Principles of Economics Level: Master 1 CE/CI Semester 1 Language: English Academic Year: 2008-2009 Prof Gilles DUFRENOT Faculty

ty of Administration and International Relationships University of Paris 12 Val de Marne Lecture Notes Chapter 1. Inflation

I.- Introduction : Basic concepts and common ideas about inflation I.1.- Several concepts to illustrate the changes in a nominal price index A rise the general level of prices in nominal terms (whosesale prices, wages, GDP deflator, CPI) Which indicator? Usually, the annualized percentage growth of the CPI or GDP deflator index. Note: be sure that you know how to compute an annualized inflation rate from monthly and quarterly data. Several countries have experienced episodes of hyperinflation (CPI changes above 50% per month): Germany (30s), developing countries, Zimbabwe (1000% per day!) Deflation : negative inflation (ex: Japan in recent years). Question: according to you, what are the reasons for Japans deflationary trap since the 1970s? Some elements of answers are: Japans increasing competitiveness and rising trade surpluses in the 1970s Pressure by the US government (threats of sanctions) to keep appreciating the yen (explain why trade surplus leads to an upward movement of the nominal exchange rate). Yen : 360 per Dollar in August 1971 to 80 yen per Dollar in April 1995, late 1990s around 120 yen per Dollar. Consequences: a decrease in the price of tradable goods (imported prices).
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Fear of an overvaluation of the interest rate leads the monetary authorities to reduce nominal interest rates thereby contributing to great bubbles in the Japanese stocks. When the bubbles burst, this accentuated deflation.

Examples: The inflation rate in France since the beginning century (see the graph) several price spikes appear corresponding to specific events : the two second World wars show up, the prices display a peak around the years corresponding to the oil shocks, since the beginning 90s CPI inflation has remained steadily low (around 2%, up until the recent surge in the food and oil price). Hyperinflation in Zimbabwe (see graph) I.2- Which indicator is best suited for the inflation rate ? CPI : basket of goods and services consumed by households (staple foods, energy, electricity, transport, etc.) -> an indication of the cost of living GDP deflator: more representative of the economy as a whole (cost of factors), less relevant to ordinary consumers: nonconsumer goods excludes the prices of the many foreign-produced goods that consumers do buy. basket includes the prices of

prices of non-tradables and tradables definition : locally-produced goods and services (hair-dresser, public transportation, housing prices, etc), goods and services that are traded and whose prices are influenced by the world prices this allows to distinguish between the supply-driven and demand driven inflation (productivity, level of income, government consumption, money, etc.).
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Ex: a trend increase in the relative price of tradables signals that demand factors are at play in driving relative price movements.

The ratio of the prices of non-tradables to tradables is an indicator of a countrys internal competitiveness (indicates whether there are some incitation in shifting production towards domestically produced goods)

Examples : Items of the CPI index (see graph) CPI, tradable and non-tradable components (see graph)

Headline and core inflation For consumers : what matters is headline inflation (standard of living) Core inflation rate : useful for calibrating monetary policy, by excluding the most volatile component of the price index (usually staple foods and energy).

I.3- What is meant by inflation is always and everywhere a monetary phenomenon or money is neutral in the long-run? The accounting identity that allows analyzing the link between money stock and prices: M V = P Y (also called the quantitative equation). What do we expect on a deductive basis? V : income velocity of money (number of times per year a euro is turned over in transactions of the final goods); depends upon numerous factors (preference for liquidity, banking depth, etc.). Y: transactions in real terms conditional on production capacities (productivity, infrastructures, etc). All things being equals, doubling M will double P. Say it another way: prices rise when there are more money purchasing the same amount of production.
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Money is injected in the economy in several manners by central banks, for example through open markets operations (by purchasing bonds and the commercial bank receives in turn money. Money is hold in the form of deposits and deposits loans). The CBs action expands the loanable funds (by business firms and households). The important point here is that we have no real price effects (in the sense that some prices are raised in comparison to others). An increase in the stock of money implies a proportional rise in all prices. The economists say that money is neutral, meaning that an expansive monetary policy has only nominal effects (no real effects). But this happens in the long-run, when the relative price effects are washed out. Question: Can you give me an, whereby a monetary expansion may imply real effects? -impact of loanable funds on the interest rates, then on the prices of bonds (link the prices of bonds to the discounted values of expected profits) and this may have detrimental effects on investment. Use the quantity equation and explain the circumstances under which the inflation dynamics is mainly linked to an increase in the quantity of money. To what extend are we sure that these assumptions hold. This is an empirical issue: which of the three factors contribute the most to inflation? Friedman provides some evidence that, historically, a long lasting inflation has been associated with a sustained growth of money supply. According to you, describe different ways of proving empirically that money is a monetary phenomenon:

Compare inflation differentials (between countries or within a country over different time periods) and the differentials of output growth and money velocity growth.

Do you understand, now, why the monetarist approach is sometimes referred as a demand-pull explanation of inflation? Money expansion fuels spending and this in turn pulls prices up. The quantity equation can also be used to account for the impact of negative supply shocks on inflation, but the latter have to be very large. a supply shock leads a rise in the general price level if the economys output shrinks by a large amount (in the differential equation, gY must be strongly negative) An example: the USA during the second oil price shocks: 9.2 percent U.S. inflation rate in 1980 (as measured by the GDP deflator, gP = 9.2 percent) negative growth of real GDP (gy = 0.2%) growth in the money stock (M1 measure, December 1980 over December 1979) accounted for 7.0 percentage points (gM = 7.0 percent). Growth of approximately 2 percent in the income-velocity of M1 accounted for the remainder (gV = 2.0 percent). Explain the following paradox, then. Assume that the economy is an overheating situation (one observes a spurt in real growth) and that inflation is rising. How can the monetary approach be evoked to explain this? I.4- Is there a relationship between unemployment and inflation

 The so-called Phillips curve describes an empirical link between the rate of inflation and the unemployment rate. first evidence: Phillipss UK 1861- 1957. Found a negative relationship between the unemployment rate and the growth rate of nominal wages: low unemployment implying a high increase in wages and conversely (wages are raised to attract a scarce labor factor). Our conjecture: wages are indexed to prices (wage-price loop) . The price you charge is proportional to the wages you pay. Figure 1 shows a Phillips curve drawn data on from the United States from 1961 to 1969. The cost of reducing unemployment would be higher: for instance, a reduction in unemployment from 5 to 4 percent would imply an increase in the inflation rate of about one and a quarter percentage points. Figure 1 The Phillips Curve, 19611969

Source: Bureau of Labor Statistics. Note: Inflation based on the Consumer Price Index. Some authors in the economic literature have challenged the theoretical underpinnings of the Phillips curve First criticism concerns money illusion. Informed workers refer to the inflation adjusted money wages (purchasing power). So, when employers want to attract
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workers, money wages first increase, but since they are connected to the general level of prices, the real wages are not affected, thereby implying that no movement occurs in the labor supply. So, there is a natural level of unemployment and no dilemma between inflation and unemployment. Friedman and the monetarists go a step further arguing that money is neutral with no real prices effects (no changes in the real wages) and thus the equilibrium on the labor and goods markets remained at its initial position. Fiscal or monetary policy used to lower unemployment below its natural rate demand is increased nominal prices are raised faster than nominal wages in the short run, employers are victims of money illusion and firms expected higher profits new workers are hired (the unemployment rate falls); However, workers progressively adjust their expectations (by observing price increases today, they anticipate future increases and then claim wages increases) leading the unemployment rate to return to its previous level (since the real wages have remain constant). Main conclusion are : A distinction is worthwhile between short-run and long-run Phillips curve swhen one assumes rational expectations According to the monetarists, the long-run Phillips curve is vertical (at a level corresponding to the natural rate of unemployment The only impact of expansionary fiscal and monetary policies is to expand inflation with no implication on the long-run unemployment rate (NAIRU) Figure 2 shows an example According to the regression line, NAIRU (unemployment rate for which the change in the rate of inflation is zero) is about 6 percent. If the economy is at NAIRU , but
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with an inflation rate that differs from zero, the government would like to reduce the inflation rate to zero. The figure suggests that contractionary monetary and fiscal policies that drove the average rate of unemployment up to about 7 percent (i.e., one point above NAIRU) would be associated with a reduction in inflation of about one percentage point per year. Thus, if the governments policies caused the unemployment rate to stay at about 7 percent, the 3 percent inflation rate would, on average, be reduced one point each yearfalling to zero in about three years.

