Inflation Chapter 7 Instructor: MELTEM INCE

Inflation and the Price Level Inflation is a process in which the price level is rising and money is losing value. Inflation is a rise in the price level, not in the price of a particular commodity. The inflation rate is the percentage change in the price level. That is, where P1 is the current price level and P0 is last year’s price level, the inflation rate is [(P1 – P0)/P0]  100

Inflation and the Price Level

Seigniorage: The revenue from printing money All governments spend money. Some of this is to buy goods and services (roads), some is to provide transfer payments (for poor). A government can finance its spending in three ways: It can rise revenue through taxes such as personal income tax It can borrow from public by selling government bonds It can print money The revenue raised through printing money is called Seigniorage.

Seigniorage: The revenue from printing money When the government prints money to finance expenditures, it increases the money supply. The increase in money supply causes inflation. Nearly imposing inflation tax. Inflation tax is paid by the holders of money. As price rise, the real value of money in the wallet decrease. When the government prints new money for its use, it makes the old money in the hands of the public less valuable. So inflation is like a tax on holding money.

Inflation and the interest rate Interest rate that the bank pays is Nominal Interest rate and the increase in your purchasing power is the real interest rate. r  i –  i= nominal interest rate  = rate of inflation r= real interest rate

Inflation and the interest rate Fisher Effect shows that nominal interest rate can change for two reasons: The real interest rate changes The inflation rate changes The quantity theory of money shows that the rate of money growth determines the rate of inflation. So Fisher Equation tells to add the real interest rate and the inflation together to determine the nominal interest rate. i  r + 

Cost of Inflation A higher inflation rate leads to a higher nominal interest rate which in turn leads to a lower real money balances. High inflation induces firms to change posted prices more often. Changing prices are sometimes very costly, such as it may require printing and distributing a new catalog. So this costs are called Menu costs. The higher the rate of inflation, the greater the variability in relative prices.

Cost of Inflation Unanticipated inflation ( – e) Realized real returns differ from expected real returns Expected r  i – e Actual r  i –  Actual r differs from expected r by e –  Numerical example: i  6%, e  4%, so expected r  2%; if   6%, actual r  0%; if   2%, actual r  4%

Cost of Inflation Unanticipated inflation ( – e) Similar effect on wages and salaries Result: transfer of wealth From lenders to borrowers when   e From borrowers to lenders when   e So people want to avoid risk of unanticipated inflation They spend resources to forecast inflation

Types of Inflation Inflation can be classified into four groups: Creeping inflation: It is the earliest stage of inflation. It can be considered to be of no danger. It is characterized by at most 3% inflation per annum. Walking Inflation: This is the second stage of inflation. It is between 3.4% and 4%. Running Inflation: Nearly 10% per annum. It gets converted into hyper-inflation. Galloping or hyper-inflation: It is the extreme form of inflation when inflation registers a growth of 100% per year. It occurred in Germany, Russia, Greece, Hungary and Austria.

Causes of Inflation Demand-pull inflation is an inflation that results from an initial increase in aggregate demand. Demand-pull inflation may begin with any factor that increases aggregate demand. Two factors controlled by the government are increases in the quantity of money and increases in government purchases. A third possibility is an increase in exports.

Demand-pull Inflation

Cost-push Inflation Cost-push inflation is an inflation that results from an initial increase in costs. There are two main sources of increased costs An increase in the money wage rate An increase in the money price of raw materials, such as oil.

Cost-push Inflation

Effects of Inflation Higher than anticipated inflation lowers the real wage rate and employers gain at the expense of workers. Lower than anticipated inflation raises the real wage rate and workers gain at the expense of employers. Higher than anticipated inflation lowers the real wage rate, increases the quantity of labor demanded, makes jobs easier to find, and lowers the unemployment rate. Lower than anticipated inflation raises the real wage rate, decreases the quantity of labor demanded, and increases the unemployment rate.

Effects of Inflation Forecasting Inflation To minimize the costs of incorrectly anticipating inflation, people form rational expectations about the inflation rate. A rational expectation is one based on all relevant information and is the most accurate forecast possible, although that does not mean it is always right; to the contrary, it will often be wrong.

Phillips curve equation The expectations-augmented Phillips curve When   e, u  When   e, u  When   e, u 

Demand vs. Supply Inflation Demand Inflation is a sustained increase in prices that is preceded by a permanent acceleration of nominal GDP growth. Supply Inflation is an increase in prices that stems from an increase in business costs not directly related to prior acceleration of nominal GDP growth.