Inflation, Disinflation, and Deflation Chapter 16

Bringing a Suitcase to the Bank  Read page 475.  Answer these 4 questions. Why did Zimbabwe’s government pursue economic policies that led to hyperinflation? What specific action taken by the government led to massive inflation? Why couldn’t Zimbabwe’s government balance its budget? What should be remembered about Zimbabwe’s experience?  Walk and share.

Classical Model of Money and Prices classical model of the price level  According to the classical model of the price level, the real quantity of money is always at its long-run equilibrium level. classical model of the price level the shortlong run  The classical model of the price level does not distinguish between the short and the long run. classical model of the price level  The classical model of the price level is good at describing economic situations only in nations experiencing hyperinflation.

Classical Model of Money and Prices

Money Supply Growth and Inflation in Brazil

Inflation Tax inflation taxreduction in the real value of money  The inflation tax is the reduction in the real value of money held by the public caused by inflation. inflation tax  When governments print money to cover a budget deficit this reduces the value of money, which amounts to an inflation tax.  Assume that the inflation rate is 10%.  This afternoon, you buy a MacDonalds’ combo that costs $6.00.  How much will you pay for the same MacDonalds’ combo next year at this time?

Inflation Tax  Seignioragedifferencevalue of moneycost  Seigniorage is the difference between the value of money and the cost to fiscally produce it; i.e., the profit made by the government from printing money. inflation taxinflation rate times the money supply  The inflation tax is equal to the inflation rate times the money supply. Real seignorage = (∆M/M) x (M/P)

Hyperinflation real money holdings.  In periods of high inflation, people reduce their real money holdings. government printing more money higher inflation rate spiraling hyperinflation  This leads to government printing more money and generating a higher inflation rate to collect the inflation tax, which subsequently creates spiraling hyperinflation.

Zimbabwe’s Inflation

 What are two expansionary fiscal policies?  Dollar for dollar, which fiscal policy expands/contracts the economy more?  What does the FED do to expand or contract the economy?  What fiscal policy is usually more popular with politicians?  What are the tools that the Fed can use to expand or contract the economy?

Moderate Inflation and Disinflation political reasons  Moderate inflation can be caused by supply shocks, or expansionary monetary or fiscal policies, that are aimed, for political reasons, at reducing the actual unemployment rate below the natural rate of unemployment.  Imagine yourself as a politician facing an election in a year or two, and suppose that the inflation rate is fairly low at the moment.  Imagine yourself as a politician in an economy suffering from inflation. Suppose your economic advisors tell you that the only way to bring inflation down is to push the economy into a recession, which will lead to higher unemployment temporarily.

Output Gap and Unemployment Rate differenceactual GDPpotential outputoutput gap  The percentage difference between the actual level of GDP and potential output is called the output gap. actual aggregate output is equal to potential outputactual unemployment rateequal natural rate of unemployment  When actual aggregate output is equal to potential output, the actual unemployment rate is equal to the natural rate of unemployment. output gap is positive unemployment rate isbelowthe natural rate  When the output gap is positive (an inflationary gap), the unemployment rate is below the natural rate. output gap is negative unemployment rate is above the natural rate.  When the output gap is negative (recessionary gap), the unemployment rate is above the natural rate.

Actual and Natural Unemployment Rate

Output Gap and Unemployment Rate

 Okun’s lawnegative output gap cyclical unemployment  Okun’s law defines the negative relationship between the output gap and cyclical unemployment. rise in the output gap of 1 percentage unemployment rate ½ a percentage  Okun’s law says that typically a rise in the output gap of 1 percentage point reduces the unemployment rate by about ½ a percentage point.

Short-Run Phillips Curve short-run Phillips curve (SRPC) negative unemployment rate and the inflation rate  The short-run Phillips curve (SRPC) shows a negative short-run relationship between the unemployment rate and the inflation rate.

