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Lecture 12

Lecture 12. THE DYNAMICS OF INFLATION AND UNEMPLOYMENT. Lecture Outline. Inflation and the Price Level Demand-Pull Inflation Cost-Push Inflation Effects of Inflation The Phillips Curve. Inflation and the Price Level.

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Lecture 12

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  1. Lecture 12 THE DYNAMICS OF INFLATION AND UNEMPLOYMENT

  2. Lecture Outline • Inflation and the Price Level • Demand-Pull Inflation • Cost-Push Inflation • Effects of Inflation • The Phillips Curve

  3. Inflation and the Price Level • Inflationis a process in which the price level rises and money loses value. • Inflation is fundamentally a monetary phenomenon. • The average level of prices is rising. • Inflation is not high prices and inflation is not a jump in prices

  4. Inflation and the Price Level • The figures distinguishes between a one time jump in prices and inflation. • Part (b) shows a one time jump in the price level.

  5. Inflation and the Price Level • Part (a) shows the process of inflation. • The inflation rate is the percentage change in the price level during a given period.

  6. Demand-Pull Inflation • Demand-pull inflationis inflation that results from an initial increase in aggregate demand. • A demand pull inflation can result from any influence that increases aggregate demand.

  7. Demand-Pull Inflation • In a demand-pull inflation, initially • aggregate demand increases • real GDP increases above potential GDP and the price level rises • money wages rise • the price level rises further and real GDP decreases toward potential GDP.

  8. Demand-Pull Inflation • A one-time increase in aggregate demand raises the price level but does not always start a demand-pull inflation. • For demand pull inflation to occur, aggregate demand must persistently increase. • The money supply must persistently grow at a rate that exceeds the growth rate of potential GDP.

  9. Demand-Pull Inflation • The figures show a demand pull inflation. • Initially, aggregate demand increases.

  10. Demand-Pull Inflation • Real GDP increases and the price level rises. • Now real GDP exceeds potential GDP.

  11. Demand-Pull Inflation • There is an inflationary gap. • The money wage rate begins to rise. • And the SAS curve shifts leftward.

  12. Demand-Pull Inflation • Real GDP decreases toward potential GDP. • The price level rises further.

  13. Demand-Pull Inflation • This process repeats in an unending price-wage spiral.

  14. Cost-Push Inflation • Cost-push inflationis an inflation that results from an initial increase in costs. • The two main sources of cost-push inflation are: • an increase in the money wage rate • an increase in the money prices of raw materials

  15. Cost-Push Inflation • In a cost-push inflation, initially • short-run aggregate supply decreases • real GDP decreases below potential GDP and the price level rises • the economy could become stuck in this stagflation situation for some time.

  16. Cost-Push Inflation • A one-time decrease in aggregate supply raises the price level but does not always start a cost-push inflation. • For cost-push inflation to occur, aggregate demand must increase in response to the cost push.

  17. Cost-Push Inflation • Just like the case of demand-pull inflation, the money supply must persistently grow at a rate that exceeds the growth rate of potential GDP if an inflation is to become persistent.

  18. Cost-Push Inflation • The following figures show a cost-push inflation. • Initially, a factor price rises.

  19. Cost-Push Inflation • Short-run aggregate supply decreases and the SAS curve shifts leftward

  20. Cost-Push Inflation • Real GDP decreases and the price level rises in a stagflation.

  21. Cost-Push Inflation • With no subsequet change in aggregate demand, the price level eventually falls.

  22. Cost-Push Inflation • There is no inflation. • For cost-push inflation to take hold, aggregate demand must increase.

  23. Cost-Push Inflation • An increase in the money supply increases aggregate demand and the AD curve shifts rightward.

  24. Cost-Push Inflation • Real GDP increases and the price level rises.

  25. Cost-Push Inflation • This process repeats to create an unending cost-price inflation spiral.

  26. HYPERINFLATION • Very high inflation rates, over 50% per month • Inflation rates observed in the US in the last 40 years are insignificant in comparison to some experiences around the world throughout history

  27. HIGH INFLATIONS IN THE 1980s Country Bolivia Argentina Nicaragua Year 1985 1989 1988 Yearly Inflation 1,152, 200 975, 000 302, 200 Rate (%) Monthly Inflation 118 95 115 Rate (%) Monthly Money 91 93 66 Growth Rate (%) Source: International Financial Statistics Yearbook, 1992, (Washington DC: International Monetary Fund)

  28. DURING HYPERINFLATIONS • Money no longer works very well in facilitating exchange • Since prices are changing so fast and unpredictably, there is typically massive confusion about the true value of commodities • Different stores may be raising prices at different rates • The same commodities may sell for radically different prices • Everyone spends all their time hunting for bargains and finding the lowest prices • Governments are forced to put an end to hyperinflation before it destroys their economies

  29. THE CAUSE OF HYPERINFLATION Excessive money growth • If a government wants to spend a specified amount of money, but is collecting less in taxes, it must cover the difference in some way: • the government may borrow the difference from the public and issue bonds, for which it must pay back what it borrows and interest in the future • the government may print new money • governments could mix borrowing and printing money to cover the deficit government deficit = new borrowing + new money created

  30. HYPERINFLATION • occurs in countries that have large deficits, but cannot borrow and are forced to print new money • is only stopped by eliminating the deficit, which is the basic cause: • increase taxes • cut spending • Once the deficit has been cut and the government stops printing money, the hyperinflation will end

