WEEK 6 Inflation, Jones, Chapter 8

Inflation The percentage change in an economys overall price level Hyperinflation an episode of extremely high inflation Greater than 500 percent per year Example: Post World War I Germany Deflation A negative growth rate of the general price level in an economy

 The inflation rate is computed as the annual percentage change in the price level

Price level in year t

The Consumer Price Index (CPI)

Price index for a bundle of consumer goods

Case Study: How Much Is That?

We can use the CPI to evaluate the value of a good in 1950 in todays dollars.

 Multiply the price of the good in 1950 times the ratio of the CPI in todays dollars to the CPI in 1950 dollars.

Its 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

8.2 The Quantity Theory of Money

Today
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.

Measures of the Money Supply

The monetary base includes currency and accounts, called reserves.
Private banks hold accounts with the economys central bank, which pay no interest. These banks ensure that they have sufficient cash on hand in case of money withdrawals.

 Other measures of currency:

M1
adds demand deposits to the money base

M2
adds savings accounts and money market account balances to M1

The Quantity Equation

The quantity theory of money allows us to make the connection between money and inflation.

Money supply

Velocity of money

Price level

Real GDP

 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.

The Classical Dichotomy Constant !elocity and the Central "an#

The classical dichotomy
States that, in the long run, the real and nominal sides of the economy are completely separate.

 In the quantity theory of money

Real GDP is assumed as exogenously given Determined by real forces.

In other words:

Bar over the Y means exogenous.

 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 $rice %e&el

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.

The Quantity Theory for Inflation

We can express the quantity equation in terms of growth rates. Using g as growth rate

Constant = 0

Rate of inflation, represented as

Thus:

Rate of inflation

Growth rate in money supply

Growth rate in GDP

 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

 According to the quantity theory of money inflation (an increase in P) is always a purely monetary phenomenon. If the money supply does not change, the price level will not change. The view that changes in the money supply affect only the price level, without a change in the level of output, is called the strict monetarist view. This view is not compatible with a nonvertical AS curve in the AS/AD model.

The strict monetarist view is not compatible with a non-vertical AS curve in the AS/AD model.

Problems with the quantity theory of money: the assumption of a constant velocity of money

Monetarists claimed that the Great Depression was a monetary phenomenon.

Market Crashes
On October 24, 1929 the market crashes. Why? falling industrial production was reported in August of 1929 (the actual recession begins in August) tight monetary policy by the Fed anticipated Smoot-Hawley (or Hawley-Smoot) tariff legislation (discussed below) pessimistic experts such as Roger Babson, who forecasted the stock market crash, September 7, 1929.

Monetarism and the great depression

Monetarists believed that the Great Depression was caused by contractionary monetary policies that reduced AD The collapse of the financial system was more a by-product of the Great Depression than its cause Figure 4.1: Despite a constant M1 until about 1931 indeed M1 dropped noticeably. Bank deposit, lending and the money multiplier dropped dramatically Thus, much of the fall in Money was the result rather than the cause of the great depression

Figure 4.1

'e&isitin( the Classical Dichotomy

When all prices in the economy double, relative prices are unchanged. When the relative prices of goods are unchanged, nothing real is affected.

 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

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.

Real and nominal interest rates

If the real rate is assumed, as per the Fisher hypothesis, to be constant, the nominal rate must change point-for-point when rises or falls. Thus, the Fisher effect states that there will be a one-for-one adjustment of the nominal interest rate to the expected inflation rate. The implication of the conjectured constant real rate is that monetary events such as monetary policy actions will have no effect on the real economyfor example, no effect on real spending by consumers on consumer durables and by businesses on machinery and equipment.

 Empirically
The real interest rate has been negative This implies that in the short run the real interest rate need not equal the MPK.

