Transcript Inflation, Disinflation, and Deflation

Inflation, Disinflation, and
Deflation
Chapter 16
Bringing a Suitcase to the Bank
 Read page 475.
 Answer these 4 questions.
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Why did Zimbabwe’s government pursue economic policies
that led to hyperinflation?
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What specific action taken by the government led to
massive inflation?
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Why couldn’t Zimbabwe’s government balance its budget?
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What should be remembered about Zimbabwe’s
experience?
 Walk and share.
Classical Model of Money and Prices
 According to the classical model of the price level,
the real quantity of money is always at its long-run
equilibrium level.
 The classical model of the price level does not
distinguish between the short and the long run.
 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
 The inflation tax is the reduction in the real value of
money held by the public caused by inflation.
 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
 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.
 The inflation tax is equal to the inflation rate
times the money supply.
 Real seignorage = (∆M/M) x (M/P)
Hyperinflation
 In periods of high inflation, people reduce their
real money holdings.
 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
Moderate Inflation and Disinflation
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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.
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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.
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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
 The percentage difference between the actual level of
GDP and potential output is called the output gap.
 When actual aggregate output is equal to potential
output, the actual unemployment rate is equal to the
natural rate of unemployment.
 When the output gap is positive (an inflationary gap),
the unemployment rate is below 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
Output Gap and Unemployment
Rate
 Okun’s law defines the negative
relationship between the output gap
and cyclical unemployment.
 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
 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 yearto-year changes in
the business cycle.
 In other words,
changes in AD create
movement along a
SRPC curve.
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Short-Run Phillips Curve
 The realities of the 1970’s showed that the
inflation-unemployment relationship was NOT
always stable and that the SRPC can shift.
 An accurate SRPC will include other factors,
such as supply shocks and expected inflation
rates.
 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
 An increase in the
expected inflation rate
shifts the short-run
Phillips curve upward.
 Why?
 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
 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.
 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.
 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.
 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 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.
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There is a zero-bound on the nominal interest rate: it
cannot go below zero.
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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
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Fed watches “core” and “expected”
inflation carefully when making
policy.
The core inflation rate is the
percentage rise in a measure of
consumer prices that excludes
volatile food and energy prices.
Fed considers “core” the best
guide to underlying inflation and
seeks to keep it at 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.
In November, the Fed began a
program to buy long-term bond
purchases to give the economy a
boost.
Federal Reserve Release of Data
 http://research.stlouisfed.org/fred2/
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?