The Inflation Problem Persistent longterm inflation a postWorld

The Inflation Problem Persistent long-term inflation – a post-World War II problem in most industrial countries. 60 years ago the idea that prices would continue to rise for the next 60 years would have been considered extreme. But prices did rise year after year from 1955 on, and now most people expect them to continue rising 1

Main questions asked Why inflation is so difficult to control? Why despite annouced plans of governments has inflation stayed with us? Why should we care about inflation? What harm or good does it do? Can we get rid of inflation? Should we change the structure of economy so that inflation becomes easier too live with? 2

The quantity theory of money The link between transactions and money expressed in the quantity equation: M x V = P x Y, M- quantity of money, V-velocity, frequency with which the dollar or euro is used in the economy, usually V does not change often; P – price level; Y-real GDP „V” and „Y” – real variables „P” and „M” – nominal variables, expressed in dollars or euro Implications of the quantity theory of money 1) If M ↑ and no change in V , P or Y must ↑ Y (real GDP) fixed at the natural rate of output, then The only variable which may change is the price level (P), P↑ = inflation Printing money (M) means inflation 2) nominal variables can not affect real variables, monetary policy can not change the level of output and employment 3

Inflation and money growth „Inflation is always and everywhere a monetary phenomenon” (Milton Friedman Nobel Prize 1976) According the quantity theory of money the growth in M is the primary determinant of the inflation rate Friedman claim is empirical not theoretical. „A Monetary History of the US 1867 -1960” with A. Schwartz: the positive correlation between money growth and inflation is evidence for the QTM (decade data) A monthly data on money growth and inflation rate do not show a close correlation between those two variables The theory works best in the long run not in the short run 4

Inflation and interest rates Two interest rates: nominal and real The real interest rate is the difference between the nominal rate and the rate of inflation The I. Fisher (1867 -1947) equation: The real interest rate = nominal interest rate - the rate of inflation According quantity theory of money the change in nominal money supply causes identical change in price (and wage level): 1% increase in M causes 1% increase in price level (no changes in output and employment) According Fisher equation real interest rate relatively stable, higher inflation compensated by higher nominal interest rate (Fisher effect) Higher inflation – higher nominal money supply and nominal interest rate - lower real demand for money because of different rate of growth in M and P. Adjustment proces of real money supply M/P to real money demand Y/V The link between inflation and interest rates is well known to stock exchange investors: bond prices move inversely with interest rates, one can get rich predicting correctly the direction in which interest rate will move Wall Street firms hire Fed Watchers to monitor monetary policy and news about inflation to anticipate changes in interest rates 5

Bond prices and interest rates A bond – a promise to pay a specific amount of interest each year and the repay the principal when the bond matures If the interest rate 8% and you want to borrow $100 You have to pay 8% for some period (20 years) and then repay $100 You may borrow $100 by selling the lender a bond, promissing to pay the specific interest The lender can sell your bond for market price = $100, if interest rate is 8% When interest rate goes up to 10%, existing bond promissing to pay 8% is worth less than $100 (present value of it is $83) So the bond prices move inversely with the interest rates 6))

Demand -pull inflation and costpush inflation Demand-pull inflation –prices pull-up by the increase of demand the shift of AD curve to the right because of: fiscal stimulus (higher government spending, lower taxes), monetary stimulus (lower interest rate), faster economic growth outside the economy Effects: rising prices, higher real GDP and employment Cost-push inflation – shift of short-run supply curve to the left because of : the increase of components costs, rising labor costs, higher indirect taxes Effects: higher prices and lower GDP, may lead to stagflation 7

Deflation When rate of inflation becomes negative – general price level falling and value of money increasing In the past it did not happen very often Most quoted cases used to be Japan due to severe recession, China due to large investment and high productivity It has been observed on individual markets as audiovisual equipment (new technologies, innovation) Case of the period 2014 -2015 8

Inflation rate in EU-28 and US, different methodology in case of US (source: Eurostat) 2010 2011 EU- 2. 1 3. 1 28 US 2. 6 3. 9 2012 2. 6 2013 1. 5 2014 0. 5 2015 0. 0 2016 0. 3 2017 1. 7 2. 2 1. 3 1, 3 - 0. 8 0, 5 1. 7 9

Do we want a deflation? Some effects: increases real value of debt held against the value of an asset (home or car bought with a loan) Leads to unemployment because falling prices diminish profits and induce cost cuts (layoffs of workers, consumers have less money and buy less goods (deflationary spiral) They postpone spendng waiting for lower prices CB may diminish interest rate to increase demand avoid the recession 10

Budget deficit and inflation Statistical data do not show the direct connection between budget deficit and inflation The link between those variables depends on that how the budget deficit is financed: Governmnet may sell bonds (money borrowed from the private sector), increased quantity of money used to finance deficit Government may print the money, attractive when budget deficit very large 11

Inflation and unemployment Phillips curve (1958): shows an inversive realtionship between the inflation rate and unemployment. The higher the rate of inflation, the lower the rate of unemployment • • The Phillips curve represents the trade-off between inflation and unemployment. Policymakers can reduce unemployment by expanding AD ( move from E (equilibrium) to A. The tightness of the labor and good markets will make for higher wages and cost increases and thus for higher inflation. The history of inflation in the 1960 s seemed to confirm the Phillps curve trade-offs. Central Bank raises the interest rate to reach inflation target. The economy slowly moves to E. The impact of interest rate change after 1 -2 years. 12

