Transcript The Costs of Inflation

Modern Principles:
Macroeconomics
Tyler Cowen
and Alex Tabarrok
Chapter 11
Inflation and the Quantity
Theory of Money
Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabarrok
Introduction
• Robert Mugabe, president of Zimbabwe
had a problem.
 His policies pushed his country, once called the
breadbasket of Africa, to the verge of
starvation.
 With nothing left to tax he turned to the last
refuge of needy governments, the printing
press.
 Result: Hyperinflation
• Inflation went from 50 percent a year to 50
percent a month to 50 percent a day!
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Introduction
• In this chapter, we learn…
 How inflation is defined and measured
 What causes inflation
 The costs and benefits of inflation
 Why governments sometimes resort to
inflation.
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Defining and Measuring Inflation
• Inflation: an ↑in the average level of prices.
• Measured using the following formula.
Pt  Pt -1
Inflation rate 
 100
Pt -1
•
Where Pt is the
average price level
in year t
The average change of all prices.
 Some prices go up and some go down.
 Think of an elevator containing many prices that
change relative to each other. As the elevator
rises, all of the prices rise. The following figure
may help.
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Defining and Measuring Inflation
At any one
point in time
some prices
are going up
and some
are going
down.
Inflation is an
increase in
the price
level.
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Defining and Measuring Inflation
• Price Indexes are used to measure
inflation.
 An index is a number that compares the price
level in one period relative to the prices in some
base year.
 An index is only a number; it is not expressed in
dollars.
 There are several price indexes
• Consumer price index (CPI)
• Producer price index (PPI)
• GDP deflator
 Let’s take a closer look at each of these…
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Defining and Measuring Inflation
1.CPI: The average price of goods bought by a
typical American consumer.
 Covers 80,000 goods.
 Weighted so that higher priced items count more.
2.Producer price indexes (PPI): The average
price received by producers.
 Includes intermediate goods as well as final goods.
3.GDP deflator: Measures the average price of
all final goods and services.
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Defining and Measuring Inflation
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Defining and Measuring Inflation
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Defining and Measuring Inflation
• Inflation in the United States and Around
•
the World
Using the CPI to calculate real prices
• Real price is the price of a good that has
been corrected for inflation.
 Example:
• 1982 price of gasoline was $1.25/gal
• 2006 it was double that at $2.50/gal.
• CPI was 100 in 1982 and 202 in 2006.
• Conclusion: The real price of gasoline
was about the same in 2006 as it was in
1982.
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Defining and Measuring Inflation
• Inflation in the United States and Around the
World (cont.)
 Hyperinflation: extremely high rates of inflation
that make inflation in the U.S. look pretty tame
by comparison.
 A lot of governments have fallen into the trap of
inflating their currency in order to pay debts.
 The next table shows some pretty dramatic
examples.
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Defining and Measuring Inflation
• Inflation in the United States and Around the World
(cont.)
Slide 12 of 49
Defining and Measuring Inflation
• Inflation in the United States and Around
the World (cont.)
• Hungary’s hyperinflation is the highest on
record.
 What cost 1 Hungarian pengo in 1945 cost
1.3 septillion pengos at the end of 1946.
 Prices doubled every 15 hours!
World's highest
denomination
banknote
Hungary (1946)
100 Quintillion pengo
100,000,000,000,000,000,000
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CHECK YOURSELF
If the CPI was 120 this time last year and is
125 right now, what is the inflation rate?
If the inflation rate goes from 1 percent to 4
percent to 7 percent over two years, what
will happen to the prices of the great
majority of goods: will they go up, stay the
same, go down, or do you not have enough
information to say?
Why do we use real prices to compare the
price of goods across time?
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The Quantity Theory of Money
• The quantity theory of money does two
things:
1. Sets out the general relationship between
inflation, money, real output, and prices.
2. Presents the critical role of the money supply in
regulating the level of prices.
• For the nation as a whole…
M v  PY
R
M  Money Supply
v  Velocity of money
P  Price level
Y  Real GDP
R
 Velocity (v): average number of times that a
dollar is spent on goods and services in a year.
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The Quantity Theory of Money
• The quantity theory of money depends
on two assumptions…
1. Real GDP is stable compared to the
money supply.
• Real GDP is fixed by the real factors of
production—capital, labor, and
technology.
• The growth rate of real GDP is limited
by how fast these factors can increase.
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The Quantity Theory of Money
•
The quantity theory of money depends on
two assumptions…(cont.)
2. The velocity of money, v, is stable compared
to the money supply.
• It is determined by various factors such as:
 Whether workers are paid monthly or
biweekly.
 How long it takes to clear a check or
electronic transaction.
 How easy it is to find an ATM.
• Factors like these may change, but they will
change slowly.
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The Quantity Theory of Money
• The Cause of Inflation
 The quantity theory is a theory of inflation.
 If YR is fixed by real factors of production and v
is stable, then it follows that inflation is caused
by an increase in the supply of money.
 The quantity theory of money can also be
written in terms of growth rates:
M  v  P  YR
• Which translates as:
 Growth rate of money + growth rate of v is
identically equal to the rate of inflation +
growth rate of real GDP.
