Written by: Edmund Quek

CHAPTER 18 INFLATION

LECTURE OUTLINE 1 2 2.1 2.1.1 2.1.2 2.2 3 4 DEFINITION AND MEASUREMENT CAUSES OF INFLATION Keynesian view Demand-pull Inflation Cost-push Inflation Monetarist view EFFECTS OF INFLATION EFFECTS OF DEFLATION

References John Sloman, Economics William A. McEachern, Economics Richard G. Lipsey and K. Alec Chrystal, Positive Economics G. F. Stanlake and Susan Grant, Introductory Economics Michael Parkin, Economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics

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DEFINITION AND MEASUREMENT

Inflation is a rise in the general price level over a period of time. Monetary economists, however, define inflation as a sustained rise in the general price level and refer to a one-off rise as a price shock. The inflation rate is calculated as the percentage increase in the Consumer Price Index over a period of time. Mathematically, t (CPIt CPIt1)/CPIt1 100, where CPIt [(Pit/Pi base year 100) Wi]. The Consumer Price Index is a price index which measures the cost of a basket of goods and services purchased by the average household. It is calculated by choosing a basket of goods and services purchased by the average household, grouping them into categories, assigning a weight to each category based by the proportion of total expenditure spent on it, choosing a base year, measuring the prices of the goods and services in the current year as well as in the base year. Suppose that there are only two goods produced in the economy, Good A and Good B. Further suppose that the base year is 2009 (i.e. CPI2009 100). Good A B Price (2009) $8 $16 Price (2011) $10 $15 Price (2012) $12 $14 Expenditure (2009) 20000 60000 Weight 1/4 3/4

CPI2012 [(12/8 100) 1/4] [(14/16 100) 3/4] 103.125 CPI2011 [(10/8 100) 1/4] [(15/16 100) 3/4] 101.563 2012 (CPI2012 CPI2011)/CPI2011 100 (103.125 101.563)/101.563 100 1.538 In most economies, a low/moderate/mild inflation rate is considered to be 3 per cent or lower. Most economies that have inflation targets have set them in this range. Inflation much higher than this range is called high inflation. Hyperinflation is very high inflation. An example of hyperinflation is the 6.5 10108 per cent inflation rate in Zimbabwe in 2008.

Note: Many lecturers use the monetary economists definition of inflation. However, some of them use it without knowing that not all economists define inflation in the same way. A check with economics textbooks (e.g. Lipsey, Mankiw, etc) will confirm this.

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2 2.1

CAUSES OF INFLATION Keynesian view

Keynesians distinguish between two types of inflation: demand-pull inflation and cost-push inflation.

2.1.1 Demand-pull inflation Demand-pull inflation occurs when the general price level rises due to an increase in aggregate demand. Given any increase in aggregate demand, the closer the economy to the full-employment equilibrium, the larger the rise in the general price level. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to a rise in the general price level (P) from P0 to P1. Aggregate demand could increase due to an increase in any of its components. For instance, when households are more optimistic about the economic outlook, they will expect their income to rise and hence increase consumption expenditure. Consumption expenditure may also rise due to other factors such as an increase in the wealth of households. A fall in interest rates will lead to more profitable planned investments resulting in an increase in investment expenditure. Investment expenditure may also rise due to other factors such as stronger business sentiment. When the economy is in a recession, the government may increase expenditure on goods and services to steer the economy back onto the path of expansion. An increase in foreign income will lead to an increase in net exports. Contractionary demand-side policies can be used to reduce demand-pull inflation (which will be explained later).

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2.1.2 Cost-push inflation Cost-push inflation occurs when the general price level rises due to a rise in the cost of production in the economy, independent of demand. When the cost of production in the economy rises independently of demand, firms will increase prices at the same output levels to maintain profitability. In other words, they will reduce output at the same prices which will lead to a decrease in aggregate supply. Aggregate supply is the total supply of goods and services in the economy over a period of time.

In the above diagram, a decrease in aggregate supply (AS) from AS0 to AS1 leads to a rise in the general price level (P) from P0 to P1. The cost of production in the economy may rise independently of demand due to several reasons. For instance, workers will bargain for higher wages when they expect prices to rise or when the labour market is tight. The prices of imported intermediate goods will rise when the exchange rate of domestic currency falls or when there is inflation in other economies. If the government increases indirect taxes such as the goods and services tax or if oil prices rise, the cost of production in the economy will rise. For instance, the sharp rise in oil prices in the early 1970s led to a huge rise in the cost of production in the world. In theory, supply-side policies can be used to reduce cost-push inflation. However, due to the long effectiveness time lag, they are not effective in the short run. In reality, contractionary demand-side policies are often used to reduce cost-push inflation, although they may cause the economy to move into a recession.

