MACROECONOMICS

Inflation

Kunal Dasgupta
Year 1999 2019

Price (per litre) |24 |75

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Year 1999 2019

Price (per pack) |16 |94

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Year 1999 2019

Price (per 10 gm) |4,000 |39,000

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Definition
Inflation is the rate at which the average price of goods and
services in an economy increases over time.

• In most countries, inflation is measured using the

Consumer Price Index (CPI).
• Inflation is one of the most important variables that
policymakers pay attention to.

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In this topic, we shall discuss

• Inflation in the Long Run

• Inflation in the Short Run

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Inflation in the Long Run
• In the short run, money market equilibrium is achieved by
the adjustment of nominal interest rate.
• In the long run, money market equilibrium is achieved by
the adjustment of the price level.

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Long Run theory of Price Level

The price level in a country depends on

• demand for money

• supply of money

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• The simplest model of money demand is the Quantity
Theory of Money. In this model, demand for money is
assumed to be proportional to nominal income:

Md V = P Y

where
Md → money demand.
P Y → nominal income.
V → velocity of money.

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• V captures the rate at which money changes hands. It
measures the value of transactions that can be carried out
by a rupee in a given time period.
• Equilibrium is achieved when nominal money supply equals
nominal money demand,
PY
M= .
V

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• The long run price level solves
MV
P = .
Y
=⇒ Price level is determined by the stock of money
supply.
• Note that
∆P ∆M ∆Y
π= = − .
P M Y
=⇒ Inflation is determined by the growth rate of money
supply.

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Why does an increase in M cause an increase in P ?

• As money supply increases, the spending ability of

consumers, firms and the government goes up.
• They respond by increasing the demand for goods and
services.
• If the supply of goods and services is unchanged, the
market clears through a price rise.

The one-to-one relation between money supply and price level

can be seen most clearly during periods of hyperinflation.

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Month Price
December 1918 0.5
December 1921 4
December 1922 163
January 1923 250
March 1923 463
June 1923 1,465
July 1923 3,465
August 1923 69,000
September 1923 1,512,000
October 1923 1,743,000,000
November 1923 201,000,000,000
Price of bread in Berlin

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Definition
Hyperinflation typically refers to a situation where the
monthly inflation rate is greater than 50 percent.

• Money ceases to function as a medium of exchange as well

as a store of value.
• People start conducting transactions with barter or a
stable foreign currency.
• Hyperinflation episodes usually end with the government
abandoning the existing currency.

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Episodes of hyperinflation

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Application: Hyperinflation in Zimbabwe

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• Zimbabwe was born on April 18, 1980.
• From late 90s, the government implemented land reforms
whereby land owned by White farmers was acquired and
re-distributed among locals.
• Many of the new farmers did not have enough knowledge
about farming.
• Zimbabwe being a primarily agrarian economy, the
subsequent decline in agricultural output had a big impact
on GDP.

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• With tax revenue drying up, the government resorted to
printing money to finance expenses.
• Hyperinflation followed.
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Currency note in Zimbabwe

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Inflation and interest rates

• Suppose a person deposits money in a savings account

paying an interest of 5%.
• Is the person necessarily richer the following year?
• Not if prices have increased by more than 5%!!
• Using i and r to denote nominal and real interest rate
respectively, we then have

r = i − π.

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Fisher Effect

• Observe that
i = r + π.

• According to the Fisher Effect, the Long Run real interest

rate r should be the same across countries, say r̄.
• Hence,
i = r̄ + π.

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Nominal interest rate in India

Inflation in India

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Cost of inflation: Shoeleather Cost

Shoeleather costs are the resources that are wasted when

inflation encourages people to reduce their money holdings.

• Inflation results in a decline in the average cash holdings.

• Less cash holding means more frequent trips to the bank.
• Costs include (i) the cost of making trips to the bank, (ii)
the opportunity cost of time, (iii) the cost of withdrawing
money from interest-bearing accounts.

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Cost of inflation: Menu Cost

Menu costs are the resources that are wasted when firms have
to adjust their prices.

• The higher is inflation, the more frequently firms must

change their prices and incur these costs.
• Example: cost of printing new price labels, new catalogs,
new ads, etc.

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Cost of inflation: Arbitrary re-distribution of wealth

Unexpected inflation redistributes wealth among the population

in a way that has nothing to do with need.

• Many long-term contracts not indexed but based on E[π].

• If π turns out different from E[π], then some gain at
others’ expense.
• If π > E[π], purchasing power is transferred from lenders to
borrowers.
• If π < E[π], purchasing power is transferred from borrowers
to lenders.

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Why would a central bank want to increase money supply if it
leads to inflation?

• All governments spend money. This spending can be

financed in three ways:
1. Through taxes
2. Borrow from the public
3. Print money
• Most countries in the world print money to finance a part
of their spending.

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If inflation is usually bad, deflation (falling prices) must be
good?