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The Quantity Theory of Money
• The Cause of Inflation (cont.)
 Important implication: If the growth rates of v
and YR are small compared to the growth rate of
M, the rate of inflation will be approximately
equal to the increase in money supply.
PM
Or more generally:
Rate of Inflation, P  M  YR  v
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The Quantity Theory of Money
• The Cause of Inflation (cont.)
 One of the most important truths of economics.
• “Inflation is always and everywhere a
monetary phenomenon”, Milton Friedman,
Nobel Prize Winner
 Milton Friedman (1912-2006)
• Ph.D. - Columbia University
• Professor - University of
Chicago
• Leader of the Chicago
“school of economics”
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The Quantity Theory of Money
• The Cause of Inflation (cont.)
 How well does the theory hold up?
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The Quantity Theory of Money
• The Cause of Inflation (cont.)
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The Quantity Theory of Money
• The Cause of Inflation (cont.)
 Some Important Caveats:
1. If M and v grow more slowly than YR, prices
will fall; this is called deflation.
2. Changes in velocity will affect prices.
 Hyperinflation: People will spend their
money faster (increase v) → even faster
increase in prices.
 Great Depression: Fear → ↓spending
(decreased v) → deflation → worse
depression.
3. In the long run, money is neutral.
Slide 23 of 49
The Quantity Theory of Money
•
An Inflation Parable
 Under some circumstances, changes in M can temporarily change YR.
Let’s see how…
 Consider a mini-economy consisting of a baker, tailor, and carpenter who
buy and sell products among themselves.
Government
prints money
to pay army
Soldiers buy from
baker, tailor, and
carpenter
When the baker, tailor,
and carpenter go to buy
from each other, they find
they are no better off than
before because of higher
prices
At first
All three work
harder to increase
output and raise their
prices.
Eventually they catch on and stop
working harder to produce more output.
Conclusion: Increase in M can boost the economy in the short run but as firms
and workers come to expect and adjust to the influx of new money, output (real
GDP) will not grow any faster than normal.
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CHECK YOURSELF
In the long run, what causes inflation?
What is the equation that represents
the quantity theory of money?
Slide 25 of 49
The Costs of Inflation
• If all prices including wages are going up,
•
then what is the problem with inflation?
We will look at four problems with
inflation.
1. Price confusion and money illusion.
2. Inflation redistributes wealth.
3. Inflation interacts with other taxes.
4. Inflation is painful to stop.
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The Costs of Inflation
1. Price Confusion and Money Illusion
 Price confusion
• Inflation makes price signals more
difficult to interpret.
• A decision maker does not always know
if the price of a product is increasing…
 Because of increased demand or
 As a result of all prices going up with
inflation.
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The Costs of Inflation
1. Price Confusion and Money Illusion (cont.)
 Money Illusion: when people mistake
changes in nominal prices for changes in real
prices.
• Example: Mary receives a 10% increase in
salary. Feeling she can now afford it, she
takes on a higher mortgage payment. The
rate of inflation is 10% and she is no better
off in terms of real salary. She now has a
higher house payment and is in danger of
losing her home.
• Result: resources are wasted in unprofitable
activities.
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The Costs of Inflation
2. Inflation Redistributes Wealth
 Inflation is type of tax. It transfers wealth to the
government.
• Even tax cheats can’t avoid this tax!
• Governments that print money to pay their
bills are using this type of tax.
 Inflation redistributes wealth among the public.
• The real rate of return for a lender is given
by…
ractual  i  
ractual  Actual rate of return, i  Nominal interest rate
  Inflation rate
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The Costs of Inflation
2. Inflation Redistributes Wealth (cont.)
 Example:
• Suppose a bank makes a 30 year home
loan at an interest rate of 7%. If the rate of
inflation is 3% over that period: bank’s
actual rate of return = 7% - 3% = 4%
• If inflation rises unexpectedly to 13% as it
did in late 1970s, the actual rate of return =
7% - 13% = - 6%!
 The lender is now losing money on the
loan.
 The borrower gains.
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The Costs of Inflation
2. Inflation Redistributes Wealth (cont.)
 What happens if people expect inflation to go
up?
• Lenders will increase nominal rates of
interest.
• Fisher effect: the tendency for nominal
interest rates to rise with expected inflation.
 This effect says that the nominal rate of
interest will be equal to expected inflation
rate plus the equilibrium rate of return.
 The Fisher effect is seen in the next
diagram.
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The Costs of Inflation
2. Inflation Redistributes Wealth (cont.)
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The Costs of Inflation
2. Inflation Redistributes Wealth (cont.)
 The actual rate of return: determined in
large part by the difference between expected
inflation and actual inflation.
 From earlier equations we have:
ractual  i  π (1)
and i  E  requilibrium (2)
Substituting i from equation (2) into equation (1)
we get:
ractual  ( E   )  requilibrium
The following table summarizes what we learn
from this result.
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The Costs of Inflation
2. Inflation Redistributes Wealth (cont.)
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The Costs of Inflation
2. Inflation Redistributes Wealth (cont.)
 Monetizing the debt: when the government
pays off its debts by printing money.