  31. INDEXED • Describes something whose payments are adjusted for changes in prices, such as bonds or nominal contracts • In practice, countries find that indexing is not the perfect solution to problems caused by inflation: • policymakers worry indexing lowers the resolve to fight inflation • Price indices are far from perfect and are extremely difficult to construct when prices are increasing rapidly • Some economists believe that indexing builds inflation into the economic system and makes it difficult to reduce inflation

  32. MONETARISTS • Economists who traditionally emphasize the important role that the supply of money plays in determining nominal income and inflation • Most famous - Milton Friedman, Nobel laureate - studied versions of quantity equation and role of money in economic life • Philip Cagan - best known for work on hyperinflations • Monetarist economists did pioneering research on link between money, nominal income and inflation

  33. Effects of Inflation • Regardless of whether its origin is demand-pull or cost-push, inflation imposes costs. • The costs depend on whether the inflation is anticipated or unanticipated.

  34. ANTICIPATED INFLATION Fully Anticipated Inflation • Inflation at 4% would mean workers would know that nominal wage increases of 4% were not real wage increases, and • Investors earning a 7% rate of interest on bonds would know that their real return would be 3% after adjusting for inflation • Menu costs -- the actual physical costs of changing prices • Shoe leather costs -- additional wear and tear necessary to hold less cash • Our tax system and financial system do not fully adjust even to fully anticipated inflation

  35. Effects of Inflation • This figure shows how anticipating inflation avoids the costs of deviations from potential GDP.

  36. Effects of Inflation • Anticipating inflation also avoids: • the redistribution of income and wealth. • errors in investment and saving decisions. • But anticipated inflation does have some costs.

  37. Effects of Inflation • The costs of anticipated inflation are: • “bootleather” costs • other transactions costs • decrease in potential GDP • decrease in the long-term growth rate. • These costs have been estimated to be very high, even for a modest inflation. • The main problem is that taxes on capital income a seriously distorted by inflation.

  38. Effects of Inflation • Unanticipated inflationcan cause the following problems: • redistribute income between firms and workers • move real GDP away from potential GDP • redistribute wealth between borrowers and lenders • result in too much or too little saving and investment

  39. Effects of Inflation • Because unanticipated inflation is costly, people try to anticipate it. • To make the best possible forecast of inflation, people use all the information they can about the source of inflation and likely trends in those sources. • Such a forecast is called a rational expectation. • An anticipated inflation avoids some of the costs of inflation.

  40. COSTS OF INFLATION Anticipated Unanticipated Inflation Inflation Institutions do Distortions in the Unfair redistributions not adjust tax system, Problems in financial markets Institutions Cost of changing Institutional adjust prices , disintegration Shoe-leather costs

  41. THE PHILLIPS CURVE - 1 • The Phillips Curve is a graph depicting a relationship between the unemployment rate and the inflation rate. The figure below shows a typical SHORT-RUN Phillips Curve.

  42. THE PHILLIPS CURVE - 2 • The implication of the negative slope is that the unemployment rate and the inflation rate are inversely related - in other words, there is a trade-off between the two. • At the beginning of the course, one things we said was that society faces a short-run trade-off between inflation and unemployment. This trade-off is embodied in the short-run Phillips Curve.

  43. THE PHILLIPS CURVE - 3 • Since inflation and unemployment are BOTH things we don't like, the relationship between the AD-AS (short-run) macroeconomic model and the Phillips Curve are important. • Understanding the relationship between economic policy and the inflation-unemployment trade-off is key to your understanding of macroeconomics.

  44. SHIFTS IN AD & THE PHILLIPS CURVE - 1 Q: What happens in the Phillips Curve diagram when there is a shift in AD? A: There is a movement along the short-run Phillips Curve and a trade-off between inflation and unemployment.

  45. SHIFTS IN AD & THE PHILLIPS CURVE - 2

  46. SHIFTS IN AD & THE PHILLIPS CURVE - 3 • In the previous slide, AD increases from AD1 to AD2. As a result, the equilibrium in the economy moves from point A to point B. • There are two important things to notice about the new equilibrium (relative to the old one): • First, notice that the price level in the economy has increased (from 102 to 106) - therefore, the rate of inflation has risen. • Second, the level of output produced in the economy has risen (from Y1 to Y2). When the level of output increases, the number of people employed also rises, indicating that the unemployment rate MUST have fallen.

  47. SHIFTS IN AD & THE PHILLIPS CURVE - 4 • Relative to point A in the figure on the right, point B MUST be a point where there is higher inflation and lower unemployment - but this just represents a movement ALONG the short-run Phillips Curve. Also, if AD were to shift in the opposite direction, there would have been a movement along the Phillips Curve in the opposite direction.

  48. THE LONG-RUN PHILLIPS CURVE - 1 The figure below depicts the long-run Phillips Curve:

  49. THE LONG-RUN PHILLIPS CURVE - 2 • Earlier in the course, we discussed the natural rate of unemployment. This was defined to be about 6% in the long-run, and it was shown that the economy tends to automatically return to this level on its own. • If this is true, then the long-run Phillips Curve is quite easy to draw - it MUST be a vertical line at 6% unemployment!

  50. THE LONG-RUN PHILLIPS CURVE - 3 • If the long-run Phillips Curve is vertical at 6%, then policymakers must be able to choose any inflation rate they desire along this line. Q: What is the cost of reducing inflation in the long-run? A: In the long-run, there is NO cost to reducing inflation.

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