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Unformatted text preview: >> Inflation, Disinflation, and Deflation
H O U R LY WA G E S 16
Source: International Monetary Fund. I
has n modern America, we complain about inflation when the overall level of prices rises a few percent over the that economists use as a rough dividing line between merely high inflation and hyperinflation. Yet Brazil’s experience was actually quite mild compared with history’s most famous example of hyperinflation, which took place course of a year. But those who lived through the late 1970s scoff—they remember when prices rose as much as 13% in a year. And in other times and places inflation gone much, much higher. For example, the accompanying figure shows the inflation rate in Brazil from 1980 to 2004. As you can see, there were many years when the Brazilian inflation rate was in triple digits—and even years when it went into four digits. For a sense of what it felt like to be a Brazilian consumer during this period, consider what happens to the price of a gallon of gas over the Inflation rate 3,000% 2,500 2,000 1,500 1,000 500
80 85 90 95 20 00 04 What you will learn in this chapter:
® 19 19 19 19 20 Why efforts to collect an inflation tax by printing money can lead to high rates of inflation How high inflation can spiral into hyperinflation as the public tries to avoid paying the inflation tax The economy-wide costs of inflation and disinflation, and the debate over the optimal rate of inflation Why even moderate levels of inflation can be hard to end Why deflation is a problem for economic policy Year ® ® ® course of a year at an inflation rate of 3,000%, equal 1990. At that rate, a gallon of gas that cost $3 at the beginning of the year would cost $93 by the end of the year. In some months, inflation in Brazil briefly reached the 50%-per-month level
You call what we’ve seen in the United States inflation? As shown in the graph above, between 1985 and 1995 Brazil demonstrated what really serious inflation—up to almost 3,000% per year—looks like. In 1992, hoping for relief, Brazilians were out on the street demanding new leadership.
Carrion Carlos/ Corbis Sygma ® to Brazil’s inflation rate in chapter 393 394 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N UNCORRECTED Preliminary Edition in Germany in 1922–1923. Toward the end of the German hyperinflation, prices were rising 16% a day, which—through compounding—meant an increase of approximately 500 billion percent over the course of five months. People became so reluctant to hold paper money, which lost value by the hour, that eggs and lumps of coal began to circulate as currency. German firms would pay their workers several times a day so that they could spend their earnings before they lost value (lending new meaning to the term “hourly wage”). Legend has it that men sitting down at a bar would order two beers at a time, out of fear that the price of a beer would rise before they could order a second round! What causes episodes of high inflation? How do they come to an end? In this chapter, we’ll look at the underlying reasons for inflation. We’ll also examine the costs of inflation, which aren’t as obvious as you might imagine. We’ll see that a falling price level, or deflation, has its own special problems. And we’ll look at the issues associated with disinflation, a reduction in the inflation rate. Money and Inflation
Even though inflation in the United States is much lower today than it was during the 1970s—and a far cry from the recent experience of Brazil—the American public and media still pay close attention to inflation. Ask any American to name some serious problems that an economy faces and chances are you’ll hear the word inflation. Yale University economist Robert Shiller did something similar in the mid-1990s, and indeed, he found that Americans consider inflation to be a problem. Three-quarters of those surveyed thought that “inflation hurts my real buying power; it makes me poorer.” And over half of the respondents thought that “preventing high inflation is an important national priority, as important as preventing drug abuse or preventing deterioration in the quality of our schools.” However, Shiller found that professional economists rarely shared these concerns. Only 12% of the economists surveyed thought that inflation makes them poorer, and only 18% considered preventing inflation an important national priority. Why do economists tend to differ so much from the general public in their impressions about inflation, at least at the moderate levels encountered in countries such as the United States? The answer lies in people’s perception of how inflation affects them. People often view inflation as reducing the value of their pay raises, even though economists argue that inflation leads to higher nominal pay increases and doesn’t necessarily reduce people’s purchasing power. But even economists who do not consider inflation to be a serious problem still believe there can be costs associated with it. To understand the true costs of inflation, we first need to analyze it’s causes. As we’ll see later in this chapter, moderate levels of inflation such as those experienced in the United States—even the double-digit inflation of the late 1970s—can have complex causes. But really high inflation is always associated with rapid increases in the money supply. To understand why, we need to revisit the effect of changes in the money supply on the overall price level. Then we’ll turn to the reasons governments sometimes increase the money supply very rapidly. Money and Prices, Revisited
In Chapter 14 we learned that in the short run an increase in the money supply increases real GDP by lowering the interest rate and stimulating investment spending and consumer spending. However, in the long run, as nominal wages and other UNCORRECTED Preliminary Edition CHAPTER 16 I N F L AT I O N , D I S I N F L AT I O N , A N D D E F L AT I O N 395 sticky prices rise, real GDP falls back to its original level. So in the long run, any given percent increase in the money supply does not change real GDP. Instead, other things equal, it leads to an equal percent rise in the overall price level—the prices of all goods and services in the economy, including nominal wages and the prices of intermediate goods, rise. And when the overall price level rises, the aggregate price level—the prices of all final goods and services—rises as well. As a result, an increase in the nominal money supply, M, leads in the long run to an increase in the aggregate price level that leaves the real quantity of money, M/P, at its original level. For example, when Turkey dropped six zeros from its currency, the Turkish lira, in January 2005, Turkish real GDP did not change. The only thing that changed was the number of zeros in prices: instead of something costing 2,000,000 lira, it cost 2 lira. When analyzing large changes in the aggregate price level, macroeconomists often find it useful to ignore the distinction between the short run and the long run. Instead, they work with a simplified model in which the effect of changes in the money supply on the aggregate price level takes place instantaneously rather than over a long period of time. You might be concerned about this assumption given that in previous chapters we’ve emphasized the difference between the short run and the long run. However, for reasons we’ll explain, this is a reasonable assumption to make in the case of high inflation. A simplified model in which the real quantity of money, M/P, is always at its longrun equilibrium level is known as the classical model of the price level, because it was commonly used by “classical” economists who wrote before the work of John Maynard Keynes. To understand the classical model and why it is useful in this context, let’s revisit the AS–AD model and what it says about the effects of an increase in the money supply. (Unless otherwise noted, we will always be referring to changes in the nominal supply of money.) Figure 16-1 reviews the effects of an increase in the money supply according to the AS–AD model. The economy starts at E1, a point of short-run and long-run equilibrium. It lies at the intersection of the aggregate demand curve AD1 and the short-run aggregate supply curve SRAS1; it also lies on the long-run aggregate supply curve, LRAS. At E1, the equilibrium aggregate price level is P1. Now suppose there is an increase in the money supply. This is an expansionary monetary policy, which shifts the aggregate demand curve to the right, to AD2, and moves the economy to a short-run equilibrium at E2. Over time, however, nominal wages adjust upward in response to the rise in the aggregate price level, and the SRAS According to the classical model of the price level, the real quantity of money is always at its long-run equilibrium level. Figure 16-1
Aggregate price level The Classical Model of the Price Level
Starting at E1, an increase in the money supply shifts the aggregate demand curve rightward, as shown by the movement from AD1 to AD2. There is a new short-run equilibrium at E2 and a higher price level at P2. In the long run, nominal wages adjust upward and push the SRAS curve leftward to SRAS2. The total percent increase in the price level from P1 to P3 is equal to the percent increase in the money supply. In the classical model of the price level, we ignore the transition period and think of the price level as rising to P3 immediately. This is a good approximation of the conditions of high inflation. LRAS SRAS2 SRAS1 E3 P3 P2 P1 AD1
Potential output E1 E2 AD2 YE Y1 Real GDP 396 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N UNCORRECTED Preliminary Edition curve shifts to the left, to SRAS2. The new long-run equilibrium is at E3, and real GDP returns to its initial level. As we learned in Chapter 14, the long-run increase in the aggregate price level from P1 to P3 is proportional to the increase in the money supply. As a result, in the long run changes in the money supply have no effect on the real quantity of money, M/P, or on real GDP. In the long run, money—as we learned—is “neutral.” The classical model of the price level ignores the short-run movement from E1 to E2, assuming that the economy moves directly from one long-run equilibrium to another long-run equilibrium. In other words, it assumes that the economy moves directly from E1 to E3 and that real GDP never changes in response to a change in the money supply. In effect, in the classical model the effects of money-supply changes are analyzed as if the short-run as well as the long-run aggregate supply curve were vertical. In reality, this is a poor assumption during periods of low inflation. With a low inflation rate, it may take a while for workers and firms to react to a monetary expansion by raising wages and prices. In this scenario, some nominal wages and the prices of some goods are sticky in the short run. As a result, there is an upward-sloping SRAS curve and changes in the money supply can indeed change real GDP (in the short run). But what about periods of high inflation? In the face of high inflation, economists have observed that the short-run stickiness of nominal wages and prices tends to vanish. Workers and businesses, sensitized to inflation, are quick to raise their wages and prices in response to changes in the money supply. This implies that under high inflation there is a quicker adjustment of wages and prices of intermediate goods than would occur in the case of low inflation. So the short-run aggregate supply curve shifts leftward more quickly and there is a more rapid return to long-run equilibrium. As a result, the classical model of the price level is much more likely to be a good approximation of reality during a period of high inflation. For Inquiring Minds explains this point further. The consequence of this rapid adjustment of all prices in the economy is that in countries with persistently high inflation, changes in the money supply are quickly translated into changes in the inflation rate. Let’s look again at Brazil. Figure 16-2 shows the annual rate of growth in the money supply (as measured by M1) and the annual rate of change of consumer prices from 1980 to 2004. As you can see, surges Figure 16-2
Inflation rate, Money supply growth rate 3,000% 2,500 2,000 1,500 1,000 500 Money Supply Growth and Inflation in Brazil
In the late 1980s and early 1990s, surges in the rate of money supply growth in Brazil were reflected in nearly simultaneous surges in inflation, with no obvious lag.
