1. Dolan, Economics Combined Version 4e, Ch. 25 Survey of Economics Edwin G. Dolan and Kevin C. Klein Best Value Textbooks 4 th edition Chapter 13 Fighting Inflation and Deflation

2. Dolan and Klein, Survey of Economics 4e, Ch. 13 Simple Demand-Side Inflation  Demand-side inflation begins when the AD curve shifts to the right while the AS curve at first does not shift.  In the short-run, prices increase as the economy moves from E 0 to E 1.  After a lag, the AS curve begins to shift upward as expectations adjust.  Prices continue to increase as the economy moves along the AD curve to E 2 and finally E 3.

3. Dolan and Klein, Survey of Economics 4e, Ch. 13 Continuous Demand-Side Inflation  A shift of the AD curve to AD 1 initially causes demand-side inflation.  Now, as the AS curve begins to shift upward, expansionary policy shifts the AD curve to prevent real output from decreasing. Inflation continues.  As long as real output remains above the natural level, the rate of inflation will accelerate each year.

4. Dolan and Klein, Survey of Economics 4e, Ch. 13 Supply Shocks  An event that causes the AS curve to shift upward is called a supply shock.  Examples:  Increase in world commodity prices  Natural disasters  Depreciation of a country’s exchange rate

5. Dolan and Klein, Survey of Economics 4e, Ch. 13 Supply-Side Inflation  Supply-side inflation occurs when the AS curve shifts upward while the AD curve remains fixed.  As the economy moves from E 2 to E 1, real output decreases and the price level increases.  If accommodating policy is used to shift the AD curve to AD 1, the economy will instead move to E 2.  There will be more inflation but a smaller decrease in real output.

6. Dolan and Klein, Survey of Economics 4e, Ch. 13 Inflation Inertia  The experience of inflation may cause firms and workers to expect prices to continue rising in the future.  In the simplest case, they may expect the rate of inflation this year to be the same as the rate of inflation last year.  The tendency of past inflation to cause expected future inflation is called inflation inertia or inflation momentum.

7. Dolan and Klein, Survey of Economics 4e, Ch. 13 Inflationary Recession  Inflationary recession occurs when AD stops growing following a period of sustained inflation.  After reaching E 2, firms expect inflation to continue because of inflation inertia.  AS is up to AS 3 in the next year and to AS 4 in the year after that.  As it does, the economy enters an inflationary recession during which the price level continues to rise but real output decreases.

8. Dolan and Klein, Survey of Economics 4e, Ch. 13 Phillips Curve as a Policy Menu  A Phillips curve shows an inverse relationship between inflation and unemployment.  When it was first introduced in the 1950s, some economists interpreted the Phillips curve as a policy menu.  Liberals might choose low unemployment at the expense of some inflation (L).  Conservatives might choose lower inflation at the expense of higher unemployment (C).

9. Dolan and Klein, Survey of Economics 4e, Ch. 13 The Long-Run Phillips Curve  If inflation increased from 0 to 4 percent, the economy would at first move from A to B along Ph 1.  Once people came to expect 4 percent inflation, the curve would shift up to Ph 2.  Further changes in inflation would move the economy along Ph 2 in the short run, until expectations changed again.  The long-run Phillips curve is a vertical line.

10. Dolan and Klein, Survey of Economics 4e, Ch. 13 Hyperinflation  Hyperinflation means very rapid inflation of thousands or millions of percent per year.  Factors that cause hyperinflation:  Increase in the money stock (M) as the government monetizes a budget deficit  Increase in velocity (V) as people try to spend money faster before it loses real value  Decrease in real output (Q) as rapid inflation causes disruption of finance and production The simple mathematics of hyperinflation  Equation of exchange: MV=PQ  Solve for P, the price level to get P=MV/Q  Possible causes of inflation (increase in P)  Increase in M  Increase in V  Decrease in Q

