Inflation

Prof. Irina A. TelyukovaUBC Economics 345Fall 2008

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Outline Inflation – continually and rapidly rising price level.

Inflation occurs whenever prices rise for any period of time, but the kind we worry about is the persistent kind.

We will find that this kind of continual and rapid inflation is a monetary phenomenon, caused by monetary policy.

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Evidence on InflationWhenever a country’s inflation rate is high and persistent, its rate of money supply growth is also very high.

Could mean that high money growth causes persistent inflation.Or vice versa.Or an outside factor causes both.

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Evidence on InflationAverage Inflation Rate vs Average Money Growth Rate

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Some EpisodesGerman Hyperinflation (1923)

Enormous budget deficits post-WWICould not raise taxes or raise sufficient funds by bond issueGovernment turned to printing money to finance the deficitResult: extreme rate of money supply growth and extreme inflation over a million percent

Similar stories in 1980’s and 1990’s in Latin America: Argentina, Brazil, Peru – large budget deficits (15% of GDP) that lead to money creation

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German Hyperinflation

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I. Can Growth of Money Supply Cause Inflation?

We turn to the AS-AD model for the answerSuppose we start out at YnGrowth of money supply causes the AD curve to shift to the right, causing an increase in pricesThis causes Y>YnThe short-run adjustments in the SRAS curve bring the economy back into balance, but prices rise furtherBut if money growth continues, then the movement of AD and AS curves will continue, and prices will continue rising

(Sustained) inflation

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Money Growth and Sustained Inflation

AD1

PLR

Y (output)

PLRAS

Yn

Initial Long-Run Equilibrium

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AD1

PLR

Y (output)

PLRAS

Yn Y’

P1

AD2

As a result of a money supply increase, AD shifts right. Output and prices increase.

Money Growth and Sustained Inflation

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AD1

PLR

SRAS1

Y (output)

PLRAS

Yn

SRAS2

P1

Y’

AD2

P2

When Y>Yn, labor markets are tight: wages rise, SRAS shifts left. Back to Yn, but prices increase more.

Money Growth and Sustained Inflation

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AD1

PLR

SRAS1

Y (output)

PLRAS

Yn

SRAS2

SRAS3

P1

Y’

P3

AD2

AD3

P2

P4

If money supply continues rising, this mechanism will continue. Sustained rise in prices results.

Money Growth and Sustained Inflation

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II. Can Fiscal Policy Cause Inflation?

Fiscal policy: suppose the government increases its expenses. When it does so, both the AD and the AS curves will adjust.If government expenses would rise continually, we could get sustained inflation. But continual rise in government expenses is not feasible – politically or financially.Same goes for tax cuts – continual cuts in taxes (or increases in taxes) are not feasible.

Fiscal policy can cause a one-time increase in prices, but not sustained inflation.

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Fiscal Policy

AD1

PLR

SRAS1LRAS

Y (output)

P

Yn

SRAS2

Y’

P1

AD2

P2

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III. Can Supply Shocks Cause Inflation?

We have to look at negative supply shocks.Suppose there is an increase in oil prices. (Or an increase in wages due to new unionization efforts by workers).The shifts in the SRAS will cause temporary increases in prices, but these are reversed by the long-run adjustment mechanism.Even repeated shocks will be repeatedly reversed.Supply shocks cannot cause inflation.

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A Negative Supply Shock

AD1

PLR

SRAS1

Y (output)

PLRAS

Yn

SRAS2

P1

Y’

Note that all of this analysis assumed that Yndoes not change over time.

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IV. Why Inflationary Monetary Policy?

We have concluded that only sustained money supply growth can cause inflation – a sustained increase in prices?

So knowing this, why would the central bank pursue repeated expansionary monetary policy?

We know that central banks pursue policies that aim at sustained output growth and especially full employment.

Given the high employment target, high money growth and inflation can result from:

negative supply shocks (cost-push inflation)expansionary fiscal policy by the government (demand-pullinflation)

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IVa. Cost-Push Inflation

Suppose there is a negative supply shock, that raises costs of productionAs a result of it, the AS curve shifts leftIf the economy were left to its own devices, we would see no effect (prices would return to original level)But suppose the government tries to intervene, conducting a policy to try to correct the imbalance, if it believes that the adjustment of the economy takes too long…Inflation can result from a repeated combination of supply shocks and accomodating (monetary) policy

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Cost-Push Inflation: A Negative Supply Shock

AD1

PLR

SRAS1

Y (output)

PLRAS

Yn

SRAS2

P1

Y’

Here is what would happen if government did not intervene.

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Cost-Push Inflation: Policy Response to Supply Shock

AD1

PLR

SRAS1

Y (output)

PLRAS

Yn

SRAS2

P1

AD2

Y’

Gov’t/CB conducts expansionary fiscal/monetary policy: results in price increase. If this repeats, inflation can result…

P2

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IVb. Demand-Pull Inflation

Policy makers could set a target for unemployment that is too low relative to the natural levelReason: it can be hard to determine what the natural rate of unemployment should beIf unemployment target is too low, government will implement policy to achieve levels of output that are too high (shifting AD curve to the right)The long-run response mechanism of the economy kicks in to produce increases in the pricePolicy makers could then increase AD again, causing more push in prices sustained inflation

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AD1

PLR

Y (output)

PLRAS

Yn YT

P1

AD2

Government/CB sets a target for output that is too high: expansionary fiscal or monetary policy.

Demand-Pull Inflation

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AD1

PLR

SRAS1

Y (output)

PLRAS

Yn

SRAS2

P1

Y’

AD2

P2

When Y>Yn, the economy adjusts in the usual way. Prices increase. If this repeats, inflation results. Again, a monetaryphenomenon.

Money Growth and Sustained Inflation

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IVc. Budget Deficits and Inflation

Budget deficit = G – T Financing government spending: through either changes in money supply (monetary base) or by borrowing

if government budget is balanced, tax revenues pay for all of government expenses – no need to borrowif budget is in surplus, there is excess tax revenue – can keep use it to repay debts (bondholders)if budget is in deficit, the excess spending must be paid using expanding monetary base, or by additional bond issue, to be sold to the public

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Budget Deficits and Inflation

If deficit is financed by bond issue, there is no effect on the monetary base no inflationary effectIf deficit is not financed by bond issue, this means that monetary base has to increase inflationary pressureHow does this increase in monetary base happen?

CB can just print money typically prohibited (cannot print money to pay bills/debts)Instead, government can issue bonds that the central bank purchases – this involves an open market operation, which in turn leads to an increase in the monetary base as we have seen

If the deficit is persistent and is answered by multiple rounds of monetary base expansion, it can lead to sustained inflation