Source: International Monetary Fund. Inflation rate Money supply growth rate 80 85 90 95 19 19 19 19 20 Year 20 04 00 UNCORRECTED Preliminary Edition CHAPTER 16 I N F L AT I O N , D I S I N F L AT I O N , A N D D E F L AT I O N 397 FOR INQUIRING MINDS I N D E X I N G T O I N F L AT I O N
When an economy experiences high inflation year after year, people take steps to protect themselves from future inflation— and these steps typically have the effect of making prices highly sensitive to changes in the money supply, even in the short run. The usual response to inflation is indexation—contracts of all kinds are written in ways that adjust for inflation. For example, wage contracts typically include a cost-ofliving adjustment, or COLA: payments to workers rise automatically with the consumer price index. The best-known COLA in the United States today involves Social Security benefits, which are automatically adjusted upward each year by the previous year’s inflation rate: if the consumer price index rose 3% last year, every retiree’s benefits are increased by 3%. Most wage contracts in the United States no longer have COLAs. In the late 1970s, however, when inflation was much higher than it is today, COLAs were widespread. Economist Steven Holland reports that the rate of wage indexation in the American economy increased through the 1970s and then fell during the early 1980s, once inflation began to fall. In high-inflation economies, similar adjustments are regularly written into labor contracts, rental agreements, loan contracts, and so on. For example, during the late 1980s and early 1990s in Brazil, almost every contract that involved delaying payment into the future was indexed for inflation. Indexation has the effect of speeding up the response of the overall price level to changes in the money supply. Even in an economy without indexation, an increase in the money supply quickly pushes up the prices of some types of goods, such as raw materials. In a highly indexed economy, these increased prices, which affect the consumer price index, quickly lead to increases in wages, which lead to increases in other prices, which feed back into wages, and so on. The result is that the long run, in which an increase in the money supply raises the overall price level by the same percentage, arrives very quickly—typically in a matter of months. in the money supply in the late 1980s and early 1990s coincide with roughly equal surges in the inflation rate. But what would lead a country to increase its money supply so much that the result is inflation in the hundreds or thousands of percent? The Inflation Tax
Modern economies use fiat money—pieces of paper that have no intrinsic value but are accepted as a medium of exchange. In the United States and most other wealthy countries, the decision about how many pieces of paper to issue is placed in the hands of a central bank that is somewhat independent of the political process. However, political leaders make the ultimate decision of whether or not to print more money. So what is to prevent a government from paying for some of its expenses not by raising taxes or borrowing but simply by printing money and using it to pay its bills? Nothing. In fact, governments, including the U.S. government, do it all the time. How can the U.S. government do this, given that the Federal Reserve, not the Treasury, issues money? The Treasury issues debt to finance the government’s purchases of goods and services, and the Fed monetizes the debt by creating money and buying the debt back from the public through open-market purchases of Treasury bills. In effect, the government can and does raise revenue by printing money. For example, in July 2005 the U.S. monetary base—bank reserves plus currency in circulation—was $26 billion larger than it had been a year earlier. This occurred because, over the course of that year, the Federal Reserve had issued $26 billion in money or its electronic equivalent and put it into circulation through open-market operations. To put it another way, the Fed created money out of thin air and used it to buy valuable government securities from the private sector. Despite the fact that the Fed is officially independent of the U.S. government, its actions enabled the government to pay off $26 billion in government debt not by raising revenue through taxes but simply by printing money. An alternative way to look at this is to say that the right to print money is itself a source of revenue. Governments have the exclusive right to print money, and they 398 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N UNCORRECTED Preliminary Edition The inflation tax is the reduction in the real value of money held by the public caused by inflation. frequently do so in order to finance expenditures. Economists refer to the revenue generated by the government’s right to print money as seigniorage, an archaic term that goes back to the Middle Ages. It refers to the right to stamp gold and silver into coins, and charge a fee for doing so, that medieval lords—seigneurs, in France—reserved for themselves. Seignorage accounts for only a tiny fraction (about 1.5%) of the U.S. government’s budget. So the government doesn’t rely on the printing press to pay its bills. But there have been many occasions in history when governments turned to their printing presses as a crucial source of revenue. According to the usual scenario, a government finds itself running a large budget deficit—and lacks either the competence or the political will to eliminate this deficit by raising taxes or cutting spending. And the government can’t borrow to cover the gap because potential lenders fear that the government’s weakness will continue, leaving it unable to repay any loans. In such a situation, governments end up printing money to cover the budget deficit. But by printing money to pay its bills, a government increases the quantity of money in circulation. And as we’ve just seen, large increases in the money supply translate into equally large increases in the aggregate price level. So printing money to cover a budget deficit leads to inflation. Who ends up paying for the goods and services the government purchases with newly printed money? The people who currently hold money pay. They pay because inflation erodes the purchasing power of their money holdings. In other words, a government imposes an inflation tax, the reduction in the real value of the money held by the public, by printing money to cover its budget deficit and creating inflation. It’s helpful to think about what this tax represents. If the inflation rate is 5%, then $1 today will be worth $0.95 a year from now. This is equivalent to a tax of 5% on the value of all money held by the public. So the size of the inflation tax over a given period is equal to the inflation rate over that period multiplied by the money supply. However, the inflation tax as we’ve just calculated it may not be a good indicator of the real amount of resources captured by the government from the public because it is a nominal measure. If we want to know the real burden of the inflation tax on the public, we have to calculate the real inflation tax, which is equal to the inflation rate multiplied by the real money supply: (16-1) Real inflation tax = Inflation rate × Real money supply Because it adjusts for the price level, the real inflation tax represents the real value of the goods and services that are lost by the public through the inflation tax. As we’ll now see, the real inflation tax plays a key role in the process by which high inflation turns into explosive hyperinflation. The Logic of Hyperinflation
Inflation imposes a tax on individuals who hold money; and, like any tax, it will lead people to change their behavior. In particular, when inflation is high, people will try to avoid holding money and will instead substitute real goods as well as interest-bearing assets for money. In the introduction to this chapter, we described how, during the German hyperinflation, people began using eggs or lumps of coal as a medium of exchange. They did this because lumps of coal maintained their real value over time but money didn’t. Indeed, during the peak of German hyperinflation, people often burned paper money, which was less valuable than wood. Moreover, people don’t just reduce their nominal money holdings—they reduce their real money holdings. Why? Because the more real money holdings they have, the greater the real amount of resources the government captures from them through the inflation tax. In 1923, Germany’s money was worth so little that children used stacks of banknotes as building blocks. akg-images UNCORRECTED Preliminary Edition CHAPTER 16 I N F L AT I O N , D I S I N F L AT I O N , A N D D E F L AT I O N 399 We are now prepared to understand how countries can get themselves into situations of extreme inflation. Recall that high inflation arises because the government must collect a large inflation tax to cover a large budget deficit. According to Equation 16-1, the real inflation tax is equal to the rate of inflation multiplied by the real money supply. But as we’ve just explained, in the face of high inflation the public reduces the real amount of money it holds. In turn, the government must generate a higher rate of inflation to collect the same amount of real inflation tax that it collected before people reduced their money holdings—an amount it needs to raise in order to cover a large budget deficit. And people respond to this new higher rate of inflation by