• Why don’t they always inflate their debt
away? Two reasons:
1. The Fisher effect: if banks know the
government is doing this, they will
simply raise interest rates.
2. Political cost: People who buy
government bonds usually vote.
Slide 35 of 49
The Costs of Inflation
2. Inflation Redistributes Wealth (cont.)
 Workers and firms are affected by inflation.
• Wage agreements are often made several
years in advance.
 Underestimating inflation → wages being
too low → supply of labor: too low.
 Overestimating inflation → wages being
too high → demand for labor: too low.
 Conclusion: errors in estimating the rate of
inflation → a misallocation of resources →
lower economic growth.
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The Costs of Inflation
2. Inflation Redistributes Wealth (cont.)
 Hyperinflation and the Breakdown of Financial
Intermediation
• If inflation is moderate and stable:
 Lenders and borrowers can forecast well.
 Loans can be signed with rough certainty
regarding the value of future payment.
• If inflation is high and volatile:
 Long-term risk becomes high and loans
may not be signed at all.
 Financial intermediation breaks down.
 Let’s look at some examples…
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The Costs of Inflation
 Hyperinflation and the Breakdown of Financial
Intermediation (cont.)
• Peru (1987-1992)
 Private loans virtually disappeared.
 Investment fell and the economy collapsed.
• Mexico
 1980s: Inflation rate at times exceeded 100%.
• Long-term loans were hard to get.
• As recently as 2002, 90% of debt matured
within one year.
 Since the 1990s: inflation has been tamed.
 Result: rapidly growing capital markets and
increased investment.
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The Costs of Inflation
2. Inflation Redistributes Wealth (cont.)
 Conclusions:
1. Unexpected inflation redistributes wealth
throughout society in arbitrary ways.
2. When inflation is high and volatile
 Unexpected inflation is difficult to
avoid.
 Long-term contracting grinds to a
halt.
• Result: economic growth suffers.
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The Costs of Inflation
3. Inflation Interacts with Other Taxes
 Inflation will produce tax burdens and tax
liabilities that do not make economic sense.
• People pay taxes on illusory capital gains.
 Example: Taxes are collected on nominal
capital gains.
 Results:
• Longer-run effect is to discourage
investment in the first place.
• Inflation increases the costs of complying
with the tax system.
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The Costs of Inflation
4. Inflation is Painful to Stop
 Slowing down the money supply can create a
recession.
 A good lesson:
• Inflation in 1980 was 13.5%.
• Tough monetary policy reduced the rate of
inflation to 3%, but the consequence was…
 The worst recession since the Great
Depression.
 Unemployment rate over 10%.
 The unemployment rate didn’t return to
near 5.5% until 1988.
Slide 41 of 49
CHECK YOURSELF
Consider unexpected inflation and
unexpected disinflation. How is wealth
redistributed between borrowers and
lenders under each case?
What happens to nominal interest rates
when expected inflation increases? What
do we call this effect?
What does unexpected inflation do to price
signals?
Slide 42 of 49
Takeaway
•
•
•
Inflation is an increase in the average level
of prices as measured by an index such as
the CPI.
Sustained inflation is always and
everywhere a monetary phenomenon.
Inflation makes price signals difficult to
interpret.
 This is especially true when people may
suffer from money illusion.
Slide 43 of 49
Takeaway
• Workers and firms adjust to predictable
•
inflation by incorporating inflation rates
into wages and contract agreements.
Anything above a mild sustained inflation
is bad for the economy.
Slide 44 of 49
Modern Principles:
Macroeconomics
Tyler Cowen
and Alex Tabarrok
Chapter 11 Appendix:
Get Real! An Excellent
Adventure
Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabbarrok
Get Real! An Excellent Adventure
Suppose you want to convert a nominal
data series into a inflation-corrected or
real data series.
Step I: Download your data into a
spreadsheet.
Source: http://www.census.gov/const/www/newressalesindex.html
Slide 46 of 49
Get Real! An Excellent Adventure
Suppose you want to convert a nominal
data series into a inflation-corrected or
real data series.
Step I: Download your data into a
spreadsheet.
Step II: We need a price index. Input your
data into your spreadsheet.
Slide 47 of 49
Get Real! An Excellent Adventure
Suppose you want to convert a nominal
data series into a inflation-corrected or
real data series.
Step I: Download your data into a
spreadsheet.
Step II: We need a price index. Input your
data into your spreadsheet.
Step III: Calculate your deflator. You do
this by dividing all of the CPIs by the CPI
in the period you use as the “base period”.
In this case it is August 2006. The deflator
equals 1 in the base period.
Slide 48 of 49
Get Real! An Excellent Adventure
Suppose you want to convert a nominal
data series into a inflation-corrected or
real data series.
Step I: Download your data into a
spreadsheet.
Step II: We need a price index. Input your
data into your spreadsheet.
Step III: Calculate your deflator. You do
this by dividing all of the CPIs by the CPI
in the period you use as the “base period”.
In this case it is August 2006. The deflator
equals 1 in the base period.
Step IV: Divide the average house price
by the deflator.
Result: There has been a real increase
In the price of housing. What would
cause this?
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