Ensuring price stability


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Ensuring price stability

  1. 1. Ensuring Price Stability 1
  2. 2. Inflation• Inflation occurs when the general level of prices is rising.• We calculate inflation by using price indexes-weighted averages of the prices of thousands of individual products.• The consumer price index (CPI) measures the cost of a market basket of consumer goods and services relative to the cost of that bundle during a particular base year. 2
  3. 3. • The rate of inflation is the percentage change in the price level:Rate of Inflation (year t) price level price level (year t) (year t-1) = 100 price level (year t-1) 3
  4. 4. Three Strains of InflationLow Inflation- characterized by prices that rise slowly and predictably. We might define this as single-digit annual inflation rates.Galloping Inflation- inflation in the double or triple-digit range of 20,100, or 200 percent a year. Once galloping inflation becomes entrenched, serious economic distortions arise.Hyperinflation- prices are rising a million or even a trillion percent a year. The most thoroughly documented case of hyperinflation took place in the Weimar Republic of Germany in the 1920’s. 4
  5. 5. Money and Hyperinflation in Germany, 1922-1924 In the early 1920s, Germany could not raise enough taxes, so it used themonetary printing press to pay the government’s bills. The stock of currency roseastronomically from early 1922 to Dec.1923, and prices spiraled upward as people 5frantically tried to spend their money before it lost all value.
  6. 6. Anticipated vs. Unanticipated Inflation• An important distinction in the analysis of inflation is whether the price increases are anticipated or unanticipated.• Economists generally believe that anticipated inflation at low rates has little effect on economic efficiency or on the distribution of income and wealth.• In reality, inflation is usually unanticipated. An unexpected jump on prices will impoverish some and enrich others. 6
  7. 7. Economic Impacts of Inflation• During periods of Inflation, all prices and wages do not move at the same rate; that is, changes in relative prices occur.• Two definite effects of inflation are: - a redistribution of income and wealth among different goods. - distortions in the relative prices and outputs of different goods, or sometimes in output and employment for the economy as a whole. 7
  8. 8. Impacts on Income and Wealth Distribution• Inflation affects the distribution of income and wealth primarily because of differences in the assets and liabilities that people hold.• The major redistributive impact of inflation comes through its effect on the real value of people’s wealth.• In general, unanticipated inflation redistributes wealth from creditors to debtors, helping borrowers and hurting lenders. An unanticipated decline in inflation has an opposite effect.• But, inflation mostly churns income and assets, randomly redistributing wealth among the population with little significant impact on any single group. 8
  9. 9. Impacts on Economic Efficiency• Inflation impairs economic efficiency because it distorts prices and price signals.• In a low-inflation economy, if the market price of a good rises, both buyers and sellers know that there has been change in the supply and/or demand conditions for that good, and they can react appropriately.• Inflation also distorts the use of money. Currency is money that bears a zero nominal interest rate. If inflation rate rises from 0-10 percent annually, the real interest rate on currency falls from 0 to -10 percent per yr.• As a result of the negative real interest rate, people devote real resources to reducing their money holdings during inflationary times. 9
  10. 10. • Many economists point to the distortion of inflation on taxes. Certain parts of the tax code are written in dollar terms. When prices rise, the real value of those provisions tends to decline.• Some economists point to menu costs of inflation. The idea is that when prices are changed, firms must spend real resources adjusting their prices.• An example is when restaurants reprint their menus, mail- order firms reprint their catalogs and stores change the price tags of their goods. 10
  11. 11. Macroeconomic Impacts on Efficiency and Growth Inflation Rate Growth of per capita GDP (% per year) (% per year) -20 – 0 0.7 0 – 10 2.4 10 – 20 1.8 20 – 40 0.4 100 – 200 -1.7 1,000+ -6.5Inflation and Economic Growth The pooled experience of 127 countries shows that the most rapid growth isassociated with low inflation rates. Deflation and moderate inflation accompany slowgrowth. While hyperinflations are associated with sharp downturns. this indicates that economic growth is strongest in countries with lowinflation, while countries with high inflation or deflation tend to grow more slowly. 11