reducing their real money holdings yet again. The process can become self-perpetuating and can easily spiral out of control. Although the amount of real inflation tax that the government tries to collect does not change, the inflation rate the government needs to impose to collect the inflation tax rises. So the government is forced to increase the money supply more rapidly, leading to an even higher rate of inflation, and so on. Here’s an analogy: Imagine a city government that tries to raise a lot of money with a special fee on taxi rides. The fee will raise the cost of taxi rides, and this will cause some people to turn to substitutes such as walking or taking the bus. As taxi use declines, the government must impose a higher fee to raise the same amount of revenue. You can imagine a vicious circle: the government imposes fees on taxi rides, which leads to less taxi use, which causes the government to raise the fee on taxis, which leads to even less taxi use, and so on. Substitute the real money supply for taxi rides and the inflation rate for the fee on taxis, and you have the story of hyperinflation. A race develops between the government printing presses and the public: the presses churn out money at a faster and faster rate, to try to compensate for the fact that the public is reducing its real money holdings. At some point the inflation rate explodes into hyperinflation, and people are unwilling to hold any Figure 16-3 money at all (and resort to trading in eggs and lumps of coal). The government is then forced to abandon its use of the inflation tax and shut down the printing presses. Money supply, Money Supply and Prices in Brazil economics in action
Money and Prices in Brazil, 1985-1995
As we noted in the introduction to this chapter, Brazil offers a relatively recent example of a country experiencing very high inflation. Figure 16-2 showed that surges in Brazil’s money supply were matched by almost simultaneous surges in Brazil’s inflation rate. But looking at rates of change doesn’t give a true feel for just how much prices went up in Brazil. Figure 16-3 shows Brazil’s money supply and aggregate price level from 1985 to 1995. We measure both the money supply and the aggregate price level as index numbers, with their 1985 levels set equal to 1. We also use a logarithmic scale, because it’s the only way to show just how much both money and prices rose. Over the course of a decade, both the money supply and the aggregate price level increased by approximately 100 billion percent. As you can see, the aggregate price level and the money supply rose in close tandem. Why did the Brazilian government increase its money supply so excessively over the course of a decade? The Aggregate price level (Index, 1985 = 1) 10,000,000,000 1,000,000,000 100,000,000 10,000,000 1,000,000 100,000 10,000 1,000 100 10 1 Money supply Aggregate price level 91 93 19 85 87 89 19 19 19 19 Year
Between 1985 and 1995, Brazil’s money supply and aggregate price level grew in close tandem—and by a huge amount. In this figure, both are expressed as index numbers, with 1985 = 1. Over the 10-year period, the money supply and the aggregate price level both rose by 100 billion percent.
Source: International Monetary Fund. 19 95 400 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N UNCORRECTED Preliminary Edition ®® ® QUICK REVIEW ® ® The classical model of the price level does not distinguish between the short and the long run. It explains how increases in the money supply feed directly into inflation. It is a good description of reality only for countries with persistently high inflation or hyperinflation. Governments sometimes print money to cover a budget deficit. The resulting loss in the value of money is called the inflation tax. A high inflation rate causes people to reduce their real money holdings, leading to more money printing and higher inflation in order to collect the inflation tax. This can cause a self-perpetuating spiral into hyperinflation. reason boils down to political conflict, which made it impossible for the country’s government to balance its budget, either by raising taxes or by cutting spending. Financial difficulties during the 1980s left Brazil unable to borrow money in world markets. Like many others before it, Brazil’s government turned to the printing press to cover the gap—leading to massive inflation. I <<<<<<<<<<<<<<<<<< >>CHECK YOUR UNDERSTANDING 16-1
1. Suppose there is a large increase in the money supply in an economy that previously had low inflation. As a consequence, output expands in the short run. Does this mean that the classical model of the price level should be abandoned when thinking about periods of high growth in the money supply? Why or why not? 2. Suppose that all wages and prices in an economy are indexed to inflation. Can there still be an inflation tax?
Solutions appear at back of book. Effects of Inflation
We’ve seen how the use of the printing press to cover a government deficit leads to inflation. And we’ve also learned how a government’s attempt to collect a large real inflation tax can lead to fiscal disaster. But even in the absence of such a disaster, inflation can have important consequences. Recall the widespread belief that inflation makes everyone worse off by raising the cost of living. As we discussed earlier, this is a fallacy. It misses the point that inflation raises the prices received by firms—which in turn determine incomes paid in the economy—as well as the prices paid by consumers. In fact, recall from the AS-AD model that when an increase in the money supply leads to a rise in the aggregate price level, in the long run real GDP and so aggregate real income are unchanged. Although it is incorrect that inflation makes everyone worse off, inflation does have important effects on the economy that are not fully captured by the AS–AD model. We’ll soon learn that unexpected inflation, although leaving real GDP and so total real income unchanged, hurts some people while helping others. Then we’ll see that anticipated inflation can indeed impose real costs on the economy; if sufficiently high, it can reduce real GDP and real incomes. Winners and Losers from Unexpected Inflation
Inflation can hurt some people while helping others for one main reason: contracts that extend over a period of time, such as loans, are normally specified in nominal terms. In the case of a loan, the borrower receives a certain amount of funds at the beginning, and the loan contract specifies how much he or she must repay at some future date. The real burden of that repayment depends greatly on the rate of inflation over the intervening years of the loan because the inflation rate over the life of the loan determines how large the repayment is in real terms. When a borrower and a lender enter into a loan contract, each party has an expectation about the future rate of inflation. If the inflation rate is higher than expected, borrowers will repay their loans with funds that have a lower real value than they had expected, and lenders will receive payment with a lower real value than they had expected. Conversely, if the inflation rate is lower than expected, borrowers will repay their loans with funds that have a higher real value than they had expected, and lenders will receive payment with a higher real value than they had expected. So inflation exceeds or is lower than expectations, either the borrower (in the case of high inflation) or the lender (in the case of low inflation) benefits from the surprise, at the other party’s expense. But if the actual inflation rate is equal to the anticipated rate, inflation does not create winners or losers in loan contracts. UNCORRECTED Preliminary Edition CHAPTER 16 I N F L AT I O N , D I S I N F L AT I O N , A N D D E F L AT I O N 401 To make this point concrete, we need to distinguish between the nominal interest rate and the real interest rate. The best way to understand the difference between them is with an example. Suppose the owner of a firm borrows $10,000 for one year at a 10% interest rate. At the end of the year, he or she must repay $11,000—the amount borrowed plus interest. But suppose that over the course of the year the average level of prices increases by 10%. Then the $11,000 repayment has the same purchasing power as the original $10,000 loan. In real terms, the borrower has in effect received a zero-interest loan. In this example, economists would say that the nominal interest rate (the interest rate in money terms) is 10%, but the real interest rate (the interest rate adjusted for inflation) is 0%. As the example shows, the real interest rate is equal to the nominal interest rate minus the rate of inflation: (16-2) Nominal interest rate = real interest rate + inflation You might be tempted to say that inflation necessarily helps borrowers and hurts lenders, but what really matters is how actual inflation compares with the inflation that borrowers and lenders expected when they entered into the loan contract. Suppose a borrower and a lender agreed on a one-year loan at a nominal interest rate of 7%, and both expected the inflation rate to be 5% over the next year. Then the expected inflation rate was taken into account when they entered into the contract: the 7% nominal interest rate represented a 2% real interest rate plus 5% for inflation. But suppose people expected a 5% inflation rate and actually experienced a 10% rate. In this case, lenders thought they were lending at a 2% real interest rate, but they actually received a negative real