Chapter 9 Inflation and Phillips

curve
Mentor Pham Xuan Truong
truongpx@ftu.edu.vn
Content
I Overview of inflation
II Cost of inflation
III Phillips curve – relationship between
inflation and unemployment
I Overview of inflation
1 Definition and computing method
Inflation is a sustained increase in the general price
level of goods and services in an economy over a period
of time
Or sustained reduction in the purchasing power per unit
of money – a loss of real value in the medium of
exchange and unit of account within the economy (each
unit of currency buys fewer goods and services)
Deflation is the contrary concept as a sustained
decrease in the general price level of goods and services
in an economy over a period of time or sustained
increase in the purchasing power per unit of money
Other related concepts: disinflation - a decrease in the
rate of inflation; hyperinflation - an out-of-control
inflationary spiral; stagflation - a combination of inflation,
slow economic growth and high unemployment; reflation
- an attempt to raise the general level of prices to
counteract deflationary pressures.
 I Overview of inflation
1 Definition and computing method

Other indices could be used to calculate

inflation: GDP deflator, PPI (producer price
index) or core price index (core CPI)
 I Overview of inflation
2 Classification
Moderate Inflation: inflation rate < 10%/year, prices
increases slowly. Moderate inflation can spur production
because price increases leading to highet profit for
enterprises,therefore, firms will increases quantity.
Galloping Inflation: inflation rate is from 10% to 99% per
year. This type will destroy economy and curb engines of
economy.
Hyper Inflation: is defined as inflation that exceeds 100%
percent per year. Costs such as shoe-leather and menu
costs are much worse with hyperinflation– and tax systems
are grossly distorted. Eventually, when costs become too
great with hyperinflation, the money loses its role as store
of value, unit of account and medium of exchange.
Bartering or using commodity money becomes prevalent.
In 1920s (1922-12/1923) Weimar Germany, CPI increased
from 1 to 10 millions
I Overview of inflation
2 Classification
Expected inflation: depends on
expectation of individuals about gp in the
future. Its impacts is small but help to adjust
production cost.
Unexpected inflation: derives from
exogenous shocks and unexpected factors
inside economy.
 I Overview of inflation
3 Causes of inflation
Demand-pull inflation is caused by
continuing rises in AD in the economy. The
increase in AD may be caused by either
increases in the money supply or increases
in G-expenditure when the economy is close
to full employment.
In general, demand-pull inflation is
typically associated with a booming
economy.
I Overview of inflation
3 Causes of inflation
Cost-push inflation is associated with
continuing rises in costs. Rises in costs may
originate from a number of different sources
such as wage increases and other higher
costs of production (e.g. raw materials).
Long run causes (LRAS)
AD must shift to the right more than LRAS
shifts
P
to the
LRAright
LRAS
S ’

AD
Y

Economy’s demands number of output

more than the improvement of country’s
production capacity
 I Overview of inflation
3 Causes of inflation
Money quantity theory – the classical theory of
inflation
Velocity and the quantity equation
Quantity equation: M × V = P × Y
+ Quantity of money (M)
+ Velocity of money (V)
+ Dollar value of the economy’s output of goods and
services (P × Y )

This quantity shows that: an increase in quantity of money

must be reflected in:
+ Price level must rise
+ Quantity of output must rise
+ Velocity of money must fall
 I Overview of inflation
3 Causes of inflation
Money quantity theory – the classical theory of inflation
Five steps - essence of quantity theory of money
1. Velocity of money: Relatively stable over time
2. Changes in quantity of money (M) will lead to Proportionate
changes in nominal value of output (P × Y)
3. Economy’s output of goods and services (Y): in long run
primarily determined by factor supplies and available production
technology. Because money is neutral then Money does not affect
output in the long run
4. Change in money supply (M): Induces proportional changes in
the nominal value of output (P × Y) and Reflected in changes in
the price level (P)
5. Therefore, Central bank - increases the money supply rapidly →
High rate of inflation.
→ Money quantity theory explains cause of long run
inflation
“Inflation is always and everywhere a monetary phenomenon.” —
 Nominal GDP, quantity of money, & velocity of
money

