Inflation, Disinflation, and Deflation

Chapter 16

Bringing a Suitcase to the Bank Read page 475.

Answer these 4 questions.

Why did Zimbabwe’s government pursue economic policies that led to hyperinflation?

What specific action taken by the government led to massive inflation?

Why couldn’t Zimbabwe’s government balance its budget?

What should be remembered about Zimbabwe’s experience?

Walk and share.

Classical Model of Money and Prices According to the classical model of the price levelclassical model of the price level,

the real quantity of money is always at its long-run equilibrium level.

The classical model of the price levelclassical model of the price level does not distinguish between the shortthe short and the long runlong run.

The classical model of the price levelclassical model of the price level is good at describing economic situations only in nations experiencing hyperinflation.

Classical Model of Money and Prices

Money Supply Growth and Inflation in Brazil

Inflation Tax The inflation taxinflation tax is the reduction in the real value of reduction in the real value of

moneymoney held by the public caused by inflation.

When governments print money to cover a budget deficit this reduces the value of money, which amounts to an inflation taxinflation tax.

Assume that the inflation rate is 10%.

This afternoon, you buy a MacDonalds’ combo that costs $6.00.

How much will you pay for the same MacDonalds’ combo next year at this time?

Inflation Tax SeigniorageSeigniorage is the differencedifference between the valuevalue

of moneyof money and the costcost to fiscally produce it; i.e., the profit made by the government from printing money.

The inflation taxinflation tax is equal to the inflation rateinflation rate times the money supplytimes the money supply. Real seignorage = (∆M/M) x (M/P)

Hyperinflation In periods of high inflation, people reduce their

real money holdings.real money holdings.

This leads to government printing more moneygovernment printing more money and generating a higher inflation ratehigher inflation rate to collect the inflation tax, which subsequently creates spiraling hyperinflationspiraling hyperinflation.

Zimbabwe’s Inflation

What are two expansionary fiscal policies? Dollar for dollar, which fiscal policy

expands/contracts the economy more? What does the FED do to expand or

contract the economy? What fiscal policy is usually more popular

with politicians? What are the tools that the Fed can use to

expand or contract the economy?

Moderate Inflation and Disinflation Moderate inflation can be caused by supply shocks, or

expansionary monetary or fiscal policies, that are aimed, for political reasonspolitical reasons, at reducing the actual unemployment rate below the natural rate of unemployment.

Imagine yourself as a politician facing an election in a year or two, and suppose that the inflation rate is fairly low at the moment.

Imagine yourself as a politician in an economy suffering from inflation. Suppose your economic advisors tell you that the only way to bring inflation down is to push the economy into a recession, which will lead to higher unemployment temporarily.

Output Gap and Unemployment Rate The percentage differencedifference between the actualactual level of

GDPGDP and potential outputpotential output is called the output gapoutput gap.

When actual aggregate output is equal to potential actual aggregate output is equal to potential outputoutput, the actual unemployment rateactual unemployment rate is equalequal to the natural rate of unemploymentnatural rate of unemployment.

When the output gap is positiveoutput gap is positive (an inflationary gap), the unemployment rate isunemployment rate is belowbelow the natural ratethe natural rate.

When the output gap is negativeoutput gap is negative (recessionary gap), the unemployment rate is unemployment rate is aboveabove the natural rate the natural rate..

Actual and Natural Unemployment Rate

Output Gap and Unemployment Rate

Output Gap and Unemployment Rate

Okun’s lawOkun’s law defines the negativenegative relationship between the output gapoutput gap and cyclical unemploymentcyclical unemployment.

Okun’s law says that typically a riserise in in the output gap of the output gap of 11 percentagepercentage point reduces the unemployment rateunemployment rate by about ½ a percentage½ a percentage point.

Short-Run Phillips Curve The short-run Phillips curve (SRPC)short-run Phillips curve (SRPC) shows

a negativenegative short-run relationship between the unemployment rate and the inflation unemployment rate and the inflation raterate.

Short-Run Phillips Curve

Movements along the SRPC represent year-to-year changes in the business cycle.

In other words, changes in AD changes in AD create create movement movement alongalong a a SRPC curveSRPC curve.

