Inflation, Disinflation, and Deflation

INFLATION, DISINFLATION, AND DEFLATION

WHAT YOU WILL LEARN IN THIS CHAPTER

• Impact of Money Printing on Inflation: Understand that printing money can lead to higher rates of inflation and even hyperinflation.

• Phillips Curve: Learn how the Phillips Curve illustrates a short-run trade-off between inflation and unemployment.

• Long-Run Trade-off: Recognize why the trade-off between inflation and unemployment disappears in the long run.

• Challenges of Ending Moderate Inflation: Explore the reasons why moderate levels of inflation can be difficult to eradicate.

• Deflation Issues: Understand why deflation poses problems for policymakers.

MONEY AND INFLATION

• Examples of Hyperinflation: Discuss the cases of Zimbabwe (2008) and Germany (1922–1923), where inflation rates peaked phenomenally (e.g., 500 billion percent inflation).

• Causes of Inflation Spirals: Examine why inflation spiraled out of control in countries like Armenia (27,000%) and Nicaragua (60,000%).

THE CLASSICAL MODEL OF MONEY AND PRICES

• Relationship Between Money Supply and Inflation: Acknowledge that high inflation is correlated with rapid increases in the money supply.

• Long-Run Money Supply Effect: In the long run, an increase in the money supply results in an equal percentage rise in the price level.

• Real Quantity of Money: Learn the formula: $ext{Real quantity of money} = rac{M}{P}$ where M is the nominal money supply and P is the price level.

MONEY SUPPLY GROWTH AND INFLATION IN VENEZUELA

• Macroeconomic Insight: Notate that inflation and money supply typically move together, especially evident during high inflation periods.

THE INFLATION TAX

• Government Financing via Money Printing: Understand that there is no significant constraint preventing a government from financing expenses through money printing.

• Monetization of Debt: Learn how the Canadian government issues debt and the Bank of Canada monetizes it by purchasing treasury bills.

• Seigniorage: Define seigniorage as the revenue generated by a government’s right to print money (typically less than 1% of the government’s budget).

• Effects of Money Printing: Acknowledge that increasing the money supply through printing triggers inflation, which leads to a decrease in the purchasing power of money.

• Definition of Inflation Tax: The inflation tax refers to the reduction in the real value of money held by the public due to inflation.

LEARN BY DOING: PRACTICE QUESTION 1

• Practice Question: "Governments that run large deficits can ______."
    - a) reduce the deficit by raising taxes
    - b) reduce the deficit by reducing spending
    - c) finance the deficit by printing money
    - d) all of the above (correct answer)

THE LOGIC OF HYPERINFLATION

• Seigniorage Equation: Define seigniorage as $ext{Seigniorage} = riangle M$ where $riangle$ indicates monthly change in money supply M.

• Real Seigniorage: The formula is defined as $ext{Real seigniorage} = rac{ riangle M}{P}$.

• Transformation of Real Seigniorage: It can be expressed as $ext{Real seigniorage} = rac{ riangle M}{M} imes rac{M}{P}$ or as the product of the rate of growth of the money supply and the real money supply.

• Public Response in Hyperinflation: When high inflation occurs, the public tends to reduce its real money holdings, which forces the government to accelerate money supply growth, thus leading to even higher inflation, resulting in a dangerous feedback loop.

MODERATE INFLATION AND DISINFLATION

• Historical Inflation Peaks: In Canada and the US, inflation peaked at 14% in the early 1980s; Britain saw a peak of 26% in 1975.

• Short-run Policy Decisions: Recognize that policies which boost economic performance can simultaneously lead to higher inflation, creating a dilemma for governments.
    - Inflationary policies may yield short-term political benefits, while those aimed at reducing inflation tend to create short-term political costs.

THE OUTPUT GAP AND THE UNEMPLOYMENT RATE

• Aggregate Output Fluctuations: Understand that aggregate output fluctuates around potential output
  t - A recessionary gap occurs when actual output falls below potential output.
    - An inflationary gap occurs when actual output exceeds potential output.

• Definition of Output Gap: The output gap quantifies the percentage difference between the actual level of real GDP and potential output.
    1. When actual aggregate output equals potential output, the unemployment rate corresponds to the natural rate of unemployment.
    2. A positive output gap is characterized by an unemployment rate that is below the natural rate.
    3. A negative output gap indicates an unemployment rate that exceeds the natural rate.

• Analytical Relationship: Fluctuations in aggregate output align with fluctuations in the unemployment rate around the natural rate.

CYCLICAL UNEMPLOYMENT AND THE OUTPUT GAP

• Unemployment Rate Variability: The actual unemployment rate varies according to the output gap, often depicted in graphical representation (e.g., Figure 16-3).

LEARN BY DOING: PRACTICE QUESTION 2

• Practice Question: "A positive output gap implies an unemployment rate ______."
    - a) above the natural rate of unemployment
    - b) below the natural rate of unemployment (correct answer)

FOR INQUIRING MINDS: OKUN’S LAW

• Cyclical Unemployment and Output Gap Dynamics: Note that fluctuations in cyclical unemployment lag behind those of the output gap.
    - Example: In 2009, a -2.1% output gap correlated with only a 1% cyclical unemployment.

• Definition of Okun’s Law: It identifies a predictable negative relationship between output gap and unemployment rate, estimating that a 1% rise in the output gap reduces unemployment by approximately 0.5%.
    - Application Example: If the natural rate of unemployment is 5.2% and the economy operates at 98% of potential output (yielding an output gap of -2%), Okun’s law yields an predicted unemployment rate of 5.2% - 0.5 × (-2%) = 6.2%.

