Category Archives: Inflation

A2 Economics – Wage Price Spiral and the Long Run Phillips Curve

Phillips CurvePart of the CIE A2 macro syllabus focuses on the wage price spiral which relates to the Phillips Curve. Here are some excellent notes that I picked up from Russell Tillson in my early days teaching at Epsom College. As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve.

During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

AS Economics – Hyperinflation causes and ends

Starting with a definition. In 1956 Phillip Cagan, an economist working at America’s National Bureau of Economic Research, published a seminal study of hyperinflation, which he defined as a period in which prices rise by more than 50% a month.

There seems to be common patterns when hyperinflation occurs in an economy. These include:

  1. Fiscal pressure – cost of funding a war, increased social welfare payments, corrupt officials taking money from the budget.
  2. Dependence of a particular resource – the resource curse. Some economies rely on exports of oil, iron ore or other resources to fund its spending. This has the effect of increasing the value of the currency and although this will make imports cheaper once the resource runs out or global prices start to drop the overvalued currency falls causing a large increase in imported prices. Furthermore governments come to depend on revenue from oil and a sudden drop in prices saw a massive drop in tax revenue – 90% of Venezuela’s revenue came from oil.
  3. Printing money – like Bolivia in the 1980’s, Venezuela overcame their shortfall in income by printing more money. The increase in the supply of money pushes up inflation. But what makes it worse is, as the inflation rate impacts the real value of government revenue, they continue to print money to finance the budget deficit which in turn exacerbates the problem – bigger budget deficit and further inflation.
  4. Exchange rate – at some stage the exchange rate will collapse as people lose confidence in the currency. Imports become ever increasingly expensive and feed into the inflation calculation.
  5. Inflationary expectations – In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue. This is evident in Venezuela as people become accustomed to higher prices and expect them to continue which makes inflation likely to continue.Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves.

Hyperinflation tends to end in two ways.

  1. The paper currency becomes so utterly worthless that it is supplanted by a hard currency. This is what happened in Zimbabwe at the end of 2008, when the American dollar took over, in effect. Prices will stabilise, but other problems emerge. The country loses control of its banking system and its industry may lose competitiveness.
  2. The second, hyperinflation ends through a reform programme. This was very much the case in Bolivia in the 1980’s – Government spending was slashed. Price controls were scrapped. Import tariffs were cut. Government budgets were balanced. Therefore this typically involves a commitment to control the budget, a new issue of banknotes and a stabilisation of the exchange rate—ideally all backed with confidence-inspiring foreign loans. Without such reform, Venezuela’s leaders, though scornful of America, may find that its people are forced eventually to adopt its dollar anyway.


  • The Economist “The half-life of a currency” September 15th 2018
  • The Economist “The roots of hyperinflation” February 12th 2018

Global Monetary Policy – why are US rates on the rise?

With the A2 mock exam next week here is a post on the theory and applied aspects of monetary policy. Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.

Further goals of a monetary policy are usually to contribute to economic growth and stability, to lower unemployment, and to maintain predictable exchange rates with other currencies.

Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values. See  mind map of Monetary Policy below.

What have caused US interest rates to increase?

The US economy has been at the forefront of the global upswing in the last couple of years and compared to other countries they are imposing a contractionary monetary policy – see graph.

The central bank in the USA, the Federal Reserve, are confident that the economy is nearly at full capacity and that inflationary pressures are starting to become evident. The main factors behind this are as follows and they all point towards an increase in aggregate demand.

  • Higher GDP growth
  • Rising investment in oil and gas industry
  • Strong consumer spending
  • Tax cuts
  • Strong employment growth
  • Tight labour market
  • Higher wages

The US is the only major economy to impose a significant contractionary monetary policy and the Fed has increased its interest rate six times in the last two years, and four more rate hikes are expected over the next 12 months. The UK and Canada have raised their policy rates tentatively, while Europe and Japan are still in the midst of unconventional easing programmes and interest rate hikes are a distant prospect. Whilst the Reserve Bank in New Zealand don’t expect rates to rise until early 2020.

