What Causes Inflation/Deflation?

Prices change when Aggregate Demand for goods and services runs ahead or lags

behind Production of goods and services (Aggregate Supply)

1

2

CPIo

Goods and Services Produced

Goods and Services PurchasedAggregate Demand

Aggregate Supply

GDPo

Aggregate Supply – Aggregate Demand

CPI

Real GDP

At this price level Aggregate Supply = Aggregate Demand

At this price level all production is sold: no accumulation of

inventories

Increase Production

3

CPIo

GDPo

Aggregate Supply

Aggregate Demand

CPI1

GDP1

Supply larger than Demand:

Inventories rise, Firms cut prices

Produce More

Demand SupplyGDPo Supply

‘Good’ Inflation

4

CPIo

Goods and Services Produced

Goods and Services Purchased

CPI1

Aggregate Demand

Aggregate Supply

Optimistic consumers buy more goods and services

Inflation

Demand higher than Supply:

Inventories Drop, prices and output

rise

Buy More

Unemployment drops

GDPo GDP1

Supply DemandGrowth

Bad Inflation

5

CPIo

Goods and Services Produced

Goods and Services Purchased

CPI1

Aggregate Demand

Aggregate Supply

Firms can not get loans

Inflation

Demand higher than Supply:

Inventories Drop, prices rise, output

drops

Produce Less

Stagflation

Supply DemandRecessionUnemployment

increases

GDPoGDP1

Deflation

• Before 1930 deflation was as likely as inflation.• Deflation is harmless even good, if lower

prices lift real incomes and hence spending power. – In the last 30 years of the 19th century, consumer

prices fell by almost half as the expansion of railways and advances in industrial technology brought cheaper ways to make everything.

– Annual real GDP GROWTH over the period averaged more than 4%.

6

Good Deflation

7

CPIo

GDPo

Aggregate Supply

Aggregate Demand

CPI1

GDP1

Deflation

Growth

Advances in technology reduce costs

Supply larger than Demand:

Inventories rise, prices drop, output

rises

Unemployment drops

Produce More

Bad Deflation

8

CPIo

GDPo

Goods and Services Produced

Goods and Services Purchased

CPI1

GDP1

Recession

Consumers feel poor as real estate and stock prices fall

Supply larger than Demand:

Inventories rise, prices and output

dropDeflation

Unemployment increases

Buy Less

Deflation is dangerous when it reflects

• A sharp drop in DEMAND, • Excess CAPACITY and • Decrease in GDP As in the Great DEPRESSION of the

early 1930s.

9

The Shape of the Aggregate Supply Curve

The book uses an upward sloping AS curve…is this always the case? Why is

it upward sloping?

10

The Shape of the Aggregate Supply Curve

AS: describes the reaction of firms to changes in demand.

11

Output Increases

Prices do not change

Prices Increase

Output Increases

Unemployment and Excess Capacity

Output can not increase

Only Pricesrise

Unemployed workers: wages low

Excess capacity: easy to produce more.

Firms do NOT raise prices but instead increase output

Lower Unemployment: wages rise

Less excess capacity: costs rise as firms produce more. To

cover increase in costs, firms raise prices

Lower Unemployment and less excess capacity

No Unemployment: wages rise faster

No excess capacity: Firms cannot produce

more, only increase prices

Minimal Unemployment no excess capacity

The Effect of an Increase in Aggregate Demand

The book uses an upward sloping AS curve…is this always the case?

• NO. The reaction of firms depends on where the economy is along the business cycle.– During a Recession (high Unemployment

and Excess Capacity) AS is horizontal– Wages do not rise due to unemployment– Firms can increase production without

raising prices.13

Why is AS upward sloping?

During the Recovery with lower unemployment and less excess capacity: AS is upward sloping

– Firms can increase output– But costs rise: lower unemployment means that

hiring workers becomes more expensive and equipment breaks down more often.

14

Firms increase both production and prices (to cover increase in costs).

The book uses an upward sloping AS curve…is this always the case?

