Chapter 18-inflation

Written by: Edmund Quek

© 2011 Economics Cafe All rights reserved. Page 1

CHAPTER 18

INFLATION

LECTURE OUTLINE

1 DEFINITION AND MEASUREMENT

2 CAUSES OF INFLATION

2.1 Keynesian view

2.1.1 Demand-pull Inflation

2.1.2 Cost-push Inflation

2.2 Monetarist view

3 EFFECTS OF INFLATION

4 EFFECTS OF DEFLATION

References

John Sloman, Economics

William A. McEachern, Economics

Richard G. Lipsey and K. Alec Chrystal, Positive Economics

G. F. Stanlake and Susan Grant, Introductory Economics

Michael Parkin, Economics

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics



1 DEFINITION AND MEASUREMENT

Inflation is a rise in the general price level over a period of time. Monetary economists,

however, define inflation as a sustained rise in the general price level and refer to a one-off

rise as a price shock. The inflation rate is calculated as the percentage increase in the

Consumer Price Index over a period of time.

Mathematically,

t (CPIt CPIt1)/CPIt1 × 100, where CPIt [(Pit/Pi base year × 100) × Wi].

The Consumer Price Index is a price index which measures the cost of a basket of goods

and services purchased by the average household. It is calculated by choosing a basket of

goods and services purchased by the average household, grouping them into categories,

assigning a weight to each category based by the proportion of total expenditure spent on it,

choosing a base year, measuring the prices of the goods and services in the current year as

well as in the base year.

Suppose that there are only two goods produced in the economy, Good A and Good B.

Further suppose that the base year is 2009 (i.e. CPI2009 100).

Good Price (2009) Price (2011) Price (2012) Expenditure (2009) Weight

A $8 $10 $12 20000 1/4

B $16 $15 $14 60000 3/4

CPI2012 [(12/8 × 100) × 1/4] [(14/16 × 100) × 3/4] 103.125

CPI2011 [(10/8 × 100) × 1/4] [(15/16 × 100) × 3/4] 101.563

2012 (CPI2012 – CPI2011)/CPI2011 × 100 (103.125 – 101.563)/101.563 × 100 1.538

In most economies, a low/moderate/mild inflation rate is considered to be 3 per cent or

lower. Most economies that have inflation targets have set them in this range. Inflation

much higher than this range is called high inflation. Hyperinflation is very high inflation.

An example of hyperinflation is the 6.5 × 10108

per cent inflation rate in Zimbabwe in 2008.

Note: Many lecturers use the monetary economists’ definition of inflation. However, some

of them use it without knowing that not all economists define inflation in the same

way. A check with economics textbooks (e.g. Lipsey, Mankiw, etc) will confirm

this.



2 CAUSES OF INFLATION

2.1 Keynesian view

Keynesians distinguish between two types of inflation: demand-pull inflation and

cost-push inflation.

2.1.1 Demand-pull inflation

Demand-pull inflation occurs when the general price level rises due to an increase in

aggregate demand. Given any increase in aggregate demand, the closer the economy to the

full-employment equilibrium, the larger the rise in the general price level. Aggregate

demand is the total demand for the goods and services produced in the economy over a

period of time and is comprised of consumption expenditure, investment expenditure,

government expenditure on goods and services and net exports.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to a

rise in the general price level (P) from P0 to P1. Aggregate demand could increase due to an

increase in any of its components. For instance, when households are more optimistic

about the economic outlook, they will expect their income to rise and hence increase

consumption expenditure. Consumption expenditure may also rise due to other factors

such as an increase in the wealth of households. A fall in interest rates will lead to more

profitable planned investments resulting in an increase in investment expenditure.

Investment expenditure may also rise due to other factors such as stronger business

sentiment. When the economy is in a recession, the government may increase expenditure

on goods and services to steer the economy back onto the path of expansion. An increase in

foreign income will lead to an increase in net exports.

Contractionary demand-side policies can be used to reduce demand-pull inflation (which

will be explained later).



2.1.2 Cost-push inflation

Cost-push inflation occurs when the general price level rises due to a rise in the cost of

production in the economy, independent of demand. When the cost of production in the

economy rises independently of demand, firms will increase prices at the same output

levels to maintain profitability. In other words, they will reduce output at the same prices

which will lead to a decrease in aggregate supply. Aggregate supply is the total supply of

goods and services in the economy over a period of time.

