INFLATION
Inflation is always and everywhere
a monetary Phenomenon
Basic Question
1. What is the meaning of inflation?
2. What causes inflation?
3. How does inflationary monetary policy
come about?
What is Inflation?
Inflation occurs when the general level of
prices is rising
We calculate inflation by using price indexes
(Consumers Price Index)
The rate of inflation is the percentage
change in the price level:
Inflation rate
Price level Y t Price level Y t-1
Price level Y t-1
x 100
The Categories of Inflation
1. Low inflation :
Prices that rise slowly and predictably
2. Galloping Inflation:
Prices are rising 20-200 percent per year
money loses its value very quickly
3. Hyper-inflation:
Prices are rising a million or even
a trillion percent per year
Inflation as a goal of monetary policy
Price stability is increasingly viewed as the
most important goal for monetary policy,
because:
A rising price level (inflation) creates
uncertainty in the economy, and that may
hamper economic growth
Inflation also makes it hard to plan for the
future
Inflation may strain a countrys social fabric
Money and Inflation
Some Evidences:
Whenever a countrys inflation rate is
extremely high for a sustained period of time,
its rate of money supply growth is
also extremely high
(Mishkin, 2003)
Views of Inflation:
1. Monetarist View:
the rapid inflation must be driven by
high money supply growth
2. Keynesian View:
High inflation cannot be driven by
fiscal policy a lone
Supply side phenomena cannot be the
source of high inflation
Monetarist view: Response to
Continually Rising Money Supply
Aggregate
Price
Level, P
P4
AS4
AS2
AS1
Ms AD
Y n to
Y un-n
wages
AS
Y to Y
P1 to P2
,etc
P3
P2
P1
AS3
AD1
Yn Y
AD2 AD3
AD4
Aggregate
Output, Y
Keynesian View: Can Fiscal Policy by
itself produce inflation?
Aggregate
Price Level, P
AS2
AS1
P2
P1
Yn
AD2
AD1
Y1
One shot
increase in
government
expenditure
leads to only a
temporary
increase in the
price level, but
not a continuing
increase.
Aggregate Output, Y
Keynesian View: Can supply side
phenomena by themselves produce
inflation?
Aggreg
ate
Price
Level, P
P2
AS2
AS1
P1
AD1
Y1
Yn Aggregate
Output, Y
A negative shock
(embargo,wage push)
leads price level will
rise temporarily but
inflation will not result
Types of Inflation
1. Cost-push inflation; which occurs
because of negative supply shocks
or a push by workers to get higher
wages
2. Demand-pull inflation; which
results when policymaker pursue
policies that shift the aggregate
demand curve to the right
Origin of Inflationary Monetary
Policy
1. High Employment Targets:
The first goal most governments pursue that
often result in inflation is high employment
Two types of inflation can result from an
activist stabilization policy to promote high
employment are :
Cost-push inflation
Demand pull inflation
2. Budget Deficits
Cost Push Inflation: with an Activist Policy to
promote High employment
Aggregat
e Price
Level, P
AS4
AS3
AS
AS1
P4
P3
P2
P1
P1
4
3
2 3
1 2
1
AD1
Y Yn
AD2 AD3
AD4
Aggregate
Output, Y
What role does monetary policy
play in a cost push inflation?
A cost push inflation is a monetary
phenomenon
because it can not occur without monetary
authorities pursuing an accommodating
policy of
higher rate of money growth
Demand Pull Inflation: The consequence of setting
too low an unemployment rate
Aggreg
ate
Price
Level, P
P4
AS4
AS2 AS1
P3
P2
P1
AS3
AD
Yn Y
AD2 AD3
AD4
Aggregate
Output, Y
Budget deficits and Inflation
Government Budget Constraint:
DEF = G T = MB + B
Where:
DEF : Gov. Budget Deficit
G : Government Spending
T : Tax revenue
MB : Change in the monetary base
B: Change in government bond held by the public
If the government deficit in financed by an
increase in bond holdings by the public,
there is no effect on the monetary base and
hence on the money supply .
But
If the deficit is not financed by increased
bonds holdings by the public, the monetary
base and the money supply in increase
A deficit can be source of a sustained
inflation only it is persistent rather than
temporary and if the government finances
it by creating money rather than bi issuing
bonds to the publics
Interest rate and Government Budget Deficit
Price Bond,
P (P
increase )
BS
Interest
Rate, i (i
increase)
BS2
P1
P2
i1
i2
BD
1
Quantity of
Bonds, B
BDR