  12. 12. What is the Optimal Rate of Inflation?• Most nations seek rapid economic growth, full employment and price stability.• Some today argue that policy should go further and aim for absolutely stable prices or zero inflation.• This school points to the value of having a predictable future price level when people make their investment decisions.• Many macroeconomists say that while a zero-inflation target might be sensible in an ideal economy, we do not live in a frictionless system.• Perhaps the most important friction is the resistance of workers to declines in money wages. 12
  13. 13. Prices in the AS-AD Framework• There is no single source of inflation. Some inflations come from the demand side; others from the supply side.• One key fact about modern inflation is that they develop an internal momentum and are costly to stop once under way. 13
  14. 14. Inertial Inflation• In modern industrial economies like the US, inflation has great momentum and tends to persist at the same rate.• Inertial inflation is like a lazy old dog. If the dog is not “shocked” by the push of the foot or the pull of a cat, it will stay put.• While inflation can persist at the same rate for a while, history shows that shocks to the economy tend to push inflation up or down.• The economy is constantly subject to changes in aggregate demand, sharp oil and commodity price changes, poor harvests, movements in the foreign exchange rate, productivity changes and other events that push inflation away from its inertial rate. 14
  15. 15. Demand-Pull Inflation• Demand-pull inflation occurs when aggregate demand rises more rapidly than the economy’s productive potential, pulling prices up to equilibrate aggregate supply and demand.• In effect, demand dollars are competing for the limited supply of commodities and bid up their prices.• One important factor behind demand inflation is rapid money-supply growth. Increases in the money supply increase aggregate demand, which in turn increase the price level. 15
  16. 16. Potential Output QP Demand-Pull Inflation P AS Occurs When Too Much Spending Chases Too Few Goods The graph illustratesthe process of demand-pullinflation in terms of AS andAD. Starting from an initial E’equilibrium at point E, suppose P’there is an expansion ofspending that pushes the AD P E ADcurve up and to the right. The AD’economy’s equilibrium movesfrom E to E’. At this higherlevel of demand, prices haverisen from P to P’. Demand-pull inflation has taken place. Real Output Q 16
  17. 17. Cost-Push Inflation• Inflation resulting from rising costs during periods of high unemployment and slack resource utilization is called cost-push inflation.• In looking for explanations of cost-push inflation, economists usually start with wages. Wages tend to rise even in recession because they are administered prices and because of the strong resistance to wage cuts.• Sometimes, cost-push shocks lead to an upward push to inflation. 17
  18. 18. Expectations and Inertial Inflation• Inflation has a very strong inertia or momentum because most prices and wages are set with an eye on the future economic conditions.• When prices and wages are rising rapidly and are expected to continue doing so, businesses and workers tend to build the rapid rate of inflation into their price and wage decisions. 18
  19. 19. Figure 32-7. An Upward Spiral Of Prices And Wages Occurs When Aggregate Supply And Demand Shift Up Together Suppose that potentialoutput is constant and that there areno supply or demand shocks. Ifeveryone expects average costs andprices to rise at 3% each year, theAS curve will shift upward at 3%per year. If there are no demandshocks, the AD curve will still shiftup at that rate. The intersection ofthe AD and AS curves will be 3%higher each year. Hence, theequilibrium moves from E to E’ toE’’. Prices are rising 3% from oneyear to the next: inertial inflationhas set in at 3%. 19
  20. 20. Price Levels vs. Inflation• An increase in aggregate demand will raise prices, other things being equal. An upward shift in the AS curve resulting from an increase in wages and other costs will raise prices, other things being equal.• But of course other things always change, in particular, AD and AS curves never sit still. Figure 32-7 shows, for example, the AS and AD curves marching up together. 20