LEARN BY DOING: PRACTICE QUESTION 3

• Practice Question: "Cyclical unemployment and the output gap ______."
    - a) move together, but cyclical unemployment fluctuates more than the output gap
    - b) have a relationship quantified by Okun’s law
    - c) are negatively related; a 1% rise in the output gap decreases cyclical unemployment by 0.5%
    - d) all of the above (correct answer)

THE SHORT-RUN PHILLIPS CURVE (1 of 2)

• Historical Analysis of the Phillips Curve: In 1958, A.W.H. Phillips observed:
    - High unemployment rates typically correlate with falling wage rates.
    - Low unemployment rates tend to coincide with rising wage rates.

• Definition of the Short-Run Phillips Curve (SRPC): The SRPC illustrates the negative short-run relationship between unemployment rates and inflation rates (see Figure 16-4).

THE SHORT-RUN PHILLIPS CURVE (2 of 2)

• Further graphical representation of the Short-Run Phillips Curve can be seen in Figure 16-5.

AGGREGATE SUPPLY CURVE AND SHORT-RUN PHILLIPS CURVE

• Figure 16-6 illustrates that:
    - An increase in aggregate demand (AD) of 4% correlates with 2% inflation.
    - An output gap of 4% decreases the unemployment rate by 4% × 0.5 = 2%, with a corresponding inflation rate of 2%.

FACTORS SHIFTING THE SHORT-RUN PHILLIPS CURVE

• Supply Shocks: A negative supply shock raises the SRPC, while a positive supply shock lowers it.

• Expected Inflation Rate: Recognize that the rate employers and employees expect in the future significantly influences actual inflation rates beyond mere unemployment rates.

EFFECTS OF EXPECTED INFLATION

• Impact of Increasing Expected Inflation: Each percentage point increase in expected inflation raises actual inflation by 1%.

UNEMPLOYMENT AND INFLATION, 1961–1990

• Historical context shows the Phillips curve operated effectively in the 1950s and 1960s but dissipated when Canada faced high unemployment alongside elevated inflation due to adverse supply shocks.

INFLATION AND UNEMPLOYMENT IN THE LONG RUN (1 of 2)

• Short-Run vs. Long-Run Phillips Curve: Acknowledge that while there exists a trade-off between unemployment and inflation in the short run, this trade-off dissipates in the long run once inflation expectations align with reality.

• Definition of Long-Run Phillips Curve (LRPC): Represents the relationship between unemployment and inflation post-adjustment of inflation expectations.

THE NAIRU AND THE LONG-RUN PHILLIPS CURVE

• Understanding NAIRU: The Non-Accelerating Inflation Rate of Unemployment (NAIRU) represents the unemployment rate where inflation stabilizes.

• Behavior of SRPC: When policymakers attempt to lower unemployment below NAIRU, inflation expectation shifts upwards, following a pattern characterized in Figure 16-11.

• Vertical Nature of LRPC: The LRPC is vertical, indicating that maintaining a long-run unemployment rate beneath NAIRU leads to accelerating inflation.

INFLATION AND UNEMPLOYMENT IN THE LONG RUN (2 of 2)

• Policy Implications: Efforts to reduce unemployment often result in rising inflation, emphasizing the necessity to maintain rate compatible with NAIRU to avoid inflationary spirals.

THE NATURAL RATE OF UNEMPLOYMENT, REVISITED

• Natural Rate Defined: The natural rate of unemployment, which NAIRU refers to, remains unaffected by cyclical economic fluctuations.

• Current Estimate: As of 2023, the estimated natural rate of unemployment in Canada stands at 6.5%.

COST OF DISINFLATION

• Definition of Disinflation: The process of bringing down inflation that is embedded in expectations.

• Once inflation has become embedded in people’s expectations, reducing it can be difficult.

• It can require a recession.

• Economic Impact: Note that significant disinflation can necessitate recessionary conditions, albeit policymakers were willing to endure such consequences to mitigate the inflation of the 1970s.

ECONOMICS IN ACTION: A TALE OF TWO DISINFLATIONS

• Inflation Expectations Over Time: Contextualize how in 1980, public expectations were around 10% with policymakers needing to positively alter those postures, versus a much more temporary expectation in 2020.

DEFLATION

• Definition: Deflation refers to a decrease in the aggregate price level and was prevalent pre-WWII, alongside its recent manifestation in Japan's economy in the 1990s.

• Winners and Losers: In deflation, lenders benefit while borrowers face increased burdens due to the higher real value of their debts.

• Debt Deflation: Understand the term debt deflation, which describes decreased aggregate demand stemming from increased real debt burdens in times of falling prices.

EXPECTED DEFLATION IMPACTS

• Interest Rate Dynamics: Recognize how nominal interest rates fall during expected deflation, aligning with the concept of a liquidity trap.

• Liquidity Trap Explanation: A liquidity trap emerges when nominal interest rates reach zero, limiting the efficacy of monetary policy.

THE ZERO LOWER BOUND IN THE CANADIAN ECONOMY

• Historical instances of the zero lower bound encounter in Canada: 1930s, 2008, and during the COVID-19 pandemic.

DEFLATION AND LIQUIDITY TRAP IN THE JAPANESE ECONOMY

• Ongoing Economic Struggles: Japan has faced prolonged deflation and economic downturns since the late 1990s, where responses included interest rate reductions facing the zero lower bound.

ECONOMICS IN ACTION: IS THE ZERO LOWER BOUND HISTORY?

• Post-Pandemic Interest Rate Policies: Recognition that after keeping interest rates low for extended periods, central banks started to incrementally raise them in 2022 to combat inflation.

• Uncertainty Logging Level Predictions: Questions arise regarding whether rates will revert to their near-zero thresholds preceding the pandemic once inflation stabilizes.