Macro Economics October 11 2011 Inflation Deflation Continued 10 13 2011 During 1960s Actual and expected pi LOW I on 30 year mortgages LOW During 1970s pi unexpectedly HIGH o winners people who borrowed in 1960s losers banks savings and loans If you borrowed in late 1970s E pi HIGH I HIGH you lost when it fell unexpectedly in 1980s Caveat if pi is too low relative to expectations i e DEFLATION then borrowers may default hurting lenders i e Great Depression Debt Deflation economy slips into a recession wages and prices fall deflation borrows default bank failures back to economy slipping to a recession o another contribution due to Irving Fisher Currently we have deflation in housing Desire to avoid debt deflation is why federal reserve targets a low positive pi rate 2 rather than 0 inflation or deflation o no deflation in US since WWII True Costs of Inflation 1 Inflation Tax all pi anticipated or not reduces real value of cash i e suppose I keep 10 000 in a safe at home if pi is 10 the real value of my stash will decrease by 10 can only avoid inflation tax by keeping your wealth in some interest bearing forms bank bonds business stocks etc if anticipated pi returns on non cash assets can adjust to offset expected pi empirically cash is a tiny fraction of aggregate US wealth pi tax is not that important for aggregate US economy inflation tax is more important in circumstances where cash is more prevalent i e poor people in the US less developed countries underground economy 2 Menu Shoe Leather Costs real resource costs incurred by business and houses in responding to inflation changing prices more frequently is costly to business i e having to change menus catalogs website prices time costs of spending more time searching for low prices i e driving to different gas stations to find lowest prices or time spent going to bank to avoid pi tax on cash o o o o o o o o o these costs are not large for low moderate pi but are very high during hyper inflation hyperinflation pi 100 per year America in 1980s examples on handout page 2 lower tables Europe in 1920s Latin usually associated with slow down of economy and recession What causes Hyper Inflation rapid growth of money supply why do governments print too much money o if governments have extremely high budget deflates that they can not finance by selling government bonds last resort is to print money to pay debts i e because of Treaty of Versilles Germany was hit hard so they had to print more money to pay things off o not going to happen here in the US Business cycles primarily caused by supply shocks changes in resources or technology that cause PPF PART II to shift in or out The Classical Model of Business Cycles popular pre 1930s main tool social production possibilities frontiers PPF o PPF represents economies resource technology change capabilities supply constraints o o o attainable will decline classical model says y axis market output x axis leisure home production c inefficient points on PPF represent max level of output y that society could produce given desired amount of leisure home production PPF slows down as people enjoy more leisure home production then market y o 1 absent interference in free market society will always be somewhere on PPF in this case by defining economy is always at full employment Y Y GDPGAP 0 UR UR UR not equal to 0 frictional unemployment is consistent with classical view o 2 business cycles in classical view primarily due to supply shocks changes in resources technology that shift PPF in or out October 9 2011 The Classical Model of Business Cycles 1 absent government interference in free market economy will choose some point on social production possibility frontier PPF resources are fully employed when economy is on PPF Y Y and UR URR on PPF i e point B not inside point C classical model assumes no unemployment only friction unemployment and people who choose leisure home production are not in labor force graph market y on y axis leisure home production x axis 2 business cycles primarily caused by supply shocks changes in resources or technology that cause PPF to shift in or out typical boom favorable supply shock internet invented good weather scientific breakthroughs oil discovery outward sift of PPF result of boom Yb Ya leisure B leisure A employment B employment A typical recession adverse supply shock shifts PPF in i e oil embargo bad weather natural disasters result Yd Yc recession leisure D employment C o o o o o o o o o employment changes in response to supply shocks are caused by voluntary substitution between market work and leisure home production due to real wage changes o typical boom favorable supply shock shifts PPF out productivity rises real wage from market work increase encourages households to work more employment rises o typical recession adverse supply shock PPF shifts in productivity decrease real wages decrease households substitute away from market work towards home production 3 other possible sources of business cycle fluctuations in classical model o A preference shifts between market output and leisure home production i e during WWII 1941 45 surge of patriotism in US households willing to give up leisure home production to increase market output of war goods classical model surge in patriotism caused movement up to left along PPF as opposed to a shift production from A to B more Y more employment less leisure home after war ended preferences reverted to normal economy goes back to point A post war recession o B government regulations can cause inefficiencies that leave economy inside PPF if we impose new greenhouse gas rules could push us inside PPF from E to F recession i e Smoot Hawley tariff of 1930 lifting regulations could get us back to PPF F to E boom 4 recessions in classical view are not driven by a lack of aggregate demand business inability to sell products o Say s law supply creates it s own demand for any given level of Y firms produce they will pay amount equal to Y in factor payments wages interest profits those payments will be spent buying Y o constraints on Y according to classical view resources technology supply constraints preference between market Y leisure home production regulations 5 no role for government stabilization policy governments should not fight recessions recessions are efficient responses to supply shocks or preference changes Shortcomings of the Classical View 1 can t explain great depression no changes in resources technology
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