Macroeconomics (ECON 1211) Lecturer: Dr B. M. Nowbutsing Topic: Inflation

1. Macroeconomics (ECON 1211)Lecturer: Dr B. M. Nowbutsing Topic: Inflation

2. 1. Inflation is ... • Inflation is a rise in the average price of goods over time • Too much money chasing too few goods • One of the first acts of the Labour government in 1997 was to make the Bank of England independent • with a mandate to achieve low inflation.

3. 2. Measuring Inflation • Price level A measure of the average prices of goods and services in the economy. • Inflation rate The percentage increase in the price level from one year to the next. • Consumer price index (CPI) An average of the prices of the goods and services purchased by the typical urban family of four. • Deflation A decline in the price level.

4. 3. Some questions about inflation • Why is inflation bad? • Inflation does have bad effects, but some popular criticisms are based on spurious reasoning • What are the causes of inflation? • What can be done about it?

5. 4. Causes of Inflation • Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to maintain their profit margins (rising imported raw materials costs,rising labour costs, higher indirect taxes imposed by the government)

6. 4. Causes of Inflation • Demand-pull inflation is likely when there is full employment of resources and when SRAS is inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD might rise for a number of reasons – some of which occur together at the same moment of the economic cycle

7. 4. Causes of Inflation • Demand-pull inflation (A depreciation of the exchange rate: increase price of imports and decrease price of exports, A reduction in direct or indirect taxation, The rapid growth of the money supply , faster economic growth in other countries)

8. 5. Inflation in Mauritius, 1975- 2006

9. 6. The quantity theory of money • The quantity theory of money says that changes in the nominal money supply lead to equivalent changes in the price level (and money wages) but do not have effects on output and employment.

10. 6. The quantity theory (2) • The quantity theory of money says: • M V = P Y • where V = velocity of circulation • If prices adjust to maintain real income (Y) at the potential level and if velocity stays constant • then an increase in nominal money supply leads to an equivalent increase in prices • but if velocity is variable or prices are sluggish, this link is broken.

11. 7. Money and prices • Milton Friedman famously claimed • ‘Inflation is always and everywhere a monetary phenomenon.’ • i.e. it results when money supply grows more rapidly than real output. • But this does not prove that causation is always from money to prices • e.g. if the government adopts an accommodating monetary policy.

12. 8. Money and inflation (2) • …but in the long run, changes in real income and interest rates significantly alter real money demand • so there may not be a perfect correspondence between excess monetary growth and inflation. • And in the short run, the link between money and prices may be broken if • velocity of circulation is variable • prices are sluggish

13. 9. Inflation and interest rates • FISHER HYPOTHESIS • a 1% increase in inflation will be accompanied by a 1% increase in interest rates • REAL INTEREST RATE • Nominal interest rate – inflation rate • i.e. the Fisher hypothesis says that real interest rates do not change much • but the nominal interest rate is the opportunity cost of holding money • so a change in nominal interest rates affects real money demand

14. 10. Hyperinflation • … periods when inflation rates are very large • in such periods there tends to be a ‘flight from money’ • people hold as little money as possible • e.g. Germany in 1922-23, Hungary 1945-46, Brazil in the late 1980s. • Large government budget deficits help to explain such periods • persistent inflation must be accompanied by continuing money growth

15. Prof. A W Phillips demonstrated a statistical relationship between annual inflation and unemployment in the UK The Phillips curve shows that a higher inflation rate is accompanied by a lower unemployment rate. Phillips curve Inflation rate (%) Unemployment rate (%) 11. The Phillips curve It suggests we can trade-off more inflation for less unemployment or vice versa.

16. Suppose the economy begins at E, with zero inflation, unemployment at the natural rate U*... An increase in government spending funded by an expansion in money supply takes the economy to A, with lower unemployment but inflation at 1. A 1 U1 U* 11. The Phillips curve and an increase in aggregate demand Inflation … but what happens next? PC0 Unemployment

17. Inflation A so we may find the economy finds its way back to the natural rate, but with continuing inflation at C. C 1 E U1 U* PC0 Unemployment 12. The Phillips curve and an increase in aggregate demand If nominal money supply is fixed in the long run, and prices and wages eventually adjust, the economy moves back to E. But nominal money supply need not be constant in the long run

18. Effectively, the long-run Phillips curve is vertical, as the economy always adjusts back to U*. LRPC its position may depend upon expectations about inflation. PC1 13. The vertical Phillips curve Inflation The short-run Phillips curve shows just a short-run trade-off – A C 1 E U1 U* PC0 Unemployment

19. Suppose the economy begins at E, with a newly-elected government pledged to reduce inflation. Monetary growth is cut to 2. E In the short run, the economy moves to A along the short- run Phillips curve. A 2 F Unemployment rises to U1 As expectations adjust, the short-run Phillips curve shifts to PC2, and U* is restored at F. U1 14. Expectations and credibility LRPC Inflation 1 PC1 PC2 U* Unemployment

20. Inflation and unemploymentin the UK 1978-99 1980 1990 1978 1986 1993 1999

21. 15. Inflation illusion • People have inflation illusion when they confuse nominal and real changes. • People’s welfare depends upon real variables, not nominal variables. • If all nominal variables (prices and incomes) increase at the same rate, real income does not change.

22. 16. The costs of inflation • Fully anticipated inflation: • Institutions adapt to known inflation: • nominal interest rates • tax rates • transfer payments • no inflation illusion • Some costs remain: • shoe-leather • the extra time and effort in transacting when we economize on holding real money • menu costs • The physical resources needed for adjustments to keep real things constant when inflation occurs

23. 16. The costs of inflation (2) • Even if inflation is fully anticipated, the economy may not fully adapt • interest rates may not fully reflect inflation • taxes may be distorted • fiscal drag may have unintended effects on tax liabilities • capital and profits taxes may be distorted

24. 17. The costs of unanticipated inflation • Unintended redistribution of income • from lenders to borrowers • from private to public sector • from young to old • Uncertainty • firms find planning more difficult under inflation, which may discourage investment • This has been seen as the most important cost of inflation

25. 19. Defeating inflation • In the long run, inflation will be low if the rate of money growth is low. • The transition from high to low inflation may be painful if expectations are slow to adjust. • Policy credibility may speed the adjustment process • Income Policy; Institutional Reform; Central Bank Independence

26. 20. The Monetary Policy Committee • Central Bank Independence may improve the credibility of anti-inflation policy • Since 1997 UK monetary policy has been set by the Bank of England’s Monetary Policy Committee • which has the responsibility of meeting the inflation target • via interest rates • which are set according to inflation forecasts.