Money and Inflation
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
1
Structure
1. Introduction
2. The Costs and the Origins of Inflation
3. The Phillips-Curve and its Implications
4. Indexation - An International Comparison
5. Conclusion
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
2
Introduction
• Inflation is a rise in the general price level and is
reported in rates of change. The inflation rate is
determined by finding the difference between
price levels for the current year and the previous
given year:
t = ( Pt - Pt-1 ) / Pt-1.
• If Y and V are constant, inflation can only arise
on the condition of
( Mt - Mt-1 ) / Mt-1 > 0.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
3
Introduction
Milton Friedman
Born 1912, Nobel prize in 1976
“Inflation is always and everywhere
a monetary phenomenon”
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
4
Introduction
Increase in Inflation and money supply in the USA
(10 years annual average examination)
Growth rate of the Inflation
1970
1960
1950
1980
1910
1940
1900
1890
1930
1920
1870
1880
Growth rate of the money supply in percent
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
5
Introduction
Different calculations of Inflation
Price index
GDP deflator
„Goods“
Only private goods
are included
All private and
public goods are
included
„International
Trade“
No distinction
between national or
international goods
Only national
goods are
summarised
„Basket of
goods“
Fixed composition
Flexible
composition
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
6
The Costs and the Origins of Inflation
The costs of a correctly anticipated Inflation:
1. „suboptimal store of money“ (cash without interest
is shifted to Financial Intermediaries = “shoe
leather costs”)
2. „menu costs“ (change price lists and convert
machines)
3. „cold progression“ in the tax system
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
7
The Costs and the Origins of Inflation
The costs of an incorrectly anticipated Inflation:
1. profit income earners benefit more than wage
earners,
2. nominal income earners lose and
3. debtors benefit at the expense of creditors.
The results are high allocation costs and an arbitrary
distribution of income and wealth.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
8
The Costs and the Origins of Inflation
• Inflation could result from an activist economic
policy.
• There are two types of Inflation:
Supply induced
Cost-push Inflation
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Demand induced
Demand-pull Inflation
9
Cost-push Inflation
Price level



Inflation is due
to accommodating
fiscal policy
Yn
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Aggregate output
10
Demand-pull Inflation
Price level



Yn Yt
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Aggregate output
11
Another Reason for Inflation:
Government budget constraint
• To see how fiscal policy is related to
monetary policy, we have to look at the
government’s budget constraint.
• DEF = G - T = MB + B
• When the public’s bond holdings do not
increase, a given deficit will have to be
financed by monetizing public debt.
• Financing a persistent deficit by money
creation will lead to sustained inflation.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
12
The Monetarist versus the Keynesian view
• The modern quantity theory of money (Milton
Friedman) concludes that changes in aggregate
spending are determined primarily by the money
supply.
• Keynesian analysis indicates that high inflation
cannot be driven by fiscal policy only.
• But both viewpoints tell us that high inflation can
occur only with a high rate of money growth.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
13
The Phillips-Curve and its Implications
• Inflation () and unemployment (u) both have a
relative negative impact on the economy as a
whole.
• In 1958 A. W. H. Phillips discovered a relationship
between unemployment and Inflation. Phillips´
research was focused on the economic statistics
between 1861 and 1957. He looked at the rate of
change in ages, and the level of unemployment.
• He found a stable, inverse relationship between
these two variables.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
14
The Phillips-Curve and its Implications
The Phillips curve can be
interpreted as a „trade-off“:
To get reduced unemployment, the
economy must suffer from more
Inflation, and to get reduced
Inflation, the economy must suffer
from more unemployment.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
15
The Phillips-Curve in the USA for 1950-1960
Inflation
8
7
6
5
Phillips-Curve
4
3
2
1
2
3
4
5
6
7
Unemployment Rate in %
Source: Economic Report to the President, 1985
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
16
Phillips-Curve
from 1961 to 1973
Unemployment Rate in %
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Increase in the price index in %
The Phillips-Curve in Germany
Phillips-Curve
from 1961 to 1996
Unemployment Rate in %
17
„Expectations-augmented“ Phillips Curve
Developed by Milton Friedman(1968) and Edmund Phelps (1967)
e
n
 =  - (u - u ) + 
Expected Inflation
Cyclial
Unemployment
„Supply Shock“
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
18
„expectations-augmented“ Phillips Curve in
the short and long run
• At a short notice Friedman and Phelps
“accepted” a trade-off between
Unemployment and Inflation.
