Lecture10 inflation

19/08/2012

10
Causes of Inflation
and the Philips Curve

Causes of Inflation

Definition and Measurement

Definition: Inflation is a continuous increase
in the general price level.
Measurement: Percentage change in the
general price level.
πt = [( Pt - Pt-1)/ Pt-1].100 (%)
General price level: measured by either
Consumer Price Index (CPI) or GDP deflator
(DGDP).

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Category of Inflation
Mild inflation
High inflation:
Hyper inflation: According to Philip
Cagan, inflation rate being from 50% per
month to 13.000% per year.

Figure 1 Inflation in the US, 1960-2002

16

14

12

10
% per year

8

6

4

2

0
1960 1965 1970 1975 1980 1985 1990 1995 2000

inflation rate inflation rate trend

Vietnam’s CPI in 2008
Chỉ số giá tháng 10 năm 2008 so với (%) Chỉ số giá 10
tháng đầu năm
Kỳ gốc Tháng 10 Tháng 12 Tháng 9 2008 so với
cùng kỳ năm
năm 2005 năm 2007 năm 2007 năm 2008
2007

CHỈ SỐ GIÁ TIÊU DÙNG 148,20 126,72 121,64 99,81 123,15
I. Hàng ăn và dịch vụ ăn uống 172,14 140,56 132,12 99,58 136,95
Trong đó: 1- Lương thực 201,99 160,06 151,41 98,09 149,58
2- Thực phẩm 161,16 132,82 124,44 100,01 133,05
3. Ăn uống ngoài gia đình 169,86 139,54 131,37 100,47 131,92
II. Đồ uống và thuốc lá 128,32 113,27 111,34 100,67 110,21
III. May mặc, mũ nón, giầy dép 126,05 112,55 110,82 100,70 109,81
IV. Nhà ở và vật liệu xây dựng (*) 148,40 122,84 116,76 98,92 122,39
V. Thiết bị và đồ dùng gia đình 125,94 111,99 111,26 100,73 108,36
VI. Dược phẩm, y tế 123,00 109,76 108,75 100,58 108,72
VII. Phương tiện đi lại, bưu điện 138,44 124,82 119,56 99,06 116,66
Trong đó: Bưu chính viễn thông 83,46 89,21 90,39 99,82 88,44
VIII. Giáo dục 115,02 106,71 106,56 100,69 103,63
IX. Văn hoá, thể thao, giải trí 115,74 109,50 109,30 100,38 105,03
X. Đồ dùng và dịch vụ khác 132,35 114,65 111,69 6 100,85 113,11

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Typical Hyper inflation in the World
Germany Russia China Greece Hungary Bolivia Nicaragua

Begin 8/1922 12/1921 2/1947 11/1943 8/1945 4/1984 4/1987

End 11/1923 1/1924 3/1949 11/1944 7/1946 9/1985 3/1991

No. of months 16 26 26 13 12 18 48

Ratio of
1,02(1010) 1,24(105) 4,15(106) 4,7(108) 3,81(1027) 1028,5 5,53(105)
begin/end price
Average inflation
rate per month 322 57 79,7 365 19800 48,1 46,45
(%)
Highest inflation
rate per month 32400 213 919,9 85,5(106) 41,9(1015) 182,8 261,15
(%)

Money growth and inflation in four typical inflation

Period Monthly Money
Inflation rate growth
% %

Germany 8/1922 => 11/1923 322% 314%
Greece 11/1943 => 11/1944 365% 220%
Hungary 8/1945 => 7/1946 19,800% 12,200%
Poland 1/1923 => 1/1924 81.4% 72.2%

Source: Philip Cagan: The Monetary Dynamics of Hyperinflation, in Milton Friedman, ed.,
Studies in the Quantity Theory of Money (Chicago: University of Chicago press, 1956), p.26

INTERNATIONAL COMPARISON
OF MONEY AND PRICE INDICES (1990-2003)

Annual growth Annual growth Annual growth
Country
of GDP deflator of CPI of food price
Vietnam 11.6 2.8 -
China 4.9 6.0 11.3
The Philippines 7.7 7.3 6.7
Indonesia 15.3 13.9 16.1
Malaysia 3.4 3.1 4.3
Thailand 3.4 4.1 4.6
South Korea 4.8 4.5 4.8
Singapore 0.6 1.3 1.4

Source: WDI 2005

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Theories of Inflation

A. Causes of inflation
1. Demand-pull inflation: An increase in
aggregate demand
2. Cost-push inflation: An increase in prices
of factors of production. Examples:
• An increase in wage level.
• An increase in input prices
3. Inertial inflation
10