interest rate of minus 3%. That is, by lending at a 7% nominal interest rate (2% real interest rate plus 5% expected inflation rate) but experiencing a 10% actual inflation rate, lenders received a real interest rate equal to 7% − 10% = −3%. Borrowers won, and lenders lost. Conversely, suppose the actual inflation rate turned out to be 0% rather than 5%. In that case, borrowers who thought they were paying a 2% real interest rate actually ended up paying a real interest rate equal to 7% (2% real interest rate plus 5% expected inflation rate) minus 0% (the actual inflation rate). Lenders won, and borrowers lost. In modern America, the most important example of how inflation can create winners and losers is home mortgages. A standard mortgage specifies a monthly dollar payment over a period of 15 to 30 years. If the overall price level is rising, the borrower’s real payment per month falls over time. How fast the payment falls depends on the rate of inflation. For example, Americans who took out mortgages in the early 1970s quickly found their real payments reduced by higher-than-expected inflation: by 1983 the purchasing power of a dollar was only 45% of what it had been in 1973. Those who took out mortgages in the early 1990s were not so lucky, because the inflation rate fell to lower-than-expected levels in the following years: in 2003 the purchasing power of a dollar was 78% of what it had been in 1993. So borrowers who took out mortgages in the early 1970s gained at the expense of lenders, who found the real value of their loans rapidly eroded by inflation. In fact, one side effect of inflation during the 1970s was to push many savings and loan institutions—a type of bank that traditionally specialized in home loans—into bankruptcy. They failed because the value of the long-term loans they had made were greatly reduced by inflation, but the interest rates they paid on short-term deposits had to keep up with inflation in order to attract depositors. The nominal interest rate is the interest rate in money terms. The real interest rate is the interest rate adjusted for inflation, equal to the nominal rate minus the inflation rate. Expected Inflation and Interest Rates
As the preceding discussion makes clear, people should base the decision of whether or not to borrow on their expectation of the real rate of interest, not the nominal rate. It is the real rate of interest that measures the quantity of real purchasing power the borrower will have to give up to repay the loan. A loan at 10% interest is very 402 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N UNCORRECTED Preliminary Edition According to the Fisher effect, an increase in expected inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged. expensive at a time of 0% inflation; it’s very cheap if inflation is near 10%; and it’s free in real terms if the inflation rate is above 10%. Like borrowers, lenders should be concerned with the real rather than the nominal interest rate. A loan at 10% interest is a very good investment if inflation is at 0% but a poor investment if inflation is running at 15%. Because inflation affects the real interest rates actually paid by borrowers and received by lenders, expected inflation has strong effects on the nominal interest rate. Recall the loanable funds model of the interest rate we developed in Chapter 9, where we described how the equilibrium nominal interest rate equalizes the quantity of loanable funds supplied and the quantity of loanable funds demanded. As with all supply and demand models, this result depends on the “other things equal” assumption. And in this market, one very important thing that must be held equal (that is, unchanged) is the expected inflation rate. So how are the results of the loanable funds model affected by changes in the expected inflation rate? In Figure 16-4, the curves S0 and D0 show the supply and demand for loanable funds given that the expected rate of inflation is 0%. In that case, equilibrium is at E0 and the equilibrium nominal interest rate is 4%. Because expected inflation is 0%, the equilibrium expected real interest rate is also 4%. Now suppose that the expected inflation rate rises to 10%. The demand for funds shifts upward to D10: borrowers are now willing to borrow as much at a nominal interest rate of 14% as they were previously willing to borrow at 4%. That’s because with a 10% inflation rate, a 14% nominal interest rate leads to a 4% real interest rate. Similarly, the supply of funds shifts upward to S10: lenders require a nominal interest rate of 14% to persuade them to lend as much as they would previously have lent at 4%. The new equilibrium is at E10: the result of an expected inflation rate of 10% is that the equilibrium nominal interest rate rises from 4% to 14%. This situation can be summarized as a general principle, known as the Fisher effect (after the American economist Irving Fisher, who proposed it in 1930): the expected real interest rate is unaffected by the change in expected inflation. According to the Fisher effect, expected inflation drives up interest rates, and each additional percentage point of expected inflation drives up the interest rate by 1 percentage point. The central point is that both lenders and borrowers base their decisions on the real rate of interest. As long as inflation is expected, it does not affect the equilibrium quantity of loanable funds or the real interest rate; all it affects is the equilibrium nominal interest rate. Figure 16-4 Interest rate The Fisher Effect
D0 and S0 are the demand and supply curves for loanable funds when the expected inflation rate is 0%. At an expected inflation rate of 0%, the equilibrium nominal interest rate is 4%. Expected inflation pushes both the demand and supply curves upward by 1 percentage point for every point of inflation. D10 and S10 are the demand and supply curves for loanable funds when the expected inflation rate is 10%. Expected inflation raises the equilibrium nominal interest rate to 14%. The real interest rate remains at 4%, and the equilibrium quantity of loanable funds also remains unchanged. Demand for loanable funds at 10% expected inflation Supply of loanable funds at 10% expected inflation S10
Demand for loanable funds at 0% expected inflation E10 D10 S0 Supply of loanable funds at 0% expected inflation 4 E0 D0 0 Q* Quantity of loanable funds UNCORRECTED Preliminary Edition CHAPTER 16 I N F L AT I O N , D I S I N F L AT I O N , A N D D E F L AT I O N 403 The Costs of Inflation
We’ve now seen how unexpected inflation produces winners and losers The question we want to ask now is whether anticipated inflation imposes costs on the economy as a whole and whether, as a result, it changes the overall level of income in the economy. (We are considering the costs that even low or moderate inflation can cause, excluding the costs of a fiscal crisis that high inflation or hyperinflation can impose on an economy.) The answer to our question is yes; anticipated inflation can impose real costs on the economy. Economists have identified several of these, the most important being shoe-leather costs, menu costs, and unit-of-account costs. We’ll discuss each in turn. Shoe-Leather Costs People hold money for convenience in making transactions. Inflation, as we’ve seen, discourages people from holding money; the result is that making transactions becomes more difficult. One typical response to inflation is that people make more transactions. In 1984–1985, when Israel experienced an episode of very high inflation, Israelis tried to hold as little money as possible, which required visiting the bank several times a week, moving money into or out of interest-bearing accounts. During the German hyperinflation, merchants employed runners to take their cash to the bank many times a day to deposit it into interest-bearing assets or to convert it into a more stable foreign currency. In each case, in an effort to avoid the inflation tax, people devoted valuable resources—the time of Israeli citizens, the labor of those German runners—that could have been used productively elsewhere. During the German hyperinflation, so many banking transactions were taking place that the number of employees at German banks nearly quadrupled—from around Such are the shoe-leather costs of inflation: when the 100,000 in 1913 to 375,000 in 1923. Similarly, during the Brazilian inflation rate in Israel hit 500% in 1985, people spent a lot hyperinflation, the financial sector of the economy accounted for of time on line at the ATM. 15% of GDP, more than twice the size of the financial sector in the United States measured as a share of GDP. The large increase in the banking sector needed to cope with the consequences of inflation represented a loss of real resources. The increased costs of transactions caused by inflation are known as shoe-leather The shoe-leather costs of inflation are the increased costs of transactions that costs, an allusion to the wear and tear of the extra running around that takes place arise from the public’s efforts to avoid when people are trying to avoid holding money. Shoe-leather costs are substantial in the inflation tax. very high-inflation economies, as anyone who has lived through a hyperinflation—or even inflation of, say, 100% per year—can attest. Most estimates suggest, however, that the shoe-leather costs of inflation at the rates seen in the United States—which has never had inflation above 13%– are quite small.
Ricki Rosen/ Corbis Saba PITFALLS what interest rate for money demand?