This figure shows the nominal value of output as measured by nominal GDP, the quantity of money
as measured by M2, and the velocity of money as measured by their ratio. For comparability, all
three series have been scaled to equal 100 in 1960. Notice that nominal GDP and the quantity of
money have grown dramatically over this period, while velocity has been relatively stable.
I Overview of inflation
4 Policies to deal with inflation
4.1.Fiscal policy comprises changes in
government expenditure and/or taxation. The
aim is to affect the level of AD through a
policy known as demand management. In
the case of controlling inflation, this involves
reducing government expenditure and/or
increasing taxation in what is called a
deflationary fiscal policy. Such policies are
likely to be effective if inflation has been
diagnosed as demand-pull since a reduction
in government expenditure or an increase in
income tax will reduce aggregate demand in
I Overview of inflation
4 Policies to deal with inflation
4.2.Monetary policy is concerned with
influencing the money supply and the
interest rate. In terms of controlling inflation,
the central bank can aim to reduce the
money supply thus reducing spending and,
therefore, the aggregate demand, or it can
increase the interest rate so as to increase
the cost of borrowing. Both policies can be
seen as deflationary monetary policy. Since
monetarists view the growth of the money
supply as being the main cause of inflation,
any control of inflation from a monetarist
I Overview of inflation
4 Policies to deal with inflation
4.3.Prices and incomes policy aim to limit
and, in certain cases, freeze wage and price
increases. In the past they have either been
statutory or voluntary. Statutory prices and
incomes policies have to be enforced by
government legislation, such as the EU
minimum wage legislation. With a voluntary
prices and incomes policy the government
aims to control prices and incomes through
voluntary restraint, possibly by obtaining the
support of the unions and employers.
 I Overview of inflation
4 Policies to deal with inflation
4.4. Supply-side policy is concerned with instituting
measures aimed at shifting the aggregate supply curve to
the right. Supply-side economics is the use of
microeconomic incentives to alter the level of full
employment and the level of potential output in the
economy. If inflation is caused by cost-push pressures,
supply-side policy can help to reduce these cost pressures in
two ways:
(1) by reducing the power of trade unions and/or firms
(e.g. by anti-monopoly legislation) and thereby encouraging
more competition in the supply of labour and/or goods,
(2) by encouraging increases in productivity through the
retraining of labour, or by investment grants to firms, or by
tax incentives, etc.
I Overview of inflation
4 Policies to deal with inflation
4.5.Learning to live with inflation involves
accepting the fact that inflation is here to stay when
standard anti –inflationary policy measures appear
ineffective. In such a situation we just have to learn to
live with inflation. Learning to live with inflation
involves the government, employers and workers
taking inflation into account in their everyday
transactions. For example, the government/employers
may use indexation in wage/pensions contracts.
Indexation is when wages or pensions are increased
in line with the current rate of inflation. Indexation is
aimed at nullifying the effects of inflation.
II Cost of inflation
The inflation tax
Revenue the government raises by creating
(printing) money
Tax on everyone who holds money

Shoe-leather costs
Resources wasted when inflation encourages
people to reduce their money holdings
Can be substantial

Menu costs
Costs of changing prices
Inflation – increases menu costs that firms
must bear
II Cost of inflation
Relative-price variability &
misallocation of resources
Market economies: rely on relative prices
to allocate scarce resources
Consumers - compare
Quality and prices of various goods
and services
Determine allocation of scarce
factors of production
Inflation - distorts relative prices
Consumer decisions – distorted
Markets - less able to allocate
 II Cost of inflation
Inflation-induced tax distortions
 Taxes – distort incentives: many taxes are more
problematic in the presence of inflation
(1) Tax treatment of capital gains
Capital gains – Profits:
Sell an asset for more than its purchase price
Inflation discourages saving
Exaggerates the size of capital gains
Increases the tax burden
(2) Tax treatment of interest income
Nominal interest earned on savings
Treated as income
Even though part of the nominal interest rate
compensates for inflation
 How inflation raises the tax burden on saving
Economy A Economy
(price B
stability) (inflation)
Real interest rate 4% 4%
Inflation rate 0.08 0 8
Nominal interest rate 4 12
(real interest rate + inflation rate)
Reduced interest due to 25 percent tax 1 3
(.25 × nominal interest rate)
After-tax nominal interest rate 3 9
(.75 × nominal interest rate)
After-tax real interest rate 3 1
(after-tax nominal interest rate –
inflation rate)

