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Inflation

Inflation. FRESH CLASSES OF MA ECONOMICS EXTERNAL KU INDIVIDUALS & GROUPS NOMINAL FEE MICRO ECONOMICS, STATISTICS & MACRO ECONOMICS GUESS PAPERS ARE ALSO AVAILABLE FROM 16 TH OF APRIL 2011. R-1173, 3 RD FLOOR ALNOOR SOCIETY, BLOCK 19, F.B.AREA, KARACHI. NEAR POWER HOUSE & MASJID E AQSA.

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Inflation

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  1. Inflation

  2. FRESH CLASSES OF MA ECONOMICS EXTERNAL KU • INDIVIDUALS & GROUPS • NOMINAL FEE • MICRO ECONOMICS, STATISTICS & MACRO ECONOMICS • GUESS PAPERS ARE ALSO AVAILABLE FROM 16TH OF APRIL 2011. • R-1173, 3RD FLOOR ALNOOR SOCIETY, BLOCK 19, F.B.AREA, KARACHI. NEAR POWER HOUSE & MASJID E AQSA. • 0322-3385752

  3. JOIN KHALID AZIZ • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. • CONTACT: • 0322-3385752 • 0312-2302870 • 0300-2540827 • R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

  4. Inflation is ... • Inflation is a rise in the average price of goods over time

  5. 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?

  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.

  7. 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.

  8. 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.

  9. 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

  10. 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

  11. 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

  12. 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 (%) The Phillips curve It suggests we can trade-off more inflation for less unemployment or vice versa.

  13. 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* The Phillips curve and an increase in aggregate demand Inflation … but what happens next? PC0 Unemployment

  14. so we may find the economy finds its way back to the natural rate, but with continuing inflation at C. C 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. Inflation But nominal money supply need not be constant in the long run A 1 E U1 U* PC0 Unemployment

  15. 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 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

  16. 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 Expectations and credibility LRPC Inflation 1 PC1 PC2 U* Unemployment

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

  18. 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.

  19. 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 • people economize on money holdings • menu costs • firms need to alter price lists etc.

  20. 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

  21. 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

  22. 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

  23. JOIN KHALID AZIZ • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. • CONTACT: • 0322-3385752 • 0312-2302870 • 0300-2540827 • R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

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