NO. The reaction of firms depends on where the economy is along the business cycle.At full employment with zero cyclical

Unemployment and NO Excess Capacity: AS is vertical.

Firms can no longer increase production.– And costs rise: zero unemployment means that

firms must hire workers away from other firms and equipment breaks down more often.

15Firms increase prices

16

Price Level

Real GDP

ASo

AD1ADo

Price Level

Real GDP

ASo AS1

ADo

Price Level

Real GDP

ASoAS1

ADo

Price Level

Real GDP

ASo

AD1ADo

Recession and deflation

12

34

Recession and inflation

Growth and deflationGrowth and inflation

E2

E1

S2

S1

D1

D2

All three graphs show the effect on prices and output when both AS and AD increase:Depending on the relative size of the shifts, prices may go up, down or remain the same. Output definitely increase.

AS shifts more than ADS2

S1

D1

D2

AD shifts more than AS

E2E1

S2

S1

D1

D2

AS shifts by the same amount as AD

P

GDP

E1

E2

Growth and inflationRecession and deflation Recession and inflation

Growth and deflation

3

E1

E2

E2

E1

S2

S1

D1

D2

3

E1

E2

E2

E1

S2

S1

D2

D1

(C)

P

Y

Use AD-AS to show the effect on prices and output

1. The Aggregate Demand induced Great Depression of the 1930’s.

2. A negative supply shock as that experienced during the 1970’s when oil prices sky rocketed.

3. The combined effects of improvements in technology and increasing government spending.

4. The combined effects of the financial system meltdown and plummeting home values.

5. Increase Government Spending in construction projects.

6. Natural disaster – earthquake, nuclear meltdown-7. Decrease in payroll tax.

Stabilization Policy: Use AS – AD diagram to:

1. Explain how the government can fight inflation. What negative consequence may this policy have?

2. Explain how the government can fight unemployment. What negative consequence may this policy have?

3. Explain how the government can fight recessions. What negative consequence may this policy have?

20

Draw three possible graphs:

• Aggregate Demand and Aggregate Supply increase.

• Aggregate Demand and Aggregate Supply decrease.

• Aggregate Demand decrease and Aggregate Supply increase.

• Aggregate Demand increase and Aggregate Supply decrease.

21

The Costs of Inflation

Why is inflation bad?

22

Obviously,

because money

buys less

THREE MISTAKESCost of Inflation

23

24

Wages and prices rise and fall together.

Inflation does not decrease real wages.

1. People believe inflation decrease real

wagesIf salaries rise @ the inflation rate,

real wages do not change

Prices

Wages

The “Robbery Coefficient”

Increase in wages = Increase in productivity + increase in prices

Increase in productivity = 3%Inflation = 2%Increase in wages = 2+3 = 5%Only 3% is “earned” by my stellar

performance (productivity). The remaining 2% is given to keep real wage from falling due to rising prices.

25

2. Workers believe they “earned” 5%

and inflation “robbed” them of

2%”What you get for your stellar

performanceWhat you get to compensate you for rising prices

Inflation is blamed for changes in relative prices

26

Suppose the price of apples = price gasoline = $2. 1 bag of apples buys you 1 gallon of gas. Basket: 1 bag of apples, 1 gallon of gas.Cost of basket: (1X$2)+ (1X$2) = $4CPI = ($4/$4)*100 = 100If the price of gas rises to $3 while the price of apples drops to $1. The apple seller now needs 3 bags of apples to buy 1 gallon of gas. Cost of basket: (1X$1)+ (1X$3) = $4CPI = ($4/$4)*100 = 100There is NO inflation but a change in relative pricesOnly if OVERALL prices rise, there is inflation

3. The apple seller blames inflation for

the drop in his buying power.

The True Costs of Inflation

Why is inflation bad?

27

1938Nominal Min Wage $0.25

CPI = 14.1Real Min Wage = $1.77

2011Nominal Min Wage $7.25

CPI = 224.9Real Min Wage = $3.22

A $1.45 increase in 73 years!

Nominal Min Wage

Real Min Wage

1. Inflation Costs: Arbitrary Redistribution of Income

• Individuals whose incomes are fixed (pensions) or grow slower than inflation (minimum wage) lose purchasing power.

