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Inflation. FRESH CLASSES OF MA ECONOMICS EXTERNAL KU INDIVIDUALS & GROUPS NOMINAL FEE MICRO ECONOMICS, STATISTICS & MACRO ECONOMICS GUESS PAPERS ARE ALSO AVAILABLE FROM 16 TH OF APRIL 2011. R-1173, 3 RD FLOOR ALNOOR SOCIETY, BLOCK 19, F.B.AREA, KARACHI. NEAR POWER HOUSE & MASJID E AQSA.

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  • FRESH CLASSES OF MA ECONOMICS EXTERNAL KU

  • INDIVIDUALS & GROUPS

  • NOMINAL FEE

  • MICRO ECONOMICS, STATISTICS & MACRO ECONOMICS

  • GUESS PAPERS ARE ALSO AVAILABLE FROM 16TH OF APRIL 2011.

  • R-1173, 3RD FLOOR ALNOOR SOCIETY, BLOCK 19, F.B.AREA, KARACHI. NEAR POWER HOUSE & MASJID E AQSA.

  • 0322-3385752


Join khalid aziz
JOIN KHALID AZIZ

  • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.

  • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.

  • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.

  • CONTACT:

  • 0322-3385752

  • 0312-2302870

  • 0300-2540827

  • R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.


Inflation is
Inflation is ...

  • Inflation is a rise in the average price of goods over time


Some questions about inflation
Some questions about inflation

  • Why is inflation bad?

    • Inflation does have bad effects, but some popular criticisms are based on spurious reasoning

  • What are the causes of inflation?

  • What can be done about it?


The quantity theory of money
The quantity theory of money

  • The quantity theory of money says that changes in the nominal money supply lead to equivalent changes in the price level (and money wages) but do not have effects on output and employment.


The quantity theory 2
The quantity theory (2)

  • The quantity theory of money says:

  • M V = P Y

    • where V = velocity of circulation

  • If prices adjust to maintain real income (Y) at the potential level and if velocity stays constant

  • then an increase in nominal money supply leads to an equivalent increase in prices

  • but if velocity is variable or prices are sluggish, this link is broken.


Money and prices
Money and prices

  • Milton Friedman famously claimed

  • ‘Inflation is always and everywhere a monetary phenomenon.’

    • i.e. it results when money supply grows more rapidly than real output.

  • But this does not prove that causation is always from money to prices

    • e.g. if the government adopts an accommodating monetary policy.


Money and inflation 2
Money and inflation (2)

  • …but in the long run, changes in real income and interest rates significantly alter real money demand

  • so there may not be a perfect correspondence between excess monetary growth and inflation.

  • And in the short run, the link between money and prices may be broken if

    • velocity of circulation is variable

    • prices are sluggish


Inflation and interest rates
Inflation and interest rates

  • FISHER HYPOTHESIS

    • a 1% increase in inflation will be accompanied by a 1% increase in interest rates

  • REAL INTEREST RATE

    • Nominal interest rate – inflation rate

    • i.e. the Fisher hypothesis says that real interest rates do not change much

    • but the nominal interest rate is the opportunity cost of holding money

    • so a change in nominal interest rates affects real money demand


Hyperinflation
Hyperinflation

  • … periods when inflation rates are very large

  • in such periods there tends to be a ‘flight from money’

    • people hold as little money as possible

      • e.g. Germany in 1922-23, Hungary 1945-46, Brazil in the late 1980s.

  • Large government budget deficits help to explain such periods

    • persistent inflation must be accompanied by continuing money growth


The phillips curve

Prof. A W Phillips demonstrated a statistical relationship

between annual inflation and unemployment in the UK

The Phillips curve shows

that a higher inflation rate

is accompanied by a

lower unemployment rate.

Phillips curve

Inflation rate (%)

Unemployment rate (%)

The Phillips curve

It suggests we can

trade-off more inflation for

less unemployment or

vice versa.


The phillips curve and an increase in aggregate demand

Suppose the economy

begins at E, with zero

inflation, unemployment

at the natural rate U*...

An increase in government

spending funded by an

expansion in money supply

takes the economy to A,

with lower unemployment

but inflation at 1.

A

1

U1

U*

The Phillips curve and an increase in aggregate demand

Inflation

… but what happens

next?

PC0

Unemployment


The phillips curve and an increase in aggregate demand1

so we may find the

economy finds its way

back to the natural rate,

but with continuing

inflation at C.

C

The Phillips curve and an increase in aggregate demand

If nominal money supply

is fixed in the long run,

and prices and wages

eventually adjust, the

economy moves back to E.

Inflation

But nominal money supply

need not be constant in the

long run

A

1

E

U1

U*

PC0

Unemployment


The vertical phillips curve

Effectively, the long-run

Phillips curve is vertical,

as the economy always

adjusts back to U*.

LRPC

its position may depend

upon expectations about

inflation.

PC1

The vertical Phillips curve

Inflation

The short-run Phillips curve

shows just a short-run

trade-off –

A

C

1

E

U1

U*

PC0

Unemployment


Expectations and credibility

Suppose the economy begins

at E, with a newly-elected

government pledged to

reduce inflation.

Monetary growth is cut to 2.

E

In the short run, the economy

moves to A along the short-

run Phillips curve.

A

2

F

Unemployment rises to U1

As expectations adjust,

the short-run Phillips curve

shifts to PC2, and U*

is restored at F.

U1

Expectations and credibility

LRPC

Inflation

1

PC1

PC2

U*

Unemployment


Inflation and unemployment in the uk 1978 99
Inflation and unemploymentin the UK 1978-99

1980

1990

1978

1986

1993

1999


Inflation illusion
Inflation illusion

  • People have inflation illusion when they confuse nominal and real changes.

  • People’s welfare depends upon real variables, not nominal variables.

  • If all nominal variables (prices and incomes) increase at the same rate, real income does not change.


The costs of inflation
The costs of inflation

  • Fully anticipated inflation:

  • Institutions adapt to known inflation:

    • nominal interest rates

    • tax rates

    • transfer payments

      • no inflation illusion

  • Some costs remain:

    • shoe-leather

      • people economize on money holdings

    • menu costs

      • firms need to alter price lists etc.


The costs of inflation 2
The costs of inflation (2)

  • Even if inflation is fully anticipated, the economy may not fully adapt

    • interest rates may not fully reflect inflation

    • taxes may be distorted

      • fiscal drag may have unintended effects on tax liabilities

      • capital and profits taxes may be distorted


The costs of unanticipated inflation
The costs of unanticipated inflation

  • Unintended redistribution of income

    • from lenders to borrowers

    • from private to public sector

    • from young to old

  • Uncertainty

    • firms find planning more difficult under inflation, which may discourage investment

  • This has been seen as the most important cost of inflation


Defeating inflation
Defeating inflation

  • In the long run, inflation will be low if the rate of money growth is low.

  • The transition from high to low inflation may be painful if expectations are slow to adjust.

  • Policy credibility may speed the adjustment process


Join khalid aziz1
JOIN KHALID AZIZ

  • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.

  • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.

  • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.

  • CONTACT:

  • 0322-3385752

  • 0312-2302870

  • 0300-2540827

  • R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.


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