1. Inflation

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4. 3 Inflation is... Inflation is a rise in the average price of goods over time Inflation is a rise in the average price of goods over time

5. 4 Some questions about inflation Why is inflation bad? Why is inflation bad? Inflation does have bad effects, but some popular criticisms are based on spurious reasoning Inflation does have bad effects, but some popular criticisms are based on spurious reasoning What are the causes of inflation? What are the causes of inflation? What can be done about it? What can be done about it?

6. 5 The quantity theory of money The quantity theory of money says that changes in the nominal money supply lead to equivalent changes in the price level (and money wages) but do not have effects on output and employment. The quantity theory of money says that changes in the nominal money supply lead to equivalent changes in the price level (and money wages) but do not have effects on output and employment.

7. 6 The quantity theory (2) The quantity theory of money says: The quantity theory of money says: M V = P Y M V = P Y where V = velocity of circulation where V = velocity of circulation If prices adjust to maintain real income (Y) at the potential level and if velocity stays constant If prices adjust to maintain real income (Y) at the potential level and if velocity stays constant then an increase in nominal money supply leads to an equivalent increase in prices then an increase in nominal money supply leads to an equivalent increase in prices but if velocity is variable or prices are sluggish, this link is broken. but if velocity is variable or prices are sluggish, this link is broken.

8. 7 Money and prices Milton Friedman famously claimed Milton Friedman famously claimed ‘Inflation is always and everywhere a monetary phenomenon.’ ‘Inflation is always and everywhere a monetary phenomenon.’ i.e. it results when money supply grows more rapidly than real output. i.e. it results when money supply grows more rapidly than real output. But this does not prove that causation is always from money to prices But this does not prove that causation is always from money to prices e.g. if the government adopts an accommodating monetary policy. e.g. if the government adopts an accommodating monetary policy.

9. 8 Money and inflation (2) …but in the long run, changes in real income and interest rates significantly alter real money demand …but in the long run, changes in real income and interest rates significantly alter real money demand so there may not be a perfect correspondence between excess monetary growth and inflation. so there may not be a perfect correspondence between excess monetary growth and inflation. And in the short run, the link between money and prices may be broken if And in the short run, the link between money and prices may be broken if velocity of circulation is variable velocity of circulation is variable prices are sluggish prices are sluggish

10. 9 Inflation and interest rates FISHER HYPOTHESIS FISHER HYPOTHESIS a 1% increase in inflation will be accompanied by a 1% increase in interest rates a 1% increase in inflation will be accompanied by a 1% increase in interest rates REAL INTEREST RATE REAL INTEREST RATE Nominal interest rate – inflation rate Nominal interest rate – inflation rate i.e. the Fisher hypothesis says that real interest rates do not change much i.e. the Fisher hypothesis says that real interest rates do not change much but the nominal interest rate is the opportunity cost of holding money but the nominal interest rate is the opportunity cost of holding money so a change in nominal interest rates affects real money demand so a change in nominal interest rates affects real money demand

11. 10 Hyperinflation … periods when inflation rates are very large … periods when inflation rates are very large in such periods there tends to be a ‘flight from money’ in such periods there tends to be a ‘flight from money’ people hold as little money as possible people hold as little money as possible e.g. Germany in 1922-23, Hungary 1945-46, Brazil in the late 1980s. e.g. Germany in 1922-23, Hungary 1945-46, Brazil in the late 1980s. Large government budget deficits help to explain such periods Large government budget deficits help to explain such periods persistent inflation must be accompanied by continuing money growth persistent inflation must be accompanied by continuing money growth

12. 11 The Phillips curve It suggests we can trade-off more inflation for less unemployment or vice versa. Prof. A W Phillips demonstrated a statistical relationship between annual inflation and unemployment in the UK Unemployment rate (%) Inflation rate (%) The Phillips curve shows that a higher inflation rate is accompanied by a lower unemployment rate. Phillips curve

13. 12 The Phillips curve and an increase in aggregate demand Unemployment Inflation PC 0 U* Suppose the economy begins at E, with zero inflation, unemployment at the natural rate U*... U1U1 11 An increase in government spending funded by an expansion in money supply takes the economy to A, with lower unemployment but inflation at  1. A … but what happens next?

14. 13 The Phillips curve and an increase in aggregate demand Unemployment Inflation PC 0 U* U1U1 11 A If nominal money supply is fixed in the long run, and prices and wages eventually adjust, the economy moves back to E. E But nominal money supply need not be constant in the long run so we may find the economy finds its way back to the natural rate, but with continuing inflation at C. C

15. 14 The vertical Phillips curve Unemployment Inflation PC 0 U* U1U1 11 A E C Effectively, the long-run Phillips curve is vertical, as the economy always adjusts back to U*. LRPC The short-run Phillips curve shows just a short-run trade-off – its position may depend upon expectations about inflation. PC 1

16. 15 Expectations and credibility Unemployment Inflation PC 2 PC 1 11 U* Unemployment rises to U 1 U1U1 Suppose the economy begins at E, with a newly-elected government pledged to reduce inflation. E LRPC Monetary growth is cut to  2. 22 In the short run, the economy moves to A along the short- run Phillips curve. A As expectations adjust, the short-run Phillips curve shifts to PC 2, and U* is restored at F. F

17. 16 Inflation and unemployment in the UK 1978-99 1978 1980 1986 1990 1999 1993

18. 17 Inflation illusion People have inflation illusion when they confuse nominal and real changes. People have inflation illusion when they confuse nominal and real changes. People’s welfare depends upon real variables, not nominal variables. People’s welfare depends upon real variables, not nominal variables. If all nominal variables (prices and incomes) increase at the same rate, real income does not change. If all nominal variables (prices and incomes) increase at the same rate, real income does not change.

19. 18 The costs of inflation Fully anticipated inflation: Fully anticipated inflation: Institutions adapt to known inflation: Institutions adapt to known inflation: nominal interest rates nominal interest rates tax rates tax rates transfer payments transfer payments no inflation illusion no inflation illusion Some costs remain: Some costs remain: shoe-leather shoe-leather people economize on money holdings people economize on money holdings menu costs menu costs firms need to alter price lists etc. firms need to alter price lists etc.

20. 19 The costs of inflation (2) Even if inflation is fully anticipated, the economy may not fully adapt Even if inflation is fully anticipated, the economy may not fully adapt interest rates may not fully reflect inflation interest rates may not fully reflect inflation taxes may be distorted taxes may be distorted fiscal drag may have unintended effects on tax liabilities fiscal drag may have unintended effects on tax liabilities capital and profits taxes may be distorted capital and profits taxes may be distorted

21. 20 The costs of unanticipated inflation Unintended redistribution of income Unintended redistribution of income from lenders to borrowers from lenders to borrowers from private to public sector from private to public sector from young to old from young to old Uncertainty Uncertainty firms find planning more difficult under inflation, which may discourage investment firms find planning more difficult under inflation, which may discourage investment This has been seen as the most important cost of inflation This has been seen as the most important cost of inflation

22. 21 Defeating inflation In the long run, inflation will be low if the rate of money growth is low. In the long run, inflation will be low if the rate of money growth is low. The transition from high to low inflation may be painful if expectations are slow to adjust. The transition from high to low inflation may be painful if expectations are slow to adjust. Policy credibility may speed the adjustment process Policy credibility may speed the adjustment process

23. 22 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: CONTACT: 0322-3385752 0322-3385752 0312-2302870 0312-2302870 0300-2540827 0300-2540827 R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN. R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.