Inflation By Charles I. Jones Media Slides Created By Dave Brown Penn State University

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1 Chapter 8 Inflation By Charles I. Jones The inflation rate is computed as the annual percentage change in the price level Price level in year t Media Slides Created By The Consumer Price Index (CPI) Dave Brown Penn State University Price index for a bundle of consumer goods 8.1 Introduction In this chapter, we learn: What inflation is, and how costly it can be. How the quantity theory of money and the classical dichotomy help us understand inflation. The relationship of interest rates and inflation through the Fisher equation. The important link between fiscal policy and high inflation. Inflation The percentage change in an economy s overall price level Hyperinflation an episode of extremely high inflation Greater than 500 percent per year Example: Post World War I Germany Case Study: How Much Is That? We can use the CPI to evaluate the value of a good in 1950 in today s dollars. 1

2 Today 8.2 The Quantity Theory of Money Currency is fiat money. Currency is paper that the government simply declares is worth a certain price. Money has value because we expect others will value it. Multiply the price of the good in 1950 times the ratio of the CPI in today s dollars to the CPI in 1950 dollars. It s not as large of a difference as the raw numbers may lead you to believe. Other price indexes The CPI excluding food and energy prices The GDP deflator Measures of the Money Supply The monetary base includes currency and accounts, called reserves. Private banks hold accounts with the economy s central bank, which pay no interest. These banks ensure that they have sufficient cash on hand in case of money withdrawals. 8.2 The Quantity Theory of Money We often think of money as paper currency. Historically Money was backed by gold or silver Other measures of currency: M1 adds demand deposits to the money base M2 adds savings accounts and money market account balances to M1 2

3 Velocity of money The average number of times per year that each piece of paper currency is used in a transaction The equation implies that the amount of money used in purchases is equal to nominal GDP. Case Study: Digital Cash Electronic forms of currency Debit cards, PayPal, travelers checks Makes up most money in advanced economies The Classical Dichotomy, Constant Velocity, and the Central Bank The classical dichotomy States that, in the long run, the real and nominal sides of the economy are completely separate. The Quantity Equation The quantity theory of money allows us to make the connection between money and inflation. In the quantity theory of money Real GDP is assumed as exogenously given Determined by real forces. In other words: Money supply Velocity of money Price level Real GDP Bar over the Y means exogenous. 3

4 The velocity of money Exogenously given constant Assumed to be constant over time In other words: No time subscript The money supply Determined by the central bank Monetary policy is exogenously given In other words: The Quantity Theory for the Price Level To solve the model Plug all the exogenous variables Solve for the price level Prices will rise as a result of Increases in the money supply Decreases in real GDP In the long run, the key determinant of the price level is the money supply. 4

5 The Quantity Theory for Inflation We can express the quantity equation in terms of growth rates. Using g as growth rate Thus: Constant = 0 Rate of inflation, represented as π Rate of inflation Growth rate in money supply Growth rate in GDP Revisiting the Classical Dichotomy Quantity Theory of Money Changes in the growth rate of money lead one-for-one to changes in the inflation rate. Empirically, this holds up both in U.S. and worldwide data. Deflation Occurs when inflation rates are negative When all prices in the economy double, relative prices are unchanged. When the relative prices of goods are unchanged, nothing real is affected. 5

6 The neutrality of money says that changes in the money supply Have no real effects on the economy Only affect prices Empirically Holds in the long run Does not hold in the short run nominal prices do not respond immediately to changes in the money supply Empirically The real interest rate has been negative This implies that in the short run the real interest rate need not equal the MPK. 8.3 Real and Nominal Interest Rates The real interest rate Is equal to the marginal product of capital Is paid in goods The nominal interest rate Is the interest rate on a savings account Is paid in dollars The Fisher equation Nominal interest rate Real interest rate Rate of inflation The nominal interest rate is generally high when inflation is high. 8.4 Costs of Inflation Individuals who are hurt during inflation: An individual who has a pension that is not indexed to inflation A bank that issues loans at fixed rates but that pays interest rates that move with the market An individual with a variable rate mortgage 6

