Chapter 9
The Goals of
Stabilization
Policy: Low
Inflation and
Low
Unemployment
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The Costs of Inflation
• Inflation is widely viewed as a social evil, but the degree of
seriousness is debated.
– Arthur Okun considered inflation as serious a problem as
unemployment and defined the “Misery Index:”
Misery Index = Inflation + Unemployment rate
– James Tobin wrote that “inflation is greatly exaggerated as a social
evil.”
• Any debate about inflation must distinguish between
moderate inflation and hyperinflation.
– Hyperinflation is very rapid inflation, sometimes defined as
p > 22% per month or p > 1,000% per year.
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9-2
Money and Inflation
• Recall the quantity equation: MSV = X = PY
• The quantity equation expressed in terms of
growth rates:
ms + v = x = p + y
• Rearranging to solve for the inflation rate yields:
p = x – y = ms + v – y
• Conclusion: In the long run, inflation equals the
excess growth of the money supply plus velocity
over real GDP.
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9-3
International Perspective:
Money Growth and Inflation
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9-4
Why Do Central Banks Allow Large
mS ?
• There are four reasons why central banks may
allow money supply to grow very rapidly:
– Temptation of demand stimulation
– Fear of recession and job loss
– Adverse supply shocks that raise prices unless central
banks introduce an extinguishing policy
• An accommodating policy calls for central banks to “print the
extra money to pay for the inflation.”
– Financing government deficits by printing money
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9-5
Nominal vs. Real Interest Rates
• The Nominal Interest Rate (i) is the rate
actually charged by banks and negotiated in
financial markets.
• The Expected Real Interest Rate (re) is the
rate that people expect to pay on their
borrowings or earn on their savings after
deducting expected inflation: re = i – pe
• The actual Real Interest Rate is: r = i – p
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9-6
When Is Inflation Harmless?
• There are four conditions necessary for inflation
to be harmless:
1. Inflation is universally and accurately anticipated.
2. An increase in pe raises i for both saving and
borrowing by the same number of percentage points.
3. All savings are held in bonds, stocks, or savings
accounts earning i; no one holds money in accounts
with an interest rate held below i.
4. Only real (not nominal) interest income is taxable, and
only the real cost of borrowing is tax deductible.
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9-7
Violation of #1: Surprise
Inflation
• Unanticipated Inflation occurs when the
actual inflation rate (p) differs from the
expected (or anticipated) inflation rate (pe).
• Suppose savers are offered i = 3% and pe = 1.
– The expected real return is: re = i – pe = 2%
• If p = 7%, the actual real return is:
r = i – p  r = 3 – 7 = - 4%
• Conclusion: Surprise inflation redistributes income
from savers to debtors.
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9-8
Violation of #2: The Fisher
Effect
• The Fisher Equation states: i = re + pe
• The Fisher Effect predicts that a one percentage
point increase in pe will raise i by one percentage
point, leaving re unaffected.
– If the Fisher Effect holds, condition #2 is not violated.
• Problem: In the real world, the expected real
interest rate often fluctuates dramatically (see
Figure 9-1).
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9-9
Figure 9-1 The 10-year Treasury
Bond Rate and the Expected Rate
of Inflation, 1970–2007
Sources: Federal Reserve Board, Selected Interest Rates, and Bureau of Economic Analysis NIPA Tables.
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9-10
Violation of #3: Money Does
Not Pay i
• Why does money not pay the market rate of
interest, i?
– Currency does not pay interest
– Banks earn no interest on reserves at the Fed, so banks
cannot afford to pay i on deposits
– Bank deposits are FDIC insured, so customers are
willing to accept lower interest rates on deposits
• Higher inflation causes harm via:
– The loss of convenience from holding less money
– The “shoe leather” cost of inflation
– Higher “menu costs” to display new prices
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9-11
Violation of #4: Nominal
Interest is Taxed
• Inflation reduces the after-tax real interest rate when
nominal interest is taxed.
– This is true even if i obeys the Fisher Effect!
• Suppose the tax rate is t = 0.3, p= 0 and i = 3%
– Initial after-tax real rate = i(1 – t) – p = 3(1 – 0 .3) = 2.1%
• Now suppose p = 10% and i = 13%.
– New after-tax real rate = 13(1-0.3) – 10 = - 0.9%
• Result: High inflation encourages people to borrow
more and save less.
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9-12
Reforms to Reduce the Cost
of Inflation
• Decontrol of Financial Institutions
– Since deregulation in the 1980s, checking, savings, and
time-deposit accounts pay interest, which lowers the
redistributive cost of inflation.
• Indexed Bonds
– An Indexed Bond pays a fixed real interest rate plus
the actual inflation rate.
• Example: Treasury Inflation-Protected Securities or TIPS
• Indexed Tax System
– In 1985, the personal income tax system was partially
indexed to inflation.
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9-13
The Indexed Bond (TIPS) Has
Arrived
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9-14
The Government Budget
Constraint
• The Government Budget Constraint relates government
spending to the sources available to finance that spending:
where…
–
–
–
–
–
–
iB B H
G T 


P
P
P
(G – T) is the basic deficit
B is the dollar amount of outstanding government bonds
i is the interest paid on B
∆B is the new amount of new bonds issued
H or High Powered Money = currency + bank reserves
∆H is the issuance of new government monetary liabilities
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9-15
Table 9-1 Annual Rates of Inflation
in Selected High Inflation
Countries, 1975–2008
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9-16
3 Types of Unemployment
•
Cyclical unemployment is the difference between actual
unemployment and the natural rate of unemployment
• The Natural Rate of Unemployment has two
components:
– Turnover (or Frictional) unemployment occurs in the normal
process of job search by individuals who have voluntarily quit
their jobs are entering the labor force for the first time or are
reentering the labor force.
– Mismatch (or Structural) unemployment occurs when there
is a mismatch between the skill or locations requirements of
job vacancies and the present skills or location of the labor
force.
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9-17
Figure 9-2 The Actual Unemployment
Rate and the Natural Rate of
Unemployment, 1980–2007
Sources: Bureau of Labour Statistics and research by Robert J. Gordon. Details in Appendix C-4.
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9-18
Table 9-2 Unemployment Rates by
Reason, Gender, and Age in July 2007
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9-19
Chapter Equations
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9-20
Chapter Equations
M V  X  PY
s
m   x  p  y
s
p  x  y  m   y
s
(9.1)
(9.2)
(9.3)
General Form
Numerical Example
r i p
r  30  3
e
e
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e
(9.4)
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Chapter Equations
General Form
Numerical Example
r i p
r 963
e
e
e
General Form
r i p
(9.5)
Numerical Example
r  3  6  3
(9.6)
ir  p
e
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e
(9.7)
9-22
Chapter Equations
iB B H
G T  

P
P
P
basic deficit
iB  B  B  H
G T   
 
P  P P  H
(9.8)
H

P
B B  b  H H  h  p
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(9.9)
(9.10)
9-23
Chapter Equations
pH
(i  p ) B
G T


P
P
(9.11)
seignorage
real interest
basic deficit =

or inflation tax
on bonds
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9-24