Fig.2 Demand-pull Fig.3 Cost-push
inflation inflation

P
P AS1 AS1

E1 AS0
P2 P1
AD2 P0
P1 E0

AD1 AD0
AD0
Y1 Y* Y
Y* Y2 Y

11

Figure 4 Inertial inflation

P AS3
AS2

AS1
P3

P2
P1
AD3

AD2
AD1

Y* Y
12

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B. Monetary approach to inflation
• Central insight: Changes in money supply is the
root cause of changes in the general price level.
• M. Friedman: “Inflation is always and
everywhere a monetary phenomenon... and it
occurs only when money grows faster than does
output”
• Quantity theory of money:
MV = PY
V = V
So: % change in P (π) =
= % change in M - % change in Y

Monetary approach to inflation

• Policy implications:
Tightening money supply is a core
solution to control inflation.
Tightening fiscal policy, too.

Fig.5 International data on money growth and inflation
Inflation rate 10,000
Democratic Republic
(percent,
logarithmic Nicaragua of Congo
scale) Angola
1,000 Georgia
Brazil

100 Bulgaria

10
Kuwait Germany

1 USA
Canada
Oman Japan

0.1
0.1 1 10 100 1,000 10,000
Money supply growth (percent, logarithmic scale)

Data for more than 100 countries in 1990s: Average growth of M1 and π

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Fig.6 Money growth and inflation in typical hyper inflation cases

10000

1000
percent growth

100

10

1
Israel Poland Brazil Argentina Peru Nicaragua Bolivia
1983-85 1989-90 1987-94 1988-90 1988-90 1987-91 1984-85

inflation growth of money supply
16

Inflation in Vietnam, 1987-2004

1987- 1990- 1995- 2000- 1987-
1989 1994 1999 2004 2004

Growth of CU 286.9 44.8 25.9 27.3 78.9

Growth of M1 286.9 44.8 25.9 27.3 78.9

Growth of M2 318.3 43.5 27.2 22.7 84.3

Openness degree 44.9 57.2 75.3 104.9 71.6

GDP growth rate 4.77 7.30 7.51 7.23 6.90
Inflation rate by
CPI 217.2 34.3 6.02 4.33 48.3
Inflation rate by
DGDP 281.1 36.4 9.38 3.76 63.9

Fig.7 Inflation rate and money growth rate in Vietnam,
1988-2004

900
800
700
600
500
400
300
200
100
0
-100
87

89

91

93

95

97

99

01

03
19

19

19

19

19

19

19

20

20

L m phát M2

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19/08/2012

Inflation Tax (IT) and Seiniorage (SE)
• Seiniorage is the revenue earned by
government from printing money.
∆M ∆M M P
=
P + ∆P M P P + ∆P
• Inflation tax: Inflation reduces purchasing
power of money in circulation.
M M P + ∆P − P ∆P M P
− =M =
P P + ∆P P( P + ∆P) P P P + ∆P

ThuÕ ®óc tiÒn ë mét sè n−íc, 1975-90*
N−íc % so víi nguån thu ngoµi % GDP
thuÕ ®óc tiÒn
Mü 6,02 1,17
Canada 6,61 1,26
Anh 5,31 1,91
Italia 28,00 6,60
Ph¸p 7,19 2,73
§øc 3,85 1,08
Bolivia** 139,5 5,00
Brazil 18,36 4,13
Chile 7,48 2,39
Ê n ®é 14,30 1,81
Hµn quèc 10,70 1,84
Mªhic« 18,70 2,71
Philippines 7,79 0,99
Thai lan 7,06 0,94
Thæ nhÜ kú 24,40 5,09
Vªnzuela 10,76 3,05
Peru 29,71 4,92
Israel 24,55 2,99
*TÝnh trung b×nh n¨m
**cña giai ®o¹n 1977-1985
20
Nguån : J. D. Sachs and F. Larrain, Macroeconomics in the Global Economy, trang 341.

Inflation and economic growth relation
T. Killick (1981): U-turn shape relation
between inflation and economic growth:
− Inflation has positive impacts on economic growth at
a low level, while it has negative impacts on econ.
growth at high level.
M. Khan and A. Senhadji (2000), with data on
140 countries in the period 1960-1998:
Inflation has an influence on the threshold of
economic growth. The range of optimal
inflation rate is:
− 1-3% per year for industrial countries, and
− 7-11% per year for developing countries

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Fig.8 U-turn shape relation
between inflation and economic growth
gY

gYmax

π* π

Controlling inflation

• Tightened fiscal policy
• Reducing G or LAS
P
increasing T results in
a reduction in Y and P. SAS
• Costs of reducing Po E1
inflation is lower Y and P1 Eo
higher U ADo

AD1

Y1 Y0 Y

Controlling inflation
• Tightened monetary
policy
• Contractionary LAS
P
monetary policy results
SAS
in higher interest rate,
Po E1
which in turn reduces
investment, and thus Y. P1 Eo
ADo
• Costs of reducing
inflation is lower Y and AD1

higher U
Y1 Y0 Y

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19/08/2012

The Short-Run Tradeoff
between Inflation and
Unemployment : Philips Curve

Unemployment and Inflation
• The natural rate of unemployment depends on
various features of the labor market.
• Examples include minimum-wage laws, the
market power of unions, the role of efficiency
wages, and the effectiveness of job search.
• The inflation rate depends primarily on growth
in the quantity of money, controlled by the
Fed.