In the presence of zero inflation, a 25 percent tax on interest income

reduces the real interest rate from 4 percent to 3 percent.
In the presence of 8 percent inflation, the same tax reduces the real
interest rate from 4 percent to 1 percent.
II Cost of inflation
Confusion and inconvenience
 Money is the yardstick with which we measure economic
transactions
 The central bank’s job is to Ensure the reliability of money. But
when the central bank increases the money supply, it will
creates inflation and erodes the real value of the unit of
account → 1 unit of money value in year t is no longer equal to
1 unit of money value year t +x → direct comparison is
inaccurate
A special cost of unexpected inflation: arbitrary
redistributions of wealth
 Inflation - volatile & uncertain when the average rate of
inflation is high
 Unexpected inflation: redistributes wealth among the
population Not by merit and Not by need
 In details, unexpected inflation redistribute wealth among
debtors and creditors, workers and employers, tax payers and
state
 II Cost of inflation
Notion: A fall in purchasing power? Inflation
fallacy
“Inflation robs people of the purchasing power of
his hard-earned dollars” – Right or wrong
Actually, when prices rise
Buyers – pay more
Sellers – get more
Inflation in incomes - goes hand in hand with
inflation in prices
→ Inflation does not in itself reduce people’s real
purchasing power. Real purchasing power of one
person is indeed reduced when inflation in incomes
of the person is lower than inflation in price
III Phillips curve – relationship
between inflation and unemployment
Background
Phillips curve initially shows the short-run
trade-off between inflation and
unemployment
Origins of the Phillips curve
- 1958, economist A. W. Phillips wrote the
article “The relationship between
unemployment and the rate of change of
money wages in the United Kingdom, 1861–
1957”. Then later economics generalized it
under the negative correlation between the
rate of unemployment and the rate of
inflation
III Phillips curve – relationship
between inflation and unemployment
Background
- 1960, economists Paul Samuelson & Robert
Solow wrote “Analytics of anti-inflation policy”
that emphasized again negative correlation
between the rate of unemployment and the
rate of inflation
- The most valuable implication from Phillips
curve is for policymakers: Monetary and fiscal
policy To influence aggregate demand Choose
any point on Phillips curve Trade-off: High
unemployment and low inflation Or low
unemployment and high inflation
III Phillips curve – relationship
between inflation and unemployment
Short run
 III Phillips curve – relationship
between inflation and unemployment
Short run
AD and AS and the Phillips curve
Phillips curve: is the combinations of inflation and
unemployment that arise in the short run. As shifts in
the aggregate-demand curve, move the economy
along the short-run aggregate-supply curve
Higher aggregate-demand
Higher output & Higher price level
Lower unemployment & Higher inflation
Lower aggregate-demand
Lower output & Lower price level
Higher unemployment & Lower inflation
 How the Phillips curve is related to the model of aggregate demand and aggregate
supply

(a) The Model of AD and AS (b) The Phillips Curve

Inflation
Price Short-run
Rate
level aggregate
(percent
supply
per year)
B B
6%
106
A High aggregate
102 demand

A
Low aggregate 2
demand
Phillips curve

0 15,000 16,000 Quantity 0 4% 7% Unemployment

unemployment unemployment of output output output Rate (percent)
=7% =4% =16,000 =15,000
This figure assumes price level of 100 for year 2020 and charts possible outcomes for the year 2021. Panel (a)
shows the model of aggregate demand & aggregate supply. If AD is low, the economy is at point A; output is
low (15,000), and the price level is low (102). If AD is high, the economy is at point B; output is high (16,000),
and the price level is high (106). Panel (b) shows the implications for the Phillips curve. Point A, which arises
when aggregate demand is low, has high unemployment (7%) and low inflation (2%). Point B, which arises
when aggregate demand is high, has low unemployment (4%) and high inflation (6%).
 III Phillips curve – relationship between
inflation and unemployment
Long run
Inflation
Rate Long-run
Phillips curve

High B
inflation

Low A
inflation

Natural rate of Unemployment

unemployment Rate
According to Friedman and Phelps, there is no trade-off between inflation and unemployment
in the long run. Growth in the money supply determines the inflation rate. Regardless of the
inflation rate, the unemployment rate gravitates toward its natural rate. As a result, the long-
run Phillips curve is vertical.
 INFLATION AND UNEMPLOYMENT IN VIETNAM:
PERIOD 1996 – 2021 (25 years)

25
2008

20

15

10
2006

5 2017
2016
2015
0
0.5 1 1.5 2 2.5 3

-5

30
 III Phillips curve – relationship
between inflation and unemployment
Long run
- Phillips curve is vertical
- If the central bank increases the money supply slowly,
in the long run: Inflation rate is low + Unemployment –
natural rate
If the central bank increases the money supply
quickly, in the long run: Inflation rate is high +
Unemployment – natural rate
→ Unemployment - does not depend on money growth
and inflation in the long run
- Expression of the classical idea of monetary neutrality:
Increase in money supply then Aggregate-demand
curve – shifts right
Price
level – increases = Inflation rate – increases
Output – natural rate = Unemployment – natural rate
 How the long-run Phillips curve is related to the model of aggregate demand and
aggregate supply