• Employers who enjoyed sale prices rising faster than wages win…

29

Inflation

Arbitrary redistribution of

income from minimum wage

workers to employers

Arbitrary redistribution of income from retirees

to government, businesses

Interest Rate

The cost paid by those who want/need to spend today

money they will make in the future.

30

The reward for those who give up spending today in order to spend tomorrow

The Inflation Cost

• If I save $100 today at 10% interest• I will get $100 + 100 (0.1) = 100 + 10 =

$110 when I need the money (retirement).

• If inflation is zero, I will have an extra $10 to spend.

31

$10 is my reward for postponing

consumption.

5% Inflation = CPI increase by 5%

32

Today Future

$100

CPI = 100 CPI = 100+ 100*0.05 =105

(105)/(100)=1.05Multiply by 1.05 ?$100(1.05) = $105

10% interest means I will get $110 in the future…

• If inflation is 5% I need $105 to buy what I could buy with $100 before. I get $110, so I got only $5 extra to spend.

• If inflation is 10%, I now need $110 to buy what I could buy with $100 before. I get $110 so I got nothing in return for my savings!

33

• If inflation is 20%, I now need $120 to buy what I could buy with $100. I get $110, but that buys less than the $100 I lent!

Inflation steals 5% of my 10% interest

Inflation Cost me ALL my reward!

Inflation Cost me 10% more than I got in interest

The borrower is happy. He used my money for

free!

The borrower is very happy. He

returned “less” than he borrowed!

The interest rate written in a

contract between lender and borrower

The Real Interest Rate

Real Interest Rate = Nominal Interest Rate – Inflation Rate.

34

10%

0%

10%

10%

0%

20%

-10%

All I need to do is charge the

correct Nominal rate!

All I need to know is the

inflation rate…

Year Inflation

2008 22009 2.52010 12011 2.32012 2.72013 3.42014

2015

2016

2017

What is your guess for inflation in

2014?

Average=2.32

?3

Guess Inflation = 3% Charge 7% nominal interest

• If you guess right, and inflation is 3%, you will make a 4% real return.

Nominal (7%) – Inflation (3%) = Real (4%)• If you guess wrong and inflation is 5%, you

will make a 2% real return Nominal (7%) – Inflation (5%) = Real (2%)

36

Year Inflation

2008 22009 2.52010 12011 2.32012 2.72013 3.4

2014

2015

2016

2017

Inflation was 26%

Average=2.32

26!

Guess Inflation = 3% Charge 7% nominal interest

• If you are very wrong and inflation is 26%, you will make a negative return (you are giving money away!) Nominal (7%) – Inflation (26%) =

Real (-19%)

38

Un-anticipated inflation hurts savers

Savings Savers

BorrowersInflation higher than nominal interest

Nominal Interest

Real interest rate is negative

2.Inflation Cost: Arbitrary Redistribution of Income

• People who save lose purchasing power.• Borrowers win

40

InflationArbitrary redistribution of income from savers to borrowers

Year Index Inflation1996 156.9  1997 160.5 2.31998 163 1.61999 166.6 2.22000 172.2 3.42001 177.1 2.82002 179.9 1.62003 184 2.32004 188.9 2.72005 195.3 3.4

What is your guess for

inflation next year (2006) if

you live in this country?

Year Index Inflation

1996 100.52 0.2

1997 101.05 0.5

1998 101.98 0.9

1999 100.79 -1.2

2000 99.85 -0.9

2001 98.78 -1.1

2002 124.33 25.9

2003 141.05 13.4

2004 147.28 4.4

2005 161.48 9.6

What is your guess for

inflation next year (2006) if

you live in this country?

U.S. Last 20 years

What is your guess for

inflation next year?

Between 1% and 6%

44

Between -2% and 6%

45

Venezuela

Between 10% and 120%

46

Between 18% and 28%

47

Between 5% and 30%

48

Between 3% and 35%

49

Your guess if you live in

this country?