In the above diagram, a decrease in aggregate supply (AS) from AS0 to AS1 leads to a rise

in the general price level (P) from P0 to P1. The cost of production in the economy may rise

independently of demand due to several reasons. For instance, workers will bargain for

higher wages when they expect prices to rise or when the labour market is tight. The prices

of imported intermediate goods will rise when the exchange rate of domestic currency falls

or when there is inflation in other economies. If the government increases indirect taxes

such as the goods and services tax or if oil prices rise, the cost of production in the

economy will rise. For instance, the sharp rise in oil prices in the early 1970s led to a huge

rise in the cost of production in the world.

In theory, supply-side policies can be used to reduce cost-push inflation. However, due to

the long effectiveness time lag, they are not effective in the short run. In reality,

contractionary demand-side policies are often used to reduce cost-push inflation, although

they may cause the economy to move into a recession.

2.2 Monetarist view

Monetarists believe that inflation is always and everywhere a monetary phenomenon. By

this, they mean that inflation can only be produced by a more rapid increase in the money

supply than in output. This view is an outgrowth of the study of the historical relationship



between the money supply and prices done by the leader of the Monetarist school of

thought, Milton Friedman. His study indicated a strong positive relationship between the

money supply and prices (A Monetary History of the United States, 1867 – 1960).

Direct (Monetarist) transmission mechanism.

Monetarists believe that in addition to money and financial assets such as bonds, people

also hold their wealth in the form of physical assets such as cars, televisions and other

consumer goods. If the money supply increases, people will find themselves holding more

money than they want. Although some of this money will be used to purchase financial

assets, some will be used to purchase physical assets which will lead to an increase in

aggregate demand. An increase in aggregate demand will lead to an increase in nominal

national income (after 6 to 9 months). Initially, the change will appear primarily in output.

However, after a few months (another 6 to 9 months), prices will rise and output will fall

back. Therefore, an increase in the money supply will only lead to higher prices in the long

run (after 12 to 18 months).

The hyperinflation of 6.5 × 10108

per cent in Zimbabwe in 2008 was an extreme monetary

phenomenon. The central bank of Zimbabwe was compelled by the government to

purchase the bonds that it issued. As a result, the money supply in Zimbabwe increased

rapidly. However, since the amount of goods produced in Zimbabwe did not increase at the

same rate, the rapid increase in the money supply led to a situation of “too much money

chasing too few goods” which resulted in hyperinflation.

Using the equation of exchange (MV PY), Monetarists argue that to achieve price

stability, the central bank should let the money supply grow at a constant rate, and this

policy rule is commonly known as the constant growth rate rule (CGRR). According to

Monetarists, V is stable (i.e. its changes are small and predictable). Therefore, if the central

bank increases the money supply at the average economic growth rate, the general price

level will be stable.

3 EFFECTS OF INFLATION

Adverse effect on the real value of savings

High inflation will reduce the real value of savings. When inflation is high, nominal

interest rates will not fully compensate for the rise in the general price level which will

reduce the amount of goods and services that can be purchased with any given amount of

savings.

Adverse effect on net exports

High inflation may lead to a decrease in net exports. When inflation is high, domestic

goods and services may become relatively more expensive than foreign goods and services.

If this happens, net exports will fall.



Adverse effect on the balance of payments

If high inflation leads to a decrease in net exports, it may increase a persistent balance of

payments deficit.

Adverse effect on investment expenditure

High inflation may lead to a decrease in investment expenditure. Since high inflation tends

to be less stable, firms will find it harder to estimate the costs and revenues of investments

when inflation is high which will lead to a decrease in investment expenditure.

High shoe-leather cost of inflation

High inflation will lead to a high shoe-leather cost of inflation. High inflation will lead to

high interest rates. Metaphorically, when interest rates are high, the transactions demand

for money will be low. Therefore, people will make frequent trips to the bank to withdraw

small amounts of money which will cause their shoes to wear out rapidly resulting in a high

shoe-leather cost of inflation. In reality, the idea of wearing out your shoes rapidly implies

more than making frequent trips to the bank. Rather, when interest rates are high, people

will spend much of their time managing their money rather than using it to produce goods

and services.

High menu cost of inflation

High inflation will lead to a high menu cost of inflation. When prices rise, firms have to

reprint price labels. For example, restaurants have to reprint menus to reflect the higher

prices of meals. When inflation is high, prices will rise frequently which will lead to a high

menu cost of inflation.

Haphazard redistribution of real income and wealth (unanticipated inflation)

Unanticipated inflation will lead to a haphazard redistribution of real income and wealth.