We learned in Chapter 14 that the demand for money depends on the interest rate. But now we’ve made a distinction between the nominal interest rate and the real interest rate. Which one affects money demand? You might be tempted to answer that it’s the real interest rate. After all, we know that the demand for money can be viewed as a demand for a real quantity of money. So shouldn’t it be real values, all the way? No. Think about the opportunity cost of holding cash: a dollar bill or a real (Brazil’s currency) offers a 0% interest rate—a 0% nominal interest rate. The alternative is to hold a bond that yields positive interest—positive nominal interest. So the interest rate that matters for money demand is the nominal rate of interest because that is what you forgo by holding money. In fact, that’s why expected inflation leads to reduced holding of money. The real rate of interest doesn’t rise, but the nominal rate does, and the nominal rate is the opportunity cost of holding money. 404 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N UNCORRECTED Preliminary Edition Menu costs We introduced the concept of menu costs—the literal cost of changing listed prices—in Chapter 15 as one reason firms are reluctant to change prices in the face of changes in aggregate demand. In the face of inflation, of course, firms are forced to change prices more often than they would if the aggregate price level were more or less stable. This means higher costs for the economy as a whole. In times of hyperinflation, menu costs can be very substantial. During the Brazilian hyperinflation, for instance, supermarket workers reportedly spent half of their time replacing old price stickers with new ones. When inflation is high, merchants may decide to stop listing prices in terms of the local currency and use either an artificial unit—in effect, measuring prices relative to one another—or a more stable currency, such as the U.S. dollar. This is exactly what the Israeli real estate market began doing in the mid-1980s: prices were quoted in U.S. dollars, even though payment was made in Israeli shekels. Menu costs are present in low-inflation economies, but they are not severe. In low-inflation economies, businesses might update their prices only sporadically—not daily or even more frequently, as is the case in high-inflation or hyperinflation economies. Also, with technological advances, menu costs are becoming less and less important, since prices can be changed electronically and fewer merchants attach price stickers to merchandise.
Article I, Section 8 of the U. S. Constitution gives Congress the power to “fix the standard of weights and measures” for the nation. The Founding Fathers realized that trade among the states would be greatly facilitated if there were no confusion about units of measurement—a pound in Massachusetts should weigh the same amount as a pound in Virginia; a foot in New York should be the same length as a foot in South Carolina. As we explained in Chapter 13, one of the roles of money is as a unit of account—a measure individuals use to set prices and make economic calculations. Just as trade among states is facilitated when everyone knows how much a pound weighs, exchange in the economy as a whole is facilitated when everyone knows how much a dollar is worth. Yet inflation causes the real value of a dollar to change over time—a dollar next year is worth less than a dollar this year. The effect, many economists argue, is to reduce the quality of economic decisions: the economy as a whole makes less efficient use of its resources. The unit-of-account costs of inflation are the costs arising from the way inflation makes money a less reliable unit of measurement. Unit-of-account costs may be particularly important in the tax system. The United States has a progressive income tax, meaning that people with higher incomes pay a higher income tax rate on those incomes. In addition, the schedule of income tax rates in the United States is indexed to inflation. That is, the threshold level of income above which a taxpayers must pay a higher tax rate goes up every year with inflation to prevent people from having to pay a higher tax rate on their income if that income is just keeping up with inflation. But in the United States and most other countries, taxable income itself is still calculated in nominal terms. For example, taxable profits are calculated as the difference between a company’s nominal costs and its nominal revenues. If costs are paid before revenues are received, inflation can distort the calculation of profit in nominal terms, making a case of no profit or loss in real terms appear like a positive profit in nominal terms. In times of high inflation, this is a serious risk. Imagine a clothing store that buys coats at wholesale during the summer and sells them at retail three months later. By law, the difference between the price at which the store buys coats and the price at which it sells them is considered a profit—and is subject to taxes. But the store cannot replace coats at the same cost it paid for the coats it just sold. It must pay the prevailing wholesale price of a coat to replace its inventory. If the wholesale price of a coat and the retail price of a coat increased by the same amount over the three-month period, from the point of view of the store’s owner the store earned no profit on the sale Unit-of-Account Costs The unit-of-account costs of inflation are the costs arising from the way inflation makes money a less reliable unit of measurement. UNCORRECTED Preliminary Edition CHAPTER 16 I N F L AT I O N , D I S I N F L AT I O N , A N D D E F L AT I O N 405 of the coats. But the Internal Revenue Service does not see it this way; it assesses taxes based on the difference between what the firm actually paid in nominal terms and what the firm received in nominal terms. During the 1970s, when the United States had relatively high inflation, the distorting effects of inflation on the tax system were a serious problem. Some businesses were discouraged from productive investment spending because inflation caused the IRS to exaggerate their true profits. Conversely, inflation encouraged excessive spending on homeownership. The U.S. income tax system allows taxpayers to deduct interest payments on home mortgages, so at a time when nominal—but not real—interest rates were high, owning a home became a very good deal. When inflation (and tax rates) were reduced in the 1980s, these problems became much less important. The Optimal Rate of Inflation
What is the optimal rate of inflation for an economy? You might be tempted to say 0%—aren’t stable prices a good thing? And haven’t we just listed several real costs to the economy from inflation? However, some economists argue that there should be a small positive inflation rate, but others suggest that even 0% inflation may be too high! In a famous analysis, University of Chicago economist Milton Friedman argued that economic policy should aim for steady deflation as a way to minimize shoeleather costs. As explained in For Inquiring Minds, Friedman suggested that the only way to truly eliminate the shoe-leather costs of inflation would be to make people indifferent between holding money and not holding money. This would mean that the nominal interest rate would need to be near 0%. But if the real interest rate is positive, a 0% nominal interest rate requires a negative rate of inflation. In practice, no central bank has tried to put Friedman’s rule into effect. On the contrary, most central banks now aim for a low but positive rate of inflation. For example, it is clear from the Federal Reserve’s actions that it prefers an inflation rate of about 2%, but it has never made a formal statement to that effect. Other central banks are less cagey. For example, the Bank of England has an explicit inflation rate target of 2.5%. The main reason most central banks aim for slightly positive inflation is their belief that monetary policy is better able to respond to adverse events when the public expects modest inflation than when the public expects 0% inflation. We’ll explain why later in this chapter, when we discuss deflation. FOR INQUIRING MINDS A C A S E F O R D E F L AT I O N ?
In 1960, Milton Friedman used the analysis of shoe-leather costs of inflation to arrive at a radical conclusion: the optimal rate of inflation is negative. That is, there should be deflation. His argument ran as follows. Even at 0% inflation, people incur shoe-leather costs when they economize on the use of money in order to avoid the opportunity cost of interest forgone. Yet it does not cost the economy anything to provide people with fiat money. So Friedman argued that even at 0% inflation, people’s efforts to limit their money holdings lead to inefficiency. To eliminate this inefficiency, Friedman concluded that the government should try to push the nominal interest rate close to 0%. The only way to do this on a sustained basis would be to have a negative inflation rate. This would reduce the nominal interest rate through the Fisher effect, leading people to hold a larger real quantity of money. Although an ingenious analysis, it has never been used as a basis for policy. Negative inflation—deflation—poses risks to economic policy, which most economists believe outweigh any gains from reduced shoe-leather costs. 406 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N UNCORRECTED Preliminary Edition economics in action
Inflation and Interest Rates in the United States
Does expected inflation really push up interest rates? A quick look at nominal interest rates and inflation in the United States over the past 55 years confirms that it does. Figure 16-5 shows the nominal interest rate on U.S. Treasury bills and the inflation rate in the United States since 1955. Both peaked around 1980, when inflation rose into double digits—and so did interest rates. Figure 16-5
Inflation rate, Interest rate 14% 12 10 8 6 4 2 0 –2
60 70 90 55 80 00 20 19 19 19 19 19 04
Inflation rate Short-term interest rate Inflation and Nominal Interest Rates
The Fisher effect tells us that each percentage point of expected inflation raises the nominal interest rate by 1 percentage point. These data show the short-term interest rate and the inflation rate in the United States over the past half-century. They moved roughly together, both reaching a double-digit peak around 1980.