Figure 2 Example of an expectations-Augmented Phillips Curve

Source: Bureau of Labor Statistics. Note: Inflation based on the Consumer Price Index. Modern macroeconomic models often employ another version of the Phillips curve in which the output gap replaces the unemployment rate as the measure of aggregate demand relative to aggregate supply. The output gap is the difference between the actual level of GDP and the potential (or sustainable) level of aggregate output expressed as a percentage of potential. This formulation explains why, at the end of the 1990s boom when unemployment rates were well below estimates of NAIRU, prices did not accelerate. The reasoning is as follows. Potential output depends not only on labor inputs, but also on plant and equipment and other capital inputs. At the end of the boom, after nearly a decade of rapid
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INVESTMENT,

firms found themselves

with too much capital. The excess capacity raised potential output, widening the output gap and reducing the pressure on prices. Many articles in the conservative business press criticize the Phillips curve because they believe it both implies that growth causes inflation and repudiates the theory that excess growth of money is inflations true cause. But it does no such thing. One can believe in the Phillips curve and still understand that increased growth, all other things equal, will reduce inflation. The misplaced criticism of the Phillips curve is ironic since Milton Friedman, one of the coinventors of its expectations-augmented version, is also the foremost defender of the view that inflation is always, and everywhere, a monetary phenomenon. The Phillips curve was hailed in the 1960s as providing an account of the inflation process hitherto missing from the conventional macroeconomic model. After four decades, the Phillips curve, as transformed by the natural-rate hypothesis into its expectations-augmented version, remains the key to relating unemployment (of capital as well as labor) to inflation in mainstream macroeconomic analysis.

APPENDIX 1 There is an inverse relationship between price and yield: when interest rates are rising, bond prices are falling, and vice versa. The easiest way to understand this is to think logically about an investment. You buy a bond for $100 that pays a certain interest rate (coupon). Interest rates (coupons) go up. That same bond, to pay then-current rates, would have to cost less: maybe you would pay $90 the same bonds if rates go up. Ignoring discount factors, here is a simplified example, a 1-year bond. Let's say you bought a 1-year bond when the 1-year interest rate was 4.00%. The bond's principal (amount you pay, and will receive back at maturity) is $100. The coupon (interest) you will receive is 4.00% * $100 = $4.00. Today: You Pay $100.00 Year 1: You receive $4.00 Year 1 (Maturity): You Receive $100 Interest Rate = $4.00 / $100.00 = 4.00% Now, today, assume the 1-year interest rate is 4.25%. Would you still pay $100 for a bond that pays 4.00%? No. You could buy a new 1-year bond for $100 and get 4.25%. So, to pay 4.25% on a bond that was originally issued with a 4.00% coupon, you would need to pay less. How much less? Today: You Pay X Year 1: You Receive $4.00 Year 1 (Maturity): You Receive $100 The interest you receive + the difference between the redemption price ($100) and the initial price paid (X) should give you 4.25%: [ ($100 - X) + $4.00 ] / X = 4.25% $104 - X = 4.25% * X $104 = 4.25% * X + X $104 = X (4.25% + 1)
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$104 / (1.0425) = X X = $99.76 So, to get a 4.25% yield, you would pay $99.75 for a bond with a 4.00% coupon.

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