equilibrium is a "macroeconomic equilibrium based on expectations that are the best available forecasts."
B. If everyone's forecasts are accurate, real GDP (Y) will be at its full-employment level (Y*).
Y = Y*
The Money wage will be set at a level that at the equilibrium price level, the real wage will be an equilibrium real wage in the labor market.
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A. If people's forecasts are wrong, employment differs from full employment.
Y not equal to Y*
B. If the actual aggregate demand curve (AD) falls short of the expected aggregate demand curve (EAD)
AD < EAD
a. Could be caused by:
i. unexpected increases in taxes,
ii. unexpected cuts in government spending,
iii. or unexpected slowdowns in the growth of the money supply --
AD < EAD
a. the actual inflation rate (INFRTE) is less than the expected inflation rate (EXINFRTE) and
INFRTE < EXINFRTE
b. real GDP (Y) is less than its full-employment amount. (Y*)
Y < Y*
C. If actual long run aggregate supply (LAS) is less than the expected long run aggregate supply (ELAS) and actual Short run Aggregate Supply less than expected Short run Aggregate Supply (ESAS)
LAS < ELAS
and
SAS < ESAS
1.--due perhaps to an unexpected slowdown in technological progress--then
2. the actual inflation rate (INFRTE) is higher than the expected inflation rate (EXINFRTE) and
INFRTE > EXINFRTE
3. real GDP (Y) decreases below full employment level (Y*),
Y < Y*
i. although it decreases by less than the ultimate long-run reduction.
(not yet shifted all the way back to actual LAS)
D. In a rational expectations equilibrium,
1. each person and firm is satisfied that he or she can make no better decisions than those that they have currently made.
E. But such an equilibrium is not static. Expectations will change with new information.
F. As long as people correctly anticipate inflation, real GDP (Y) does not change as a result of the inflation.
Y = Y*
1. Money wage (MW) bargains would always produce equilibrium real wage (W).
e.g.
a. prices expected to rise 10% due to expected shift in AD curve
b. money wages increased 10%
c. SAS shifts to left to compensate for AD shift to the right.
d. Total effect is to shift up price level by 10%
e. Self fulfilling anticipations.
f. Hard to change inflationary anticipations.
V. Interest Rates and Inflation
A. The nominal interest rate (rn) is the interest actually paid or received in the market;
B. The real interest rate (r) adjusts the nominal interest rate for inflation.
C. The nominal interest rate (rn) is approximately equal to:
1. the real interest rate (r) plus
2. the expected inflation rate (EXINFRTE).
(note you have to also compensate for the fact that the interest as well as the principal has lost value.
e.g. $100 loan
15% interest rate
%115 is nominal payback
loss in value is 11.50
net increase in real value is 15 - 11.50
real interest rate is $4.50
need a nominal interest rate of 15.5% to get a 5% real rate if the inflation rate is 10%
D. Data from both the United States and international experiences support the view that (in the long run):
1. higher anticipated inflation (EXINFRTE) leads to
2. higher nominal interest rates (rn).
E. If the central bank (e.g. the Fed) unexpectedly increases the quantity of money (M),
1. Nominal interest rates (rn) fall.
(temporarily because real balances (L) increased)
F. But if the central bank continues to increase the money supply (M),
1. people anticipate inflation and
Demand for real balances (LL) rises
2. Nominal interest rates (rn) rise.
3. Real interest rates (r) are restored
V. Inflation Over the Business Cycle: The Phillips Curve
A. A Phillips curve is a curve that plots the relationship between:
1. the inflation rate (INFRTE) and
2. the unemployment rate (U).
B. Popularized by A.W. Phillips who was at the London School of Economics in the 1950s.
C. There is a short run and long run Phillips curve.
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A. The short-run Phillips curve shows the inflation - unemployment relationship holding constant:
1. the expected inflation rate (EXINFRTE) and
2. the natural rate of unemployment (U*).
B. A short-run Phillips curve demonstrates that:
1. a higher actual inflation rate (INFRTE) lowers
2. the unemployment rate (U).
C. Explained by the AD-AS model
1. Unanticipated shift of AD curve
2. Unanticipated rise in the Price Level
3. Unanticipated rise in Y
4. Unanticipated fall in unemployment
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A. The long-run Phillips curve shows the relationship between:
1. the inflation rate (INFRTE) and
2. the unemployment rate (URTE) when:
INFRTE = f (URTE)
3. the actual inflation rate (INFRTE) equals the expected inflation rate (EXINFRTE).
INFRTE = EXINFRTE
B. A long-run Phillips curve is vertical at the natural rate of unemployment (URTE*).
URTE = URTE*
1. Along the long-run Phillips curve
a. an increase in the inflation rate (INFRTE) has no effect on the unemployment rate (U*).