Sources: Bureau of Labor Statistics; Federal Reserve Bank of St. Louis. Year ®® ® QUICK REVIEW ® ® An unexpectedly high inflation rate benefits borrowers and hurts lenders by reducing the real interest rate paid on loans. Expected inflation raises nominal interest rates through the Fisher effect. Even anticipated inflation imposes shoe-leather costs, menu costs, and unit-of-account costs. Movements in inflation and nominal interest rates do not, of course, match exactly. For one thing, other factors besides inflation affect the equilibrium nominal interest rate. For another, the nominal interest rate reflects expected inflation, not actual inflation. To the extent that actual inflation is either higher or lower than expected inflation, the nominal interest rate will not move in tandem with the actual inflation rate. Through much of the 1970s, inflation ran faster than people expected, leading to negative real interest rates. During the 1980s inflation ran below most people’s expectations, leading to very high real interest rates. But the key message from Figure 16-5 is that inflation does push up nominal interest rates, and roughly one-for-one, as the Fisher effect predicts. I <<<<<<<<<<<<<<<<<< >>CHECK YOUR UNDERSTANDING 16-2
1. For each of the following cases, calculate the real interest rate paid on the loan as well as who gained and who lost from unexpected inflation. a. The nominal interest rate is 8%, and both borrowers and lenders expect an inflation rate of 5%, over the life of their loans. The actual inflation rate is 3%. b. The nominal interest rate is 6%, and both borrowers and lenders expect an inflation rate of 4% over the life of their loans. The actual inflation rate is 7%. 2. The widespread use of technology has revolutionized the banking industry, making it much easier for customers to access and manage their assets. Does this mean that the shoe-leather costs of inflation are larger or smaller than they used to be?
Solutions appear at back of book.
15 12 9 6 3 0 -3 20 UNCORRECTED Preliminary Edition CHAPTER 16 I N F L AT I O N , D I S I N F L AT I O N , A N D D E F L AT I O N 407 Moderate Inflation and Disinflation
The governments of wealthy, politically stable countries like the United States and Britain don’t find themselves forced to print money to pay their bills. Yet over the past 40 years both countries, along with a number of other nations, have experienced uncomfortable episodes of inflation. In the United States, inflation peaked at 13% at the beginning of the 1980s. In Britain, the inflation rate reached 26% in 1975. Why did policy makers allow this to happen? To understand inflation rates in such cases, it is helpful to shift our focus away from the link between money and prices and look at the policy trade-offs that governments face. Causes of Moderate Inflation
In Chapter 15 we learned that most economists believe that in the short run there is a trade-off between unemployment and inflation. If the government makes an effort to keep unemployment below the natural rate of unemployment, the short-run Phillips curve implies that this will lead to a higher inflation rate than people expect. Over time, however, people will come to expect this higher level of inflation, and the short-run Phillips curve will shift upward. If the government insists on keeping unemployment below its natural rate, this will lead to further increases in expected inflation, and so on. So keeping unemployment below its natural rate requires an ever-higher rate of inflation. This analysis suggests that policy makers should not try to achieve an unemployment rate below the natural rate. However, imagine yourself as a politician facing an election in a year or two, and suppose that inflation is fairly low at the moment. You might well be tempted to push the unemployment rate down right now, as a way to please voters. This will have long-run costs: low unemployment will lead to gradually rising inflation, and future governments will face an unpleasant choice between raising unemployment or living with inflation. But that’s a problem for the future—right now you have an election to win. This scenario explains why governments might follow expansionary monetary and fiscal policies that lead the economy into inflation. Does this happen in the real world? The evidence is mixed: it’s hard to find a systematic pattern of opportunistic behavior, but there are some specific cases in which governments appear to have attempted to stimulate the economy for short-term electoral gain but at long-term economic cost. A less cynical but similar scenario emphasizes the role of wishful thinking. The natural rate of unemployment changes over time, and estimates of the natural rate are often controversial. A government can easily convince itself that it’s safe to target a rate of unemployment that is, in fact, well below the natural rate. (It’s especially easy to reach that conclusion when it’s politically advantageous to do so.) By the time it becomes clear that the target was too ambitious, substantial inflation may be embedded in people’s expectations. Situations like these explain how countries with no need to impose an inflation tax nonetheless developed double-digit inflation rates in the 1970s. And once they found themselves experiencing moderately high inflation, it was difficult to bring inflation back down. The Problem of Disinflation
Suppose that, for whatever reason, an economy gets into a situation of moderate inflation. Why doesn’t it just reverse policy and end the inflation? The answer is that once the public has come to expect continuing inflation, bringing inflation down is painful. 408 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N UNCORRECTED Preliminary Edition Disinflation is the process of bringing down inflation that has become embedded in expectations. Recall our description in Chapter 15 of how a persistent attempt to keep unemployment below the natural rate leads to accelerating inflation. To reduce inflation that is built into expectations, policy makers need to run the process in reverse, keeping the unemployment rate above the natural rate for an extended period of time. The process of bringing down inflation that has become embedded in expectations is known as disinflation. Disinflation can be very expensive. As the following Economics in Action documents, the U.S. climbdown from high inflation at the beginning of the 1980s appears to have cost the equivalent of almost 20% of a year’s real GDP. The justification for paying these costs is that they lead to a permanent gain. Although the economy does not recover the short-term productivity losses caused by disinflation, it no longer suffers from the other costs associated with the persistently high inflation. In fact, the United States, Britain, and other wealthy countries that experienced inflation in the 1970s eventually decided that the pain of bringing inflation down—the large reduction in real GDP in the short term—was worth the required suffering. Some economists argue that the costs of disinflation can be reduced if policy makers explicitly state their determination to reduce inflation. A clearly announced, credible policy of disinflation, they contend, can reduce expectations of future inflation and so shift the short-run Phillips curve downward. Some economists believe that the clear determination of the Federal Reserve to combat the inflation of the 1970s was credible enough that the costs of disinflation, huge though they were, were lower than they might otherwise have been. Supply Shocks
Another factor that contributed to the rise of U.S. inflation in the 1970s and its decline in the 1980s was a series of supply shocks, first negative and then positive. In Chapter 10 we showed how negative supply shocks can lead both to a fall in aggregate output and to a rise in the aggregate price level. During the 1970s there were major negative supply shocks, driven by political events in the Middle East that drove up the price of oil. These supply shocks led directly to inflation. They also made it hard for the government to pursue an anti-inflationary policy, because high inflation was coupled with relatively high unemployment rates. When it is already high, risking further increases in unemployment is a particularly bitter pill to swallow in order to achieve lower inflation rates. In the 1980s the same process operated in reverse. A fall in oil prices, especially after 1985, allowed policy makers to preside over declining inflation without the need to impose high unemployment. economics in action
The Great Disinflation of the 1980s
As we’ve mentioned several times in this chapter, the United States ended the 1970s with a high rate of inflation, at least by its own historical standards—13% in 1980. Part of this inflation was the result of one-time events, especially a world oil crisis. But expectations of future inflation at 10% or more per year appeared to be firmly embedded in the economy. By the mid-1980s, however, inflation was running at about 4% per year. Panel (a) of Figure 16-6 shows the annual rate of change in the “core” consumer price index (CPI)—also called the core inflation rate. This index, which excludes energy and food prices, is widely regarded as a better indicator of underlying inflation trends than the UNCORRECTED Preliminary Edition CHAPTER 16 I N F L AT I O N , D I S I N F L AT I O N , A N D D E F L AT I O N 409 Figure 16-6 The Great Disinflation
(b) . . . but Only at the Expense of a Huge Sacrifice of Output and High Unemployment (a) The “Core” Inflation Rate in the United States Came Down in the 1980s . . . Core inflation rate 14% 12 10 8 6 4 2
83 85 87 89 81 79 Output gap (percent of potential output) 2% 0 –2 –4 –6 –8
83 87 79 81 85 19 19 19 19 19 89 19 19 19 19 19 19 Year
Panel (a) shows the U.S. “core” inflation rate, which excludes food and energy. It shows the sharp fall in inflation during the 1980s. Panel (b) shows that disinflation came at a heavy cost: the economy developed a huge output gap, and actual aggregate output didn’t return to potential output until 1987. If Year
you add up the output gaps over the period, you find that the economy sacrificed about 18% of a year’s real GDP. If we had to do that today, it would mean giving up more than $2 trillion in goods and services.