Between -10% and 50%

50

Ecuador

Between -5% and 50%

Guessing Inflation is not easy

When past inflation is high and volatile: Argentina, Colombia,

Uruguay and Venezuela

51

Guessing Inflation is easier

When past inflation numbers are low and stable : U.S.

52

The Cost of Un-anticipated Inflation

When your guess about inflation turns out to be wrong.

53

2. Costs of Inflation: Redistribution of Income

• Lenders and savers lose• Borrowers win

54

InflationArbitrary redistribution of income from lenders and savers to borrowers

High inflation is volatile and difficult to guess

Capital Gains

• It is the difference between the (higher) selling price and the (lower) purchase price, resulting in a financial profit for an investor.

• Examples: profit that results from selling stocks, bonds or real estate.

55

Inflation: The most unfair tax…Capital gains and interest income are

taxed.• Suppose you lend (or buy any interest

bearing asset for) $100 for a 15% return.– Suppose that we have agreed that a fair tax

on your interest income is 30%.• In this transaction you make $15 in

interest income– The government takes 30% of that = $4.50.

56

4. Costs of Inflation: The Inflation Tax

If inflation is 5%: • You make 15% Nominal interest ($15) and pay

30% tax ($4,50).• You make 10% in real interest ($10) BUT YOU

STILL PAY $4,50 in tax!– The tax is taken from the nominal return

not from the real return– $4,50 out of a $10 is equivalent to a tax of

45% instead of the intended 30%.57

58

$100$115 Nominal interest income= $15Intended Tax = $4.50/15 = 0.3

CPI = 100

Today CPI = 105

Tomorrow5% inflation

15% nominal interest

$115/1.05=$109.52Real interest income = $9.52Real Tax = $4.50/1.05 = $4.2857Tax you pay = 4.2857/9.52 = 0.45

$115

30%

45%

The tax you pay increases because of inflation

5% inflation

59

$100$115 Nominal Capital Gain = $15Intended Tax = $4.50/15 = 0.3

Today Tomorrow5% inflation

$115/1.05=$109.52Real Capital Gain = $9.52Real Tax = $4.50/1.05 = $4.2857Tax you pay = 4.2857/9.52 = 0.45

$100

30%

45%

The tax you pay increases because of inflation

15% Interest Income15% Capital Gain

3. Costs of Inflation: Inflation Tax

• Individuals whose incomes come mainly from capital gains and interest income lose

• Government wins

60

InflationArbitrary redistribution of income from capital gains an interest income taxpayers to government

6161

< year> year

Wages, interest, rent, profits

higher>

15%

Reduced to 0%

Before May 03

20%

15% 20%

3.8% investment Income Tax for >$250K to fund Medicare

sam

e

15%

0 – $8,500

$8,500- $34,500

$34,500 – $83,600

$83,600 – $174,400$174,400 - $379,150Over $379,150

15%

20%

The struggle with the administration over increasing taxes

on capital gains.

63

“ It’s a war,It’s like when Hitler invaded

Poland in 1939.”

Stephen Schwartzman, chairman and cofounder of the Blackstone Group, one of

the world’s largest private-equity firms.

Who suffers from inflation?• People on fixed incomes & workers (if

wages/pensions are not adjusted by inflation)• The poor (government transfers to the poor are

not adjusted by inflation).– Wages and pensions can be easily adjusted for

inflation…• Lenders

– Lenders could factor inflation and taxes into the interest rate

• Individuals whose incomes come mainly from capital gains and interest income…– The government could index tax system (charge tax

on real returns)

Who Gains from Inflation?

Borrowers! Because they pay back less than they borrowed…Business, if the prices they receive rise faster than the wages they pay-inflation hides real wage drops-Government because tax revenues increase as inflation increases the effective tax.

65

Who is hurt from Deflation?

Borrowers! Because they pay back MORE than they borrowed…Business, the prices they receive rise SLOWER than the wages they pay-deflation hides real wage increasesGovernment because tax revenues DECREASE as deflation pushes taxpayers into lower income brackets.