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Short-Run Phillips Curve The realities of the 1970’s showed that the inflation-inflation-

unemployment relationship wasunemployment relationship was NOT always stablealways stable and that the SRPC can shift.

An accurate SRPCaccurate SRPC will include other factors, such as supply shockssupply shocks and expected inflation expected inflation ratesrates.

Most economists accept that the expected inflation rate—the rate of inflation that employers and workers expectexpect in the near future—is the most most important factorimportant factor, other than the unemployment rate, affecting inflation.

Short-Run Phillips Curve An increase in the increase in the

expected inflation rateexpected inflation rate shifts the short-run Phillips curve upwardupward.

Why?

DisinflationDisinflation is the process of bringing down inflation that is embedded in expectations.

What do you think? If you expected that prices would be rising

sharply in the near future, and it was time to negotiate a contract for your pay, what would you demand?

Why might it be in the interest of the business to pay you the higher wage?

Hiring workers might be more expensive later Output is selling for higher prices

Policy Issues

The SRPC seems to suggest that policy makers (Congress and the Fed) must make a choice a choice between higher levels of inflationbetween higher levels of inflation and lower lower levels of unemploymentlevels of unemployment, or vice versa.

In other words, there seems to be a trade-off there seems to be a trade-off between inflation and unemploymentbetween inflation and unemployment but you can’t have both of them at a low level.

What policies might be used to bring about disinflation?

Inflation and Unemployment in the Long Run The non-accelerating inflation rate of

unemployment (NAIRU) is the employment rate at which inflation does not change over time.

The long-run Phillips curve (LRPC)long-run Phillips curve (LRPC) shows the relationship between unemployment and inflation in the long run, after expectations of inflation have had time to adjust to experience.

Although there is a short-term trade-off between inflation and unemployment, in the long run there is none.

If you think back to the self-correcting economy, then in the long run, the economy returns to full employment.

Long-Run Phillips Curve What this means is that in the long run,

unemployment will be at 4-5%.

The only thing that changes is the level of inflation so low inflation is preferable to high inflation.

The LRPC is verticalLRPC is vertical at the NAIRU.

The NAIRU is another name for the natural rate of unemployment.

What do you think? Assume that the government reduces the

level of unemployment compensation. Explain how this affects the natural rate

of unemployment. Using a correctly labeled graph, show

how this affects the long-run Phillips curve.

Answer

The natural rate of unemployment DECLINED.

The LRPC shifted to the LEFT. Why?

Taking away unemployment benefits provides people with more incentive to look for work.

Therefore the natural rate of unemployment would decline.

Deflation Debt deflationDebt deflation is the reduction in aggregate demandreduction in aggregate demand arising

from the increaseincrease in the real burden of outstanding debtreal burden of outstanding debt caused by deflationdeflation.

Unexpected deflation benefits lenders as it hurts borrowers.

There is a zero-boundzero-bound on the nominal interest ratenominal interest rate: it cannot go below zero.

A liquidity trapliquidity trap is a situation in which conventional monetary monetary policy is ineffectivepolicy is ineffective because nominal interest rates cannot rates cannot fall below zerofall below zero.

Deflation makes it more likely that interest rates will get very close to the zero bound, thereby pushing the economy toward a liquidity trap.

The Zero Bound in US History

Deflation Scare of 2010 Fed watches “core”“core” and

“expected”“expected” inflation carefully when making policy.

The core inflation ratecore inflation rate is the percentage rise in a measure of consumer prices that excludes volatile food and energy prices.

Fed considers “core”“core” the bestbest guide to underlying inflation and seeks to keep it at 2%.2%.

In summer and early fall of 2010, both the “core” and expected inflation rate fell below 2%.fell below 2%.

In August 2010, Ben Bernanke signaled that the Fed would take action.

In November, the Fed began a program to buy long-term bondbuy long-term bond purchases to give the economy a boost.

Federal Reserve Release of Data

http://research.stlouisfed.org/fred2/

What do you think? What policy can be used to address

deflation in an economy?

Which way does the short-run Phillips curve move in response to a fall in commodities prices?

Why is it important for the central bank to be independent from the part of the government responsible for spending?