inflation. 1 fresh classes of ma economics external ku fresh classes of ma economics external ku...
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InflationInflation
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FRESH CLASSES OF MA FRESH CLASSES OF MA ECONOMICS EXTERNAL KUECONOMICS EXTERNAL KU
INDIVIDUALS & GROUPSINDIVIDUALS & GROUPSNOMINAL FEENOMINAL FEEMICRO ECONOMICS, STATISTICS MICRO ECONOMICS, STATISTICS
& MACRO ECONOMICS& MACRO ECONOMICSGUESS PAPERS ARE ALSO GUESS PAPERS ARE ALSO
AVAILABLE.AVAILABLE.R-1173, 3R-1173, 3RDRD FLOOR ALNOOR FLOOR ALNOOR
SOCIETY, BLOCK 19, F.B.AREA, SOCIETY, BLOCK 19, F.B.AREA, KARACHI. NEAR POWER HOUSE & KARACHI. NEAR POWER HOUSE & MASJID E AQSA.MASJID E AQSA.
0322-33857520322-3385752
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JOIN KHALID AZIZJOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS,
B.COM.B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE FINANCIAL ACCOUNTING OF ICMAP STAGE
1,3,4 ICAP MODULE B, B.COM, BBA, MBA & 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.MODULE D, BBA, MBA & PIPFA.
CONTACT:CONTACT: 0322-33857520322-3385752 0312-23028700312-2302870 0300-25408270300-2540827 R-1173,ALNOOR SOCIETY, BLOCK R-1173,ALNOOR SOCIETY, BLOCK
19,F.B.AREA, KARACHI, PAKISTAN.19,F.B.AREA, KARACHI, PAKISTAN.
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Inflation is ...Inflation is ...
Inflation is a rise in the Inflation is a rise in the average price of goods average price of goods over timeover time
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Some questions about Some questions about inflationinflation
Why is inflation bad?Why is inflation bad?Inflation does have bad effects, but Inflation does have bad effects, but
some popular criticisms are based on some popular criticisms are based on
spurious reasoningspurious reasoning
What are the causes of inflation?What are the causes of inflation?
What can be done about it?What can be done about it?
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The quantity theory of The quantity theory of moneymoney
The quantity theory of money says The quantity theory of money says
that changes in the nominal money that changes in the nominal money
supply lead to equivalent changes in supply lead to equivalent changes in
the price level (and money wages) the price level (and money wages)
but do not have effects on output but do not have effects on output
and employment.and employment.
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The quantity theory (2)The quantity theory (2)
The quantity theory of money says:The quantity theory of money says: M V = P YM V = P Y
where V = velocity of circulationwhere V = velocity of circulation If prices adjust to maintain real income (Y) at If prices adjust to maintain real income (Y) at
the potential level and if velocity stays the potential level and if velocity stays constantconstant
then an increase in nominal money supply then an increase in nominal money supply leads to an equivalent increase in pricesleads to an equivalent increase in prices
but if velocity is variable or prices are but if velocity is variable or prices are sluggish, this link is broken.sluggish, this link is broken.
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Money and pricesMoney and prices
Milton Friedman famously claimed Milton Friedman famously claimed
‘‘Inflation is always and everywhere a Inflation is always and everywhere a
monetary phenomenon.’monetary phenomenon.’ i.e. it results when money supply grows more i.e. it results when money supply grows more
rapidly than real output.rapidly than real output.
But this does not prove that causation is But this does not prove that causation is
always from money to pricesalways from money to prices e.g. if the government adopts an e.g. if the government adopts an accommodatingaccommodating
monetary policy.monetary policy.
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Money and inflation (2)Money and inflation (2)
……but in the long run, changes in real but in the long run, changes in real income and interest rates significantly income and interest rates significantly alter real money demandalter real money demand
so there may not be a perfect so there may not be a perfect correspondence between excess monetary correspondence between excess monetary growth and inflation.growth and inflation.
And in the short run, the link between And in the short run, the link between money and prices may be broken ifmoney and prices may be broken if velocity of circulation is variablevelocity of circulation is variable prices are sluggishprices are sluggish
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Inflation and interest Inflation and interest ratesrates
FISHER HYPOTHESISFISHER HYPOTHESIS a 1% increase in inflation will be accompanied by a 1% increase in inflation will be accompanied by
a 1% increase in interest ratesa 1% increase in interest rates REAL INTEREST RATEREAL INTEREST RATE
Nominal interest rate – inflation rateNominal interest rate – inflation rate i.e. the Fisher hypothesis says that i.e. the Fisher hypothesis says that realreal interest interest
rates do not change muchrates do not change much but the nominal interest rate is the opportunity but the nominal interest rate is the opportunity
cost of holding moneycost of holding money so a change in nominal interest rates affects so a change in nominal interest rates affects real real
money demandmoney demand
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HyperinflationHyperinflation
… … periods when inflation rates are very periods when inflation rates are very largelarge
in such periods there tends to be a ‘flight in such periods there tends to be a ‘flight from money’from money’ people hold as little money as possiblepeople hold as little money as possible
e.g. Germany in 1922-23, Hungary 1945-46, Brazil in the e.g. Germany in 1922-23, Hungary 1945-46, Brazil in the late 1980s.late 1980s.
