Inflation Chapter 24

Inflation Since 1900 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved –10 –

The Consumer Price Index (CPI) The consumer price index (CPI) measures the prices of a fixed "basket" of consumer goods. It is weighted according to each component's share of an average consumer's expenditures.

Composition of CPI Recreation (5.9%) Food and beverage (16.4%) Apparel (4.2%) Transportation (16.6%) Medical care (6.0%) Housing (40.5%) Other (5.0%) Education and Communication (5.4%)

CPI and “True” Inflation Quality bias Substitution bias

Costs of Inflation “Noise” in price system Distortion in tax system (capital depreciation allowances don’t keep up) “Shoe leather” costs Unexpected redistribution of wealth Interference with long run planning

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become 'profiteers,' who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth- getting degenerates into a gamble and a lottery. ---J.M. Keynes, 1919

Hyperinflation Germany, early 1920’s inflation was at 1,000,000 %

Precondition Inflation is always and everywhere a monetary phenomenon. ~Milton Friedman

Types of Inflation Demand Pull Excessive aggregate demand → inflationary gap → inflation. (AD curve shifts right) Cost Push Rising costs of production. For example, rising wages. (SRAS curve shifts in.)

Government Budget Constraint Deficit = G – T= ΔMB + ΔB G: government spending T: taxes net of transfer payments ΔMB: change in monetary base ΔB: change in government bonds held by the public

Monetizing the Debt Government issues bonds, and the central bank buys them.

Seigniorage under Fiat Money Interest that the Treasury does not have to pay on its borrowing.

Activist vs Non-Activist Activist (Keynesian) believes policy can make a positive difference. A non-activist (New Classical) believes policy will be, at best, neutral.

Lucas Critique Activist policy is ineffective because people change their expectations. For example, expanding the money supply won’t increase output because business decision-makers will expect inflation.

Rational Expectation An expectation based on all available information. Related to the efficient markets hypothesis.

New Classical Models Rapid adjustment to potential output. Anticipated policy has no effect. Flexible wages and prices.

New Keynesian Model Like the new classical model except wages and prices are “sticky” in the short- run. Policy can make a difference but only in the short-run. Original Keynesian emphasized uncertainty and “animal spirits”, saw the economy as a dynamic organism rather than an equilibrating machine.

Implications New classical economists are non-activists, economic conservatives. New Keynesians have more faith in the effectiveness of macroeconomic policy.