ECON248: Money and Banking Ch.4: Inflation Dr.

Mohammed Alwosabi

DEFINITION OF INFLATION
Chapter 4 • Inflation is a process of continuous
(persistent) increase in the price level,
which results in a decrease of the value of
money (decrease in its purchasing power).
• In the definition of inflation we have to
MONEY AND INFLATION observe that:
1.Inflation is an increase in the prices of all
goods and services not only of a particular
good or service. An increase in the price of
one good is not inflation.
Dr. Mohammed Alwosabi 2.Inflation is an ongoing process, not a one-
1 time jump in the price level. 2

• Milton Friedman proposed that "inflation is • The German hyperinflation of the 1921-23
always and everywhere a monetary supports the proposition that excessive
phenomenon". monetary growth causes inflation and not
• The source of inflation is the high growth the other way around since the increase in
rate of money supply with “too much money monetary growth appears to have been
chasing too few goods”. exogenous, the government expands the
• A quick and simple solution to fighting money y supply
pp y to finance its expenditures.
p
inflation is reducing the growth rate of the • Evidence for Latin American countries over
money supply. the ten-year period 1989-1999 indicates that
• The proposition that inflation is the result of in every case in which a country's inflation
a high rate of money growth is supported by rate is extremely high for any sustained
evidence from inflationary episodes period of time, its rate of money growth is
throughout the world. 3
extremely high 4

INFLATION RATE: • These two equations show the connection

• To measure the inflation rate, we calculate between the inflation rate and the price
the annual percentage change in the price level.
level. • If the price level in the current year is higher
Pthis year - Plast year than that of the last year, the inflation rate
Inflation Rate = × 100 will be positive meaning higher inflation rate
Plast year
Ö the lower is the value of money.
• we measure the price level (P) of a country
using GDP Deflator or CPI.
GDP Deflator this year - GDP Deflator last year
Inflation Rate = × 100
GDP Deflator last year

CPI - CPI
Inflation Rate = × 100
this year last year

CPI last year

5 6

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ECON248: Money and Banking Ch.4: Inflation Dr. Mohammed Alwosabi

VIEWS OF INFLATION 3. Negative supply shocks increase the price

• According to aggregate demand and supply level, but cannot increase the inflation rate.
analysis, inflation is caused by • Suppose that the economy is at the natural
expansionary monetary policies. rate of output. In the absence of
• A continually increasing money supply accommodating policy and everything else
causes a continual increase in aggregate held constant, the net result of a negative
demand everything else held constant.
demand, constant supply shock is that the economy returns
• Fiscal policy alone cannot produce inflation to full employment at the initial price level.
because
1.There is a limit on the total amount of
possible government expenditure.
2.Decreasing taxes also has a limit.
7 8

SOURCES OF INFLATION —At a given price level, cost-push inflation

• Inflation usually occurs as a result of starts as the rise in the cost of production,
expansionary monetary policy. because of an increase in the money wage
(1) Cost-Push Inflation and High Employment rate or an increase in the prices of raw
Targets material ⇒ firms are willing to produce less
amount of the output ⇒ SAS decreases ⇒
• Cost-push inflation arises due to a SAS shifts leftward ⇒ an increase in prices
p
d
decrease in
i supplyl as a result
lt off the
th rise
i in i and unemployment and a decrease in RGDP
the per-unit cost of production. ⇒ stagflation
• The negative supply shocks mainly occur
because of the push by workers to get
higher wages, the increase in the prices of
other factors of production, or the increase
9
in the prices of raw materials (e.g. oil price) 10

• Suppose that the last year price level was P0

P
LAS and PGDP is Y0, where AD0, SAS0 and LAS
SAS3 intersect at point A, the LR FE equilibrium.
• If, in the current year, nominal wages or
SAS2 prices of other factors of production
P4
E
SAS1
increase ⇒ production cost increases ⇒
P3 D
firms reduce production ⇒ SAS  ⇒ SAS
curve shifts leftward to SAS1 to point B.
B
P2 C
• At point B, price level increases to P1 and
AD3
P1 B RGDP decreases to Y1 and therefore
P0 A AD2 unemployment increases above its natural
rate (below FE)
AD1
Y
Y1 Y0
11 12

