week 5_sii2013 [compatibility mode](2)

8/14/2019 Week 5_SII2013 [Compatibility Mode](2)

1/65

WEEK 6

Inflation, Jones, Chapter 8


2/65

Inflation

The percentage change in an economy s overallprice level

Hyperinflation an episode of extremely high inflation Greater than 500 percent per year

Example: Post World War I Germany

Deflation

A negative growth rate of the general price level in aneconomy


3/65

The inflation rate is computed as the

annual percentage change in the pricelevel

The Consumer Price Index (CPI)

Price index for a bundle of consumer goods

Price level inyear t


4/65


5/65

Case Study: How Much Is That?

We can use the CPI to evaluate thevalue of a good in 1950 in today sdollars.


6/65


7/65

Multiply the price of the good in 1950times the ratio of the CPI in today sdollars to the CPI in 1950 dollars.

Its not as large of a difference as theraw numbers may lead you to believe.

Other price indexes The CPI excluding food and energy prices The GDP deflator


8/65

Today

Currency is fiat money.

Currency is paper that the governmentsimply declares is worth a certain price. Money has value because we expect others

will value it.

8.2 The QuantityTheory of Money


9/65


10/65

Other measures of currency:

M1 adds demand deposits to the money base

M2 adds savings accounts and money marketaccount balances to M1


11/65


12/65

The Quantity Equation

The quantity theory of money allows usto make the connection between money

and inflation.

Price

level

Real

GDP

Money

supply

Velocityof money


13/65

Velocity of money The average number of times per year that

each piece of paper currency is used in a

transaction The equation implies that the amount of

money used in purchases is equal tonominal GDP.


14/65

The Classical Dichotomy Constant!elocity and the Central "an#

The classical dichotomy States that, in the long run, the real and

nominal sides of the economy arecompletely separate.


15/65

In the quantity theory of money Real GDP is assumed as exogenously given Determined by real forces.

In other words:

Bar over the Y means exogenous.


16/65

The velocity of money

Exogenously given constant Assumed to be constant over time

In other words:

No timesubscript


17/65

The money supply

Determined by the central bank Monetary policy is exogenously given

In other words:


18/65


19/65


20/65


21/65

Prices will rise as a result of

Increases in the money supply Decreases in real GDP

In the long run, the key determinant of theprice level is the money supply.


22/65

The Quantity Theory for Inflation

We can express the quantity equation interms of growth rates.

Using g as growth rate


23/65


24/65

Quantity Theory of Money Changes in the growth rate of money lead

one-for-one to changes in the inflation rate. Empirically, this holds up both in U.S. and

worldwide data.

Deflation Occurs when inflation rates are negative


25/65


26/65

According to the quantity theory of moneyinflation (an increase in P ) is always a purelymonetary phenomenon.

If the money supply does not change, theprice level will not change.

The view that changes in the money supplyaffect only the price level, without a change inthe level of output, is called the strictmonetarist view.

This view is not compatible with a nonverticalAS curve in the AS / AD model.


27/65

The strict monetarist view is not compatible with anon-vertical AS curve in the AS / AD model.


28/65

Problems with the quantity theory of money: theassumption of a constant velocity of money


29/65

Monetarists claimed that the Great Depression was amonetary phenomenon.


30/65

Market CrashesOn October 24, 1929 the market crashes. Why?

falling industrial production was reported inAugust of 1929 (the actual recession begins inAugust)tight monetary policy by the Fedanticipated Smoot-Hawley (or Hawley-Smoot)tariff legislation (discussed below)

pessimistic experts such as Roger Babson,who forecasted the stock market crash,September 7, 1929.


31/65


32/65


33/65

Monetarism and the greatdepression Monetarists believed that the Great Depression was caused by

contractionary monetary policies that reduced AD

The collapse of the financial system was more a by-product ofthe Great Depression than its cause

Figure 4.1: Despite a constant M1 until about 1931 indeed M1dropped noticeably.