2.2

Monetarist view

Monetarists believe that inflation is always and everywhere a monetary phenomenon. By this, they mean that inflation can only be produced by a more rapid increase in the money supply than in output. This view is an outgrowth of the study of the historical relationship

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between the money supply and prices done by the leader of the Monetarist school of thought, Milton Friedman. His study indicated a strong positive relationship between the money supply and prices (A Monetary History of the United States, 1867 1960). Direct (Monetarist) transmission mechanism. Monetarists believe that in addition to money and financial assets such as bonds, people also hold their wealth in the form of physical assets such as cars, televisions and other consumer goods. If the money supply increases, people will find themselves holding more money than they want. Although some of this money will be used to purchase financial assets, some will be used to purchase physical assets which will lead to an increase in aggregate demand. An increase in aggregate demand will lead to an increase in nominal national income (after 6 to 9 months). Initially, the change will appear primarily in output. However, after a few months (another 6 to 9 months), prices will rise and output will fall back. Therefore, an increase in the money supply will only lead to higher prices in the long run (after 12 to 18 months). The hyperinflation of 6.5 10108 per cent in Zimbabwe in 2008 was an extreme monetary phenomenon. The central bank of Zimbabwe was compelled by the government to purchase the bonds that it issued. As a result, the money supply in Zimbabwe increased rapidly. However, since the amount of goods produced in Zimbabwe did not increase at the same rate, the rapid increase in the money supply led to a situation of too much money chasing too few goods which resulted in hyperinflation. Using the equation of exchange (MV PY), Monetarists argue that to achieve price stability, the central bank should let the money supply grow at a constant rate, and this policy rule is commonly known as the constant growth rate rule (CGRR). According to Monetarists, V is stable (i.e. its changes are small and predictable). Therefore, if the central bank increases the money supply at the average economic growth rate, the general price level will be stable.

EFFECTS OF INFLATION

Adverse effect on the real value of savings High inflation will reduce the real value of savings. When inflation is high, nominal interest rates will not fully compensate for the rise in the general price level which will reduce the amount of goods and services that can be purchased with any given amount of savings. Adverse effect on net exports High inflation may lead to a decrease in net exports. When inflation is high, domestic goods and services may become relatively more expensive than foreign goods and services. If this happens, net exports will fall.

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Adverse effect on investment expenditure High inflation may lead to a decrease in investment expenditure. Since high inflation tends to be less stable, firms will find it harder to estimate the costs and revenues of investments when inflation is high which will lead to a decrease in investment expenditure. Adverse effect on the balance of payments If net exports fall, the current account and hence the balance of payments will deteriorate. A deterioration in the balance of payments may lead to a persistent balance of payments deficit resulting in adverse consequences such as high imported inflation, high cost-push inflation, lower national income, higher unemployment and rising foreign debt. Higher economic growth An increase in net exports and investment expenditure will lead to an increase in the aggregate demand and hence the national income resulting in higher economic growth in the economy. Lower unemployment Since national income is equal to national output, the increase in national income will lead to a rise in the demand for labour resulting in a fall in unemployment, assuming the size of the labour force remains the same. High shoe-leather cost of inflation High inflation will lead to a high shoe-leather cost of inflation. High inflation will lead to high interest rates. Metaphorically, when interest rates are high, the transactions demand for money will be low. Therefore, people will make frequent trips to the bank to withdraw small amounts of money which will cause their shoes to wear out rapidly resulting in a high shoe-leather cost of inflation. In reality, the idea of wearing out your shoes rapidly implies more than making frequent trips to the bank. Rather, when interest rates are high, people will spend much of their time managing their money rather than using it to produce goods and services. High menu cost of inflation High inflation will lead to a high menu cost of inflation. When prices of goods and services rise, firms have to reprint price labels. For example, restaurants have to reprint menus to reflect the higher prices of meals. When inflation is high, prices of goods and services will rise frequently which will lead to a high menu cost of inflation. Haphazard redistribution of real income and wealth (unanticipated inflation) Unanticipated inflation will lead to a haphazard redistribution of real income and wealth. Consider a wage contract that specifies a wage increase of 3 per cent on the assumption that the general price level will remain unchanged. If inflation unexpectedly turns out to be 10 per cent, the 3 per cent increase in nominal wages will mean a 7 per cent decrease in real wages. In this instance, real income will be haphazardly redistributed from workers to firms. Further, unanticipated inflation will decrease the liabilities of debtors and the assets of creditors in real terms. In other words, when there is unanticipated inflation, debtors will