2
ECON248: Money and Banking Ch.4: Inflation
• If government fiscal and monetary policies
remain unchanged, the economy would
move back to point A
• However, as a response to the increase in P
and unemployment, and a decrease in
RGDP, the government increases money
supply (MS) (also called quantity of money,
Qm),) G or decreases T ⇒ AD increases ⇒
AD curve starts to shift rightward until it
reaches AD1 at point C, where AD1
intersects with SAS1 and LAS.
• At point C, the economy is at higher price
level (P2) and RGDP goes back to PGDP (Y0)
at full employment
13
• Note that a one-time increase in the price of
one resource without any following change
in AD produces stagflation but not inflation.
• The combination of a successful wage push
by workers and the government's
commitment to high employment leads to
cost-push
cost push inflation.
• Cost-push inflation is a monetary
phenomenon because it cannot occur
without the monetary authorities pursuing
an accommodating policy of a higher rate of
money growth.
15
• In the absence of an accommodating
monetary policy and everything else held
constant, a push by workers to get higher
wages will cause higher unemployment and
higher prices, and the net result of a
negative supply shock is that the economy
returns to full employment
p y at the initial price
p increase in spending faster than the
level.
17
Dr. Mohammed Alwosabi
• With the new higher price, money wage rate
and prices of other productive resources
start to increase again which leads to
increase in the cost of production ⇒ SAS
curve will shift leftward from SAS1 to SAS2
⇒ stagflation ⇒ the process will be
repeated ⇒ higher price level (inflation)
• This is an ongoing process of rising price
level.
14
• Accommodating policy (usually monetary
policy) occurs when government pursue
active, discretionary policy to eliminate high
unemployment that developed after a
successful wage push by workers.
• Monetary expansion increases AD
repeatedly, and wages continue to adjust
upward. This recipe leads to inflation
16
(2) Demand-Pull Inflation
• Demand-pull inflation occurs when policy
makers pursue policies that raise AD and
shift the aggregate demand curve to the
right
• Demand-pull inflation is a result of the
increase in production of output.
• An increase in aggregate demand is caused
mainly by the increase in Money supply
(MS) (quantity of money,Qm), or the
increase in any of C, I, G, or X
18
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ECON248: Money and Banking
• Suppose the economy is at LR full
employment equilibrium point A, where
LAS, AD0 and SAS0 intersect with each
other. At this point, RGDP = PGDP = Y0 and
P = P0.
• Then, because government goal is to
achieve high level of employment (high level
of output), government may increase Qm,
or G, or decrease T, which leads to an
increase in AD ⇒ AD curve shifts rightward
from AD0 to AD1 ⇒ the new SR equilibrium
is at point B,
P LR and FE level (Y0) and the price level
LAS SAS3
SAS2
P4 E inflation to proceed, AD must persistently
D
P3 SAS1
P2 C
AD3
P1 B target of high employment (and high
P0 A AD2
AD1
Y a result P is higher (P2), the result is the
Y0 Y1
• In either case ⇒ increase in AD ⇒ AD curve
will shift from AD1 to AD2 ⇒ the process
will continue ⇒ higher price level (inflation)
• This is an ongoing process of rising price
level.
• From the discussion above, according to
aggregate demand and supply analysis, it is
evidenced that high inflation cannot be
driven by fiscal policy alone. High money
growth produces high inflation. Inflation is
caused by expansionary monetary policies.
Ch.4: Inflation Dr. Mohammed Alwosabi
• At B, RGDP is greater than PGDP, price
level increases from P0 to P1, ⇒ real wage
rate has decreased and unemployment falls
below its natural rate (above FE) ⇒ there is
a shortage of labor ⇒ money wage rate
starts to increase to attract more labor ⇒
SAS starts to decrease ⇒ SAS curve starts
to shift leftward ⇒ P starts to increase and
RGDP starts to decrease until SAS curve
shifted to SAS1 where it intersects AD1 and
LAS at point C
19 20
• At point C, RGDP goes back to its potential
increase further to P2.
• This process is only a one-time rise in P. For
increase.
• At this stage two actions may occur
simultaneously:
(1) Government wants to achieve a specific
production) so it will increase G, Qm or
decrease taxes, and
(2) Since now the money wage is higher
which means people can spend more and as
21 increase in Qm 22
ACTIVIST / NONACTIVIST POLICY DEBATE
• Activist is an economist who views the self-
correcting mechanism through wage and
price adjustment to be very slow and hence
sees the need for the government to pursue
active, discretionary policy to eliminate high
unemployment whenever it develops.