Troubles with the Phillips curve after 1970 1970 s: unemployment rate and the inflation rate>10% (UK). Effects of the supply shock: oil prices tripled, rising the price level, 1973 -74). Short run Phillips curve shifted up, equilibrium point E much higher on LRPC than in 1960. Two possible reactions of government: a) increase in M (easy monetary policy) to avoid the decrease in M/P and in AD. Unemployment does not grow, but the rate of inflation goes up; b) no change in M (restrictive monetary policy). Higher inflation means lower M/P, higher interest rate and the recession. Case b) called stagflation – a period of continuing inflation combined with a recession or stagnation of economic activity (1969 -71 US). Why tight monetary policy not effective? 1)Inflation expectations built in to wages contracts. Tight monetary policy affects output and employment but has no effects on inflation (prices are not going down). 2) expectations on future of economic policy very important, the role of government credibility. Once workers convinced the government really will fight inflation, more easy monetary and fiscal policy would be possible That was the case of US disinflation in 1980 s (P. Volcker period) or UK in 1980 s ( M. Thatcher period) How does a policy become credible? A question for political scientists, not for economists only a political cycles: each new government makes a tough-sounding predictions on inflation Most of them gave up on their counter-inflationary policies – not long run approach, policies adjusted to election timetable 13

The Phillips curve long run (1) (M. Friedman 1968 r. ) • • People interested in real not nominal wages, they adjust nominal wages to inflation rate E – long run equilibrium lays on the short run Phillips curve. Trade-off between inflation and unemployment only during the short period of adjustment to AD change. Once workers expectations on inflation have time to adjust, the natural rate of unemployment (NRU) is compatible with any rate of inflation, does not depend on inflation rate Short run Phillips curve will shift with a persistent change in the average rate of inflation. The more quickly workers expectations adapt to inflation, the more quickly unemployment will return to NRU. 14

The Phillips curve long run (2) Long run equilibrium constant rate of inflation No errors made in inflation expectations Nominal wages adjusted to inflation expectations to keep real wages at long run equilibrium level Nominal interest rate high enough to compensate inflation and keep real interest rates at equilibrium level All agents are able to adjust to inflation because they know the future inflation rate Let us assume the inflation rate=10%. Monetary policy target: 10% rate of growth of nominal money supply or 10% inflation rate Long run equilibrium at E (10% inflation and 10% rate of growth of nominal money supply )

Expectations and credibility The new government – new inflation target, lower than before But workers expecting higher inflation rate adjusted their nominal wages to higher prices Firms reaction: lower output and employment If new government is credibile enough lower inflation expectations taken into consideration during next wage negotiations Short term Ph. curve shifts down and the economy slowly moving back to a new equilibrium at a long run Ph. curve (NRU) What will happen when no one believes in a new 16

The costs of inflation Shoe – leather costs – inflation wears out the shoe leather of consumers because they need more time and more effort to make transactions with smaller real stock of money (M/P) Menu costs – costs of changing tag printing new catalogs, costs of parking meters adjustment, pay telephones or slot machines. Introduction of tokens may diminish the costs. Redistribution of income from creditors to debtors because prices change faster than nominal interest Redistribution between the old and the young: the old built up savings in savings bank or in the form of pension, increase in the price level will make the poorer in real terms. The young are debtors, they gain from inflation Inflation redistributes income away from the poor toward the rich, but a little evidence on that Bracket creep when share of taxes in a given amount of real income increases with the increase in prices. Rising uncertainty about future price levels and inflation rates 17

Hyperinflation Extraordinary periods in which instability of prices so extreme that it disorganizes the production, markets and redistributes income and wealth in society Inflation rates exceed 1000% per year Often associates with war or social revolution. Case of Bolivia 1985 11. 000%, Poland 1989 almost 700%, Germany 1920 s Germany: money exploded, for every reichsmark that he held in Jan. 1922, the average person held 20 million in late 1923. Inflation rate has increased from 80% per year (5% per month) in 1922 to 30. 000% per month or 20% per day in 1923 Not only money worthless but also all assets fixed in nominal terms (governments bonds, pensions, insurance policies) – middle class ruined by inflation, and inflation has raised the support for „law and order” government Beneficiares of the hyperinflation: the debtors 18

What can be done about inflation? 1. new policies to help monetary and fiscal policy fight inflation: a)incomes policies influencing wages and other incomes directly rather then through AD b) wage and price control. Both failed: income policy treated as a substitute to macroeconomic policy rather than complement; price control difficult to administer 2. change the way those policies are used , so that inflation rate once lowered will stay low. Preventing rapid money growth usually mentioned here: targets for money growth announced. 3. we can learn to live with inflation, institutions should be fully adjusted for inflation: indexation automatically adjusts payments for the effects of inflation, but is difficult to implement, lags between the time price change and the time payments can be adjusted. Imperfect indexation and still present shoe-leather costs keep inflation costs high. None of 3 methods presents any quick and easy solution to the inflation problem 19

Changes in inflation rate in Poland (2017 1. 6) source: Eurostat year Inflation rate % 1982 70. 3 1986 17. 0 1988 73. 9 1989 639. 3 1990 249. 3 1993 37. 2 1998 13. 2 2010 2. 6 2011 3. 9 2013 2015 0. 8 - 0. 7 20

Inflation rates in Poland 21

Balcerowicz shock therapy Rising the interest rate above the inflation level Reduction of subsidies and tax exemptions, tax system reform Substantial decrease in real wages (elimination of price control of consumption goods) Tight fiscal and monetary policy allowed to decrease the inflation rate Ending the state control over income levels Recommendations to privatize the state owned industries The Balcerowicz plan passed to the law December 1989 22