Short-Run Phillips Curve  Movements along the SRPC represent year- to-year changes in the business cycle. changes in AD create movement along a SRPC curve  In other words, changes in AD create movement along a SRPC curve... B A

Short-Run Phillips Curve inflation-unemployment relationship was always stable  The realities of the 1970’s showed that the inflation-unemployment relationship was NOT always stable and that the SRPC can shift. accurate SRPC supply shocksexpected inflation rates  An accurate SRPC will include other factors, such as supply shocks and expected inflation rates. expectmost important factor  Most economists accept that the expected inflation rate—the rate of inflation that employers and workers expect in the near future—is the most important factor, other than the unemployment rate, affecting inflation.

Short-Run Phillips Curve increase in the expected inflation rate upward  An increase in the expected inflation rate shifts the short-run Phillips curve upward.  Why?  Disinflation  Disinflation is the process of bringing down inflation that is embedded in expectations.

What do you think?  If you expected that prices would be rising sharply in the near future, and it was time to negotiate a contract for your pay, what would you demand?  Why might it be in the interest of the business to pay you the higher wage?  Hiring workers might be more expensive later  Output is selling for higher prices

Policy Issues a choice between higher levels of inflationlower levels of unemployment  The SRPC seems to suggest that policy makers (Congress and the Fed) must make a choice between higher levels of inflation and lower levels of unemployment, or vice versa. there seems to be a trade-off between inflation and unemployment  In other words, there seems to be a trade-off between inflation and unemployment but you can’t have both of them at a low level.  What policies might be used to bring about disinflation?

Inflation and Unemployment in the Long Run  The non-accelerating inflation rate of unemployment (NAIRU) is the employment rate at which inflation does not change over time. long-run Phillips curve (LRPC)  The long-run Phillips curve (LRPC) shows the relationship between unemployment and inflation in the long run, after expectations of inflation have had time to adjust to experience.  Although there is a short-term trade-off between inflation and unemployment, in the long run there is none.  If you think back to the self-correcting economy, then in the long run, the economy returns to full employment.

Long-Run Phillips Curve  What this means is that in the long run, unemployment will be at 4-5%.  The only thing that changes is the level of inflation so low inflation is preferable to high inflation. LRPC is vertical  The LRPC is vertical at the NAIRU.  The NAIRU is another name for the natural rate of unemployment.

What do you think?  Assume that the government reduces the level of unemployment compensation. Explain how this affects the natural rate of unemployment. Using a correctly labeled graph, show how this affects the long-run Phillips curve.

Answer  The natural rate of unemployment DECLINED.  The LRPC shifted to the LEFT.  Why? Taking away unemployment benefits provides people with more incentive to look for work. Therefore the natural rate of unemployment would decline.

Deflation  Debt deflationreduction in aggregate demand increasereal burden of outstanding debt deflation  Debt deflation is the reduction in aggregate demand arising from the increase in the real burden of outstanding debt caused by deflation.  Unexpected deflation benefits lenders as it hurts borrowers. zero-boundnominal interest rate  There is a zero-bound on the nominal interest rate: it cannot go below zero. liquidity trap monetary policy is ineffective rates cannot fall below zero  A liquidity trap is a situation in which conventional monetary policy is ineffective because nominal interest rates cannot fall below zero.  Deflation makes it more likely that interest rates will get very close to the zero bound, thereby pushing the economy toward a liquidity trap.

The Zero Bound in US History

Deflation Scare of 2010 “core”“expected”  Fed watches “core” and “expected” inflation carefully when making policy. core inflation rate  The core inflation rate is the percentage rise in a measure of consumer prices that excludes volatile food and energy prices. “core”best 2%.  Fed considers “core” the best guide to underlying inflation and seeks to keep it at 2%. fell below 2%.  In summer and early fall of 2010, both the “core” and expected inflation rate fell below 2%.  In August 2010, Ben Bernanke signaled that the Fed would take action. buy long-term bond  In November, the Fed began a program to buy long-term bond purchases to give the economy a boost.

Federal Reserve Release of Data 

What do you think?  What policy can be used to address deflation in an economy?  Which way does the short-run Phillips curve move in response to a fall in commodities prices?  Why is it important for the central bank to be independent from the part of the government responsible for spending?