(a) The Model of AD and AS (b) The Phillips Curve

Inflation
Price Long-run Long-run
Rate
level aggregate supply Phillips curve

B
P2 1. An increase in B
the money supply 3. . . . and
A increases aggregate increases the
P1 demand . . . inflation rate . . .
A
2. . . . raises
AD2
the price
level . . . Aggregate demand, AD1

0 Natural rate Quantity of output 0 Natural rate Unemployment

of output of output Rate
4. . . . but leaves output and unemployment
at their natural rates.
Panel (a) shows the model of AD and AS with a vertical aggregate-supply curve. When expansionary monetary
policy shifts the AD curve to the right from AD 1 to AD2, the equilibrium moves from point A to point B. The price
level rises from P1 to P2, while output remains the same. Panel (b) shows the long-run Phillips curve, which is
vertical at the natural rate of unemployment. In the long run, expansionary monetary policy moves the economy
from lower inflation (point A) to higher inflation (point B) without changing the rate of unemployment
 III Phillips curve – relationship
between inflation and unemployment
The shift of Phillips curve
+ long run: Labor-market policies that affect the
natural rate of unemployment will shift the Phillips
curve. Policy change - reduce the natural rate of
unemployment → Long-run Phillips curve shifts left,
Long-run aggregate-supply shifts right → For any
given rate of money growth and inflation , we have
lower unemployment and higher output
+ short run: Each short-run Phillips curve reflects a
particular expected rate of inflation. Expected
inflation – changes short-run Phillips curve shifts.
Changes of expected inflation (or expected price)
induces shift of AS curve
 III Phillips curve – relationship
between inflation and unemployment
The shift of Phillips curve
The equation of short run Phillips curve could be given as

Unemployment rate = Natural rate of

unemployment - a(Actual inflation –
Expected inflation)
where a - parameter that measures how
much unemployment responds to
→ short run Phillips curve shifts upward/rightward as
unexpected
expected inflationinflation
increases or AS curve shifts
downward/leftward
short run Phillips curve shifts downward/leftward as expected
inflation decreases or AS curve shifts downward/rightward
Notion: supply shock plays the same role as expected
inflation in terms of Short run AS shift
 How expected inflation shifts short-run Phillips
curve
Inflation
Rate Long-run 2. . . . but in the long run, expected
Phillips curve inflation rises, and the short-run
Phillips curve shifts to the right.
B C

Short-run Phillips curve

with high expected
1. Expansionary policy moves A inflation
the economy up along the
short-run Phillips curve . . . Short-run Phillips curve
with low expected
inflation
Natural rate of Unemployment Rate
unemployment
The higher the expected rate of inflation, the higher the short-run trade-off
between inflation and unemployment. At point A, expected inflation and
actual inflation are equal at a low rate, and unemployment is at its natural
rate. If the Fed pursues an expansionary monetary policy, the economy
moves from point A to point B in the short run. At point B, expected inflation
is still low, but actual inflation is high. Unemployment is below its natural
 How shift of the short-run Phillips curve is related to the model of aggregate demand and
aggregate supply: An adverse shock to aggregate supply

(a) The Model of AD and AS (b) The Phillips Curve

1. An adverse shift 4. . . . giving policymakers
Price 3. . . . and raises Inflation a less favorable trade-off
in aggregate supply . . .
level the price level . . . Rate between unemployment
AS2 and inflation.

Aggregate
B supply, AS1
P2 B

A
P1 A

Aggregate PC2
demand Phillips curve, PC1
0 Y2 Y1 Quantity of output 0 Unemployment
Rate
2. . . . lowers output . . .
Panel (a) shows the model of aggregate demand and aggregate supply. When the aggregate-supply curve
shifts to the left from AS1 to AS2, the equilibrium moves from point A to point B. Output falls from Y 1 to Y2, and
the price level rises from P1 to P2. Panel (b) shows the short-run trade-off between inflation and unemployment.
The adverse shift in aggregate supply moves the economy from a point with lower unemployment and lower
inflation (point A) to a point with higher unemployment and higher inflation (point B). The short-run Phillips curve
shifts
Key concepts
- Inflation, deflation, disinflation, reflation
- Demand pull inflation
- Cost push inflation
- Money quantity theory
- Velocity of money
- Phillips curve
- Inflation unemployment trade off
- Shoe-leather cost, menu cost, inflation tax,
inflation fallacy
- Expected inflation