Laugher Curve
Chapter 13
Part 1
Inflation
Equation of exchange
Economics is the only field in which two
people can share a Nobel Prize for saying
opposing things.
Specifically, Gunnar Myrdahl and
Friedrich S. Hayek shared one.
Some Basics about Inflation
The Distributional Effects of
Inflation
• Inflation is a continuous rise in the price
level.
• It is measured using a price index.
• There are individual winners and losers in
an inflation.
• On average, winners and losers balance out.
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The Distributional Effects of
Inflation
The Distributional Effects of
Inflation
• The winners are those who can raise their
prices or wages and still keep their jobs or
sell their goods.
• Unexpected inflation redistributes income
from lenders to borrowers.
• The losers in an inflation are those who
cannot raise their wages or prices.
Expectations of Inflation
• Expectations play a key role in the
inflationary process.
– Rational expectations are the expectations that
the economists' model predicts.
– Adaptive expectations are those based, in some
way, on what has been in the past.
– Extrapolative expectations are those that
assume a trend will continue.
• People who do not expect inflation and who
are tied to fixed nominal contracts are likely
lose in an inflation.
Productivity, Inflation, and
Wages
• Changes in productivity and changes in
wages determine whether inflation may be
coming.
• There will be no inflationary pressures if
wages and productivity increase at the same
rate.
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Productivity, Inflation, and
Wages
• The basic rule of thumb:
Inflation = Nominal wage increases –
Productivity growth
Deflation
• Deflation is the opposite of inflation and is
associated with a number of problems in the
economy.
• Deflation – a sustained fall in the price
level.
Deflation
Theories of Inflation
• Deflation places a limit on how low the Fed
can push the real interest rate.
• Deflation is often associated with large falls
in stock and real estate prices.
• The two theories of inflation are the
quantity theory and the institutional theory.
– The quantity theory emphasizes the connection
between money and inflation.
– The institutional theory emphasizes market
structure and price-setting institutions and
inflation.
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The Quantity Theory of Money
and Inflation
• The quantity theory of money is
summarized by the sentence:
• Inflation is always and everywhere a
monetary phenomenon.
The Equation of Exchange
• Equation of exchange – the quantity of
money times velocity of money equals price
level times the quantity of real goods sold.
MV = PQ
z M = Quantity of money
z V = velocity of money
z P = price level
z Q = real output
z PQ = the economy’s
nominal output
The Equation of Exchange
Velocity Is Constant
• Velocity of money – the number of times
per year, on average, a dollar goes around to
generate a dollar’s worth of income.
• The first assumption of the quantity theory
is that velocity is constant.
• Its rate is determined by the economy’s
institutional structure.
Velocity =
Nominal GDP
Money supply
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Velocity Is Constant
• If velocity remains constant, the quantity
theory can be used to predict how much
nominal GDP will grow.
• Nominal GDP will grow by the same percent
as the money supply grows.
Real Output Is Independent of the
Money Supply
• The second assumption of the quantity
theory is that real output (Q) is independent
of the money supply.
• Q is autonomous – real output is determined
by forces outside those in the quantity
theory.
Real Output Is Independent of the
Money Supply
Examples of Money's Role in
Inflation
• The quantity theory of money says that the
price level varies in response to changes in
the quantity of money.
• The quantity theory lost favor in the late
1980s and early 1990s.
• The formerly stable relationships between
measurements of money and inflation
appeared to break down.
• With both V and Q unaffected by changes in
M, the only thing that can change is P.
%∆M ⇒ %∆P
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• The relationship between money and
inflation broke down because:
– Technological changes and changing regulations in
financial institutions.
– Increasing global interdependence of financial
markets.
U.S. Price Level and Money
Relative to Real Income
Price level and money relative
to real income (1960 = 1)
Examples of Money's Role in
Inflation
6
5
Price level
4
Money
3
2
1
0
1960
• The empirical evidence that supports the
quantity theory of money is most
convincing in Brazil and Chile.
Inflation and Money Growth
Annual percent change in
inflation (%)
Inflation and Money Growth
1965 1970 1975 1980 1985 1990 1995 2000 2005
100
90
Argentina
80
70
60
Nicaragua Poland
50
Chile
40
Zaire
30
20
Indonesia
10 U.S.
0
0
10
20
30
40
50
60
70
80
90
Annual percent change in the money supply (%)
100
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The Inflation Tax
The Inflation Tax
• Central banks in nations such as Argentina
and Chile are not a politically independent
as in developed countries.
• Their central banks sometimes increase the
money supply to keep the economy running.
• The increase in money supply is caused by
the government deficit.
• The central bank must buy the government
bonds or the government will default.
The Inflation Tax
The Inflation Tax
• Financing the deficit by expansionary
monetary policy causes inflation.
• The inflation works as a kind of tax on
individuals, and is often called an inflation
tax.
• It is an implicit tax on the holders of cash and
the holders of any obligations specified in
nominal terms.
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The Inflation Tax
Policy Implications of the
Quantity Theory
• Central banks have to make a monetary
policy choice:
• Supporters of the quantity theory oppose an
activist monetary policy.
– Ignite inflation by bailing out their governments
with an expansionary monetary policy.
– Do nothing and risk recession or even a breakdown
of the entire economy.
– Monetary policy is powerful, but unpredictable
in the short run.
– Because of its unpredictability, monetary policy
should not be used to control the level of output
in an economy.
Policy Implications of the
Quantity Theory
Policy Implications of the
Quantity Theory
• Quantity theorists favor a monetary policy
set by rules not by discretionary monetary
policy.
• Many central banks use monetary regimes
or feedback rules.
• A monetary rule takes money supply decisions
out of the hands of politicians.
– New Zealand has a legally mandated monetary
rule based on inflation.
– The Fed does not have strict rules governing
money supply, but it works hard to establish
credibility that it is serious about fighting inflation.
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