Large government budget deficits help to Large government budget deficits help to explain such periodsexplain such periods persistent inflation must be accompanied by persistent inflation must be accompanied by
continuing money growthcontinuing money growth
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The Phillips curveThe Phillips curve
It suggests we can trade-off more inflation forless unemployment orvice versa.
Prof. A W Phillips demonstrated a statistical relationshipbetween annual inflation and unemployment in the UK
Unemployment rate (%)
Infla
tion
rate
(%
)
The Phillips curve showsthat a higher inflation rateis accompanied by a lower unemployment rate.
Phillips curve
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The Phillips curve and an The Phillips curve and an increase in aggregate demandincrease in aggregate demand
Unemployment
Infla
tion
PC0U*
Suppose the economy begins at E, with zeroinflation, unemploymentat the natural rate U*...
U1
1
An increase in governmentspending funded by an expansion in money supplytakes the economy to A,with lower unemploymentbut inflation at 1.
A
… but what happens next?
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The Phillips curve and an The Phillips curve and an increase in aggregate demandincrease in aggregate demand
Unemployment
Infla
tion
PC0U*U1
1
A
If nominal money supply is fixed in the long run,and prices and wageseventually adjust, theeconomy moves back to E.
E
But nominal money supplyneed not be constant in thelong run
so we may find the economy finds its way back to the natural rate, but with continuing inflation at C.
C
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The vertical Phillips curveThe vertical Phillips curve
Unemployment
Infla
tion
PC0U*U1
1
A
E
C
Effectively, the long-run Phillips curve is vertical, as the economy always adjusts back to U*.
LRPC
The short-run Phillips curveshows just a short-run trade-off –
its position may dependupon expectations aboutinflation.
PC1
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Expectations and credibilityExpectations and credibility
Unemployment
Infla
tion
PC2
PC1
1
U*
Unemployment rises to U1
U1
Suppose the economy beginsat E, with a newly-elected government pledged toreduce inflation.
E
LRPC
Monetary growth is cut to 2.
2
In the short run, the economymoves to A along the short-run Phillips curve.A
As expectations adjust, the short-run Phillips curveshifts to PC2, and U*is restored at F.
F
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Inflation and unemploymentInflation and unemploymentin the UK 1978-99in the UK 1978-99
02468
1 01 21 41 61 82 0
4 6 8 1 0 1 2
U n e m p l o y m e n t
Infl
atio
n
1978
1980
1986
1990
1999 1993
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Inflation illusionInflation illusion
People have inflation illusion when People have inflation illusion when they confuse nominal and real they confuse nominal and real changes.changes.
People’s welfare depends upon real People’s welfare depends upon real variables, not nominal variables.variables, not nominal variables.
If all nominal variables (prices and If all nominal variables (prices and incomes) increase at the same rate, incomes) increase at the same rate, real income does not change.real income does not change.
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The costs of inflationThe costs of inflation
Fully anticipated inflation:Fully anticipated inflation: Institutions adapt to known inflation:Institutions adapt to known inflation:
nominal interest ratesnominal interest rates tax ratestax rates transfer paymentstransfer payments
no inflation illusionno inflation illusion
Some costs remain:Some costs remain: shoe-leathershoe-leather
people economize on money holdingspeople economize on money holdings menu costsmenu costs
firms need to alter price lists etc.firms need to alter price lists etc.
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The costs of inflation (2)The costs of inflation (2)
Even if inflation is fully anticipated, Even if inflation is fully anticipated, the economy may not fully adaptthe economy may not fully adaptinterest rates may not fully reflect interest rates may not fully reflect
inflationinflationtaxes may be distortedtaxes may be distorted
fiscal drag may have unintended effects on fiscal drag may have unintended effects on tax liabilitiestax liabilities
capital and profits taxes may be distortedcapital and profits taxes may be distorted
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The costs of unanticipated inflationThe costs of unanticipated inflation
Unintended redistribution of incomeUnintended redistribution of incomefrom lenders to borrowersfrom lenders to borrowersfrom private to public sectorfrom private to public sectorfrom young to oldfrom young to old
UncertaintyUncertaintyfirms find planning more difficult under firms find planning more difficult under
inflation, which may discourage inflation, which may discourage investmentinvestment
This has been seen as the most This has been seen as the most important cost of inflationimportant cost of inflation
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Defeating inflationDefeating inflation
In the long run, inflation will be low if In the long run, inflation will be low if the rate of money growth is low.the rate of money growth is low.
The transition from high to low The transition from high to low inflation may be painful if inflation may be painful if expectations are slow to adjust.expectations are slow to adjust.
Policy credibility may speed the Policy credibility may speed the adjustment processadjustment process
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JOIN KHALID AZIZJOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS,
B.COM.B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE FINANCIAL ACCOUNTING OF ICMAP STAGE
1,3,4 ICAP MODULE B, B.COM, BBA, MBA & 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.MODULE D, BBA, MBA & PIPFA.
CONTACT:CONTACT: 0322-33857520322-3385752 0312-23028700312-2302870 0300-25408270300-2540827 R-1173,ALNOOR SOCIETY, BLOCK R-1173,ALNOOR SOCIETY, BLOCK
19,F.B.AREA, KARACHI, PAKISTAN.19,F.B.AREA, KARACHI, PAKISTAN.