ECON 272 Notes on Inflation and Deflation

Notes on Macro Policy and Inflation and Deflation (ECON 272)

For good or bad, the government manipulates the money supply (not all economists agree that the government should do this). In the United States, this is undertaken by the Federal Reserve (or the FED) - the Central Bank of the United States - which we will discuss in detail later.

Three Major Theories on Macroeconomic Policy (remember, policy means government policy):

Monetary Policy -

Fiscal Policy -

No Policy -

We will discuss fiscal policy and no policy later. Right now - let's discuss monetary policy. Monetary policy is related to the concepts of inflation and deflation.

Definitions

Inflation:

The definition you usually hear:

Must be careful though - this does not say anything about the cause (or consequences) of the price changes. Inflation is a money supply and money demand issue! The cause is almost always an increase in the money supply without an offsetting increase in money demand (so this is how many economists define inflation).

Deflation:

The definition you usually hear:

Must be careful though - this does not say anything about the cause of the price changes. The cause is basically an decrease in the money supply without an offsetting decrease in money demand (so this is how many economists define deflation).

The Causes

Before we discuss what causes inflation or deflation, let's define a few things:

1. The money stock or supply (MS):

There are different "measures" used. M1 is the "most liquid" measure.

M1 includes funds that are readily accessible for spending. M1 consists of: (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of nonbank issuers; (3) demand deposits; and (4) other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts. Seasonally adjusted M1 is calculated by summing currency, traveler's checks, demand deposits, and OCDs, each seasonally adjusted separately.

http://research.stlouisfed.org/fred2/series/M1

M2 includes a broader set of financial assets held principally by households. M2 consists of M1 plus: (1) savings deposits (which include money market deposit accounts, or MMDAs); (2) small-denomination time deposits (time deposits in amounts of less than $100,000); and (3) balances in retail money market mutual funds (MMMFs). Seasonally adjusted M2 is computed by summing savings deposits, small-denomination time deposits, and retail MMMFs, each seasonally adjusted separately, and adding this result to seasonally adjusted M1.

http://research.stlouisfed.org/fred2/series/M2

2. Velocity of money (V):

http://research.stlouisfed.org/fred2/series/M2V

3. Money demand (MD):

Note that when velocity is high, the demand for money is low and vice versa. Why?

4. Aggregate Supply (AS) - this is basically what GDP is attempting to measure and what Deb calls "the pie":

5. Aggregate Demand (AD):

Causes of inflation: (assuming velocity is constant)

First - let's do a little in class demonstration.

1. (Most important and prevalent). An increase in the MS (money supply or stock) without an offsetting increase in MD (money demand). An increase in money demand is often due to an increase in Aggregate Supply (AS) or GDP. As the pie gets larger -- need more money to facilitate trade - but if the money supply is growing faster than the pie -- inflation.

2. A decrease in MD without an offsetting decrease in MS. Here the pie is shrinking for example, but the money supply is not.

Note: When the MS is increased (or MD is decreased) -- ceteris paribus, this causes AD to go up -- increasing prices.

Causes of deflation: (assuming velocity is constant)

1. An increase in MD without an offsetting increase in MS. Here the pie is getting larger but the money supply is not growing as fast.

2. A decrease in MS without an offsetting decrease in MD. Here the money supply is shrinking but the pie is not shrinking as much.

Note: When the MD is increased (or MS is decreased) -- ceteris paribus, this causes AD to go down -- decreasing prices.

Let's look a little deeper into the process of Inflation

First some definitions:

Purchasing Power of Money (PPM): Why inversely related to prices?

The model also assumes a price level (meaning an average price increase) (which is not realistic - we will add to this soon):

Basic steps in the process of inflation:

1. Increase the money supply, hold money demand, velocity and aggregate supply constant.

2. This creates:

3. Therefore,

4. This creates:

5. Which causes business owners to:

6. Therefore:

Inflation and the value of the dollar has dropped!!

But this simple explanation does not explain everything going on - we must also look at:

The Non-Neutrality of Money (Inflation)

When inflation takes place and prices increase - that is not all that happens! In other words, an increase in the money supply without an offsetting increase in the demand for money effects the economy in different ways (it is not "neutral" with respect to how the increase in the money supply might change outcomes in the economy).