• Activist argues that monetary and fiscal
policies should be deliberately used to
smooth out the business cycle.
23 24
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ECON248: Money and Banking Ch.4: Inflation
• They are in favor of economic fine-tuning,
which is the frequent use of monetary and
fiscal policies to counteract even small
undesirable movements in economic
activity.
• According to activists, the economy does
not always equilibrate quickly enough at
natural real GDP.
• They believe that activist monetary policy
works; it is effective at smoothing out the
business cycle.
25
• According to nonactivists, in modern
economies, wages and prices are
sufficiently flexible to allow the economy to
equilibrate at reasonable speed at natural
real GDP.
• They believe activist monetary policies may
not work, and may be more destabilizing
rather than stabilizing, and are likely to
make matters worse rather than better.
27
• Nonactivists contend that an activist policy
of shifting the aggregate demand curve will
be costly because it produces more
volatility in both the price level and output
• There are five time lags that prevent an
activist policy from returning aggregate
output to full employment instantaneously
1. The data lag is the time it takes for
policymakers to obtain the data that tell
them what is happening to the economy,
2. The recognition lag is the time it takes for
policymakers to be sure of what the data
are signaling about the future course of
the economy. 29
Dr. Mohammed Alwosabi
• Nonactivist is an economist who believes
that the performance of the economy would
be improved if the government avoided
active policy to eliminate unemployment
• Nonactivists argue against the use of
deliberate fiscal and monetary policies.
• They believe the discretionary policies
should
h ld beb replaced
l d by
b a stable
t bl and
d
permanent monetary and fiscal framework
and the rules should be established in place
of activist policies.
26
• If aggregate output is below the natural rate
level, advocates of activist policy would
recommend that the government try to
eliminate the high unemployment by
attempting to shift the aggregate demand
curve to the right while advocates of
nonactivist policy would recommend that
the government to do nothing.
• According to activist, the wage and price
adjustment process being extremely slow,
and a nonactivist policy results in a large
loss of output
28
3. The legislative lag represents the time it
takes to pass legislation to implement a
particular (fiscal) policy
4. The implementation lag is the time it takes
for policymakers to change policy
instruments once they have decided on a
new policy.
5 The
5. Th effectiveness
ff ti lag
l isi the
th time
ti that
th t it
takes for an activist policy to actually
influence economic activity.
• The existence of lags prevents the
instantaneous adjustment of the economy
to policies changing aggregate demand.
30
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ECON248: Money and Banking Ch.4: Inflation
• Activist believe that even with time lags,
activist policy moves the economy to full
employment before the economy's self-
correcting mechanism would
• Activists usually view fiscal policy as
having a shorter effectiveness lag than
monetary policy, but there is substantial
uncertainty about how long this lag isis.
• Nonactivists usually view fiscal policy as
having a longer implementation lag than
monetary policy, but there is substantial
uncertainty about how long this lag is
31
1. Higher than anticipated inflation
(unexpectedly high) ⇒ lowers the real
wage rate ⇒ employers gain at the
expense of workers ⇒ increases the
quantity of labor demanded, makes jobs
easier to find, and lowers the
unemployment
p y rate.
2. Lower than anticipated inflation
(unexpectedly low) ⇒ raises the real wage
rate ⇒ workers gain at the expense of
employers ⇒ decreases the quantity of
labor demanded, and increases the
unemployment rate. 33
• Unanticipated inflation has two main
consequences in the market for financial
capital: it redistributes income and results
in too much or too little lending and
borrowing.
1. When the inflation rate is higher than
anticipated (unexpectedly high) ⇒ the real
interest rate is lower than anticipated ⇒
borrowers gain but lenders lose ⇒
borrowers want to have borrowed more
and lenders want to have loaned less.
35
Dr. Mohammed Alwosabi
Effects of Inflation
• Inflation may be anticipated (expected) or
unanticipated (unexpected)
• A moderate anticipated (expected) has a
small cost, but a rapid anticipated inflation
is costly because it decreases potential GDP
and slow growth
growth.
• Unanticipated (unexpected) inflation has
two main consequences in the labor market.
