The Costs of Inflation: Understanding the Impact and Relationships

1. Chapter 10 The Goals of Stabilization Policy: Low Inflation and Low Unemployment

2. The Costs of Inflation Inflation is widely viewed as a social evil, but the degree of seriousness is debated Arthur Okun considered inflation as serious a problem as unemployment and defined the “Misery Index:” Misery Index = Inflation + Unemployment rate James Tobin wrote that “inflation is greatly exaggerated as a social evil.” Any debate about inflation must distinguish between moderate inflation and hyperinflation Hyperinflation is very rapid inflation, sometimes defined as p > 22% per month or p > 1,000% per year

3. Money and Inflation Recall the quantity equation: MSV = X = PY The quantity equation expressed in terms of growth rates: ms + v = x = p + y Rearranging to solve for the inflation rate yields: p = x – y = ms + v – y Conclusion: In the long run, inflation equals the excess growth of the money supply plus velocity over real GDP In the long run, v=0  inflation is just the excess of money supply growth over GDP growth

4. International Perspective Money Growth and Inflation

5. Why do Central Banks Allow Large mS ? There are four reasons why central banks may allow money supply to grow very rapidly: Temptation of demand stimulation Fear of recession and job loss Adverse supply shocks that raise prices unless central banks introduce an extinguishing policy An accommodating policy calls for central banks to “print the extra money to pay for the inflation.” Financing government deficits by printing money

6. Nominal vs. Real Interest Rates The Nominal Interest Rate (i) is the rate actually charged by banks and negotiated in financial markets. The Expected Real Interest Rate (re) is the rate that people expect to pay on their borrowings or earn on their savings after deducting expected inflation: re = i – pe The actual Real Interest Rate is: r = i – p

7. When Is Inflation Harmless? There are four conditions necessary for inflation to be harmless: Inflation is universally and accurately anticipated. An increase in pe raises i for both saving and borrowing by the same number of percentage points. All savings are held in bonds, stocks, or savings accounts earning i; no one holds money in accounts with an interest rate held below i. Only real (not nominal) interest income is taxable, and only the real cost of borrowing is tax deductible.

8. Violation of #1: Surprise Inflation Unanticipated Inflation occurs when the actual inflation rate (p) differs from the expected (or anticipated) inflation rate (pe). Suppose savers are offered i = 3% and pe = 1. The expected real return is: re = i – pe = 2% If p = 7%, the actual real return is: r = i – p r = 3 – 7 = - 4% Conclusion: Surprise inflation redistributes income from savers to debtors. Surprise deflation redistributes income from borrowers to lenders

9. Violation of #2: The Fisher Effect The Fisher Equation states: i = re + pe The Fisher Effect predicts that a one percentage point increase in pe will raise i by one percentage point, leaving re unaffected. If the Fisher Effect holds, condition #2 is not violated. Problem: In the real world, the expected real interest rate often fluctuates dramatically (see Figure 9-1).

10. Figure 10-1 The 10-year Treasury Bond Rate and the Expected Rate of Inflation, 1970-2010

11. Wizard of Oz: Monetary Allegory The Wonderful Wizard of Oz (1900) by L. Frank Baum  1939 movie “The Wizard of Oz” (Oz = Ounce of gold) Economic conflicts of late 19th century U.S. 3 decades following Civil War characterized by deflation P↓ by 40% (Farm Prices↓ by 55%)  Farmers hurt Problem: Gold standard which limited mS Solution: Coinage of silver  MS↑  p>0  Farmers gain References in the book Dorothy = America & Toto (short for Teetotaler) = the Prohibition Party Scarecrow = western farmer Tin Woodsman = workingman (with joints rusted from unemployment) Cowardly lion = William Jennings Bryan, leader of free silver movement D’s house lands on Wicked Witch of the East (gold standard stronghold) Leaves silver slippers, representing coinage of silver Wicked Witch of West destroyed by water, which solves farm problems!

12. Violation of #3: Money Does Not Pay i Why does money not pay the market rate of interest, i? Currency does not pay interest Banks earn no interest on reserves at the Fed, so banks cannot afford to pay i on deposits Bank deposits are FDIC insured, so customers are willing to accept lower interest rates on deposits Higher inflation causes harm via: The loss of convenience from holding less money The “shoe leather” cost of inflation Higher “menu costs” to display new prices

13. Violation of #4: Nominal Interest is Taxed Inflation reduces the after-tax real interest rate when nominal interest is taxed. This is true even if i obeys the Fisher Effect! Suppose the tax rate is t = 0.3, p= 0 and i = 3% Initial after-tax real rate= i(1 – t) – p = 3(1 – 0 .3) = 2.1% Now suppose p = 10% and i = 13%. New after-tax real rate = 13(1-0.3) – 10 = - 0.9% Result: High inflation encourages people to borrow more and save less.

14. Reforms to Reduce the Cost of Inflation Decontrol of Financial Institutions Since deregulation in the 1980s, checking, savings and time-deposit accounts pay interest, which lowers the redistributive cost of inflation. Indexed Bonds An Indexed Bond pays a fixed real interest rate plus the actual inflation rate. Example: Treasury Inflation-Protected Securities or TIPS Indexed Tax System In 1985, the personal income tax system was partially indexed to inflation.

15. The Indexed Bond (TIPS) Protects Investors from Inflation

16. The Government Budget Constraint The Government Budget Constraint relates government spending to the sources available to finance that spending: where… (G – T) is the basic deficit B is the dollar amount of outstanding government bonds i is the interest paid on B ∆B is the new amount of new bonds issued H or High Powered Money = currency + bank reserves ∆H is the issuance of new government monetary liabilities

17. Large Recessions Can Cause Large Deficits

18. The Basic Deficit and Inflation The Government Budget Constraint can be expressed: (1) If (B/P) and (H/P) are to remain stable over time, the growth rates of B and H must equal inflation: Substituting p into (1) yields… see next slide!