The problem is, many models in economics don't catch all of these outcomes because they assume a price level in order to use a math model (we will discuss one later - MV=PQ or the equation of exchange). These models are very poor in that they are misleading and do not really show the reality of inflation.

Injection Effects or Cantillon Effects:

In order to understand the non-neutrality of money, let's discuss injection effects that take place due to an increase in the money supply (or Cantillon effects - an Irish economist (1680s - 1734):

Economist F. A. Hayek discussed the Cantillon effect as being similar to the process of pouring honey into a saucer. The honey forms a blob in the middle of the saucer first and then eventually spreads out to the edges. Prices also do not rise evenly as new money is not distributed evenly. Those who get the new money first benefit (at the time) because they receive it prior to prices increasing (the blob). However, those who receive the money later are basically "taxed" - because the value has declined as prices increase (the edges of the saucer).

"An increase of money circulating in a State always causes there an increase of consumption and a higher standard of expenses. But the dearness caused by this money does not affect equally all the kinds of products and merchandise proportionably to the quantity of money, unless what is added continues in the same circulation as the money before, that is to say unless those who offered in the Market one ounce of silver be the same and only ones who now offer two ounces when the amount of money in circulation is doubled in quantity, and that is hardly ever the case. I conceive that when a large surplus of money is brought into a State the new money gives a new turn to consumption and even a new speed to circulation. But it is not possible to say exactly to what extent."

-Richard Cantillon

Therefore not all prices increase at the same time or in the same amount (percentage). Furthermore, not all people are affected by inflation in the same way.

‘Inflation and credit expansion, . . . , do not add anything to the amount of resources available. They make some people more prosperous, but only to the extent that they make others poorer.‘

-Ludwig von Mises

A main point to consider here is that relative price changes occur - and these changes in relative prices lead to changes in resource allocation. Since the increase in the money supply causes the changes, once this money is done circulating through the economy and prices have increased -- the allocation of resources that took place due to the changes in relative prices becomes unprofitable (consumer preferences have not driven the change in resource allocation - instead - where the money supply increased did). Remember, as von Mises says above -- the pie did not increase with the increase in the money supply, but how the pie ended up being distributed did!!

Relative price changes and resource misallocation:

Misallocation of resources:

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How Does the Government Measure Inflation/Deflation?

Consumer Price Index (CPI): The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. It is based on the expenditures of almost all residents of urban or metropolitan areas, including professionals, the self-employed, the poor, the unemployed and retired persons as well as urban wage earners and clerical workers. Not included in the CPI are the spending patterns of persons living in rural non-metropolitan areas, farm families, persons in the Armed Forces, and those in institutions, such as prisons and mental hospitals. What is the latest? http://www.bls.gov/ CPI historically: https://research.stlouisfed.org/fred2/series/CPIAUCSL

Base year for the CPI = 100.0. An increase of 16.5 percent from the reference base, for example, is shown as 116.5. This change can also be expressed in dollars as follows: the price of a base period market basket of goods and services in the CPI has risen from $10 in 1982-84 to $11.60.

The Core CPI:

Dollar Conversion Calculator

What is included in the CPI? The CPI represents all goods and services purchased for consumption by the reference population. The Bureau of Labor Statistics (BLS) has classified all expenditure items into more than 200 categories, arranged into eight major groups. Major groups and examples of categories in each are as follows:

FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, service meals and snacks)
HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)
APPAREL (men's shirts and sweaters, women's dresses, jewelry)
TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)
RECREATION (televisions, pets and pet products, sports equipment, admissions);
EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

Also included within these major groups are various government-charged user fees, such as water and sewerage charges, auto registration fees, and vehicle tolls. In addition, the CPI includes taxes (such as sales and excise taxes) that are directly associated with the prices of specific goods and services. However, the CPI excludes taxes (such as income and Social Security taxes) not directly associated with the purchase of consumer goods and services.

The CPI does not include investment items, such as stocks, bonds, real estate, and life insurance. (These items relate to savings and not to day-to-day consumption expenses.)

Producer Price Index (PPI): The Producer Price Index is a family of indexes that measures the average change over time in the selling prices received by domestic producers of goods and services. So it is from the perspective of the seller, not the consumer.

