1©The McGraw-Hill Companies, 2002

Inflation is ...

• Inflation is a rise in the price level.• Pure inflation is when goods and input

prices rise at the same rate.• 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.

2©The McGraw-Hill Companies, 2002

Some questions about inflation

• What are the causes of inflation?

• What are the effects and hence costs of inflation?

• What can be done about it?

• These are the questions we seek to answer in what follows.

3©The McGraw-Hill Companies, 2002

Inflation in the UK, 1950-2000

0

5

10

15

20

25

30

1950

1960

1970

1980

1990

2000

% p

.a.

Source: Economic Trends Annual Supplement, Labour Market Trends

4©The McGraw-Hill Companies, 2002

The quantity theory (1)

• The quantity theory of money says:

• “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.”

5©The McGraw-Hill Companies, 2002

The quantity theory (2)• We can state it algebraically as:

– MV = PY– where V = velocity of circulation

Y = potential level of real GDPP = the price levelM = nominal money supply

– Given constant velocity, if prices adjust to maintain real income at the potential level

– an increase in nominal money supply leads to an equivalent increase in prices.

6©The McGraw-Hill Companies, 2002

Money, prices and inflation (1)• 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 notice that the quantity theory equation does not tell us whether prices determine quantity or vice versa.

7©The McGraw-Hill Companies, 2002

Money, prices and causation (a)

• In money market equilibrium, the supply of real money equals the demand for money i.e.– M/P = Y/V

• If the demand for real money is constant, M/P is constant.

• Monetary policy can fix M, in which case M P

8©The McGraw-Hill Companies, 2002

Money, prices and causation (b)

• OR monetary policy can try and fix P over time, in which case P M

• This latter approach is known as inflation targeting

• in contrast to the former approach which indirectly targets the money supply.

9©The McGraw-Hill Companies, 2002

Money, prices and inflation (2)

• In any case, in the long run, potential real GDP and interest rates will significantly alter real money demand

• Therefore, in the long-run there may not be a perfect correspondence between excess monetary growth and inflation.

10©The McGraw-Hill Companies, 2002

Money, prices and inflation (3)

• Also, in the short run, the link between money and prices may be broken if:– the velocity of circulation is variable– prices are sluggish.

• For all the above reasons, we must therefore interpret the quantity theory with care.

11©The McGraw-Hill Companies, 2002

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 minus 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.

12©The McGraw-Hill Companies, 2002

Hyperinflation• Hyperinflations are periods when inflation rates

are very large• During such periods there tends to be a ‘flight

from cash’, i.e. people hold as little cash 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 supply growth

13©The McGraw-Hill Companies, 2002

• In 1958, Prof. A W Phillips demonstrated a statistical relationship between annual inflation and unemployment in the UK.

• The Phillips curve relates higher unemployment to lower inflation.

• It implies we can trade-off higher inflation for lower unemployment and vice versa.

The Phillips curve (1)

14©The McGraw-Hill Companies, 2002

The Phillips curve

Infla

tion

rate

(%

)

Phillips curve

Unemployment rate (%)

U*

15©The McGraw-Hill Companies, 2002

The long-run Phillips curve (1)

• The vertical long-run Phillips curve implies that sooner or later, the economy will return to U* whatever the inflation rate.

• The position of the short-run Phillips curve depends on expected inflation.

16©The McGraw-Hill Companies, 2002

The long-run Phillips curve (2)

• The long-run and short-run curves intersect when actual and expected inflation are equalised.

• The long run Phillips curve shows that in the long-run there is no trade-off between unemployment and inflation.

17©The McGraw-Hill Companies, 2002

The long-run Phillips curve and an increase in aggregate demand (1)

… but what happens next?

Unemployment

Infla

tion

PC1U*

Suppose the economy beginsat E, with unemploymentat the natural rate U*, andinflation at 1

E1

An increase in governmentspending funded by an expansion in money supplytakes the economy to A,with lower unemployment(U1) but inflation at 2.

A2

U1

18©The McGraw-Hill Companies, 2002

If the nominal money supply continues to expand at the same rate thereafter, the economy will eventually move to B on PC2.At B, inflation expectationscoincide with actual inflationand nominal wages have been renegotiated so thatthe real wage and hence,employment are the same as before the monetaryexpansion,i.e. there is no trade-off between unemployment and inflation in the long-run

LRPC

Unemployment

Infla

tion

PC1U*

1

A

E

2

U1PC2

B

The Long-run Phillips curve and an increase in aggregate demand (2)

19©The McGraw-Hill Companies, 2002

Unemployment

Infla

tion

PC1U*

1

A

E

2

U1PC2

Effectively, the long-run Phillips curve is vertical, as the economy always adjusts back to U*.The short-run Phillips curveshows just a short-run trade-off:its position may dependupon expectations aboutinflation.

B

The long-run Phillips curve and an increase in aggregate demand (3)

LRPC

20©The McGraw-Hill Companies, 2002

Expectations and credibility

Unemployment

Infla

tion

PC1

1

U*

Unemployment rises to U1

U1

Suppose the economy beginsat E, with a newly-elected government pledged toreduce inflation.

E

LRPC

Monetary growth is cut to 2.

2

In the short run, the economymoves to A along the short-run Phillips curve.

A

PC2

As expectations adjust, the short-run Phillips curveshifts to PC2, and U*is restored at F.

F

21©The McGraw-Hill Companies, 2002

Inflation and unemploymentin the UK 1978-2000

0

5

10

15

20

3 5 7 9 11 13

Unemployment

Infla

tion

1978

1980

1986

1990

2000

1993

22©The McGraw-Hill Companies, 2002

Inflation illusion

• People have inflation illusion when they confuse nominal and real changes.

• 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.

23©The McGraw-Hill Companies, 2002

The costs of inflation (1)

• Fully anticipated inflation:• Institutions adapt to known inflation:

– nominal interest rates– tax rates– transfer payments

• there is no inflation illusion

• Some costs remain:– shoe-leather

• people economise on money holdings

– menu costs• firms need to alter price lists etc.

24©The McGraw-Hill Companies, 2002

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 become distorted

• fiscal drag may have unintended effects on tax liabilities

• capital and profits taxes may be distorted

25©The McGraw-Hill Companies, 2002

The costs of unanticipated inflation

• Unintended redistribution of income– from lenders to borrowers– from private to public sector– from old to young

• Uncertainty– firms find planning more difficult under

inflation, which may discourage investment

• This has been seen as the most important cost of inflation

26©The McGraw-Hill Companies, 2002

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.

27©The McGraw-Hill Companies, 2002

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

(underlying) inflation target

– via interest rates

– which are set according to inflation forecasts.

28©The McGraw-Hill Companies, 2002

Why inflation targeting?

• Unpredictable changes in real money demand undermined attempts to use a nominal money target.

• Setting inflation targets involves an element of forward-looking.

• MPC performance so far has been creditable.