lecture 16

Introduction to Inflation

Inflation is a chapter focusing on the causes and measures of inflation, pulling together previously discussed concepts.

Inflation: An overall rise in the average price level in an economy.
Types of Inflation:
- Headline Inflation: Overall Consumer Price Index (CPI).
- Core Inflation: Excludes energy prices for a better economic outlook.
- Deflation: Overall fall in price levels (negative inflation).
- Disinflation: Reduction in the inflation rate (e.g., from 9% to 3%).

Neutrality of Money Theory: In the long run, changes in the money supply affect nominal variables but not real variables. More money leads to higher prices without increased production or employment.
Classical Theory of Inflation: Increased money supply in the economy leads to inflation through shifts in aggregate demand, without affecting output in the long run.
Quantity Theory of Money: Describes the relationship between money supply and inflation using the equation M × V = P × Y, with:
- M = money supply
- V = velocity of money
- P = price level
- Y = real GDP.

More Money = Higher Prices: Printing more money will result in inflation rather than increased real economic output.
Long-run theories do not explain short-term inflation variations but suggest that inflation occurs when the money supply grows faster than real GDP over time.
Milton Friedman’s assertion: "Inflation is always and everywhere a monetary phenomenon."

Recent economic climate: Low unemployment, low inflation—public perception of economic health often does not match economic indicators.
Trust in inflation data is low, creating disconnects in public understanding.

Costs regardless of Predictability:
- Menu Costs: Costs associated with changing prices frequently (e.g., updating menus for restaurants).
- Shoe Leather Costs: Increased costs and efforts to manage money due to inflation (ex: frequent trips to the bank).
- Tax Distortions: Inflation can push individuals into higher tax brackets, affecting real purchasing power, due to tax brackets not being adequately indexed to inflation.

Anticipated Inflation: When inflation is expected and factored into wages and prices, leading to self-fulfilling cycles of inflation as actors adjust to expected conditions.
Unanticipated Inflation: Leads to confusion and adjustments that can create economic inefficiency; it can redistribute wealth arbitrarily between debtors and creditors.

Modest, predictable inflation (around 2-3%) has positive implications for the economy but high or unpredictable inflation is detrimental.
Understanding these concepts is vital for grasping the dynamics of inflation and its impacts on the economy.