Sources: Bureau of Labor Statistics; Congressional Budget Office. overall CPI. By this measure, inflation fell from about 12% at the end of the 1970s to about 4%. How was this disinflation achieved? At great cost. Beginning in late 1979, the Federal Reserve imposed strongly contractionary monetary policies, which pushed the economy into its worst recession since the Great Depression. Panel (b) shows the Congressional Budget Office estimate of the U.S. output gap from 1979 to 1989: by 1982, actual output was 7% below potential output, corresponding to an unemployment rate of more than 9%. Aggregate output didn’t get back to potential output until 1987. Our analysis of the Phillips curve in Chapter 15 tells us that a temporary rise in unemployment, like that of the 1980s, is needed to break the cycle of inflationary expectations. Once expectations of inflation are down, the economy can return to the natural rate of unemployment at a lower inflation rate. And that’s just what happened. But the cost was huge. If you add up the output gap over 1980–1987, you find that the economy sacrificed approximately 18% of an average year’s output over the period. If we had to do the same thing today, that would mean giving up more than $2 trillion worth of goods and services. I ®® ® QUICK REVIEW ® >>>>>>>>>>>>>>>>>>>> >>CHECK YOUR UNDERSTANDING 16-3
1. British economists believe that the natural rate of unemployment in that country rose sharply during the 1970s, from around 3% to as much as 10%. During that period Britain experienced a sharp acceleration of inflation, which for a time went above 20%. How might these facts be related? 2. Why is disinflation so costly for an economy? Are there ways to reduce these costs?
Solutions appear at back of book. Countries can get into situations of moderate inflation because governments are tempted to seek an unemployment rate below the natural rate for political reasons. Disinflation—bringing down inflation that has become embedded in expectations—can impose high costs in unemployment and lost output.
15 12 9 6 3 19
2 1 0 -1 -2 -3 -4 -5 -6 -7 -8 410 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N UNCORRECTED Preliminary Edition Deflation
Before World War II, deflation—a falling aggregate price level—was almost as common as inflation. In fact, the U.S. consumer price index on the eve of World War II was 30% lower than it had been in 1920. After World War II, inflation became the norm in all countries. But in the 1990s deflation reappeared in Japan and proved difficult to reverse. Other countries, including the United States, became concerned that they might face similar problems. Why is deflation a problem? And why is it hard to end? Effects of Unexpected Deflation
Unexpected deflation, like unexpected inflation, produces both winners and losers— but in the opposite direction. Lenders, who are owed money, gain because the real value of borrowers’ payments increases. Borrowers lose because the real burden of their debt rises. In a famous analysis at the beginning of the Great Depression, Irving Fisher (who described the Fisher effect on interest rates) suggested that the effects of deflation on borrowers and lenders can worsen an economic slump. Deflation, in effect, takes real resources away from borrowers and redistributes them to lenders. Fisher argued that borrowers, who lose from deflation, are typically short of cash and will be forced to cut their spending sharply when their debt burden rises. Lenders, however, are less likely to increase spending sharply when the values of the loans they own rise. The overall effect, said Fisher, is that deflation reduces aggregate demand, deepening an economic slump, which, in a vicious circle, may lead to further deflation. The effect of deflation in reducing aggregate demand, known as debt deflation, probably played a role in the Great Depression. Debt deflation is the reduction in aggregate demand caused by deflation. Effects of Expected Deflation
The effects of expected deflation are, as you might expect, the reverse of the effects of expected inflation: deflation leads to lower nominal interest rates and to increased demand for money. There is, however, a limit to the effect of expected deflation on nominal interest rates. Look back at the example in Figure 16-4, where the equilibrium nominal interest rate is 4% if the expected inflation rate is 0%. Clearly, if the expected inflation rate is −3%—if the public expects deflation at 3% per year—the equilibrium nominal interest rate will be 1%. But what would happen if the expected rate of inflation is −5%? Would the nominal interest rate fall to −1%? No. Nobody would lend money at a negative rate of interest because they could do better by simply holding cash. Economists say that there is a zero bound on the nominal interest rate: it cannot go below zero. This zero bound can limit the effectiveness of monetary policy. Suppose the economy is depressed, with output below potential output and the unemployment rate above the natural rate. Normally the central bank can respond by cutting interest rates so as to increase aggregate demand. If the nominal interest rate is already zero, however, the central bank cannot push it down any farther. A situation in which monetary policy can’t be used because nominal interest rates cannot fall below the zero bound is known as a liquidity trap. A liquidity trap can occur whenever there is a sharp reduction in demand for loanable funds. The U.S. economy was up against the zero bound for much of the 1930s. Such situations are, however, more likely to arise when the public expects deflation than when it expects inflation. After World War II, when inflation became the norm around the world, the zero bound largely vanished as a problem—until the 1990s. In the 1990s, however, Japan found itself up against the zero bound, and it also experienced persistent deflation. The Japanese experience alarmed other countries, which There is a zero bound on the nominal interest rate: it cannot go below zero. A liquidity trap is a situation in which monetary policy can’t be used because nominal interest rates cannot fall below zero. UNCORRECTED Preliminary Edition CHAPTER 16 I N F L AT I O N , D I S I N F L AT I O N , A N D D E F L AT I O N 411 feared that they might experience similar problems. In 2001 and 2002, deflation concerns increased in the United States as the inflation rate dipped below 2%. These fears are the main reason most central banks seek a positive inflation rate, of 2% or 2.5%, rather than 0% inflation. Studies by economists at the Federal Reserve and elsewhere indicate that inflation at such low rates imposes very small costs on the economy and makes a liquidity trap unlikely. Figure
Inflation rate, Interest rate 8% 6 4 2 16-7 Deflation in Japan Short-term interest rate economics in action
Japan’s Trap 0
Inflation rate –2 90 95 00 19 19 After a boom in the late 1980s, Japan experienced a reYear cession in the early 1990s. The recession was not particularly severe, but it proved very persistent. And in During the 1990s, Japan slipped into deflation. the face of a sustained output gap, the inflation rate in The Bank of Japan tried to fight this by reducing Japan steadily declined. By the middle of the 1990s the call money rate, the short-term interest rate Japan had become the first major economy to experithat corresponds to the Federal funds rate in the ence deflation since the 1930s. U.S. By 1996, however, the call money rate was Figure 16-7 shows Japan’s inflation rate and the close to 0%—and by 2004 it actually was 0%, its call money rate—the interest rate that corresponds to lower limit. Japan found itself in a liquidity trap, with no room for monetary expansion. the federal funds rate in the U.S.—from 1990 to Source: International Monetary Fund. 2004. With a brief exception in 1996 and 1997, inflation fell steadily, becoming negative in the late 1990s. The Bank of Japan, the counterpart of the Federal Reserve, steadily reduced interest rates in an effort to fight deflation. By ®® Q U I C K R E V I E W 1998, however, it had reduced the call money rate all the way to 0%—and the economy was still depressed. This experience demonstrated that the liquidity trap ® Unexpected deflation helps lenders is a real problem in the modern world. and hurts borrowers. This can lead Japan’s inability to stimulate the economy by reducing interest rates was one reato debt deflation, which has a contractionary effect on aggregate son for its extensive use of expansionary fiscal policy during the 1990s. In Chapter 12 demand. we described the “bridge to nowhere” linking Awaji Island to the Japanese mainland; ® Deflation makes it more likely that such construction projects were, in part, a substitute for monetary expansion. I >>>>>>>>>>>>>>>>>>>> >>CHECK YOUR UNDERSTANDING 16-4