Consider a wage contract that specifies a wage increase of 3 per cent on the assumption that

the general price level will remain unchanged. If inflation unexpectedly turns out to be 10

per cent, the 3 per cent increase in nominal wages will mean a 7 per cent decrease in real

wages. In this instance, real income will be haphazardly redistributed from workers to

firms. Further, unanticipated inflation will decrease the liabilities of debtors and the assets

of creditors in real terms. In other words, when there is unanticipated inflation, debtors will

owe creditors less in terms of goods and services. In this instance, wealth will be

haphazardly redistributed from creditors to debtors.

Haphazard redistribution of real income (anticipated inflation)

Anticipated inflation will also lead to a haphazard redistribution of real income. Some

private pension plans are stated in nominal terms and others compensate for up to only 5

per cent inflation. Therefore, even if inflation had been anticipated, people who live on

fixed nominal income will see their real income erode away over time. In this instance, real

income will be haphazardly redistributed from pensioners to firms.

Although high inflation is undesirable for the economy, low inflation is desirable. Low

inflation is desirable for the economy because it injects some downward flexibility into real

wages resulting in lower unemployment. Although it is easy for firms to increase real



wages by increasing nominal wages, the converse is not true because workers are resistant

to pay cuts. Therefore, if inflation is maintained at 3 per cent or less, firms can cut real

wages without cutting nominal wages which will lead to lower unemployment. Another

way to understand why some inflation is necessary for achieving low unemployment is

through the short-run Phillips curve which shows the inverse relationship between inflation

and unemployment.

In the above diagram, when the inflation rate is 0, the unemployment rate is 0. At a zero

per cent inflation rate, the unemployment rate is 1, which may be intolerably high.

Note: A nominal value is measured in terms of money. A real value is measured in terms

of goods and services. Suppose that a firm pays a worker an income of $1000.

Further suppose that the only good in the economy is lipstick which costs $20 each.

In this case, the nominal income of the worker is $1000 and the real income is 20

lipsticks. It is important for students to note that firms and workers are concerned

with real income. Similarly, lenders and borrowers are concerned with real interest

rate. Suppose that a lender charges a borrower an interest rate of 7 per cent. Further

suppose that inflation is 3 per cent. In this case, the real interest rate is 4 per cent.

This means that although the borrower will pay back 7 per cent more to the lender in

terms of money, the lender will only receive 4 per cent more from the borrower in

terms of goods and services.

4 EFFECTS OF DEFLATION

Although high inflation is undesirable for the economy, this does not mean that deflation is

necessary desirable for the economy. Deflation is a fall in the general price level over a

period of time. Deflation may bring about benefits to the economy such as an increase in

the real value of savings, an increase in net exports, a correction of a persistent balance of

payments deficit and a low shoe-leather cost of inflation. However, deflation may lead to a



decrease in aggregate demand and this is undesirable for the economy because deflation is

usually due to a decrease in aggregate demand. In other words, deflation may worsen a

recession.

Deflationary expectations

Deflation may lead to deflationary expectations and hence a decrease in aggregate demand.

When the general price level falls, households may expect it to fall further. If this happens,

they will put off the purchases of some durable goods which will lead to a decrease in

consumption expenditure and hence aggregate demand. For instance, deflation in Japan in

the late 1990s was of concern to the Japanese government due to this reason.

Widespread bankruptcy

Deflation may lead to widespread bankruptcy and hence a decrease in aggregate demand.

Deflation increases the real value of debts. Since most firms are in debt, high deflation may

lead to widespread bankruptcy. If this happens, investment expenditure and hence

aggregate demand will fall. For instance, in the Great Depression of 1930s, many farmers

in the US lost their farms through foreclosures as a result of the heavy debt burden due to

falling prices.

Rise in interest rates

Deflation may lead to a rise in interest rates and hence a decrease in aggregate demand.

Deflation is a return on holding money because it increases the real value of money.

Therefore, if deflation leads to deflationary expectations, the demand for money will

increase which will lead to a rise in interest rates resulting in a decrease in consumption

expenditure, investment expenditure, net exports and hence aggregate demand.

Redistribution of wealth from debtors to creditors

Unanticipated deflation will redistribute wealth from debtors to creditors which will lead to

a decrease in aggregate demand. Unanticipated deflation will increase the liabilities of

debtors and the assets of creditors in real terms. In other words, when there is unanticipated

deflation, debtors will owe creditors more in terms of goods and services. When this

happens, wealth will be redistributed from debtors to creditors. Since debtors have a

marginal propensity to consume higher than that of creditors, the redistribution of wealth

will lead to a decrease in consumption expenditure and hence aggregate demand.

Economy & Finance

Chapter 18-inflation