URTE not a function of INFRTE
2. This is known as the "natural rate hypothesis".
3. In the long run, the Expected inflation rate will equal the actual inflation rate and
EINFRTE = INFRTE
unemployment will equal the natural rate.
URTE = URTE*
4. Natural rate hypothesis comes from Edmund Phelps (Columbia) and Milton Friedman (Chicago)
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From Begg p. 495
a. Start from full employment equilibrium.
b. Once for all increase in M
c. interest rates fall
d. Investment increases
e. unemployment falls
(movement along SR Phillips curve)
Phase II
a. wages rise and prices rise
b. interest rates rise
c. AD falls
d. unemployment rises
e. eventually wages stop rising
Conclusion
SR Phillips curve shows the temporary trade off while the economy is adjusting to a shock in aggregate demand.
An increase in AD requires a temporary inflation while moving to the new equilibrium price and wage level.
Speed of movement depends on flexibility of wages and prices.
Extreme monetarists think it is almost instantaneous. Some Keynesians think it will take a long time.
The vertical long run Phillips curve.
If no money illusion, the equilibrium values of all real values will be unaffected by the rate of inflation. Assuming everyone has had time to adjust to inflation rate. (Expected inflation)
Economy will always revert to natural rate of unemployment after all adjustments are made.
Expectations and credibility
1. Assume government commits itself to a lower rate of growth of M than before.
2. But businesses locked into wage contacts based on old higher inflation rates.
3. inflation causes reduction in real money supply and fall in AD.
4. There is involuntary unemployment.
5. unemployment is higher and only a small reduction in inflation because slow down in growth of M was not anticipated.
PHASE II
6. in the next year however inflationary expectations have fallen. wages go up more slowly. Phillips curve shifts downward.
7. Cut in wage growth pushes unemployment down towards the natural rate.
BAD ALTERNATIVE
Workers think slow down in money growth is temporary.
Insist on big wage increases
Keep shifting up the SR Phillips curve
Unemployment keeps increasing because government really wasn't increasing M (hence AD as fast as labor unions thought.
Governments resolve may crack and it may increase M to reduce unemployment and wages and prices will continue to go up.
This is why governments make long term commitments about rates of inflation.
An Aggregate supply shock
1. If government does not accommodate the shock, will be stagflation.
2. Gradually the economy gets back to the natural rate of unemployment
3. If the government does accommodate the shock, government increases rate of money growth and has permanently higher rate of inflation.
4. period of stagflation can be shortened if government commitment not to accommodate the shock is credible.
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A. The short-run Phillips curve shifts when the expected inflation rate (EXINFRTE) changes.
1. A higher expected inflation rate (EXINFRTE) shifts the short-run Phillips curve up.
a. it will shift up by the amount of the increase in the expected inflation rate.
2. A higher actual rate of inflation (INFRTE) will be needed to bring the real wage (W) down to the full employment level.
B. A change in the natural rate of unemployment (U*) shifts both:
1. the long-run Phillips curve and
2. the short-run Phillips curve.
F. The data for the United States are consistent with a shifting short-run Phillips curve.
1. The short-run Phillips curve has shifted due to:
a. changes in the expected inflation rate (EXINFRTE) and
b. changes in the natural rate of unemployment (U*).
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Topics from Begg
1. Discussion of hyperinflation
a. Flight from money
2. Government deficits and inflation
a. printing money to cover a deficit is inflationary
b. no obvious link between the size of the budget deficit and the inflation rate.
C deficit in the public sector can be financed in one of two ways
1. Selling bonds to private sector
2. printing money
D. Since real income and interest can change, there need not be a close relationship between money growth and inflation.
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Adaptation to anticipated inflation
1. Shoe leather costs (rapid spending) small real balances
2. menu costs - repricing
3. Failures of institutions to adapt to anticipated inflation
a. interest rate ceilings
b. tax bracket creep
c. taxing capital gains
Unexpected inflation
1. Redistribution
2. problems of making contracts given uncertainty about inflation rate.
What can be done about inflation
1. Aggregate Demand policies
2. incomes policies (influencing wages etc)
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X. Summary of the lecture
Key concepts
1. Cost-push inflation
2. Demand-pull inflation
3. Long-run Phillips curve
4. Natural rate hypothesis
5. Nominal interest rate
6. Phillips curve
7. Rational expectations
8. Rational expectations equilibrium
9. Rational expectations hypothesis
10. Short-run Phillips curve
Review Questions
1. Explain how a price-wage inflation spiral occurs.
2. Explain how a cost-price inflation spiral occurs.
3. What is the connection between expected inflation and nominal interest rates?