• Central banks all over the world prefer mild inflation over
deflation.
• There is little incentive to spend today if the expectation is
for cheaper prices tomorrow.
• A decline in aggregate demand, in turn, could trigger a
recession in the economy.

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Example: Deflation in Japan

• Post World War II, Japan experienced an economic miracle

driven, among other factors, by high investment rates and
rising productivity.
• But in the late 80s, Japan witnessed an asset price bubble,
driven partly by loose monetary policy.
• The bubble eventually burst in early 90s, triggering a
period of economic stagnation.

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CPI inflation rates in Japan (1990 - 2015)

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GDP per capita in Japan (1960 - 2010)

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Inflation in the Short Run
• Previously, we had considered a classic theory of nominal
rigidity.
• The modern theory of nominal rigidity gives a central role
to imperfect information.

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The Imperfect Information model

Assumptions:

• Each supplier produces just one good.

• Production is done using own labor.
• Prices are perfectly flexible.

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• We assume that a supplier knows the price of the good
that she produces .....
• ..... but does not know price level at the time she makes
her production decision; so uses E[P ] instead.
• Now, suppose P rises but E[P ] does not.
• Lacking perfect information, the supplier believes that it is
only the price of her product that has gone up.
• She responds by increasing output.

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• In this model, the SRAS (Short Run AS) curve takes the
following form:

Y = Y ∗ + α(P − E[P ]),

where Y ∗ is the natural rate of output or full employment

level of output, and α is a positive constant.
• Other things equal, Y and P are positively related, so the
SRAS curve is upward-sloping.

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Definition
An inflationary gap arises when equilibrium output is more
than the full employment level, i.e., Y > Y ∗ .

Definition
A deflationary gap arises when equilibrium output is less than
the full employment level, i.e., Y < Y ∗ .

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When there is an inflationary gap,

• Actual unemployment (u) is lower than the natural rate

(un ).
• Cyclical unemployment (u − un ) is negative.

When there is a deflationary gap,

• Actual unemployment (u) is higher than the natural rate

(un ).
• Cyclical unemployment (u − un ) is positive.

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The empirical relationship between output gap and cyclical
unemployment is captured by the Okun’s Law.

Definition
Each extra percentage point of cyclical unemployment is
associated with about a 2 percentage point fall in the output
gap.

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Okun’s Law (in the U.S.)

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• Two of the most important goals of policymakers in any
country are
1. low inflation
2. low unemployment
• But these goals often conflict in the short run.
• This trade-off between inflation and unemployment is
called the Phillips curve.

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The Phillips curve

The Phillips curve states that actual inflation π depends on

• expected inflation, E[π]

• cyclical unemployment, u − un
• supply shocks, v

in the following way:

π = E[π] − β(u − un ) + v,

where β is a positive constant.

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To derive the Phillips curve, one needs

• the SRAS curve

• the presence of supply shocks
• the relation between output gap and cyclical unemployment

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The Phillips Curve

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Shifts in the Phillips Curve

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• For the Phillips curve to be useful for policymaking, one
needs to have an idea of how inflation expectations are
formed.
• A simple and plausible assumption is that expected
inflation is based on past inflation.
• This assumption is called adaptive expectations.

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“Why is our money ever less valuable? Perhaps it is simply that
we have inflation because we expect inflation, and we expect
inflation because we have had it.”

Robert Solow

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The Phillips curve under adaptive expectations becomes:

π = π−1 − β(u − un ) + v,

where π−1 is inflation in the previous period. In this form, the

Phillips curve implies that inflation has inertia:

• In the absence of supply shocks or cyclical unemployment,

inflation will continue indefinitely at its current rate.
• Past inflation influences expectations of current inflation,
which in turn influences the wages and prices that people
set.

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A drawback of adaptive expectations

• Suppose the central bank of a country announces a policy

to tighten money supply growth in the future.
• If expectations are adaptive, then expected inflation will
not change because it is based on past inflation.

Such situations call for an alternative model of expectation

formation.

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• One such alternative is rational expectations.
• The assumption here is that individuals base their
expectations on all available information, .....
• ..... including information about current and prospective
future policies.
• Supporters of rational expectations argue that if individuals
have rational expectations, the inflation-unemployment
trade-off might be significantly weaker.

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Example :

• Suppose u = un and π = E[π] = 6%.

• Now, suppose RBI announces that it will do whatever is
necessary to reduce inflation from 6 to 4 percent as soon as
possible.
• If the announcement is credible, E[π] could fall by the full
2 percentage points.
• Then, π can fall without an increase in u – a painless
disinflation.

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Rational expectations highlight two important determinants of
inflation expectation:

• How information about future policies is conveyed by

central banks.
• How credible announcements by central banks are.

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• One way to anchor individual’s expectation about future
inflation is to have an explicit inflation target.
• Under inflation targeting, a central bank announces a
specific target for the inflation rate to the public.
• It achieves this target by using its main short-term
monetary instrument, the interest rate.

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Example:

• The Bank of England adopted inflation targeting in 1992.

• Since 2003, the target set by the Bank has been 2 percent.

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