12 Part 2 INFLATION, AND DEFLATION

Causes of Inflation – starting at p. 301 In the long run, inflation occurs if the quantity of money grows faster than potential GDP quantity theory of money from chapter 8 In the short run, many factors can start inflation, and real GDP and the price level interact. To study these interactions, we distinguish between two sources of inflation: Demand-pull inflation Cost-push inflation ∆𝑷 𝑷 = ∆𝑴 𝑴 + ∆𝑽 𝑽 - ∆𝒀 𝒀

Demand-Pull Inflation Inflation that starts because aggregate demand increases is called demand-pull inflation. Demand-pull inflation can begin with any factor that increases aggregate demand such as: monetary policy that cuts interest rates (by increasing the quantity of money), an increase in government expenditure a tax cut, an increase in investment stimulated by an increase in expected future profits. an increase in exports The potential difficulty with both demand-pull and cost-push inflation stories is how the one-time increase translates into an inflationary process. It is relatively easy to come up with stories as to why aggregate demand might shift continuously to the right, for example because of persistent and growing government budget deficits. What is a little harder is to provide a plausible story as to why the monetary authorities would continue to accommodate this with continuous increases in the quantity of money. Point out that this has been rare in the United States, and has tended to happen when the political situation was such that the Fed was not willing to be blamed for an increase in unemployment. In other countries, particularly where the central bank is less independent than the Fed, it has been more common.

Demand Pull Inflation Initial Effect of an Increase in Aggregate Demand starting from Full Employment An increase in aggregate demand (for any reason) shifts the AD curve rightward.

Demand Pull Inflation The price level rises, real GDP increases. The increase in AD creates an inflationary gap. The rising price level is the first step in the demand-pull inflation. This is short-run!

Demand Pull Inflation Money Wage Rate Response (long-run) The money wage rate rises and the SAS curve shifts leftward. The price level rises more and real GDP decreases back to potential GDP. With no further increase in AD, the process ends with the price level increasing from 110 to 121. One shot deal! A one - time increase in the price level. This is not inflation.

Demand Pull Inflation For demand pull inflation, aggregate demand must keep increasing - the process just described keeps repeating. Inflation (which is a sustained increase in the price level) requires a sustained increase in aggregate demand.

Demand Pull Inflation Although any of several factors can increase aggregate demand to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it. Demand-pull inflation occurred in the United States during the late 1960s.

Demand Pull Inflation – 1960s 1960s: positive demand shocks C and I were increasing and G was increasing because of Vietnam and President Johnson’s War on Poverty. Unemployment was very low - close to 3% In this situation: as G increases holding T fixed the deficit increases and the government sells bonds, interest rates increase. (chapter 7, loanable funds) Also, as the demand for money increases, interest rates increase. (chapter 8, money demand) Fed policy was to maintain low interest rates Increased the money supply What effect does this have on AD?

There are two main sources of increased costs: Cost-Push Inflation An inflation that starts with an increase in costs of production is called cost-push inflation. There are two main sources of increased costs: 1. An increase in the money wage rate 2. An increase in the price of raw materials, such as oil These are referred to a negative supply shocks. The text gives a good description of the first oil price increase in the 1970s as a cost-push inflation, and contrasts it well with the Fed’s refusal to accommodate the second oil price increase in 1979. An explanation of how cost-push can be a more widespread cause of inflation in other countries can be given in terms of countries where labor is highly unionized, and in effect there are attempts by different interest groups to obtain shares of GDP that add up to more than 100 percent, with accommodation by a weak monetary authority. Such a process of repeated wage increases, inflation, and monetary accommodation can give rise to continuing inflation. Analysts often “explain” the cause of inflation by focusing attention on the good or service whose price increased the most during the most recent time period. This is incorrect; inflation is caused by monetary growth. One way to point out the fallacy is to use a baseball analogy. Several years ago the average number of home runs hit during major league baseball games increased. Virtually every commentator asked whether the ball had been doctored to make it livelier. No one explained the additional home runs by saying “home runs are higher because Parkin is hitting more home runs than last year.” To explain inflation, economists are looking for an explanation similar to the “doctored ball” explanation of the additional home runs, not an explanation that focuses on the performance of specific players.

Cost-Push Inflation Initial Effect of a Decrease in Aggregate Supply starting from Full Employment An increase in the price of oil decreases short-run aggregate supply and shifts the SAS curve leftward. Real GDP decreases and the price level rises – recession with inflation - called stagflation.