Bank deposit, lending and the money multiplier droppeddramatically

Thus, much of the fall in Money was the result rather than thecause of the great depression


34/65

Figure 4.1


35/65

'e&isitin( the Classical Dichotomy

When all prices in the economy double,relative prices are unchanged.

When the relative prices of goods areunchanged, nothing real is affected.


36/65

The neutrality of money says that changesin the money supply Have no real effects on the economy

Only affect prices Empirically

Holds in the long run Does not hold in the short run

nominal prices do not respond immediatelyto changes in the money supply


37/65

8.3 Real and Nominal InterestRates

The real interest rate Is equal to the marginal product of capital Is paid in goods

The nominal interest rate Is the interest rate on a savings account

Is paid in dollars


38/65


39/65


40/65

Empirically The real interest rate has been negative This implies that in the short run the real

interest rate need not equal the MPK.


41/65

D fl ti


42/65

In 2009, an interesting event occurred: the real interestrate actually became larger than the nominal interest rate.How could this happen? What happened to inflation in2009? If the real interest rate were always equal to themarginal product of capital, then these negative rateswould be puzzling; the marginal product of capital is the

extra amount of output that could be produced byinstalling an extra unit of capital, and this amount is surelynot negative. The graph, then, suggests that in the shortrun, the real interest rate can depart from the marginalproduct of capital.

Deflation


43/65

8.4 Costs of Inflation

Individuals who are hurt during inflation: An individual who has a pension that is not

indexed to inflation A bank that issues loans at fixed rates but

that pays interest rates that move with themarket An individual with a variable rate mortgage


44/65

Large surprise inflations can lead to largedistributions in wealth. People with debts can pay back their loans

with new cheaper dollars. Creditors wind up losers.


45/65

Taxes Based on nominal incomes

Economic decisions Based on real variables

Tax distortions are more severe wheninflation is high.


46/65

Inflation also distorts relative prices. Some prices are faster at adjusting to inflation

than other prices are.

Shoe leather costs of inflation People want to hold less money when

inflation is high.

Menu costs The costs to firms of changing prices

frequently.


47/65

Case Study: The )a(e*$rice Spiral and$resident +i,on s $rice Controls

At the time, the view was: Strong unions pushed for high wages Strong corporations translated rising costs

to rising prices Strong unions demanded even higher

wages.

Wage-price spiral, resulting in inflation


48/65

Nixon froze wages and prices for 90 daysto break the spiral. High unemployment resulted from an

expansionary policy that brought the return ofinflation.

Price controls also distort economicdecisions.

8 5 The Fiscal Causes of High


49/65

8.5 The Fiscal Causes of High

Inflation The government budget constraint

Governmentfunds

Tax revenue

Borrowing

Changes inthe stock ofmoney

The government budget constraint says


50/65

The government budget constraint says

that the government has three basic waysto finance its spending. Taxes

Borrowing Printing money

If none of those methods work, thegovernment may be forced to print moneyto satisfy the budget constraint.

Hyperinflations are generally a reflection ofsuch fiscal problems.


51/65

If a government runs large budget deficits,


52/65

g g gas debt rises Lenders may worry the government will have

trouble paying back loans

They may stop lending to the governmentaltogether.

Debt solution: Raising taxes? May not be politically feasible

The government may resort to printing

currency to finance its budget. Lenders to the government will be paid backin currency that is worth less than the dollars

lent.


53/65

Central "an# Independence

Monetary Policy Conducted by Federal Reserve Fiscal Policy

President and Congress

Central Bank Independence

An attempt to prevent fiscal considerationsfrom leading to excessive inflation


54/65

Case Study: Episodes of Hi(hInflation

Episodes of high inflation tend to recur. Hyperinflations can stop just as quickly

as they start.

Countries experiencing hyperinflationtypically raise about 5 percent of GDPfrom the inflation tax.

Argentina raised 10 percent of GDP thisway.