19. Why Inflation is Tempting to Governments The Government Budget Constraint can be expressed: Seignorage is the revenue the gov’t receives from p From the household perspective, seignorage = inflation tax Inflation is tempting to governments for 2 reasons: Revenue from printing money (i.e. seignorage) Decrease in the real amount of interest owed on government debt

20. What Factors Cause a Hyperinflation? Recall: A hyperinflation is defined as p ≥ 1,000% per yr Method 1: The “unholy trinity” Adverse supply shock  P↑ Monetary accommodation leads to rapid nominal GDP growth  inflation accelerates Wage indexation or a Cost of Living Adjustment (COLA) calls for an automatic increase in wages in response to an increase in the price index  begins inflationary spiral Higher prices make goods less attractive to foreigners  $ depreciates  imports more expensive  more inflation Higher cost of living  higher indexed wages  more inflation! Method 2: Deficit financing via MS↑ Often linked to war time spending People postpone paying taxes  real budget deficit↑

21. How to End a Hyperinflation Stabilization Strategy: Steps a government must take to end hyperinflation Key Ingredient: Sharp reduction in budget deficit Cut expenditures and subsidies Raise taxes Perhaps shift to an easily enforceable broad-based tax (e.g. value-added tax) Other steps sometimes needed to end an inflationary spiral Pursue an incomes policy:an attempt by policy makers to moderate increases in wages and other income, either by persuasion or legal rules Foster credibility:the extent to which households and firms believe that an announced monetary or fiscal policy will actually be implemented and maintained as announced.

22. Table 10-1 Annual Rates of Inflation in Selected High Inflation Countries, 1975–2010

23. 3 Types of Unemployment Cyclical unemployment is the difference between actual unemployment and the natural rate of unemployment The Natural Rate of Unemployment has two components: Turnover (or Frictional)unemployment occurs in the normal process of job search by individuals who have voluntarily quit their jobs, are entering the labor force for the first time or are reentering the labor force Mismatch (or Structural) unemployment occurs when there is a mismatch between the skill or locations requirements of job vacancies and the present skills or location of the labor force

24. Figure 10-2 The Actual Unemployment Rate and the Natural Rate of Unemployment, 1980–2010

25. Sources of Mismatch Unemployment In an imaginary economy with identical jobs and workers, no structural employment can occur But skill difference among jobs  structural U possible If U is low and AD is growing rapidly  job vacancies↑ wages↑ p↑ What causes mismatch of skills? Lack of job training Inflexibility of relative wages (e.g. Wmin  high teen U) Discrimination Low-term U  slow deterioration of job skills (e.g. “99-ers”) Solutions to lack of job training? 3 basic categories Better public education Subsidies for firms to train workers Gov’t-financed training programs

26. Turnover Unemployment and Job Search Theory The basic reason for turnover unemployment is explained by the theory of “search” unemployment An unemployed person may be better off turning down jobs According to job search theory, unemployment is a socially valuable, productive activity Unemployed individuals “invest” in job search Cost = Cost of search itself + foregone W from accepting job Payoff = Prospect of higher W +/or better working conditions If Payoff > Cost  Stay unemployed and continue search Government can reduce turnover U by: Providing better employment agencies  more info  less search Reducing motivation for quitting, reentry and initial entry Change economic incentives that lengthen job search

27. Table 10-2 Unemployment Rates by Reason, Sex, and Age in August 2010

28. Why Did UN Decline After 1990? Figure 10-2 shows that the natural unemployment (UN) declined from 6.5% (mid-1980s) to 5.0% (after 2000) Why? Fraction of teens (who normally have higher U) fell This explains 1/3 of the decline in UN By 2000, inmates in prison (mostly young men) had quadrupled Some of these men would have added to U Growth in temporary help agencies  vacancies filled faster Reduced both turnover and mismatch unemployment Internet made job search easier

29. Figure 10-3 The Actual Unemployment Rate and Natural Unemployment, 2005-10, and Both Optimistic and Pessimistic Forecasts for 2011-20.

30. The Human Cost of Persistent U January, 2011: # of U.S. unemployed was almost 15M 45M more are no longer in work force Half of the unemployed have been out of work ≥ 6 months About 1.5M “99-ers” have been out of work ≥ 99 months Effects of unemployment Formerly middle class people, now have savings depleted Difficulty maintaining home and car payments Some no longer can afford Internet access Food pantries & shelters report former donors now need help Arrange for families with only cars to park/sleep in safety Young people cannot start careers  “holes” in resumes Some do not get married; instead move back in with their parents People older than 50 are subject to age discrimination Psychological cost: Feelings of uselessness Research estimates that if U↑ by 1%  37,000 more deaths

31. Why Did Unemployment Rise Less in Europe than in the U.S. after 2007

32. Conclusion: Dealing with Inflation and U Both inflation and unemployment are costly Four options to reduce the costs of inflation Restrictive monetary and fiscal policies  Y↓ and U↑ temporarily Price and wage controls Cost-reducing policies such as reducing burden of regulations Issuance of indexed bonds (e.g. TIPS) and reform of tax system Options to reduce Unemployment Avoidance of cyclical U  Fed responsibility Turnover U  Not a big problem Mismatch U  programs to increase skills Student loans for college Adult learn-to-read programs Better prenatal care and improved funding for programs like Head Start National testing standards to raise national education levels Consequence of 2000-06 housing bubble for policies Monetary and fiscal policy mix not as effective Reducing mismatch U due to location not possible  Focus on skills↑