  21. 21. Suppose, forexample, that the thirdperiod’s AD’’ curve shifted tothe left to AD’’’ because of amoney contraction. This mightcause a recession with a newequilibrium at E’’’ on the AS’’curve. At this point, outputwould have fallen belowpotential; prices and theinflation rate would be lowerthan at E’’, but the economywould still be experiencinginflation because the pricelevel at E’’’ is still above theprevious period’s equilibriumE’ with price P’. 21
  22. 22. The Phillips Curve• Developed by economist Alban William Phillips, the Phillips curve is a useful tool for analyzing short-run movements of unemployment and inflation.• An important piece of inflation arithmetic underlies this curve.Example: Say that labor productivity rises at a steady rate of 1%each year. Further, assume that firms set prices on the basis ofaverage labor costs, so prices always change just as much asaverage labor costs per unit of output. If wages are rising at4%, and productivity is rising at 1%, then average labor costswill rise at 3%. Consequently, prices will also rise at 3%. 22
  23. 23. The Short-run Phillips W/W P/PCurve Depicts The Trade- off Between Inflation Annual Wage Rise (percent per year) And Unemployment Price Inflation (percent per year) 8 9 A short-run Phillips 7Curve shows the inverse 8 6 7relationship betweeninflation and 5 6unemployment. The 4 5blue-wage scale on the 3 4right-hand vertical axis Phillips 2 Curve 3is higher than the blackleft-hand inflation scale 1 2by the assumed 1percent growth rate of 0 1average labor 1 2 3 4 5 6 7 8 9 10productivity. Unemployment Rate (percent) 23
  24. 24. The Nonaccelerating Inflation Rate of Unemployment• The nonaccelerating inflation rate of unemployment (NAIRU) is that unemployment rate is consistent with a constant inflation rate.• At the NAIRU, upward and downward forces on price and wage inflation are in balance, so there is no tendency for inflation to change.• NAIRU is the lowest unemployment rate that can be sustained without upward pressure on inflation. 24
  25. 25. The Nonaccelerating Inflation Rate of UnemploymentPutting this differently, a stable inflation rate will occurwhen two conditions are met:1. No excess demand. Inflation neither rises nor falls at the NAIRU because the upward wage pressures from job vacancies just match the downward wage pressure from unemployment.2. No supply shocks. Inflation will stay on track if there are no supply shocks from oil or other commodity prices, from exchange rates, from productivity, or from other factors that affect the costs of production-that is, if there are no AS shocks. 25
  26. 26. The Phillips Curve Or The Phillips Curl?Data on unemploymentand inflation over the lastthree decades show acomplicated relationship.Modern NAIRU theoriesexplain the Phillips curland the inward andoutward drift by changesin the expected rate ofinflation. 26
  27. 27. Shifting Phillips Curve How Shocks Move The Long-run Phillips Curve Phillips CurvePeriod 1: The economy starts at SRPC’point A. Period 2: The economy Cexpands, with unemploymentfalling below the NAIRU and SRPC Inflation Rate Dlanding at pt. B. As a Bresult, inflation rises above theinertial rate. Period 3: As time Short-runpasses, the higher inflation Phillips Curve Abecomes anticipated and gets (periods 3 and 4)built into the new short-run Short-runPhillips curve, SRPC’. Period 4: Phillips CurveWhen the economy comes back (Periods 1 andto the NAIRU at pt. D, it is now 2)saddled with higher inertial andactual inflation rates. U* (sustainable rate) Unemployment rate 27
  28. 28. The Vertical Long-Run Phillips Curve• According to the NAIRU theory, the only level of unemployment consistent with a stable inflation rate is the NAIRU.• The NAIRU theory of inflation has two important implications for economic policy. First it implies that there is a minimum level of unemployment that an economy can sustain in the long- run.• But even with this long-run constraint, there is much room in the short-run for business cycles. A country might expand the economy and enjoy low unemployment for a period.• Eventually, this prosperity comes at the price of rising inflation. Conversely, when a nation thinks that its inertial inflation rate is too high, it can steel itself for a period of austerity, tighten money, induce a recession and thereby reduce inflation. 28
  29. 29. Declining NAIRU• The best evidence suggests that, after having risen in the 1970s and 1980s, the NAIRU in the US has declined sharply because of the decrease in the power of labor unions.• Another important structural feature lowering the NAIRU is the strengthening of competition in the American economy.• A further source of decline in NAIRU is demographic shifts. As the population aged in the 1990s, there were fewer high- unemployment-rate teenagers in the labor force.• Some believe that the NAIRU declined temporarily because of the recent upsurge in productivity growth. The productivity acceleration after 1995 has allowed firms to increase wages without the higher wages being reflected in higher inflation. 29