• But in their view the Philips curve will be
generated in a vertical line in the long run.
– Demand management is useless and leads
only to Inflation (Deflation)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
19
„expectations-augmented“ Phillips Curve in
the short and long run
Long run Phillips-Curve
Short run PhillipsCurve with high
inflation expectation
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
20
Indexation – An International Comparison
• Changes in price indices are sometimes used
to adjust wage rates or transfer payments.
This is called “Indexation”.
• “Full Indexation” occurs when the wages or
payments are increased at the same rate as the
price index used to measure the inflation rate.
• “Indexation” is especially widespread in
developing countries with high inflation rates.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
21
Indexation – An International Comparison
• Keeping up with inflation: real income
stays constant.
1. an arbitrary distribution of income and
wealth.
2. Elimination of “Inflation Costs” in the field
of national savings and wages.
“Indexation:
Are you beating inflation or
is inflation beating you?”
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
22
Indexation – An International Comparison
• The Business Rates in England
• “Scala mobile” in Italy
• The Prohibition of Indexation in Germany
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
23
The Business Rates in England
• Vertical grants are the most important financial
source of the local authorities in England.
• The Council Tax and the Business Rates
amount only to one third.
11%
33%
44%
12%
tax
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
fees
grants
other revenues
24
The Business Rates in England
• The Business Rates replaced the Domestic
Rates on 1st April 1990.
• The complete tax revenues belong to the local
authorities, but the respective yield of the
municipalities is not dependent on the collected
tax. In fact all cities and municipalities „assign“
the collected tax to a fund of the central
government. The central government
distributes the revenues with a local
equalisation system - mostly based on the
number of inhabitants – back to the local
authorities.
– „Re-Distributed Business Rates“
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
25
The Business Rates in England
•
The Business Rates tax only Non-Domestic
Property.
•
Two factors determine the tax burden of the
Business Rates:
1. The Rateable Value of the property, which is fixed
by the Valuation Office Agency (VOA).
2. The Multiplier, which is fixed annually by the
central government.
•
Example: A Rateable Value of 10,000 £, in the
tax year 2001-2002 the Multiplier amounted to
43 Pence = 4,300 £ tax burden.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
26
The Business Rates in England
•
The „political“ task of the Multiplier is to
minimize the tax burden for the population
(voters) and on the other side to generate a
constant tax yield for the local authorities.
–
•
The Multiplier is is fixed annually by the central
government, but it is forbidden by law to raise the
Multiplier to a higher figure than the inflation rate.
An „ Indexation“, but not a “full indexation”
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
27
“Scala mobile” in Italy
• In Italy the relationship between employer
and trade unions was extremely tense.
• Therefore from 1946 until 1992 the wages
increased at the same rate as the price
index.
– “scala mobile”
– In the majority of the years a “Full Indexation”
• In 1992 the scala mobile were repealed:
– 1993 „Ciampi protocol“
– 1996 „Accordo per il Lavoro“
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
28
The Prohibition of Indexation
in Germany
• In 1948 every form of Indexation was abolished
in Germany.
– confidence-building measure
• It was only allowed by permission of the
Bundesbank to index some price levels. These
permissions were rare.
• Because of the introduction of the €, the
abolishment of the indexation of loans was
cancelled in 1999.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
29
The Prohibition of Indexation
in Germany
• Today the indexation of wages, leasing
and fees is still forbidden.
• The central government has heralded an
inflation-indexed bond with a volume of
10 billion € for the year of 2005.
• Nowadays more than 26 countries
worldwide offer an inflation-indexed bond.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
30
Conclusion
• Inflation is a sustained increase in the general
level of prices for goods and services.
• Variations on inflation include deflation,
hyperinflation and stagflation.
• Two theories as to the cause of inflation are
demand-pull inflation and cost-push inflation.
• No inflation (or deflation) is not necessarily a
good thing.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
31