66

Inflation does no special harm to the poor• During inflationary periods the prices paid by

the poor rise neither faster nor slower than the prices paid by the rest of us.– Inflation does not raise the incomes of the rich

relative to those of the poor.• The opposite is true: Real incomes at the

bottom rise relative to those at the top– Making income distribution slightly more equal.

• Only identifiable loss: government’s failure to index transfers to the poor and tax real instead of nominal returns.

67

Year Inflation RateMarket yield on U.S. Treasury

securities at 1-year Nominal Real Interest Rate

1994 2.6 7.141995 2.5 5.311996 3.4 5.471997 1.7 5.531998 1.6 4.521999 2.7 5.842000 3.4 5.62001 1.6 2.222002 2.5 1.452003 2 1.312004 3.3 2.672005 3.4 4.352006 2.5 4.942007 4.2 3.262008 -0.1 0.492009 -0.2 0.62

Calculate the Real Interest Rate = Nominal Interest – Inflation Rate

69

Year Inflation Rate Market yield on U.S. Treasury securities at 1-

year Nominal

Real Interest

Rate1994 2.6 7.14 4.541995 2.5 5.31 2.811996 3.4 5.47 2.071997 1.7 5.53 3.831998 1.6 4.52 2.921999 2.7 5.84 3.142000 3.4 5.6 2.22001 1.6 2.22 0.622002 2.5 1.45 -1.052003 2 1.31 -0.692004 3.3 2.67 -0.632005 3.4 4.35 0.952006 2.5 4.94 2.442007 4.2 3.26 -0.942008 -0.1 0.49 0.592009 0.62

Real Interest Rates can be NEGATIVE!

You are then giving money

away!

This is the interest the Government Pays on

Bonds

How do we Fight Inflation?

• Joblessness.• Slow down Aggregate Demand for

goods and services.• Policy tool of choice: interest rate

hikes by the Federal Reserve Bank.

70

True or False?

71

1. Inflation is a serious problem because inflation causes real wages to decline.

2. Changes in relative prices usually lead to increases in real income because prices have changed.

3. Inflation tends to redistribute real income from lenders to borrowers.

4. Inflation is a very minor problem for lenders because it is relatively easy to estimate future rates of inflation.

5. The incentive to lend increases as the real rate of interest decreases.

6. Low inflation rates tend to accelerate into higher and higher rates of inflation.

Quiz

1. You agree to lend Claudia $1,000 for one year. The interest on the loan is 5%. If at the end of the year prices have increased by 7%, in real terms, who won and who lost? Why?

2. If you want to increase your purchasing power by 5% by lending money and you expect inflation to be 3% during the life of the loan, what interest rate should you charge on that loan?

72

3. The CPI today is 100 you expect the CPI to be 97 tomorrow. If you borrow $100 today at 5%. Will the change in prices help you or hurt you in real terms? Why?

4. Explain how the current U.S. tax system levies taxes on capital gains and earned interest. What does this mean for the costs of inflation?

73

The Phillips Curve

If we plot past data on Inflation and unemployment we observe:

There is a temporary trade off between inflation and unemployment

74

Infl

ati

on

Unemployment

Years of HighInflation

Years of LowInflation

Years of LowUnemployment

HighUnemployment

The trade off between unemployment and inflation

In order to reduce inflation by 1%, we must hold unemployment above the

natural rate two (to 2 and a half) percentage points.

75

Unemployment

Inflation

9.9%

The trade off between unemployment and inflation

A reduction in inflation from 10% to 4% (6% points) costs (6x2) 12% in terms of extra unemployment…

77

Paul Volcker: Chairman of the Federal Reserve under Jimmy

Carter and Ronald Reagan (from August 1979 to August 1987)

Unemployment above the NRU (5.8%)

78

1980: 1.3 points

1981: 1.8 points

1982: 3.9 points

1983: 3.8 points

1984: 1.7 points

Total: 12.5 points

Between 1980 and 1985 a 6% reduction in inflation cost unemployment to be 12.5% points above the natural rate.

Unemployment

Inflation

Bush 89-93

Clinton 93-01

Bush 01-09

Obama 09-

80