CHAPTER 33
Inflation, Disinflation, and Deflation
PowerPoint® Slides
by Can Erbil
© 2005 Worth Publishers, all rights reserved
What you will learn in this chapter:
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
Money and Prices
According to the classical model of the price level, the real quantity of money is always at its long-run equilibrium 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.
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.
The Inflation Tax and Hyperinflation
The inflation tax is the reduction in the real value of money held by the public caused by inflation, 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.
A vicious circle of a shrinking real money supply and a rising rate of inflation, leads to hyperinflation and a fiscal crisis.
Money and Prices in Brazil, 1985–1995
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%.
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.
The Costs of Inflation
Shoe-leather costs
Menu costs
Unit-of-account costs
Inflation and Nominal Interest Rates in the .
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.
The Great Disinflation of the 1980s
Panel (a) shows the . “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 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.
Effects of Deflation
Effects of Unexpected Deflation:
- Debt deflation
Effects of Expected Deflation:
- Zero bound
- Liquidity trap
Japan’s Trap
During the 1990s, Japan slipped into deflation. The Bank of Japan tried to fight this by reducing the call money rate, the short-term interest rate that corresponds to the Federal funds rate in the United States. By 1996, however, the call money rate was close to 0%—and by 2004 it actually was 0%, its lower limit. Japan found itself in a liquidity trap, with no room for monetary expansion.
Source: International Monetary Fund.
The End of Chapter 16
coming attraction:
Chapter 17:
The Making of Modern Macroeconomics
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.
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.
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%.
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.
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.
Panel (a) shows the . “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 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.
During the 1990s, Japan slipped into deflation. The Bank of Japan tried to fight this by reducing the call money rate, the short-term interest rate that corresponds to the Federal funds rate in the United States. By 1996, however, the call money rate was close to 0%—and by 2004 it actually was 0%, its lower limit. Japan found itself in a liquidity trap, with no room for monetary expansion.
Source: International Monetary Fund.