Cost-Push Inflation The initial increase in costs creates a one-time rise in the price level. This is not inflation. To create inflation, aggregate demand must increase. That is, the Fed must increase the quantity of money persistently.

Cost-Push Inflation Suppose that the Fed stimulates aggregate demand to counter the higher unemployment rate and lower level of real GDP. Real GDP increases and the price level rises again.

Cost-Push Inflation A Cost-Push Inflation Process If negative supply shocks continue…. and the Fed responds by increasing the quantity of money, ... a process of cost-push inflation continues.

Cost-Push Inflation Cost-push inflation occurred in the United States during the 1970s when the Fed responded to the OPEC oil price rise by increasing the quantity of money.

Expected Inflation - Suppose aggregate demand increases, but the increase is expected (anticipated), so its effect on the price level is expected. Wages will adjust upward at the same time reflecting the expected inflation.

Expected Inflation and money wage rate rises in line with the expected price level The AD curve shifts rightward and the SAS curve shifts leftward at the same time… so that the price level rises as expected and real GDP remains at potential GDP.

Expected Inflation means people must forecast Theory of Rational Expectations The best forecast available is one that is based on all the relevant information. A rational expectation is not necessarily correct, but it is the best available. Forecasting Inflation Great quote: “we expect inflation because we have it, we have inflation because we expect it.”

Deflation An economy experiences deflation when it has a persistently falling price level. A one-time fall in the price level either because the AD shifts to the left or SAS shifts to the right is NOT deflation. Examples of “one-timers”: a fall in exports, or a fall in profit expectations, increase in the capital stock that increases potential GDP, an agricultural boom.

Deflation and The Quantity Theory of Money What Causes Deflation Primarily a monetary phenomenon. Expressing the equation of exchange in growth rates: ∆𝑴 𝑴 + ∆𝑽 𝑽 = ∆𝑷 𝑷 + ∆𝒀 𝒀 Rearranging: ∆𝑷 𝑷 = ∆𝑴 𝑴 + ∆𝑽 𝑽 - ∆𝒀 𝒀 Deflation occurs if money growth rate is low relative to velocity and growth in economic activity.

Deflation and The Quantity Theory of Money ∆𝑷 𝑷 = ∆𝑴 𝑴 + ∆𝑽 𝑽 - ∆𝒀 𝒀 Suppose growth in V is 0.5% and growth in Y is 3% and growth in M is 2.5% ∆𝑃 𝑃 = 2.5% + 0.5% -3.0% = 0 Suppose growth in V is 0.5% and growth in Y is 3% and growth in M is 2.0% ∆𝑃 𝑃 = 2.0% + 0.5% -3.0% = -0.5% Deflation occurs if money growth rate is low relative to velocity and growth in economic activity.

Deflation What are the Consequences of Deflation? Unanticipated deflation redistributes income and wealth, lowers real GDP and employment, and diverts resources from production. deflation is generally not expected (“unanticipated”). Loans and wage contracts are entered into with the expectation some inflation. As prices unexpectedly fall - workers with long-term contracts see real wages increase, but firms see profits fall. They cut back on employment. firms re-evaluate investment plans and cut back on projects that are now viewed as unprofitable… as investment falls, growth in capital stock is reduced and the growth rate in potential GDP is reduced. Classroom activity Check out Economics in the News: The Stagnating Eurozone

∆𝑷 𝑷 = ∆𝑴 𝑴 + ∆𝑽 𝑽 - ∆𝒀 𝒀 Deflation in Japan 1998 - 2013 Real GDP growth rate was 0.8 percent a year, the money growth rate was 2.5 percent a year, and the rate of velocity change was -3 percent a year. Inflation rate = [2.5 + (-3) – 0.8] percent a year. Deflation rate = 1.3 percent a year. ∆𝑷 𝑷 = ∆𝑴 𝑴 + ∆𝑽 𝑽 - ∆𝒀 𝒀 Classroom activity Check out Economics in Action: Fifteen Years of Deflation in Japan

Deflation in Japan 1998 - 2013 What are the Consequences of Deflation? At first deflation was not expected (“unanticipated”). Loan and wage contracts entered into with the expectation some inflation. When the price level started to fall, real wages and the real value of debt increased. With higher debt and real wages, business firms cut back on investment and hiring and they cut production. As investment falls, growth in capital stock slowed and the growth rate in potential GDP slowed. RGDP growth fell to 1.5% in the 1990s and 0.5% in the 2000s, down from around 5% in the 1970s and 80s. Classroom activity Check out Economics in the News: The Stagnating Eurozone