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Krugman/Wells

©2009 Worth Publishers

Inflation, Disinflation,and Deflation

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WHAT YOU WILL LEARN IN THIS CHAPTER

Why efforts to collect an inflation tax by printingmoney can lead to high rates of inflation andhyperinflation

What the Phillips curve is and the nature of theshort-run trade-off between inflation andunemployment

Why there is no long-run trade-off between inflationand unemployment

Why expansionary policies are limited due to theeffects of expected inflation

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WHAT YOU WILL LEARN IN THIS CHAPTER

Why even moderate levels of inflation can be hardto end

Why deflation is a problem for economic policy andleads policy makers to prefer a low but positiveinflation rate

Why the nominal interest rate cannot go below thezero bound and the danger this poses of theeconomy falling into a liquidity trap, makingconventional monetary policy ineffective

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Money and Prices

According to the classical model of the pricelevel, the real quantity of money is always at itslong-run equilibrium level.

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Money and Prices

YP

P3

P1

E1

AD1

SR

SRAS1

LRAS

Aggregateprice level

Real GDPPotentialoutput

Y1

P2 E2

AD2

E3

AS2

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Money Supply Growth and Inflation in Zimbabwe

2

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Money Supply Growth and Inflation in Brazil

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The Inflation Tax

The inflation tax is the reduction in the real valueof 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 thegovernment is reflected by the real inflation tax,the inflation rate times the real money supply.

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FOR INQUIRING MINDS

Indexing to Inflation People try to protect themselves from future inflation. The most common way of achieving such protection is

through indexation—contracts are written so that the termsof the contract automatically adjust for inflation.

In a highly indexed economy, higher prices feed rapidly intochanges in the consumer price index. That, in turn, quicklyleads to increases in wages, further leading to increases inother prices.

The result is that the long run, the period in which anincrease in the money supply raises the overall price levelby the same percentage, arrives very quickly. Underindexation, the prospect that a one-time increase in pricescan spark a persistent rise in inflation poses a much greaterrisk.

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Inflation and Wages in Europe and the United States

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Stuckflation

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The Logic of Hyperinflation

In order to avoid paying the inflation tax, peoplereduce their real money holdings and force thegovernment to increase inflation to capture thesame amount of real inflation tax.

In some cases, this leads to a vicious circle of ashrinking real money supply and a rising rate ofinflation.

This leads to hyperinflation and a fiscal crisis.

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The Logic of Hyperinflation

In 1923, Germany’s money was worth so little thatchildren used stacks of banknotes as buildingblocks or built kites with them.

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_ECONOMICS IN ACTIONZimbabwe’s Inflation Zimbabwe’s money supply growth was matched by almost

simultaneous surges in its inflation rate. Why didZimbabwe’s government pursue policies that led to runawayinflation?

The reason boils down to political instability, which in turnhad its roots in Zimbabwe’s history.

Robert Mugabe, Zimbabwe’s president, tried to solidify hisposition by seizing farms and turning them over to hispolitical supporters.

But because this seizure disrupted production, the resultwas to undermine the country’s economy and its tax base. Itbecame impossible for the country’s government to balanceits budget either by raising taxes or by cutting spending.

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_ECONOMICS IN ACTIONConsumer Prices in Zimbabwe, 1999-2008

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Money and Prices in Brazil, 1985-1995

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Moderate Inflation and Disinflation

The governments of wealthy, politically stablecountries like the United States and Britain don’tfind themselves forced to print money to pay theirbills.

Yet over the past 40 years both countries, alongwith a number of other nations, have experienceduncomfortable episodes of inflation.

In the United States, the inflation rate peaked at 13%at the beginning of the 1980s. In Britain, theinflation rate reached 26% in 1975.

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Moderate Inflation and Disinflation

In the short run, policies that produce a boomingeconomy also tend to lead to higher inflation, andpolicies that reduce inflation tend to depress theeconomy.

This creates both temptations and dilemmas forgovernments.

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The Output Gap and the Unemployment Rate

When actual aggregate output is equal to potentialoutput, the actual unemployment rate is equal tothe natural rate of unemployment.

