Money, Inflation and Unemployment
Module Convenor: Luke Buchanan-Hodgman
Contact: [email protected] Office: Keynes D2.12 Contact Hours: Thursday 10-11
Website: https://sites.google.com/site/buchananhodgman
Learning Objectives
1. LO1: Cover the different types of price changes (inflation, deflation, disinflation etc.), how inflation is measured and its impact on the store of value function of money
2. LO2: Examine the different ways inflation can be modelled using our AS-AD framework, explaining the way governments accommodative practices can create inflationary persistence
Some Useful Preliminaries
You will hear many different terms used when reading about historical and contemporary episodes of price level changes. Some useful definitions are;
I Inflation: the rate at which the price level rises (Pt−Pt−1 >1)
I Hyperinflation: a very high rate of inflation - usually in excess of 50% per month
I Deflation: a fall in the price level (Pt−Pt−1 <1)
I Disinflation: a reduction in the rate of inflation (Pt−Pt−1 <Pt−1−Pt−2)
What
is
Inflation and how is it calculated?
I What is inflation?
It is very important to remember that when we talk of inflation, we are notreferring to the rise in the price of a single good or service. Instead we are referring to the behaviour of aweighted average of prices included in the relevant index (CPI, RPI etc)
I How is it calculated?
We simply calculate the annual percentage change in the price level of the weighted average basket of goods in whichever index we are using. For example, is this year’s price level in index form is 105, but last year’s was 102, then inflation is;
105−102 102
Inflation versus a one-off rise in the price level
2000 2002 2004 2006 2008 2010
100 110 120 130 140 150
Price
Level
UK Inflation: the facts (ONS data)
1989 1993
1998
2003
2008 2012
−
2.5
0
2.5
5
7.5
10
P
ercent
Inflation and the Store of Value Function of Money
An important role of any defined form of money is that it is a store of value. By this we mean that it can be used
intertemporally- i.e., we will accept money today in return for payment as we trust that it will carry that value over to tomorrow when we desire to spend it.
I How does inflation erode this characteristic?
Zimbabwe’s Hyperinflation: Money as a Store of Value?
Date Month-on-Month Inflation Rate (%) Year-on-Year Inflation Rate (%)
March 2007 50.54 2,200.20
April 2007 100.70 3,713.90
May 2007 55.40 4,530.00
June 2007 86.20 7,251.10
July 2007 31.60 7,634.80
August 2007 11.80 6,592.80
September 2007 38.70 7,982.10
October 2007 135.62 14,840.65
November 2007 131.42 26,470.78
December 2007 240.06 66,212.30
January 2008 120.83 100,580.16
February 2008 125.86 164,900.29
March 2008 281.29 417,823.13
April 2008 212.54 650,599.00
May 2008 433.40 2,233,713.43
June 2008 839.30 11,268,758.90
July 2008 2,600.24 231,150,888.87
August 2008 3,190.00 9,690,000,000.00
September 2008 12,400.00 471,000,000,000.00
October 2008 690,000,000.00 3,840,000,000,000,000,000.00
November 2008 79,600,000,000.00 89,700,000,000,000,000,000,000.00
Modelling Inflation: AS-AD
We are able to analyse changes in the price level within the AS-AD as it is on the y-axis. But can we examine bothchangesin the price level and theirpersistence?
I Changesin the price level simply imply that, relative to the last period, the price level has increased. However, changes tell us nothing about the absolute value of prices. We can define changes: Pt−Pt−1. The AS-AD model can show this
occurs due to shocks which shift the curves in that model
Modelling Inflation: AS-AD: Demand-Pull
Y∗ Y1
P0
P1
P2
P3
P4
AD0 AD1 AD2 SRAS0 SRAS1 SRAS2 LRAS
E0 E1 E2
Real GDP
Price
Modelling Inflation: AS-AD: Demand-Pull
I Change in inflation: in the diagram above, an initial positive aggregate demand shock shifts the AD curve up the SRAS schedule. However, asY1>Y∗we know that employment is above its equilibrium rate translating in a labour shortage. This puts upward pressure on the money wage. As money wages increase, the SRAS shifts up the new AD schedule. Thus we have moved from
E0toE1. We have seen the price level increase fromP0→P1→P2.
I Persistent (demand-pull) inflation: this requirespersistentincreases in the AD - this usually takes the form of successive government spending shocks and requires that the quantity of money must also increase (monetary validation). We have seen the price level increase fromP0→P1→P2→P3→P4
Has this ever happened? In the UK in the 1970’s, the government expanded the economy with the aim of achieving the
Modelling Inflation: AS-AD: Cost-Push
Y1 Y∗
P0
P1
P2
P3
P4
AD0 AD1 AD2 SRAS0 SRAS1 SRAS2 LRAS
E0 E1 E2
Real GDP
Price
Modelling Inflation: AS-AD: Cost-Push
I Change in inflation: in the diagram above, an initial negative supply shock, short-run aggregate supply shifts the SRAS curve up the AD schedule. However, asY1<Y∗we know that employment is below its equilibrium rate translating in a labour surplus. However, a decrease in money wages is occurs slowly due to contractual rigidities. Because f this, the BoE could enact expansionary monetary policy in order to increase aggregate demand. Thus we have moved
fromE0toE1. We have seen the price level increase fromP0→P1→P2.
I Persistent (cost-push) inflation: this requirespersistentnegative supply shock - this has taken the form of spiraling oil prices in the past. When monetary policy accommodates negative supply shocks in this fashion, we observe persistent increases in inflation. We see the price level increase from
P0→P1→P2→P3→P4
Inflation and Unemployment: The Phillips Curve
In light of the discussion we have just had on inflation, lets review the topic of the Phillips Curve from an earlier lecture
I The Phillips Curve shows the empirical inverse relationship between (money wage) inflation and unemployment
I This had important policy implications - if high employment and low and stable inflation are both desirable, the Phillips Curve implied that one is achievable only if you sacrifice the other.
Inflation and Unemployment: The Short-Run Phillips Curve
0 2 4 6 8 10 12
0 5 10 15 20 SRPC x y z α1 β1 α2 β2
Unemployment Rate (% workforce)
Inflation and Unemployment: The Short-Run Phillips Curve
The inflation rate (π) depends on three factors;
1. Expected inflation πe;
2. The output gapb(Y −Y∗), where Y is actual output, Y∗ is potential output and b is a coefficient determining the passthrough from the output gap to inflation;
3. supply (cost) shocks: s. So we can write:
Learning Objectives
1. LO1: Cover the different types of price changes (inflation, deflation, disinflation etc.), how inflation is measured and its impact on the store of value function of moneyX
2. LO2: Examine the different ways inflation can be modelled using our AS-AD framework, explaining the way governments accommodative practices can create inflationary persistence X