Unemployment and Inflation
• Society faces a short-run tradeoff between
unemployment and inflation.
• If policymakers expand aggregate demand,
they can lower unemployment, but only at the
cost of higher inflation.
• If they contract aggregate demand, they can
lower inflation, but at the cost of temporarily
higher unemployment.

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19/08/2012

THE PHILLIPS CURVE

• The Phillips curve illustrates the
short-run relationship between
inflation and unemployment.

Figure 9 The Phillips Curve

Inflation
Rate
(percent
per year)

6 B

A
2

Phillips curve

0 4 7 Unemployment
Rate (percent)

Aggregate Demand, Aggregate Supply, and
the Phillips Curve

• The Phillips curve shows the short-
run combinations of unemployment
and inflation that arise as shifts in the
aggregate demand curve move the
economy along the short-run
aggregate supply curve.

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19/08/2012

Aggregate Demand, Aggregate Supply, and
the Phillips Curve

• The greater the aggregate demand for
goods and services, the greater is the
economy’s output, and the higher is the
overall price level.
• A higher level of output results in a lower
level of unemployment.

Figure 8 How the Phillips Curve is Related to
Aggregate Demand and Aggregate Supply

(a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve

Price Inflation
Level Short-run Rate
aggregate (percent
supply per year)
6 B
106 B

102 A
High
A
aggregate demand 2
Low aggregate
Phillips curve
demand
0 7,500 8,000 Quantity 0 4 7 Unemployment
(unemployment (unemployment of Output (output is (output is Rate (percent)
is 7%) is 4%) 8,000) 7,500)

SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF EXPECTATIONS
• The Phillips curve seems to offer
policy-makers a menu of possible
inflation and unemployment
outcomes.

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The Long-Run Phillips Curve

• In the 1960s, Friedman and Phelps
concluded that inflation and
unemployment are unrelated in the long
run.
• As a result, the long-run Phillips curve is
vertical at the natural rate of unemployment.
• Monetary policy could be effective in the
short run but not in the long run.

Figure 9 The Long-Run Phillips Curve

Inflation
Rate Long-run
Phillips curve

High B
1. When the inflation
Fed increases
the growth rate
of the money
supply, the
rate of inflation 2. . . . but unemployment
increases . . . A remains at its natural rate
Low
in the long run.
inflation

0 Natural rate of Unemployment
unemployment Rate

Figure 10 How the Phillips Curve is Related to
Aggregate Demand and Aggregate Supply


Price Long-run aggregate Inflation Long-run Phillips
Level supply Rate curve
1. An increase in 3. . . . and
the money supply increases the
increases aggregate inflation rate . . .
B
P2 demand . . . B
2. . . . raises
the price
A
level . . . P A
AD2
Aggregate
demand, AD
0 Natural rate Quantity 0 Natural rate of Unemployment
of output of Output unemployment Rate
4. . . . but leaves output and unemployment
at their natural rates.

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Expectations and the Short-Run Phillips Curve

• Expected inflation measures how much
people expect the overall price level to
change.
• In the long run, expected inflation adjusts to
changes in actual inflation.
• The Fed’s ability to create unexpected inflation
exists only in the short run.
• Once people anticipate inflation, the only way to
get unemployment below the natural rate is for
actual inflation to be above the anticipated rate.

Expectations and the Short-Run Phillips Curve

Unemployment Rate =

Natural rate of unemployment - a Actual − Expected
inflation inflation ( )
• This equation relates the unemployment
rate to the natural rate of
unemployment, actual inflation, and
expected inflation.

Figure 11 How Expected Inflation Shifts
the Short-Run Phillips Curve

2. . . . but in the long run, expected
inflation rises, and the short-run
Inflation Phillips curve shifts to the right.
Rate Long-run
Phillips curve

C
B

Short-run Phillips curve
with high expected
inflation

A
1. Expansionary policy moves
with low expected
the economy up along the
inflation
short-run Phillips curve . . .
unemployment Rate

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The Natural Experiment for the Natural-Rate
Hypothesis

• The view that unemployment
eventually returns to its natural rate,
regardless of the rate of inflation, is
called the natural-rate hypothesis.
• Historical observations support the
natural-rate hypothesis.

