Lectures in Macroeconomics- Charles W. Upton

Optimal Inflation

0 eRN rr

Optimal Inflation

The Optimal Inflation Rate

• The private cost of holding money is rN• Economic Efficiency requires setting

PC=SC.

Optimal Inflation

The Optimal Inflation Rate

• The private cost of holding money is rN• Economic Efficiency requires setting

PC=SC.

SC = 0

Optimal Inflation

The Optimal Inflation Rate

0 eRN rr

Optimal Inflation

The Optimal Inflation Rate

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Optimal Inflation

The Optimal Inflation Rate

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Optimal Inflation

The Optimal Inflation Rate

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Optimal Inflation

The Optimal Inflation Rate

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Optimal Inflation

Conclusion

• A 1% inflation rate costs $250 million

• Concentrate on price stability

Optimal Inflation

Uncertainty Costs

• Suppose next year's inflation rate is equally likely to be three, six, or nine percent.

3

1%)9(

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1%)6(

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P

P

P

Optimal Inflation

Production

• The CEO of Acme Widgets must price the product a year in advance.

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P

P

P

Optimal Inflation

Production

• If the inflation rate turns out to be exactly six percent, the right price would be $1.00 each.

P$1

Optimal Inflation

Production

• If the inflation rate turns out to be 3%, he will have overpriced.

P$1

Optimal Inflation

Production

• If the inflation rate turns out to be 9%, he will have under priced.

P$1

Optimal Inflation

Production

• If the inflation rate turns out to be exactly six percent, the right price would be $1.00 each.

• If the inflation rate turns out to be nine percent, widgets would be priced 3% too low. He will sell more, but make less money.

• If the inflation rate turns out to be only three percent, widgets will be priced 3% too high and both demand and profits will suffer.

If the uncertainty can be ended, Acme can make more money.

At 3%, =$70

At 6%, = $100

At 9%, = $70

Optimal Inflation

Production

• If the inflation rate turns out to be exactly six percent, the right price would be $1.00 each.

• If the inflation rate turns out to be nine percent, widgets would be priced 3% too low. He will sell more, but make less money.

• If the inflation rate turns out to be only three percent, widgets will be priced 3% too high and both demand and profits will suffer.

At 3%, = $70

At 6%, = $100

At 9%, = $70

80$70$3

1100$

3

170$

3

1)( E

Optimal Inflation

Production

• If the inflation rate turns out to be exactly six percent, the right price would be $1.00 each.

• If the inflation rate turns out to be nine percent, widgets would be priced 3% too low. He will sell more, but make less money.

• If the inflation rate turns out to be only three percent, widgets will be priced 3% too high and both demand and profits will suffer.

If no uncertainty,

=$100

Optimal Inflation

Extra Uncertainty

At 0%, = $50

At 6%, = $100

At 12%, = $503

1%)12(

3

1%)6(

3

1%)0(

P

P

P

Suppose

Optimal Inflation

Extra Uncertainty

At 0%, = $50

At 6%, = $100

At 12%, = $503

1%)12(

3

1%)6(

3

1%)0(

P

P

P

Suppose

67$50$3

1100$

3

150$

3

1)( E

Optimal Inflation

Extra Uncertainty

At 0%, = $50

At 6%, = $100

At 12%, = $503

1%)12(

3

1%)6(

3

1%)0(

P

P

P

Suppose

Moral: the greater the uncertainty, the greater the chance you have made a mistake that costs you money.

Optimal Inflation

End

©2003 Charles W. Upton. All rights reserved