The Economic Effects of Inflation and Deflation

The Effects of Inflation

1. Debtors gain at the expense of lenders (with unanticipated inflation).

Positive Time Preferences:

Risk:

Real rate of interest:

Nominal rate of interest:

Example:

2. The value of the dollar falls (inflation is a "hidden tax"). Basically the cost of holding money increases when inflation takes place.

3. Inflation acts as an investment tax. For example, take the capital gains tax (taxes on an increase in the value of an asset). These become even more burdensome to businesses with inflation.

Capital gain:

Capital loss:

Example: If you buy an asset for $1,000 and due to inflation (50%) - you are able to sell it for $1,500. But your wealth remains unchanged because the dollar value has declined by 50% -- you can't buy more with your $1,500 than you could with your $1,000 before the inflation. Now -- capital gains tax! Since the nominal value of your asset has increased -- guess what, you pay a tax on that nominal value. You end up worse off. Your incentive during inflation -- don't invest in capital assets and productivity falls.

Remember: people pay taxes on "nominal dollars".

4. Uncertainty - inflation increases uncertainty - resources devoted to avoiding inflation -- wealth is lost. Fewer long term contracts (less economic growth) and more resources spent trying to "guess" the inflation rate (contract clauses, searching for cheaper relative prices, etc.).

5. Lower savings (less economic growth):

6. Injection (Cantillon) effects: Relative price changes - leading to changes in resource allocation (of both consumer goods AND capital goods). (Bubbles and booms/busts). Where the additional money is spent matters. But this additional money is not real productivity (NOT real wealth creation) - hence, false "signals" are created in the economy which lead to bad decisions regarding resource allocation. Eventually those bad decisions will have consequences. People are affected differently.

7. Unemployment increases in the longer term due to the misallocation of resources and the loss of economic growth - from all the reasons above - distorts signals in the market (relative price changes, etc.) - (and more on this later).

The Effects of Deflation:

Lenders gain at the expense of debtors (just the opposite as above). So if there is enough deflation and people anticipate it -- the interest rate should be lowered. Such that the nominal rate = the real rate + the expected rate of inflation (this would be negative to take into account deflation).

2. Relative price responses - people spend their time trying to guess the magnitude and timing of price changes instead of spending their time being productive.

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The Myths Surrounding Inflation

Remember, a myth is something that people believe to be true but it is NOT. So the following five statements are myths -- they are not true!

The first three myths are all related to the same explanation as to why they are myths. When prices increase in one (or a few markets) - due to changes in wages, regulations, supply and demand, etc. - those price increases are not inflation. If consumers pay the higher prices in certain markets, then they must be decreasing their consumption elsewhere (money supply held constant) - therefore, demand and prices are falling elsewhere in the economy. Again, there is a re-distribution of money in the economy - but prices are not generally increasing.

1. Unions cause inflation.

2. Minimum wage laws cause inflation. (However, a minimum wage above the market wage does cause unemployment -- at least that's what most economists, and their research, will tell you).

3. A shortage of goods causes inflation.

4. Money is wealth for a society.

5. The government debt causes inflation.

First - let's talk about how/why the U.S. federal government goes into debt.

Government Debt vs. Private Debt (private businesses engage in both equity financing and debt financing - know the difference) -- the government simply goes into debt to pay for its expenditures.

Private Corporation:

Sells stocks:

Sells bonds:

Government sells bonds (NOT stocks). Engages in debt financing, so-to-speak.

The U.S. Treasury creates the bonds and issues (sells) them to the public (or even to the government itself).

Treasury Bonds or Bills:

U. S. Treasury vs. The FED (central bank of the U.S.) - don't confuse them!!

Some definitions:

Budget Deficit:

https://research.stlouisfed.org/fred2/series/M318501A027NBEA

Balanced Budget:

Budget Surplus:

So what is the difference between the budget deficit and the government's debt?

Why do people think that the government debt (or deficit spending by the government) causes inflation? Because the government engages in:

Monetizing the Debt:

So people see a correlation between the debt and inflation and jump to the conclusion that one caused the other! Careful!!

Debt as % of GDP

https://research.stlouisfed.org/fred2/series/GFDEGDQ188S

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Why Do Governments/Central Banks Inflate the Money Supply

One of the main reasons that governments and/or central banks increase the money supply (without economic growth taking place to absorb the new money) is monetary policy. Many economists believe that this is a good policy to undertake when the economy is not doing well.