Money as a store of value: Post-War Germany to present day Venezuela

If you have studied any economics course you will no doubt have come across the functions of money. One of the four functions of money is the store of value.

Store of value
Once a commodity becomes universally acceptable in exchange for goods and services, it is possible to store wealth by holding a stock of this commodity. It is a great convenience to hold wealth in the form of money. Consider the problems holding wealth in the form of wheat. It may deteriorate, it is costly to store, must be insured, and there will be significant handling costs in accumulating and distributing it.

However in a country which is being ravaged by hyperinflation money as a store value is rather inadvisable due to the fact that the return for putting in the bank will not be greater than the inflation which reduces its value. So what do people do to preserve their savings from hyperinflation? The importance of the function of money is dramatically illustrated by the experience of Germany just after World War II, when paper money was rendered largely useless because, despite inflationary conditions, price controls were effectively enforced by the American, French, and British armies of occupation. People had to resort to barter or to inefficient money substitutes – cigarettes and cognac – as these became stores of real wealth.

Venezuela is a current example of a country which has this problem. Some of the examples of wealth preservation can be seen on the Caracas skyline with the building boom that is taking place. This would usually be indicative of a growing economy but businesses are so worried about preserving their earnings that they are prepared to build white elephants as they see it as a better alternative that all their income being whipped out by inflation. On a smaller scale, eggs seem to be holding their value and are also a useful medium of exchange – it is easier to pay people in eggs as it has value and is much more portable (a characteristic of money) remember post-war Germany with wheel barrows of bank notes. In fact people are more likely to be accepting of eggs than banknotes.

Causes of hyperinflation

As with hyperinflation in Bolivia in the 1980’s, the weaknesses in public finances is the main cause of Venezuela’s hyperinflation. The reliance on a single source of income – oil export revenue – as well as increased social welfare spending left the government short of cash. Their solution was to go to the printers and print more money to pay its bills. This feeds inflation which in turn means that the government has to print more money as tax receipts are eroded by hyperinflation. Therefore more money is created to fill the gap in revenue = inflation increasing.


In the 1980’s and 90’s a lot of the middle class in Venezuela kept their money offshore in US dollar accounts. But with capital controls making it hard to transfer large amounts of cash, property seemed to be a viable hedging option. However property was too valuable as an inflation hedge. Car ownership became a store of value in that as well as getting you from A to B it was possible to sell the car for more than it was bought for. Some bought shares so as to deposit money and then sell them for larger amounts of cash. For the low incomes the options are limited but they also lack financial acumen as they tend not to act quickly enough to invest in a broader range of assets and refinance debt when interest rates are low. With hyperinflation the long term becomes the next week.

Source: The Economist – A trunkful of bolivares – July 21st 2018

Venezuela – can’t print money quickly enough

The extent of the inflation crisis in Venezuela has led to people to make origami objects out of 2, 5 and 100 bolivares bank notes as they are worth more sold as souvenir items than their face value. The free market exchange rate is 3.5 million bolivares = 1US$.

Venezuela’s problems started when oil prices collapsed – 95% of Venezuela’s export revenue is from oil. With falling oil revenue and therefore foreign currency the government has less money to buy imports. The inflation figure is due to hit 1,000,000% by the end of the year and this has been mainly caused by the printing of money to finance the deficit which amounts to 30% of GDP. But there is another problem in that they don’t have enough bank notes to go around. Like a lot of things in Venezuela bank notes are imported and the central bank printer produces less than 5% of cash in circulation. Since 2016 there have been major problems with note denominations.

December 2016 – President Maduro decrees that 100 Bolivar note will be withdrawn from circulation but the larger denominations never turned up. 500-bolivar notes turn up on emergency flights but too few came and inflation had eroded the value to 20 cents.

