Professional Documents
Culture Documents
By:
Irfan Siddiqui
Introduction
Inflation. In simplest terms, the tendency
of prices to go up.
Because…………..
Ignoring inflation is like ignoring
elephant in a room !
Inflation
Now, before analyzing inflation
PF
A
P0 Keynesian AS
D
Price , P
PF AS3
AS2
A AS 1
P0 AS 0
AD
yF y0
Output , y
Long Run Neutrality of Money
In Short run increase in Money supply will
Increase Output above full employment and
wages and price of products will reduce
Reduction in interest rate in short run will
increase investment and will help in reducing
unemployment rate
But, ……….
Money supply increase in long run has neutral
effect at economy , thus excess supply of money
will not stay longer and would create inflation
and reverse cycle of neutrality of money will be
in action.
Neutrality of Money
.
Interest Rate
M0 M1
rF
ro
Md 0
Unemployment rate
I I’ I
Money
Investment
When there is a shift in Money supply (from Mo to M1) money demand would decrease
, thus interest rate will decreases and investment in Economy will increases which will
bring rate of unemployment at lower side.
Neutrality of Money
A shift in Money demand from Mdo to
Md 1 will raise interest rate and
.
Interest Rate
rF
Md 1
ro
Md 0
Unemployment rate
I I’ I
Money
Investment
but , after reaching certain level labor cost will become unbearable, cost of production
would be higher and Price hike will start due to surplus money supply, this surplus
money supply will cause inflation , as a result invt. will reduce and unemployment level
will rise .
Neutrality of Money
.
Interest Rate
M0 M1
rF
Md 1
ro
Md 0
Unemployment rate
I I’ I
Money Investment
Now, at the time of inflation, unemployment would rise, hoarding of commodities would
start. People will change their spending habits, savings would be preferred rather than
investment and above all , SBP will raise discount rate or CRR ratio to tighten up
monetary system. Thus, a shift in demand of Money would occur , which will reduce
investments .
Money Growth , Inflation and
Interest Rates
Now , we know when economy operates
at full employment in long run , money is
neutral .
Suppose SBP increases money supply at
5% a year, so inflation will grow by 5% a
year
However , wages are also rising at 5% ,
now ; there will be no inflation as wages
are also rising at the same %.
Money Growth , Inflation and
Interest Rates
But inflation is measured in two ways
One the existing one and other is
expectation of inflation
Now, lets say on basis of 5% increase in
inflation , automobile producers will on
average expect their prices to be 5%
higher next year.
Expected inflation
When the public expect inflation , nominal interest rate
would differ from real interest rate
Expected Real
Rate of interest = Nominal rate – expectations of
inflation
10% - 6%
Expected Real Rate of interest = 4%
Thus if you invest Rs 100 at the end of year you
will get
Rs 110 , but with expectation of 6% inflation , real
gain is only Rs 4 not 10.
Expected inflation
Therefore, when inflation grows it hurts
your purchasing power
Instead of Rs 10 gain , it is expected that
your gain would be Rs 4, thus to maintain
purchasing power , you require extra Rs 6.
If two countries have identical real interest
rate and one has higher level of inflation
would also have a higher nominal interest
rate.
Credibility and Inflation
Why SBP Governor is very conservative and
constantly warning about the dangers of inflation?
Because these policy makers do influence
expected inflation rate and it does effect actual
behavior of the economy.
The Creditability of Central bank plays very
important role fighting against inflation
When Credibility
is lost
Credibility and Inflation
Full employment but at higher
Recessio
cost , higher wages
n
. F AS1
PF 1 A Full employment
at PF price level
and AS0 , Wages level ,
D
Price , P
PF point D
AS0
A
P0
AD 1
AD 0
ym yF
Output , y
In era of expected inflation, producers and lenders are not sure about profit
margin, so unexpected price hike would occur with a fear of inflation which will
create panic , excess margin would be taken , as long as selling items are
unavoidable this shift would sustain like petrol and basic food items
Credibility and Inflation
Full employment but at higher
Recessio
cost , higher wages
n
. F AS1
PF 1 A Full employment
at PF price level
and AS0 , Wages level ,
D
Price , P
PF point D
AS0
A
P0
AD 1
AD 0
ym yF Output , y
but economy would slow down in shape of minimum usage and if appropriate
actions to control inflation would not be taken price hike would continue but
investments will fall, unemployment would occur , agg. Demand would shift
backward and output level will also reduce , thus Recession will emerge and
would provide new point of equilibrium that is A which will soon decline towards
unemployment.
Credibility and Inflation
Full employment but at higher
Recessio
cost , higher wages
n
. F AS1
PF 1 A Full employment
at PF price level
and AS0 , Wages level ,
D
Price , P
PF point D
AS0
A
P0
AD 1
AD 0
ym yF Output , y
To avoid recession , central bank plays its role and control inflation at the mid level
and tries to control money supply by tightening up the money market.. Thus , in a
successful economy equilibrium at point D would be tried to achieve rather than at
point A , which is a point of no return or could be said point of depression.
Inflation and the Velocity of Money