When the output gap is positive (an inflationarygap), the unemployment rate is below the naturalrate.

When the output gap is negative (a recessionarygap), the unemployment rate is above the naturalrate.

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Cyclical Unemployment and the Output Gap

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Cyclical Unemployment and the Output Gap

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FOR INQUIRING MINDSOkun’s LawAlthough cyclical unemployment and the output gap move together,cyclical unemployment seems to move less than the output gap. Forexample, the output gap reached -8% in 1982, but the cyclicalunemployment rate reached only 4%.

This observation is the basis of an important relationship originallydiscovered by Arthur Okun, John F. Kennedy’s chief economicadviser. Modern estimates of Okun’s law—the negative relationshipbetween the output gap and the unemployment rate— typically findthat a rise in the output gap of 1 percentage point reduces theunemployment rate by about 1⁄2 of a percentage point.

For example, suppose that the natural rate of unemployment is 5.2%and that the economy is currently producing at only 98% of potentialoutput. In that case, the output gap is -2%, and Okun’s law predictsan unemployment rate of 5.2% - 1⁄2 x (-2%) = 6.2%.

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Short-run Phillips Curve

The short-run Phillips curve is the negative short-run relationship between the unemployment rateand the inflation rate.

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Unemployment and Inflation, 1955-1968

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The Short-Run Phillips Curve

When theunemployment rate islow, inflation is high.

Inflationrate

0

When the unemploymentrate is high, inflation is low.

Unemployment rate

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FOR INQUIRING MINDS

The Aggregate Supply Curve and the Short-RunPhillips Curve Figure 16-8 on the next slide shows how changes in the

aggregate price level and the output gap depend onchanges in aggregate demand.

Consider two possible paths for the economy over the nextyear.

One is that aggregate demand remains unchanged and theeconomy stays at E1.

The other is that aggregate demand shifts rightward to AD2and the economy moves to E2. At E2, real GDP is $10.4trillion, $0.4 trillion more than potential output. Meanwhile, atE2 the aggregate price level is 102.

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FOR INQUIRING MINDSThe AD-AS Model and the Short-Run Phillips Curve

E1 E1

LRAS

SRAS

SRPCAD1

100

0$10

6%0

Real GDPPotentialoutput

(trillions of dollars)Unemployment rate

E2

AD2

102

10.4

E2

4

2%

Aggregateprice level

(a) An increase inaggregate demand . . .

(b) . . . leads to both inflationand a fall in the unemploymentrate.

Inflationrate

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The Short-Run Phillips Curve and Supply Shocks

0

SRPC0

Inflationrate

Unemploymentrate

SRPC1

A negative supplyshock shiftsSRPC up.

SRPC2A positive supplyshock shiftsSRPC down.

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Inflation Expectations and the Short-Run PhillipsCurve

6%

5

4

3

2

1

0

–1

–2

–3

8%76543

SRPC0

Inflationrate

Unemployment rate

SRPC2

SRPC shifts up bytheamount of theincreasein expected inflation.

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Inflation and Unemployment in the Long Run

The nonaccelerating inflation rate ofunemployment, or NAIRU, is the unemploymentrate at which inflation does not change over time.

The long-run Phillips curve shows therelationship between unemployment and inflationafter expectations of inflation have had time toadjust to experience.

Disinflation is the process of bringing downinflation that is embedded in expectations.

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The NAIRU and the Long-Run Phillips Curve

8%

7

6

5

4

3

2

1

0

–1

–2

–3

8%76543

SRPC 0

E0

Inflationrate

Unemployment rate

Nonaccelerating inflationrate of unemployment,NAIRU

SRPC2

SRPC4E2

E4

C

B

A

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The Natural Rate of Unemployment

The natural rate of unemployment is the portion ofthe unemployment rate unaffected by the swings ofthe business cycle.

The NAIRU is another name for the natural rate. The level of unemployment the economy “needs” in

order to avoid accelerating inflation is equal to thenatural rate of unemployment.