7 Large surprise inflations can lead to large distributions in wealth. People with debts can pay back their loans with new cheaper dollars. Creditors wind up losers. Case Study: The Wage-Price Spiral and President Nixon s Price Controls At the time, the view was: Strong unions pushed for high wages Strong corporations translated rising costs to rising prices Strong unions demanded even higher wages. Wage-price spiral, resulting in inflation Taxes Based on nominal incomes Economic decisions Based on real variables Tax distortions are more severe when inflation is high. Nixon froze wages and prices for 90 days to break the spiral. High unemployment resulted from an expansionary policy that brought the return of inflation. Price controls also distort economic decisions. Inflation also distorts relative prices. Some prices are faster at adjusting to inflation than other prices are. Shoe leather costs of inflation People want to hold less money when inflation is high. Menu costs The costs to firms of changing prices frequently. 8.5 The Fiscal Causes of High Inflation The government budget constraint Government funds Tax revenue Borrowing Changes in the stock of money 7

8 The Inflation Tax Seignorage and the inflation tax Names for the revenue that the government obtains from printing more money (ΔM) The inflation tax Shows up as a rise in the price level Is paid by people holding currency Case Study: Episodes of High Inflation Episodes of high inflation tend to recur. Hyperinflations can stop just as quickly as they start. Countries experiencing hyperinflation typically raise about 5 percent of GDP from the inflation tax. Argentina raised 10 percent of GDP this way. If a government runs large budget deficits, as debt rises Lenders may worry the government will have trouble paying back loans They may stop lending to the government altogether. Debt solution: Raising taxes? May not be politically feasible The government may resort to printing currency to finance its budget. Lenders to the government will be paid back in currency that is worth less than the dollars lent. Central Bank Independence Monetary Policy Conducted by Federal Reserve Fiscal Policy President and Congress Central Bank Independence An attempt to prevent fiscal considerations from leading to excessive inflation 8

9 Hyperinflation Ends when the rate of money growth falls rapidly The government gets its finances in order through lower spending, higher taxes, and new loans The coordination problem People build their expectations into the prices they set. Summary Inflation The annual percentage change in the overall price level in an economy A dollar today is worth much less than it was a decade ago. 8.6 The Great Inflation of the 1970s During the Great Inflation, The rate peaked below 15 percent Yet the inflation tax was a small fraction of government spending The quantity theory of money is our basic model for understanding the long-run determinants of the price level and therefore of inflation. There are two ways to express the solution. For the price level For the rate of inflation Inflation rose in the 1970s for the following reasons: OPEC coordinated increases in oil prices that spurred inflation. The Federal Reserve grew the money supply too rapidly. Policymakers pursued such a policy because of the productivity slowdown. The classical dichotomy The real and nominal sides of the economy are largely separate. Real economic variables, like real GDP, are determined only by real forces like the investment rate and TFP. They are not influenced by nominal changes, such as a change in the money supply. Classical dichotomy holds in the long run but not necessarily in the short run. 9

10 The nominal interest rate Paid in units of currency Real interest rate Paid in goods Related by the Fisher equation This concludes the Lecture Slide Set for Chapter 8 Macroeconomics Third Edition by Charles I. Jones Nominal interest rate Real interest rate Rate of inflation W. W. Norton & Company Independent Publishers Since 1923 Inflation Can be very costly to an economy Generally transfers resources from lenders and savers to borrowers Can cause high effective tax rates distortions to relative prices shoe-leather costs menu costs The government budget constraint says that the government has three basic ways to finance its spending. Taxes Borrowing Printing money If none of those methods work, the government may be forced to print money to satisfy the budget constraint. Hyperinflations are generally a reflection of such fiscal problems. 10