November 2017 – 100,000 bolivar notes arrive but not enough too meet demand. Traders sell bundles of assorted banknotes for up to three times their face value – needed for small budget items such as bus fares, coffee etc.

Much of the economy runs on debit cards and bank transfers but the checkout computers cannot cope with such large denominations. Maduro’s solution here was to create a ‘sovereign bolivar’ worth a thousand times more and it will fit more easily on screens. However this will do nothing for the stemming inflation. But again they place the order with the printers too late and they will be nearly worthless when they arrive. However the overseas printers are doing well out of it.

Below is a very informative video from CNN about the on-going crisis.

Looks like inflation might hit 2% in New Zealand

The ASB Bank produce a very good Economic Report and below are some of the points they make with regard to inflationary pressures – useful for NCEA Level 2 and 3 as well as CIE AS and A2 level. The CPI will be on the rise with higher global commodity prices (see graph below) as well as the weakening NZ dollar which in turn makes imports more expensive.

  • Commodity-price related influences are expected to directly contribute around 1 percentage point to annual CPI inflation over 2018. The direct impact is expected to wane.
  • The period of retail deflation looks like it might be coming to an end. The lower NZD and pending increases in wage costs could see this component add to inflation. The extent to which prices will firm will depend on retail margins.
  • Administered price increases will add roughly half a percentage point to annual inflation despite the impact of the free tertiary fees policy. Higher prices for tobacco and local authority rates seem to be a fact of life: one driven by health objectives, the other by perennial infrastructure demand and a lack of competitive pressure.
  • The labour market is likely to become more of a source of price increases. We note that higher wages need not impact on consumer prices if they are offset by a corresponding increase in labour productivity/trimming in producer margins.
  • Price increases from the housing group are expected to subside. It is no longer a sellers’ market for existing dwellings. The balance of power for building work looks to be increasingly shifting towards the customer and away from the provider. Rental dwelling inflation is expected to remain moderate.

Breakdown of CPI Weighting

Source: ASB Bank – Economic Note – Inflation Watch 26 July 2018

Dairy debts make NZ Banks vulnerable

New Zealand dairy farmers are making banks worried about their ability to keep up with their mortgage payments. Four recent issues haven’t helped the cause:

1. Falling produce prices making it harder for farms to service debt
2. Mycoplasma bovis cutting productivity and profitability of the sector
3. Regulatory changes  – restrictions on foreign ownership and therefore reducing the value of dairy farms
4. Environmental regulations – increasing operating costs for farms

Whilst the last two might improve the long-term sustainability of the dairy sector they could reduce the profitability of highly indebted farms and their equity buffers.

Banks are closely monitoring about 20% of their dairy farm loans because of concerns about the borrowers’ financial strength. Although a dairy downturn is unlikely to threaten the solvency of the banking system, it does weaken their position if there is another external shock like another GFC. Bank lending in the dairy sector has been consistent over the last few year years but the proportion of loans on principal and interest terms has increased from 6% in January 2017 to 12% in March this year.

Although the average mortgage for most farm types has decreased in dollar value over the past six months, the average mortgage amount increased in the dairy farms – see graph below. The average mortgage for dairy farms is the highest at $5.1 million for the first time since the survey began in August 2015.

The table below shows the average current mortgage by sector over the years shown. Dairy farmers continue to hold the largest proportion of mortgages in excess of $2 million. They are also more likely to have a mortgage over $2 million – 62.5% of all dairy farms – and $20 million – 3.4% of dairy farms.

Source: Federated Farmers of New Zealand – Banking Survey – May 2018

The NAIRU in New Zealand

Below is an extract from a RBNZ paper from March this year on Estimating the NAIRU and the Natural Rate of Unemployment. Especially useful for A2 students.

The headline unemployment rate in New Zealand has been trending down over time. This fall in the unemployment rate has not been accompanied by a rise in inflation, suggesting that the underlying natural rate and the NAIRU may have also declined through time. In this section, we document some of the changes in the New Zealand economy that have influenced the unemployment rate over history.

