11InflationAgenda• Inflation¾ Definitions• The Costs and Benefits of Inflation • The “Simple” Phillips Curve2Inflation: Definitions• Definitionπ(t) = {[ ( P(t) – P(t-1) ] / P(t-1) } * 100• π is dynamic and, therefore, more complicated than the P level, which is static.3Inflation: DefinitionsInflation Rate04812161960 1965 1970 1975 1980 1985 1990 1995 2000Year-on-Year Percent Change4Inflation: Definitions• Inflation¾ A sustained rise in the general level of prices.• Accelerating Inflation¾ A rising inflation rate.• Disinflation¾ A slowing inflation rate.5Inflation: Definitions• Deflation¾ A sustained fall in the general level of prices.• Hyperinflation¾ An inflation rate of 50% per month or more.• More than 1% per day.• 100-fold increase in prices per year.• 2 million-fold increase in prices over 3 years.6Costs of Inflation• Inflation can be either:¾ Anticipated or¾ Unanticipated• Incorrectly anticipated27Costs of Inflation• Costs of inflation¾ Arbitrary redistribution of income• Creates winners and losers¾ Information and Uncertainty costs• Reduces information and increases uncertainty¾ Institutional and Constitutional costs• Degrades institutions and conventions¾ Shoe-Leather and Menu costs• Absorbs resources from productive activities8Costs of Inflation• Arbitrary Redistribution of Income¾ from those who do not, or cannot, raise their prices ¾ tothose who can, and do, raise their prices • and still sell their goods• Contracts can prevent price increases¾ Mortgages and other fixed interest rate contracts• Redistribution from lenders to borrowers if inflation rises¾ Wage contracts• Redistribution from employees to businesses if inflation rises¾ Fixed pensions• Redistribution from retirees to pension plans if inflation rises9Costs of Inflation• Arbitrary Redistribution of Income¾ Results from unanticipated inflation• Or incorrectly anticipated¾ However, this is a zero sum situation• Winners win exactly what losers lose• Therefore, not a macroeconomic problem– Unless there is a substantial international net creditor/debtor status.10Costs of Inflation• Informational and Uncertainty Costs¾ Informational costs: relative prices become less meaningful the faster is inflation• Leads to Money Illusion• Higher inflation reduces the time period for which price information is valuable¾ Uncertainty costs: higher inflation generally leads to more variable inflation. More variability leads to less certainty• Which can reduce economic growth11Costs of Inflation• Institutional and Constitutional Costs¾ Very high inflation undermines institutions and conventions based on relatively fixed prices¾ Reflected in erosion of faith in government, the economy, and money12Costs of Inflation• Shoe-Leather and Menu Costs¾ Higher inflation increases the cost of doing business by requiring resources to be devoted to adjusting to rapid price changes• Shoe-leather costs: Resources used by increased cash management practices• Menu costs: Costs associated with frequent price changes313Costs of Inflation• High inflation will reduce long-term growth¾ Diverts resources away from production¾ Distorts and/or delays expenditures by consumers and businesses• Because of higher interest rates• Because of greater uncertainty¾ Devalues institutions and the use of money• Lower inflation may boost long-term growth¾ This has led to mandates for central bank independence and exclusive focus on inflation14Benefits of Inflation• Benefits of inflation¾ Facilities relative price changes¾ Money illusion• Facilitates real wage adjustment¾ Negative real interest rates• Important for macroeconomic policy¾ Seignorage• Revenue derived from money creation15Costs of Hyperinflation• Shoe-leather costs become very serious• Menu costs are substantially higher• Relative price signals are meaningless• Microeconomic inefficiencies skyrocket• Tax distortions become huge• Massive inconvenience• Becomes intolerable16Costs of Deflation• The real burden of debt rises.• Generates a self-perpetuating economic contraction by delaying expenditures by consumers and businesses.• Renders monetary policy totally ineffective.• Arbitrary redistribution of income.¾ From borrowers to lenders.• Who have lower mpc’s.17Inflation and Policy• What is an appropriate level for inflation?¾ High inflation is “undoubtedly bad”• But how high is “high” inflation?¾ Hyperinflation is clearly too high¾ Deflation is also “undoubtedly bad”¾ Zero inflation also imposes costs¾ Low inflation is likely “best”• But how low is “low” inflation?• How high is “low” inflation?18Inflation and Policy• What is an appropriate level for inflation?¾ Reducing inflation has costs• Reduced output• Slower growth• Higher unemployment419The Phillips Curve• Observations¾ When inflation is high, unemployment tends to be low¾ When inflation is low, unemployment tends to be high20The Phillips Curve• The inverse relationship between inflation and unemployment is called “the Phillips Curve”¾ The core of many models of the economy• Tells policy makers the conditions for effective policy, i.e., what the trade-offs are.21The Phillips CurveUπPhillips Curve22The Phillips Curve• Position and slope are important¾ Position identifies the attainable goals• Points off the curve are not attainable¾ Slope identifies the trade-off• Steep curve => big change in inflation for small change in unemployment• Flat curve => small change in inflation for big change in unemployment23The Phillips CurveUπPC∆π∆π∆ U ∆ U24The Phillips Curve• Instability of the Phillips Curve¾ The actual relationship between inflation and unemployment has been unstable.• Hypothetical shape valid only for short time periods• Shifts generally due to supply shocks525The Phillips CurveUπPCPCPC26The Phillips Curve• Long-Run and Short-Run Phillips Curves¾ In the short-run, there may be a trade-off .• A difficult policy tool because of potential shifts.• Still one of the most relied on short-term decision making tools.¾In the long-run, there is no trade-off. • The Phillips curve is vertical at the natural