It redistributes income and results in the
departure from full employment
32
3. If workers and employers base their wages
on an inflation forecast that turns out to be
correct, neither workers nor employers
gain or lose from the inflation.
34
2. When the inflation rate is lower than
anticipated (unexpectedly low) ⇒ the real
interest rate is higher than anticipated ⇒
lenders gain but borrowers lose ⇒
borrowers want to have borrowed less and
lenders want to have loaned more
• We can conclude from the above that
Inflation that is higher than expected,
transfers resources from workers to
employers and from lenders to borrowers.
• The opposite is true
36
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ECON248: Money and Banking Ch.4: Inflation
• High levels of unanticipated inflation have
other negative impacts on economies for a
number of reasons.
1. They lead to distortions in the economy and
give confusing price signals to producers.
2. For individuals on fixed incomes, the rise in
prices increases the cost of living, eroding
purchasing
h i power.
3. For investors it erodes the value of saving,
while effectively reducing the real rate of
borrowing for debtors.
37
Snapshot on the Current Inflation In GCC
Countries (2007- 08) (Reading)
• The growth rate of money supply in Gulf
countries has in some cases exceeded 20
percent. (Check the latest rates of inflation
in GCC countries)
• With this double digit inflation nominal
interest rates are way below the inflation
rate which has resulted in negative real
rates of interests.
39
3. The increase in the price of oil added to
the increase in the food prices and other
product prices as well.
4. Huge money supply and abundant
liquidity, triggered by sharply higher oil
revenues, that is accompanied by a fixed
supply of goods and services.
5. The rise in demand for real estate, which
i
increases reall estate
t t prices
i in
i addition
dditi tot
sharp increase in the cost of housing due
to shortage in property supplies such as
steel and cement.
41
Dr. Mohammed Alwosabi
4. It makes goods produced in the country
more expensive relative to goods
produced abroad resulting in a decrease in
exports and an increase in imports
5. People who hold a lot of money loose from
inflation because money value becomes
less overtime.
6. Those who own “real” assets such as land,
stocks, etc. gain from inflation because the
value of these assets goes up with
inflation.
38
Factors Causing Inflation in GCC States
1. As a result of pegging GCC currencies -
except for the Kuwaiti dinar- to a
weakening dollar there has been an
increase in the cost of goods that are
imported from countries whose currencies
had appreciated against the dollar, like the
EU, Japan and China.
2. Rising food prices internationally due to
the high demand for some types of grains
such as corn to use them as bio fuels.
40
5. The dollar peg forces GCC central banks to
follow the US Federal Reserve in setting
interest rates. But while the US central
bank continues cutting rates to stimulate a
sluggish economy, GCC central banks are
faced with expanding economies that were
already overheating at the higher rates.
Cutting interest rate just fuel the inflation
more.
6. The increase in wages without controlling
goods markets that just increase prices to
take advantage of the wage rise
42
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ECON248: Money and Banking Ch.4: Inflation Dr. Mohammed Alwosabi

Solutions adopted by GCC 2. As a recommended basket, GCC states

• It is not necessary to adopt all solutions by
all countries. Different countries adopted
different solutions
1. De-peg GCC Currencies from the tumbling
dollar and track a currency basket of their
main trade partners
partners, including the US
dollar, euro, sterling and yen. The
European Union is now the main trading
partner of the GCC accounting for 35 per
cent of their foreign trade, followed by
Asian countries 30 per cent and the US 10
per cent. 43
may link their currencies with the
International Monetary Fund's Special
Drawing Rights (SDRs), a mixed basket of
currencies.
3. Revaluation: the link to the dollar should be
revisited without necessarilyy de-pegging
p gg g
the Gulf currencies,
4. Price should be controlled by
governments, especially of the necessary
products.
44

5. Increase in interest rates should be

implemented to reduce money supply and
liquidity in the hands of public.
6. Increase the reserve requirement for banks
forcing lenders to keep more customer
deposits in their vaults.
7. Central banks should engage in open
market
k t operations
ti to
t decrease
d the
th
abundant liquidity.
8. Create a suitable environment to invest the
liquidity surplus in import substitution
products.

45 46