The Natural Experiment for the Natural Rate
Hypothesis

• The concept of a stable Phillips curve
broke down in the in the early ’70s.
• During the 1970’s and 1980’s, the
economy experienced high inflation
and high unemployment
simultaneously.

Figure 12 The Phillips Curve in the 1960s

Inflation Rate
(percent per year)

10

8

6

1968
4
1966
1967

2
1965 1962
1964 1961
1963

0 1 2 3 4 5 6 7 8 9 10 Unemployment
Rate (percent)

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Figure 13 The Breakdown of the Phillips Curve

Inflation Rate
(percent per year)

10

8

6 1973
1971
1969 1970
1968 1972
4
1966
1967

2 1962
1965
1964 1961
1963

0 1 2 3 4 5 6 7 8 9 10 Unemployment
Rate (percent)

THE ROLE OF SUPPLY SHOCKS
• Historical events have shown that the short-run
Phillips curve can shift due to changes in
expectations.
• The short-run Phillips curve also shifts because
of shocks to aggregate supply.
• Major adverse changes in aggregate supply can
worsen the short-run tradeoff between
unemployment and inflation.
• An adverse supply shock gives policymakers a less
favorable tradeoff between inflation and
unemployment.

• A supply shock is an event that directly
alters the firms’ costs, and, as a result, the
prices they charge.
• This shifts the economy’s aggregate
supply curve. . .
• . . . and as a result, the Phillips curve.

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Figure 14 An Adverse Shock to Aggregate Supply


Price Inflation
Level AS2 Rate 4. . . . giving policymakers
Aggregate a less favorable tradeoff
supply, AS between unemployment
and inflation.
B
P2 B
3. . . . and 1. An adverse
raises A shift in aggregate A
the price P supply . . .
level . . . PC2
Aggregate
demand Phillips curve, P C
0 Y2 Y Quantity 0 Unemployment
of Output Rate
2. . . . lowers output . . .

• In the 1970s, policymakers faced two
choices when OPEC cut output and raised
worldwide prices of petroleum.
• Fight the unemployment battle by
expanding aggregate demand and
accelerate inflation.
• Fight inflation by contracting aggregate
demand and endure even higher
unemployment.

Figure 15 The Supply Shocks of the 1970s

Inflation Rate
(percent per year)

10
1981 1975
1980
1974
1979
8
1978

6 1977
1973 1976

4 1972

2

0 1 2 3 4 5 6 7 8 9 10 Unemployment
Rate (percent)

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19/08/2012

THE COST OF REDUCING INFLATION

• To reduce inflation, the Fed has to pursue
contractionary monetary policy.
• When the Fed slows the rate of money
growth, it contracts aggregate demand.
• This reduces the quantity of goods and
services that firms produce.
• This leads to a rise in unemployment.

Figure 16 Disinflationary Monetary Policy
in the Short Run and the Long Run

1. Contractionary policy moves
the economy down along the
Inflation short-run Phillips curve . . .
Long-run
Rate
Phillips curve

A

with high expected
inflation
C B

with low expected
inflation
unemployment 2. . . . but in the long run, expected Rate
inflation falls, and the short-run
Phillips curve shifts to the left.


• To reduce inflation, an economy must endure
a period of high unemployment and low
output.
• When the Fed combats inflation, the economy
moves down the short-run Phillips curve.
• The economy experiences lower inflation but at
the cost of higher unemployment.

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19/08/2012


• The sacrifice ratio is the number of
percentage points of annual output that
is lost in the process of reducing inflation
by one percentage point.
• An estimate of the sacrifice ratio is five.
• To reduce inflation from about 10% in 1979-
1981 to 4% would have required an
estimated sacrifice of 30% of annual output!

Summary
• The Phillips curve describes a negative
relationship between inflation and
unemployment.
• By expanding aggregate demand, policymakers
can choose a point on the Phillips curve with
higher inflation and lower unemployment.
• By contracting aggregate demand, policymakers
can choose a point on the Phillips curve with
lower inflation and higher unemployment.

Summary
• The tradeoff between inflation and
unemployment described by the Phillips
curve holds only in the short run.
• The long-run Phillips curve is vertical at
the natural rate of unemployment.

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19/08/2012

Summary
• The short-run Phillips curve also shifts
because of shocks to aggregate supply.
• An adverse supply shock gives
policymakers a less favorable tradeoff
between inflation and unemployment.

Summary
• When the Fed contracts growth in the
money supply to reduce inflation, it
moves the economy along the short-run
Phillips curve.
• This results in temporarily high
unemployment.
• The cost of disinflation depends on how
quickly expectations of inflation fall.

19

Lecture10 inflation

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