Deflation
In 2009, an interesting event occurred: the real interest rate actually became larger than the nominal interest rate. How could this happen? What happened to inflation in 2009? If the real interest rate were always equal to the marginal product of capital, then these negative rates would be puzzling; the marginal product of capital is the extra amount of output that could be produced by installing an extra unit of capital, and this amount is surely not negative. The graph, then, suggests that in the short run, the real interest rate can depart from the marginal product of capital.

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

 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.

 Taxes
Based on nominal incomes

Economic decisions
Based on real variables

Tax distortions are more severe when inflation is high.

 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.

Case Study: The )a(e*$rice Spiral and $resident +i,ons $rice 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

 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.

8.5 The Fiscal Causes of High Inflation

The government budget constraint
Government funds Tax revenue Changes in the stock of Borrowing money

 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.

The Inflation Ta,

Seignorage and the inflation tax
Names for the revenue that the government obtains from printing more money (M)

The inflation tax

Shows up as a rise in the price level Is paid by people holding currency

 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 "an# 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

Case Study: Episodes of Hi(h 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.

 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.

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

 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.

Deflation and the Great Depression

End This Depression Now! (Paul Krugman)

The great American economist Irving Fisher laid out the story in a classic 1933 article titled The Debt-Deflation Theory of Great Depressions Imagine, said Fisher, that an economic downturn creates a situation in which many debtors find themselves forced to take quick action to reduce their debt. They can liquidate, that is, try to sell whatever assets they have, and/or they can slash spending and use their income to pay down their debts. Those measures can work if not too many people and businesses are trying to pay down debt at the same time. But if too many players in the economy find themselves in debt trouble at the same time, their collective efforts to get out of that trouble are selfdefeating. If millions of troubled homeowners try to sell their houses to pay off their mortgagesor, for that matter, if their homes are seized by creditors, who then try to sell the foreclosed propertiesthe result is plunging home prices, which puts even more homeowners underwater and leads to even more forced sales.

Deflation

More from Fisher: The more the debtors pay, the more they owe.
End This Depression Now! (Paul Krugman) If banks worry about the amount of Spanish and Italian debt on their books, and decide to reduce their exposure by selling off some of that debt, the prices of Spanish and Italian bonds plungeand that endangers the stability of the banks, forcing them to sell even more assets. If consumers slash spending in an effort to pay off their credit card debt, the economy slumps, jobs disappear, and the burden of consumer debt gets even worse. And if things get bad enough, the economy as a whole can suffer from deflationfalling prices across the boardwhich means that the purchasing power of the dollar rises, and hence that the real burden of debt rises even if the dollar value of debts is falling. Irving Fisher summed it up with a pithy slogan that was a bit imprecise, but gets at the essential truth He argued that this was the real story behind the Great Depressionthat the U.S. economy came into a recession with an unprecedented level of debt that made it vulnerable to a self-reinforcing downward spiral.

The Great Depression and the Debt-Deflation theory

Irving Fisher: financial systems are responsible for the business cycle The focus is on volatile lending and borrowing behaviors During booms we have lending booms and build ups of debt As the debt grows firms and households positions become more fragile If a negative external shock happens can significantly change market perceptions. In particular say a drop in M, a rise in the interest rate can induce borrowers to sell part of their assets in an attempt to recoup part of their debt. Herd behavior and panic. The more asset prices drop the more fragile the financial position of indebted agents become because DEBT IS NOT INDEXED. A drop in P reduces the price of assets but does not reduce the value of the debt Eventually many firms and households become insolvent.

Panic, Herd Behavior and Expectations

Fisher believed that market agents tend to overreact Lenders and borrowers are somehow irrational even in terms of expectations So a good questions is about the formulation of expectations

Fisher and deflation

Deflation, whether caused by P falling or by the falling of assets prices, is extremely costly. Debt is not indexed. When P drops, debt is not changing, but asset real value drop. For Fisher this is what causes risk of insolvency, credit reductions and recessions However, the relationship between deflation and output is not the same across time and space. Large debt can be very much affected by a moderate deflation, while a moderate deflation may not cause any panic in case of moderate debt.