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owe creditors less in terms of goods and services. In this instance, wealth will be haphazardly redistributed from creditors to debtors. Haphazard redistribution of real income (anticipated inflation) Anticipated inflation will also lead to a haphazard redistribution of real income. Some private pension plans are stated in nominal terms and others compensate for up to only 5 per cent inflation. Therefore, even if inflation had been anticipated, people who live on fixed nominal income will see their real income erode away over time. In this instance, real income will be haphazardly redistributed from pensioners to firms. Although high inflation is undesirable for the economy, low inflation is desirable. Low inflation is desirable for the economy because it injects some downward flexibility into real wages resulting in lower unemployment. Although it is easy for firms to increase real wages by increasing nominal wages, the converse is not true because workers are resistant to pay cuts. Therefore, if inflation is maintained at 3 per cent or less, firms can cut real wages without cutting nominal wages which will lead to lower unemployment. Another way to understand why some inflation is necessary for achieving low unemployment is through the short-run Phillips curve which shows the inverse relationship between inflation and unemployment.

In the above diagram, when the inflation rate is 0, the unemployment rate is 0. At a zero per cent inflation rate, the unemployment rate is 1, which may be intolerably high. Note: A nominal value is measured in terms of money. A real value is measured in terms of goods and services. Suppose that a firm pays a worker an income of $1000. Further suppose that the only good in the economy is lipstick which costs $20 each. In this case, the nominal income of the worker is $1000 and the real income is 20 lipsticks. It is important for students to note that firms and workers are concerned with real income. Similarly, lenders and borrowers are concerned with real interest rate. Suppose that a lender charges a borrower an interest rate of 7 per cent. Further

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suppose that inflation is 3 per cent. In this case, the real interest rate is 4 per cent. This means that although the borrower will pay back 7 per cent more to the lender in terms of money, the lender will only receive 4 per cent more from the borrower in terms of goods and services. 4 EFFECTS OF DEFLATION

Although high inflation is undesirable for the economy, this does not mean that deflation is necessary desirable for the economy. Deflation is a fall in the general price level over a period of time. Deflation may bring about benefits to the economy such as an increase in the real value of savings, an increase in net exports, a correction of a persistent balance of payments deficit and a low shoe-leather cost of inflation. However, deflation may lead to a decrease in aggregate demand and this is undesirable for the economy because deflation is usually due to a decrease in aggregate demand. In other words, deflation may worsen a recession. Deflationary expectations Deflation may lead to deflationary expectations and hence a decrease in aggregate demand. When the general price level falls, households may expect it to fall further. If this happens, they will put off the purchases of some durable goods which will lead to a decrease in consumption expenditure and hence aggregate demand. For instance, deflation in Japan in the late 1990s was of concern to the Japanese government due to this reason. Widespread bankruptcy Deflation may lead to widespread bankruptcy and hence a decrease in aggregate demand. Deflation increases the real value of debts. Since most firms are in debt, high deflation may lead to widespread bankruptcy. If this happens, investment expenditure and hence aggregate demand will fall. For instance, in the Great Depression of 1930s, many farmers in the US lost their farms through foreclosures as a result of the heavy debt burden due to falling prices. Rise in interest rates Deflation may lead to a rise in interest rates and hence a decrease in aggregate demand. Deflation is a return on holding money because it increases the real value of money. Therefore, if deflation leads to deflationary expectations, the demand for money will increase which will lead to a rise in interest rates resulting in a decrease in consumption expenditure, investment expenditure, net exports and hence aggregate demand. Redistribution of wealth from debtors to creditors Unanticipated deflation will redistribute wealth from debtors to creditors which will lead to a decrease in aggregate demand. Unanticipated deflation will increase the liabilities of debtors and the assets of creditors in real terms. In other words, when there is unanticipated deflation, debtors will owe creditors more in terms of goods and services. When this happens, wealth will be redistributed from debtors to creditors. Since debtors have a marginal propensity to consume higher than that of creditors, the redistribution of wealth will lead to a decrease in consumption expenditure and hence aggregate demand.

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