In fact, economists estimate the natural rate ofunemployment by looking for evidence about theNAIRU from the behavior of the inflation rate andthe unemployment rate over the course of thebusiness cycle.

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Cost of Disinflation

Once inflation has become embedded inexpectations, getting inflation back down can bedifficult because disinflation can be very costly,requiring the sacrifice of large amounts ofaggregate output and imposing high levels ofunemployment.

However, policy makers in the United States andother wealthy countries were willing to pay thatprice of bringing down the high inflation of the1970s.

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GLOBALCOMPARISON

Disinflation Around the World

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The Great Disinflation of the 1980s

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Deflation

Debt deflation is the reduction in aggregatedemand arising from the increase in the realburden of outstanding debt caused by deflation.

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Deflation

Effects of Expected Deflation: There is a zero bound on the nominal interest rate:

it cannot go below zero. A situation in which monetary policy can’t be used

because nominal interest rates cannot fall belowthe zero bound is known as a liquidity trap.

A liquidity trap can occur whenever there is a sharpreduction in demand for loanable funds.

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The Zero Bound in U.S. History

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Japan’s Lost Decade

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_ECONOMICS IN ACTIONTurning Unconventional In 2004, the Federal Reserve began raising the target

federal funds rate. In mid-2007, a sharp increase inmortgage defaults led to massive losses in the bankingindustry and a financial meltdown. At first the Fed was slowto react; but by September 2007, it began lowering thefederal funds rate aggressively.

Why the sharp about-face by the Federal Reserve?Bernanke, an authority on monetary policy and the GreatDepression, understood the threat of deflation arising from asevere slump and how it could lead to a liquidity trap.

Through repeated interest rate cuts, the Fed attempted toget back “ahead of the curve” to stabilize the economy andprevent deflationary expectations that could lead to aliquidity trap.

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_ECONOMICS IN ACTIONCheck Out Our Low, Low Rates

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SUMMARY

1. In analyzing high inflation, economists use the classicalmodel of the price level, which says that changes in themoney supply lead to proportional changes in the aggregateprice level even in the short run.2. Governments sometimes print money in order to financebudget deficits. When they do, they impose an inflation tax onthose who hold money. Revenue from the real inflation tax, theinflation rate times the real money supply, is the real value ofresources captured by the government. In order to avoidpaying the inflation tax, people reduce their real moneyholdings and force the government to increase inflation tocapture the same amount of real inflation tax revenue. In somecases, this leads to a vicious circle of a shrinking real moneysupply and a rising rate of inflation, leading to hyperinflationand a fiscal crisis.

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SUMMARY

3. The output gap is the percentage difference between theactual level of real GDP and potential output. A positive outputgap is associated with lower-than-normal unemployment; anegative output gap is associated with higher than-normalunemployment. The relationship between the output gap andcyclical unemployment is described by Okun’s law.

4. Countries that don’t need to print money to covergovernment deficits can still stumble into moderate inflation,either because of political opportunism or because of wishfulthinking.

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SUMMARY

5. At a given point in time, there is a downward-slopingrelationship between unemployment and inflation known as theshort-run Phillips curve. This curve is shifted by changes inthe expected rate of inflation. The long-run Phillips curve,which shows the relationship between unemployment andinflation once expectations have had time to adjust, is vertical.It defines the non-accelerating inflation rate ofunemployment, or NAIRU, which is equal to the natural rateof unemployment.

6. Once inflation has become embedded in expectations,getting inflation back down can be difficult becausedisinflation can be very costly. However, policy makers in theUnited States and other wealthy countries were willing to paythat price of bringing down the high inflation of the 1970s.

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SUMMARY

7. Deflation poses several problems. It can lead to debtdeflation, in which a rising real burden of outstanding debtintensifies an economic downturn. Also, interest rates aremore likely to run up against the zero bound in an economyexperiencing deflation. When this happens, the economyenters a liquidity trap, rendering conventional monetary policyineffective.

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The End of Chapter 16

coming attraction:Chapter 17:

Macroeconomics Events andIdeas