  30. 30. Doubts About the NAIRU• Critics wonder whether the NAIRU is a stable and reliable concept.• Another question is whether an extended period of high unemployment will lead to a deterioration of job skills, to loss of on-the-job training and experience and thereby to a higher NAIRU. 30
  31. 31. Dilemmas of Anti-Inflation PolicyHow Long is the Long-Run? o The length of time that it takes the economy to adjust fully to a shock is not known with precision. Recent studies suggest that full adjustment takes at least 5 years or perhaps even a decade. The reason for the long delay is that it takes years for expectations to adjust, for labor and other long-term contracts to be renegotiated, and for all these effects to percolate through the economy. 31
  32. 32. Dilemmas of Anti-Inflation PolicyHow Much Does It Cost to Reduce Inflation? o Studies of this subject find that the cost of reducing inflation varies depending upon the country, the initial inflation rate, and the policy used. o To understand the cost of disinflation, consider the Phillips curve. If the Phillips curve is relatively flat, reducing inflation will require much unemployment and loss in output; if the Phillips curve is steep, a small rise in unemployment will bring down inflation quickly and relatively painlessly. 32
  33. 33. Dilemmas of Anti-Inflation PolicyCredibility and Inflation o One of the most important questions in anti-inflation policy concerns the role of credibility of policy. Many economists argue that the Phillips curve approach is too pessimistic. The dissenters hold that credible and publicly announced policies would allow anti-inflation policies to reduce inflation with lower output and unemployment costs. o Many economists were skeptical about claims that credibility would significantly lower the output costs of disinflation. 33
  34. 34. Dilemmas of Anti-Inflation PolicyHow Can We Lower the NAIRU? o Improve Labor Market Services. Some unemployment occurs because job vacancies are not matched up with unemployed workers. Through better information, such as computerized job lists, the amount of frictional and structural unemployment can be reduced. o Bolster Training Programs. Many believe that government or private training programs can help unemployed workers retool for better jobs in growing sectors. o Remove Government Obstacles. Some economists call for reforming the unemployment-insurance system and for reducing the disincentives for work in health, disability and social security programs. If welfare cuts bring into the workforce unskilled and inexperienced workers who tend to have higher unemployment rates, these measures may well raise the NAIRU. 34
  35. 35. Dilemmas of Anti-Inflation PolicyWanted: A Low-Cost Anti-Inflation Policy o Income policies were popular in an earlier time. Income policies are government policies that attempt to moderate inflation directly. Unfortunately, mandatory price controls tend to become ineffective because people evade them. Moreover, they are unlikely to slow price and wage increases unless they are accompanied by restrictive fiscal and monetary policies. o A Market Strategy. This approach would rely on the discipline of markets to restrain price and wage increases. Particularly in open economies, one of the most important anti-inflation policies is international competition. Policies that strengthen market forces may increase the resistance to price and wage increases, particularly in imperfectly competitive labor and product markets. 35
  36. 36. Dilemmas of Anti-Inflation PolicyWanted: A Low-Cost Anti-Inflation Policy o Tax-based Income Policies (TIP) have been proposed as a way of using the market mechanism to attain macroeconomic objectives. The enthusiasts of TIP stress, however, that it is a complement and not a substitute for the discipline of the market mechanism and for the tight fiscal and monetary policies necessary to contain inflation. o Profit-Sharing Policies have been proposed by Martin Weitzman and James Meade. The idea here is to devise new kinds of labor contracts that give workers a share of the profits or revenues rather than a straight wage. Under such an approach, the marginal cost of a worker would be less than the average compensation, so it would be less profitable for firms to lay off workers in recession. 36