1. Why won’t anyone lend money at a negative nominal rate of interest? How can this pose problems for monetary policy?
Solution appears at back of book. interest rates will end up against the zero bound. When this happens, the economy is in a liquidity trap, and monetary policy is ineffective. • A LOOK AHEAD •
In the course of our presentation of macroeconomics, we’ve referred a number of times to history—both the history of events, such as the Great Depression, and the history of ideas, like those of John Maynard Keynes. Both types of history help us understand why macroeconomics is the way it is. In the next chapter we’ll step back from the details of specific models, and look at the making of modern macroeconomics—at how events and ideas interacted to produce the analysis we now rely on. 20 20 04 412 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N UNCORRECTED Preliminary Edition SUMMARY
1. In analyzing high inflation, economists use the classical model of the price level, which says that changes in the money supply lead to proportional changes in the aggregate price level even in the short run. 2. Governments sometimes print money in order to cover budget deficits. When they do, they impose an inflation tax, equal to the inflation rate times the money supply, on those who hold money. The real value of resources captured by the government is reflected by the real inflation tax, the inflation rate times the real money supply. In order to avoid paying the inflation tax, people reduce their real money holdings and force the government to increase inflation to capture the same amount of real inflation tax. In some cases, this leads to a vicious circle of a shrinking real money supply and a rising rate of inflation, leading to hyperinflation and a fiscal crisis. 3. The nominal interest rate is equal to the real interest rate plus the inflation rate. The expected inflation rate is accounted for in the nominal interest rate on a loan. Inflation that is higher than expected benefits borrowers and hurts lenders; inflation that is lower than expected benefits lenders and hurts borrowers. According to the Fisher effect, expected inflation raises the nominal interest rate one-for-one so that the real interest rate remains unchanged. 4. Inflation imposes shoe-leather costs, costs incurred as people try to avoid holding money; menu costs, the costs of changing prices; and unit-of-account costs, costs that arise because money ceases to be a reliable measure of value. Although there are arguments for a negative rate of inflation (deflation), in practice policy makers tend to aim for low but positive rates of inflation. 5. Countries that don’t need to print money to cover government deficits can still stumble into moderate inflation rates, either because of political opportunism or because of wishful thinking. When this happens, getting inflation back down can be difficult because disinflation can be very costly, requiring the sacrifice of large amounts of potential output and imposing high levels of unemployment. However, policy makers in the United States and other wealthy countries were willing to pay the price of bringing down the high inflation of the 1970s. 6. Deflation poses several problems. It can lead to debt deflation, intensifying an economic downturn. Also, interest rates are more likely to run up against the zero bound in an economy experiencing deflation. When this happens, the economy enters a liquidity trap, rendering monetary policy ineffective. KEY TERMS
Classical model of the price level, p. 000 Inflation tax, p. 000 Nominal interest rate, p. 000 Real interest rate, p. 000 Fisher effect, p. 000 Shoe-leather costs, p. 000 Unit-of-account costs, p. 000 Disinflation, p. 000 Debt deflation, p. 000 Zero bound, p. 000 Liquidity trap, p. 000 UNCORRECTED Preliminary Edition CHAPTER 16 I N F L AT I O N , D I S I N F L AT I O N , A N D D E F L AT I O N 413 PROBLEMS
1. In the economy of Scottopia, policy makers want to lower the unemployment rate and raise real GDP by using monetary policy. Using the accompanying diagram, show why this policy will ultimately result in a higher aggregate price level but no change in real GDP.
Aggregate price level d. After three years, what is the cumulative inflation tax? e. Redo parts a through d with an inflation rate of 25%. Why
is hyperinflation such a problem? 5. Concerned about the crowding-out effects of government borrowing on private investment spending, a candidate for president argues that the Unite States should just print money to cover the government’s budget deficit. What are the advantages and disadvantages of such a plan? 6. Boris Borrower and Lynn Lender agree that Lynn will lend Boris $10,000 and that Borris will repay the $10,000 with interest in one year. They agree to a nominal interest rate of 8%, reflecting a real interest rate of 3% on the loan and a commonly shared expected inflation rate of 5% over the next year. LRAS SRAS1 P1 E1 AD1 a. If the inflation rate is actually 4% over the next year, how
Y1 Real GDP does that lower-than-expected inflation rate affect Boris and Lynn? Who is better off? b. If the actual inflation rate is 7% over the next year, how
2. In which of the following examples would the classical model of the price level be relevant? does that affect Boris and Lynn? Who is better off? 7. Using the accompanying diagram, explain what will happen to the market for loanable funds when there is a fall of 2 percentage points in the expected future inflation rate. How will the change in the expected future inflation rate affect the equilibrium quantity of loanable funds?
Interest rate a. There is a great deal of unemployment in the economy and
no history of inflation. b. The economy has just experienced five years of hyperinflation. c. Although the economy had experienced inflation in the
10% to 20% range about 10 years ago, more recently prices have been stable and the unemployment rate has reflected the natural rate of unemployment. 3. The Federal Reserve regularly releases data on the U.S. monetary base. You can access that data at various websites, including the website for the Federal Reserve Bank of St. Louis. Go to http://research.stlouisfed.org/fred2/ and click on “Reserves and Monetary Base” and then on “Board of Governors Monetary Base, Adjusted for Changes in Reserve Requirements, Seasonally Adjusted (SA)” for the latest report.
r1 S1 E
8% D1 0 Q1 a. How much did the monetary base grow in the last month? b. How did this help in the government’s efforts to finance
its deficit? Quantity of loanable funds c. Why is it important for the central bank to be independent
from the part of the government responsible for spending? 4. Answer the following questions about the (nominal) inflation tax. 8. In the following examples, is inflation creating winners and losers at no net cost to the economy or is inflation imposing a net cost on the economy? If a net cost is being imposed, which type of cost is involved? a. When inflation is expected to be high, workers get paid
more frequently and make more trips to the bank. a. Maria Moneybags keeps $1,000 in her sock drawer for a
year; over the year, the inflation rate is 10%. What is the inflation tax for this year? b. Lanwei is reimbursed by her company for her work-related
travel expenses. Sometimes, however, the company takes a long time to reimburse her. So when inflation is high, she is less willing to travel for her job. b. Maria continues to keep the $1,000 in her drawer for the a
second year; over the year, the inflation rate is again 10%. What is the inflation tax for the second year? c. Hector Homeowner has a mortgage with a fixed 6% interest rate that he took out five years ago. Over the years, the inflation rate has crept up unexpectedly to its present level at 7%. c. For a third year, Maria keeps the $1,000 in the drawer;
over the year, the inflation rate is again 10%. What is the inflation tax for the third year? 414 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N UNCORRECTED Preliminary Edition d. In response to unexpectedly high inflation, the manager of
Cozy Cottages of Cape Cod must reprint and resend expensive color brochures correcting the price of rentals this season. 9. The accompanying diagram shows mortgage interest rates and inflation during 1990–2005 in the economy of Albernia. When would home mortgages have been especially attractive and why?
Inflation rate, Interest rate 12% 10 8 6 4 2
90 Inflation rate, Interest rate 7% 6 5 4 3 2 1
96 97 98 Interest rate Inflation rate 99 00 02 01 03 19 19 19 19 04 20 20 20 20 20 Year Mortgage interest rate Inflation rate 93 19 96 02 19 20 05 19 19 99 11. The economy of Brittania has been suffering from high inflation with an unemployment rate equal to its natural rate. Policy makers would like to disinflate the economy with the lowest economic cost possible. How can they try to minimize the unemployment cost of disinflation? Is it possible for there to be no cost of disinflation? 12. Who are the winners and losers when a mortgage company lends $100,000 to the Miller family to buy a house worth $105,000 and during the first year prices unexpectedly fall by 10%? What would you expect to happen if the deflation continued over the next few years? How would continuing deflation affect the economy as a whole? 20 Year 10. The accompanying diagram shows data for the short-term (three-month) interest rate as reported by the European Central Bank and inflation for the euro area for 1996 through mid-2005. How would you describe the relationship between the two? How does the pattern compare to that of the United States in Figure 16-5? >web... To continue your study and review of concepts in this chapter, please visit the Krugman/Wells website for quizzes, animated graph tutorials, web links to helpful resources, and more. www.worthpublishers.com/krugmanwells 20 05 ...
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