The other main reason has to do with politics. The government (including politicians) can benefit from inflation in many ways. And although in the U.S., the FED is supposed to be politically independent -- there is a lot of evidence that says otherwise.

First let's discuss four ways that the government benefits (or at least politicians looking at short term solutions). Remember, politicians are always looking at the short term (basically the time frame until their next election). Their main concern is to get votes (otherwise they would not be politicians). One way of getting votes is to make government spending promises to groups of voters. For example, a politician promising to pass a bill that would force taxpayers to pay college tuition for students. That is one way of gaining votes from students. But all of these spending promises require taxpayer money. So note this as we go through these.

1. Inflation is a hidden tax (on savings/purchases and on capital gains). The government benefits by obtaining "revenue" in a "sneaky" way. That way politicians don't lose as many votes. Furthermore, when governments run large deficits - leading to a large debt - they often turn to monetizing the debt so that they don't have to make "tough" political decisions - like cutting spending or raising taxes in the short term.

Why is it considered "hidden"?

2. Tax bracket creep (without perfect indexing). With a progressive income tax system (such as the federal government in the U.S.) - people can move into higher tax brackets with inflation (with a cost of living raise). Therefore they end up paying more income tax even though they are not better off in real terms. Again, the government gains tax revenue without actually increasing tax rates.

2017 Tax Brackets:

http://www.forbes.com/sites/kellyphillipserb/2016/10/25/irs-announces-2017-tax-rates-standard-deductions-exemption-amounts-and-more/#112c8e87387a

Unless the tax brackets are perfectly indexed to inflation - the government again obtains more revenue.

3. Stimulate exports and decrease imports. The so-called "trade deficit" is a politically hot topic. Therefore, by decreasing the trade deficit - politicians gain votes.

Trade deficit:

When the dollar is devalued (due to inflation) against another currency, it becomes cheaper for foreigners to buy from people in the U.S. and more expensive for people in the U.S. to buy from a foreigner.

Basically when someone imports something they make two exchanges:

Example:

4. Government is typically a debtor and can pay back money that is worth less than when it was borrowed. Again, a revenue issue for the government.

Now let's discuss the basic theory behind monetary policy - that is using the money supply to "stimulate" the economy.

5. Monetary Policy Stimulus - Quantitative Easing (QE): Increasing the MS is seen as a way of "stimulating" the economy and bringing down unemployment. This is (again) a short-run policy that is also politically expedient (politicians tend to gain more votes).

But also - some economists regard this as sound monetary policy. Some do not. BIG disagreement here!!

Phillips Curve Trade-off theory. Inflation thought to be a cure for unemployment. Phillips (1950's) - following the idea of Keynesian economics (that an economy is driven by demand) and the short run is the only relevant time frame for policy/economic analysis (keep these in mind).

Here's the short run theory (basically speaking):

Note that nominal wages do not increase as quickly as prices do. This is key to the theory. Real wages decrease during the inflationary period. This allows businesses to have the revenue to hire more people.

Why do the wages increase more slowly than the prices?

Graph:

But what happens in the long run?

Workers catch on that their real wages have gone down --

Graph:

Critics of the theory stepped in:

Critic #1: Milton Friedman

Friedman - explains how the long run inflation that can result from this theory can be very high (lead to "hyper-inflation). This is due to his theory of

Adaptive Expectations:

Critic #2: F. A Hayek

Hayek - agreed that there are negative long run effects. However, Hayek said that Friedman ignored injection effects from inflation - and the relative price changes and mal-investment that follow. Therefore, in the long run, there is stagflation.

Stagflation:

Graph:

Critic #3: James Buchanan:

Buchanan - agreed with the negative long run effects. He added a political argument. He said that once this policy of increasing the money supply for a short-run stimulus starts - politicians will jump on it as a way to get votes in the short-run. Therefore, it is likely to lead to high rates of inflation and a continuation of the policy due to political reasons.

So the Phillips Curve theory lost favor with (some) economists in the 1970s with stagflation (both high inflation and high unemployment at the same time). However, is still very popular among Keynesian economists (short run oriented) and many politicians (who are also short run oriented).

We will discuss the more recent (and more specific) ways the FED conducts monetary policy today in our next section.