55/65


56/65


57/65

Hyperinflation Ends when the rate of money growth falls

rapidly

The government gets its finances in orderthrough lower spending, higher taxes, andnew loans

The coordination problem People build their expectations into the prices

they set.


58/65

8.6 The Great Inflation of the1970s

During the Great Inflation, The rate peaked below 15 percent

Yet the inflation tax was a small fraction ofgovernment spending


59/65

Inflation rose in the 1970s for the followingreasons: OPEC coordinated increases in oil prices that

spurred inflation. The Federal Reserve grew the money supply

too rapidly. Policymakers pursued such a policy because

of the productivity slowdown.

Deflation and the Great


60/65

Deflation and the GreatDepression

End This Depression Now! (Paul Krugman)

The great American economist Irving Fisher laid out the story in a classic1933 article titled The Debt-Deflation Theory of Great Depressions

Imagine, said Fisher, that an economic downturn creates a situation inwhich many debtors find themselves forced to take quick action to reducetheir debt. They can liquidate, that is, try to sell whatever assets they have,and/or they can slash spending and use their income to pay down theirdebts. Those measures can work if not too many people and businessesare trying to pay down debt at the same time.

But if too many players in the economy find themselves in debt trouble atthe same time, their collective efforts to get out of that trouble are self-defeating. If millions of troubled homeowners try to sell their houses to pay

off their mortgagesor, for that matter, if their homes are seized bycreditors, who then try to sell the foreclosed propertiesthe result isplunging home prices, which puts even more homeowners underwater andleads to even more forced sales.

D fl ti


61/65

Deflation

More from Fisher: The more the debtors pay, the


62/65

p y

more they owe. End This Depression Now! (Paul Krugman) If banks worry about the amount of Spanish and Italian debt on their books,

and decide to reduce their exposure by selling off some of that debt, the

prices of Spanish and Italian bonds plungeand that endangers thestability of the banks, forcing them to sell even more assets.

If consumers slash spending in an effort to pay off their credit card debt, theeconomy slumps, jobs disappear, and the burden of consumer debt getseven worse. And if things get bad enough, the economy as a whole cansuffer from deflationfalling prices across the boardwhich means that thepurchasing power of the dollar rises, and hence that the real burden of debtrises even if the dollar value of debts is falling.

Irving Fisher summed it up with a pithy slogan that was a bit imprecise, but

gets at the essential truth He argued that this was the real story behind the Great Depressionthat

the U.S. economy came into a recession with an unprecedented level ofdebt that made it vulnerable to a self-reinforcing downward spiral.

Th G D i d h


63/65

The Great Depression and theDebt-Deflation theory

Irving Fisher: financial systems are responsible for the business

cycle The focus is on volatile lending and borrowing behaviors During booms we have lending booms and build ups of debt As the debt grows firms and households positions become

more fragile

If a negative external shock happens can significantly changemarket perceptions. In particular say a drop in M, a rise in theinterest rate can induce borrowers to sell part of their assets inan attempt to recoup part of their debt.

Herd behavior and panic. The more asset prices drop the more

fragile the financial position of indebted agents become becauseDEBT IS NOT INDEXED. A drop in P reduces the price of assets but does not reduce the

value of the debt Eventually many firms and households become insolvent.

P i H d B h i d


64/65

Panic, Herd Behavior andExpectations

Fisher believed that market agents tendto overreact

Lenders and borrowers are somehow

irrational even in terms of expectations So a good questions is about the

formulation of expectations


65/65

Fisher and deflation Deflation, whether caused by P falling or by

the falling of assets prices, is extremelycostly. Debt is not indexed. When P drops, debt is

not changing, but asset real value drop. For Fisher this is what causes risk of

insolvency, credit reductions and recessions However, the relationship between deflation

and output is not the same across time andspace. Large debt can be very much affectedby a moderate deflation, while a moderatedeflation may not cause any panic in case ofmoderate debt.

week 5_sii2013 [compatibility mode](2)

Documents