Chapter

Inflation

* Principles of economics: chapter 30 & 35

 Chapter objectives
• Definition of Inflation
• Cause of inflation
• Costs of Inflation
• The relationship between inflation
and unemployment

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 Inflation
• Inflation
- Increase in the overall level of prices
OR
- Decrease in the purchasing power of money
• Hyperinflation
- Generally defined as inflation exceeding 50%
per month
• Deflation

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3
 Cause of inflation
• The Classical Theory of Inflation
(Quantity theory of money)
– Quantity of money available
• Determines the value of money
– Growth rate in quantity of money
available
• Determines the inflation rate

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The Classical Theory of Inflation
• Velocity and the quantity equation
• Velocity of money (V)
– Rate at which money changes hands
• V = (P × Y) / M
– P = price level (GDP deflator)
– Y = real GDP
– M = quantity of money

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The Classical Theory of Inflation
• Velocity and the quantity equation
• Quantity equation: M × V = P × Y
• Quantity of money (M)
• Velocity of money (V)
• Dollar value of the economy’s output of
goods and services (P × Y )

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The Classical Theory of Inflation
• Five steps - essence of quantity
theory of money
1. Velocity of money
• Relatively stable over time
2. Changes in quantity of money (M)
• Proportionate changes in nominal
value of output (P × Y)

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The Classical Theory of Inflation
• Five steps - quantity theory of
money
3. Economy’s output of goods and
services (Y)
• Primarily determined by factor
supplies
• And available production technology

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The Classical Theory of Inflation
• Five steps - quantity theory of
money
4. Change in money supply (M)
• Induces proportional changes in the
nominal value of output (P × Y)
– Reflected in changes in …
5. Central bank - increases the money
supply rapidly
• High rate of …

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 Money and prices during four
hyperinflations (a, b)

This figure shows the quantity of money and the price level during four
hyperinflations.
(Note that these variables are graphed on logarithmic scales. This means that equal
vertical distances on the graph represent equal percentage changes in the variable.)
In each case, the quantity of money and the price level move closely together. The
strong association between these two variables is consistent with the quantity theory
of money, which states that growth in the money supply is the primary cause of
inflation 10
 The Costs of Inflation
• Shoeleather costs
– Resources wasted when inflation
encourages people to reduce their
money holdings
– Can be substantial
• Menu costs
– Costs of changing prices
– Inflation – increases menu costs that
firms must bear
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 The Costs of Inflation
• Confusion and inconvenience
– Money: Yardstick with which we
measure economic transactions
– Inflation changes the yardstick we
use to measure transactions
– Complicates long-range planning
and the comparison of dollar
amounts over time

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 The Costs of Inflation
• Relative-price variability &
misallocation of resources
– Firms don’t all raise prices at the
same time
– So the relative prices can vary and
can distort all the allocation of
resources

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 The Costs of Inflation
• Inflation-induced tax distortions
– Taxes are based on nominal income,
and some are not adjusted for
inflation
– Inflation causes people to pay more
taxes even when their real incomes
don’t increase
=> Inflation increases savers’ tax
burdens

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 The Costs of Inflation
• A special cost of unexpected
inflation: arbitrary redistributions of
wealth
• Unexpected inflation
– Redistributes wealth among the
population
• Not by merit
• Not by need
– Redistribute wealth among debtors
and creditors
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The Short-Run Trade-off
between Inflation and
Unemployment
 The Phillips Curve
• Phillips curve
– Shows the short-run trade-of
– Between inflation and
unemployment
• Origins of the Phillips curve (text
book)

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 The Phillips Curve
Inflation
Rate
(percent
per year)
B
6

A
2

Phillips curve
4% 7 Unemployment
Rate (percent)

The Phillips curve illustrates a negative association between the inflation rate and the
unemployment rate. At point A, inflation is low and unemployment is high. At point B, inflation
is high and unemployment is low.
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 The Phillips Curve
• Aggregate demand (AD), aggregate
supply (AS), and the Phillips curve
• Phillips curve
– Combinations of inflation and
unemployment
– That arise in the short run
– As shifts in the aggregate-demand
curve
– Move the economy along the short-
run aggregate-supply curve
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 The Phillips Curve
• AD, AS, and the Phillips curve
• Higher aggregate-demand
– Higher output & Higher price level
– Lower unemployment & Higher
inflation
• Lower aggregate-demand
– Lower output & Lower price level
– Higher unemployment & Lower
inflation
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 How the Phillips curve is related to the model of
aggregate demand and aggregate supply
(a) The Model of AD and AS (b) The Phillips Curve
Inflation
Price Short-run
Rate
level aggregate
(percent
supply
per year)
B B
6%
106
A High aggregate
102 demand

A
Low aggregate 2
demand
Phillips curve

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

unemployment unemployment of output output output Rate (percent)
=7% =4% =16,000 =15,000
This figure assumes price level of 100 for year 2020 and charts possible outcomes for the year 2021. Panel (a)
shows the model of aggregate demand & aggregate supply. If AD is low, the economy is at point A; output is
low (15,000), and the price level is low (102). If AD is high, the economy is at point B; output is high (16,000),
and the price level is high (106). Panel (b) shows the implications for the Phillips curve. Point A, which arises
when aggregate demand is low, has high unemployment (7%) and low inflation (2%). Point B, which arises
when aggregate demand is high, has low unemployment (4%) and high inflation (6%). 21
 The Phillips Curve
• The long-run Phillips curve
– Is vertical
– If the Fed increases the money supply slowly
• Inflation rate is low
• Unemployment – natural rate
– If the Fed increases the money supply
quickly
• Inflation rate is high
• Unemployment – natural rate
– Unemployment - does not depend on money
growth and inflation in the long run

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 The long-run Phillips curve

Inflation
Rate Long-run
Phillips curve

High B
1. When the
inflation
Fed increases
the growth rate 2. . . . but unemployment
of the money remains at its natural rate
supply, the in the long run.
rate of inflation A
increases . . . Low
inflation

Natural rate of Unemployment

unemployment Rate

According to Friedman and Phelps, there is no trade-off between inflation and unemployment
in the long run. Growth in the money supply determines the inflation rate. Regardless of the
inflation rate, the unemployment rate gravitates toward its natural rate. As a result, the long-
run Phillips curve is vertical. 23