11. Dolan and Klein, Survey of Economics 4e, Ch. 13 Ending Hyperinflation: Conventional Policy  One way to stop hyperinflation is to use conventional monetary policy to slow the rate of growth of M.  This requires that the government finance its budget deficit by borrowing rather than printing money.  As the rate of inflation slows, velocity falls and real output growth recovers. The simple mathematics of hyperinflation  Equation of exchange: MV=PQ  Solve for P, the price level to get P=MV/Q  Possible causes of inflation (increase in P)  Increase in M  Increase in V  Decrease in Q

12. Dolan and Klein, Survey of Economics 4e, Ch. 13 Ending Hyperinflation: ERB Stabilization  Another way to stop hyperinflation is to use a fixed exchange rate to link the country’s currency to a stable foreign currency like the dollar or euro.  As soon as people expect the currency to have a stable value, velocity decreases, causing the inflation rate to fall.  The government must also reform fiscal policy and stop printing money to finance the budget deficit.  This approach is called exchange- rate based stabilization policy. The simple mathematics of hyperinflation  Equation of exchange: MV=PQ  Solve for P, the price level to get P=MV/Q  Possible causes of inflation (increase in P)  Increase in M  Increase in V  Decrease in Q

13. Dolan and Klein, Survey of Economics 4e, Ch. 13 Demand-Side Deflation  Demand-side deflation begins when something happens to shift the AD curve to the left (for example, a slowdown in investment or a decrease in net exports).  The economy moves down and to the left along its aggregate supply curve from E 1 to E 0.  The price level and real output both decrease.

14. Dolan and Klein, Survey of Economics 4e, Ch. 13 Supply-Side Deflation  Supply-side deflation begins when a favorable supply shock causes firms to expect a decrease in costs of production and shifts the AS curve downward.  The economy moves from E 0 to a new short-run equilibrium at E 1.  Firms react to the expectation of lower production costs partly by increasing output and partly by passing along lower costs to their customers through price reductions.  As this happens, real output increases and the price level falls.

15. Dolan and Klein, Survey of Economics 4e, Ch. 13 Asymmetries of Deflation  During deflation, adjustment to a change in the price level may be slower than during inflation.  Reasons for slower adjustment:  Nominal wages may be slow to decrease when demand decreases.  Financial markets may experience defaults and foreclosures.  Interest rates cannot fall below zero.

16. Dolan and Klein, Survey of Economics 4e, Ch. 13 The Zero Interest Rate Bound  The real interest rate (r) equals the nominal interest rate R) minus the rate of inflation ( π). r = R - π  Expected inflation does not affect the real interest rate because borrowers and lenders add an “inflation premium” to the nominal rate in order to keep the real interest rate constant.  During deflation, the real interest rate rises because the nominal rate cannot fall below zero. Examples:  Suppose that with no inflation ( π=0), the nominal rate R = 3% so the real rate r also equals 3%. r = R – π → 3% = 3% - 0%  If inflation rises to 5%, the nominal rate rises to 8% and the real rate stays at 3%. r = R – π → 3% = 8% - 5%  If there is deflation of -5%, the nominal rate falls to 0%, but it cannot fall further. As a result, the real interest rate is equal to the rate of inflation, with the sign reversed, that is, to 5% in this example: r = R – π → 5% = 0% -(-5%)

17. Dolan, Economics Combined Version 4e, Ch. 25 The Liquidity Trap  When nominal interest rates fall close to zero, monetary policy loses its effectiveness and the economy enters a liquidity trap,  The monetary base rises rapidly, but the money stock rises only a little because banks accumulate excess reserves.  At low interest rates, people hoard cash; even though the money stock rises, planned expenditure, aggregate demand, and real GDP fall.

18. Dolan, Economics Combined Version 4e, Ch. 25 Liquidity Trap: MS/MD perspective (Based on Appendix to Ch. 10)  As the interest rate approaches zero, monetary policy loses its effectiveness.  Doubling the money stock from 100 to 200 has a big effect on the interest rate.  Doubling it from 400 to 800 does not have much effect.

19. Dolan and Klein, Survey of Economics 4e, Ch. 13 Quantitative Easing  When the economy is in a liquidity trap, lowering the target interest rate does not have much effect.  Instead, the central bank uses quantitative easing to increase bank reserves-- even after interest rates are near zero.  Examples: Buy long-term bonds, buy mortgage-backed securities, make direct loans to financial institutions, etc.  The Fed began to use this kind of quantitative easing in late 2008.

