Module 33 Notes INFLATION, DISINFLATION, & DEFLATION
Classical model of the Price Level – in times of high inflation, the short-run
disappears and Eq goes from 1 to 3.
This quick adjustment of prices and wages translates into a quick turn from an ↑
MS to ↑ in inflation.
Government prints $$ when:
1. They are running a large budget deficit and they lack the confidence or political
will (political instability) to get rid of it by raising taxes or cutting spending.
Or
2. They are a bad credit risk. (Can’t borrow $$ from other countries because the
rest of the world views their circumstances as so weak they don’t think that
country could pay back the loan)
Who ends up paying for the printing of this cash?
Inflation Tax – the lowering in value of currency held by the people of a
government that is printing so much $$ that it is creating inflation.
Seignorage = ΔM (U.S. < 1% of budget …so we are told)
Real seignorage = (ΔM/M) x (M/P) or Rate of growth of the MS x Real MS
It becomes a vicious cycle as people hold less and less money and the gov’t prints
more and more $$$$. → Hyperinflation
“Tax” on CA burritos… Example in class
Inflation and Disinflation:
Policies that tend to produce a booming economy (Expansionary) also tend to lead
to high inflation.
Policies that reduce inflation (Contractionary) also tend to depress the economy.
(Disinflation – bringing inflation down)
Politicians many times have to pick their poison…
Relationship between the Output Gap and the Unemployment Rate: This should
be pretty logical…
1. When actual Aggregate Output is = Potential Output, the unemployment rate =
Natural rate of unemployment (Frictional + Structural)
2. When the output gap is + (inflationary gap), the unemployment rate is below
the natural rate & when the output gap is negative, the unemployment rate is
above the natural rate.
Okun’s Law – Negative relationship between the output gap and the
unemployment rate
Module 34 Short-Run Phillip’s Curve: (SRPC)
The unemployment rate and the inflation rate (normally) have an inverse relationship
The SRPC is downward sloping due to changes in AD (when AD , inflation  & unemployment  & V.V.)
Neg. supply shock shifts it up (both unemployment & inflation rise) & Pos. supply shocks shift it down (both
unemployment & inflation fall)
Expected inflation rate – most important factor affecting inflation, other than the unemployment rate. (It is
believed that expected inflation and actual inflation have a 1-to-1 relationship)
Expected inflation shifts the SRPC upwards & lower inflation expectations shift the SRPC downward.
It is not possible to get lower unemployment in the long run by accepting higher inflation rates.
NAIRU – Nonaccelerating inflation rate of unemployment (translated – Unemployment Rate at which inflation
does not Δ over time.
Long Run Phillips Curve (LRPC) – after expectations of inflation have had time to adjust to experience.
It is vertical because any Unemployment rate below the NAIRU (or LRPC) leads to ever-accelerating inflation.
To avoid accelerating inflation over time, the unemployment rate must be set high enough that the actual rate
of inflation matches the expected rate of inflation.
NAIRU is the same thing as the natural rate of unemployment!
Disinflation – bringing down inflation that has already become solidified in expectations. This can be very
difficult and not pleasant for the people either.
If policy makers are clear in their intentions to reduce inflation, expected inflation will come down and thus
shift the SRPC down and help to curb the cost of disinflation to some extent.
In the LR, when the actual inflation rate gets embedded into people’s expectations, there is no longer a tradeoff between inflation & unemployment.
Deflation – a falling aggregate price level. Why deflation is a problem and why is it hard to end?
Just like under inflationary times, during deflationary times, there are winners and losers, except in the
opposite direction. Lenders are better off during times of deflation with fixed interest rates.
Debt Deflation – the effect of deflation in reducing AD, helped make the Great Depression what it was.
Remember the Fischer Effect? The role that expected inflation played in Δing the nominal I. R.
Will the nominal interest rate ever go below 0%????
There is what is called a zero bound on the nominal interest rate. No one in their right mind will ever loan out
$$ for negative interest!!!!
Liquidity Trap – a situation where lowering the interest rate through monetary policy can’t be used because
the interest rate is already up against the zero bound. This will cause lending to stop and thus I & C will drop.