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Lesson 6.1 Inflation, expectations and credibility
Sergio A. Berumen Universidad Rey Juan Carlos

Inflation is ...
• Inflation is a rise in the price level. • Pure inflation is when goods and input prices rise at the same rate. • One of the first acts of the Labour government in 1997 was to make the Bank of England independent
– with a mandate to achieve low inflation.

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• What are the causes of inflation? • What are the effects and hence costs of inflation? • What can be done about it? • These are the questions we seek to answer in what follows.

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Inflation in the UK, 1950-2003
30 25 20

% p.a.

15 10 5 0

1950

Source: Economic Trends Annual Supplement, Labour Market Trends
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1960

1970

1980

1990

2000

Thequantity theory (1)
• The quantity theory of money says:
• “Changes in the nominal money supply lead to equivalent changes in the price level (and money wages) but do not have effects on output and employment.”

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The quantity theory (2)
• We can state it algebraically as: – MV = PY – where V = velocity of circulation Y = potential level of real GDP P = the price level M = nominal moneysupply – Given constant velocity, if prices adjust to maintain real income at the potential level – an increase in nominal money supply leads to an equivalent increase in prices.

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Money, prices and inflation (1)
• Milton Friedman famously claimed “Inflation is always and everywhere a monetary phenomenon.”
– i.e. it results when money supply grows more rapidly than real output.

• Butnotice that the quantity theory equation does not tell us whether prices determine quantity or vice versa.

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Money, prices and causation (a)
• In money market equilibrium, the supply of real money equals the demand for money i.e. – M/P = Y/V • If the demand for real money is constant, M/P is constant. • Monetary policy can fix M, in which case M P

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Money, prices and causation (b)
• ORmonetary policy can try and fix P over time, in which case P M • This latter approach is known as inflation targeting • in contrast to the former approach which indirectly targets the money supply.

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Money, prices and inflation (2)
• In any case, in the long run, potential real GDP and interest rates will significantly alter real money demand • Therefore, in the long-run there may not bea perfect correspondence between excess monetary growth and inflation.

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Money, prices and inflation (3)
• Also, in the short run, the link between money and prices may be broken if: – the velocity of circulation is variable – prices are sluggish. • For all the above reasons, we must therefore interpret the quantity theory with care.

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Inflation and interest rates
• FISHERHYPOTHESIS
– a 1% increase in inflation will be accompanied by a 1% increase in interest rates

• REAL INTEREST RATE
– Nominal interest rate minus inflation rate – i.e. the Fisher hypothesis says that real interest rates do not change much – but the nominal interest rate is the opportunity cost of holding money – so a change in nominal interest rates affects real money demand.
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Hyperinflation• Hyperinflations are periods when inflation rates are very large • During such periods there tends to be a ‘flight from cash’, i.e. people hold as little cash as possible
– e.g. Germany in 1922-23, Hungary 1945-46, Brazil in the late 1980s.

• Large government budget deficits help to explain such periods
– persistent inflation must be accompanied by continuing money supply growth
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ThePhillips curve (1)
• In 1958, Prof. A W Phillips demonstrated a statistical relationship between annual inflation and unemployment in the UK. • The Phillips curve relates higher unemployment to lower inflation. • It implies we can trade-off higher inflation for lower unemployment and vice versa.

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The Phillips curve
Inflation rate (%)

Phillips curve

U*
Unemployment rate (%)
14...