20. Dolan and Klein, Survey of Economics 4e, Ch. 13 Productivity-Driven Supply-Side Deflation  Beginning from E 0, productivity growth has two effects:  Natural real output increases from N 0 to N 1, shifting the long- run AS curve rightward.  Higher productivity lowers the expected cost of production, shifting the short-run AS curve downward and to the right.  If AD remains unchanged, the price level will fall while real output increases; and the economy will move to a new equilibrium at E 1.

21. Dolan and Klein, Survey of Economics 4e, Ch. 13 Effects of Productivity-Driven Deflation  Productivity-driven supply- side deflation is less likely to be harmful than demand-side deflation.  Labor markets will not be disrupted.  Nominal wages need not fall.  Real wages rise as prices fall.  Financial markets will be less affected.  Productivity-driven deflation will be gradual so nominal interest rates will be low but positive.  Real incomes will be rising, limiting problems of defaults and foreclosures.

22. Dolan and Klein, Survey of Economics 4e, Ch. 13 Inflation-targeting and Productivity-driven Deflation  If the central bank follows an inflation targeting strategy, it can prevent deflation by shifting AD strongly to the right.  Prices will not fall despite increased productivity.  Real output rises above its natural level.

23. Dolan, Economics Combined Version 4e, Ch. 25 The Danger of Asset Bubbles  Interest rates must be kept very low to prevent deflation during a productivity boom.  Some sectors of the economy become vulnerable to asset bubbles and overinvestment.  Example: Housing price bubble during the early 2000s Bubble

24. Dolan, Economics Combined Version 4e, Ch. 25 What to Do About Asset-Price Bubbles?  Official Fed policy in the 1990s and 2000s:  Do not burst asset bubbles.  Let them follow their course and deal with the consequences later.  Alternative policies:  Use nominal GDP target.  Use Taylor rule.  Directly target asset prices and attempt to burst bubbles.  Compromise and “lean against the bubble” without bursting it.

25. Dolan, Economics Combined Version 4e, Ch. 25 Supplement Japan’s Lost Decade See Ch. 25, question for discussion

26. Dolan, Economics Combined Version 4e, Ch. 25 Inflation and Output Gap  From 1995 through 2005, Japan suffered a decade of almost constant, gradual deflation.  During this period the economy stagnated, with a persistent negative output gap—the “lost decade”.

27. Dolan, Economics Combined Version 4e, Ch. 25 Japan: Deflation and Unemployment  As the output gap grew, the unemployment rate rose.  High unemployment weakened Japan’s famous lifetime employment policy.  After the deflation, unemployment did not return to its very low rate of previous decades.

28. Dolan, Economics Combined Version 4e, Ch. 25 Hitting the ZIRB  During the deflation, the Bank of Japan aggressively pushed interest rates down.  From mid-2001 through 2005, short-term money market rates were.001%, effectively at the ZIRB.  In the spring of 2006, rates began to rise above zero again.

29. Dolan, Economics Combined Version 4e, Ch. 25 Liquidity Trap and Quantitative Easing  Quantitative easing produced rapid growth of the monetary base.  Growth of M2 + CDs did not accelerate, showing a falling money multiplier.  Nominal GDP fell, showing a decrease in velocity. Source: BOJ Quarterly Bulletin May 2003, Role of Monetary Policy

30. Dolan, Economics Combined Version 4e, Ch. 25 Fiscal Policy During Japanese Deflation Fiscal policy in Japan was also extremely expansionary. Combined with easy monetary policy, it has been compared to dropping money from a helicopter. www.pdclipart.org

31. Dolan, Economics Combined Version 4e, Ch. 25 Lessons of Japan’s Lost Decade  Once deflation starts, it can be hard to eliminate.  Deflation damages real output, financial markets, and labor markets.  Even aggressive tools, like quantitative easing and fiscal stimulus, are not foolproof.