As a first step, we disaggregate the unemployment rate into three sub-components as follows:

a. Cyclical unemployment results from changes in aggregate demand conditions over the course of a business cycle. As firms experience weaker demand, existing workers may be laid off and fewer new workers will be hired.
b. Frictional unemployment refers to the regular short-term churn in the labour market, both within, and in and out of, the labour force. It is determined by the efficiency of the matching process given the diversity of job-seekers and vacancies.
c. Structural unemployment represents a more fundamental mismatch between those hiring and job seekers given their skills and geographic location. This could arise from long-lasting changes in the structure of the economy such as socio-demographic trends, technological change, or a rapid change in the mix of industries.

The lines between these categorisations can be indistinct. For example, some argue that a prolonged period of cyclical unemployment could also lead to hysteresis effects that could spill over to structural unemployment. For example, an extended period of unemployment may lead to an erosion of human capital making workers less attractive to employers and hence reducing their bargaining power. In principle, frictional unemployment and structural unemployment should be captured by the trend in the NAIRU or the natural rate, as both forms of unemployment may continue to exist even if the labour market is in equilibrium. This is because those that are structurally unemployed may not be easily drawn back into employment despite an increase in labour demand and an upward adjustment in wages. In addition, the level of frictional unemployment is largely determined by the efficiency with which potential workers and employers can find jobs. In contrast, cyclical unemployment captures when the labour market may be operating below capacity as a result of a shortfall in demand.

Monetary policy has little influence over the level of frictional and structural employment. These are largely determined by the evolution of technology and the obsolescence of skills, and by structural policies to facilitate the acquisition of new skills and improve the match between employers and job-seekers. For example, policies that affect the cost of hiring (e.g. employment protection laws), the incentives for job finding (e.g. unemployment insurance), or the bargaining power of workers (unionisation and labour contract laws).

In Figure 3, we decompose the pool of unemployed workers on the basis of unemployment durations. In particular, we categorise those who have been unemployed for less than 4 weeks as contributing to frictional unemployment, 4 to 52 weeks as cyclical unemployment, and greater than 52 weeks as structural unemployment.

New Zealand’s Phillips Curve 1993-2017

Bill Phillips (a New Zealander) discovered a stable relationship between the rate of inflation (of wages, to be precise) and unemployment in Britain from the 1850’s to 1960’s. Higher inflation, it seemed, went with lower unemployment. To economists and policymakers this presented a tempting trade-off: lower unemployment could be bought at the price of a bit more inflation. The downward-sloping Phillips curve is apparent in the graph below which plots core inflation against headline unemployment for New Zealand.

There has been also an apparent shift inwards of this relationship where lower rates of unemployment have become possible for a given level of inflation, particularly relative to the 1990s. The simple plot in the graph does not take into account other factors such as changes in import prices, inflationary expectations and capacity constraints which also have the potential to shift the Phillips Curve. These are discussed further below:

1. The price of imports. As the price of imports increase whether it is raw materials or finished products, the price of local goods become more expensive which increase the general price level. Also if a country finds that its exchange rate depreciates the price of imports rises. Oil is a very inelastic import and with a barrel of oil below $30 in 2016 there was little pressure on the CPI. Where inflation has been higher is in those countries that have withdrawn price subsidies and also had sharply falling currencies – Argentina 24% and Egypt 32%.

2. Public Expectations. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves. In Japan firms and employees have become conditioned to expect a lower rate of inflation. Prime minister Shinzo Abe has called for companies to raise wages by 3% to try and kick start inflation.

3. Capacity pressures. This refers to how much ‘slack’ there is in the economy or the ability to increase total output. If capacity pressures are tight that means an economy will find it difficult to increase output so there will be more pressure on prices as goods become more scarce. Unemployment is the most used gauge to measure the slack in the economy and as the economy approached full employment the scarcity of workers should push up the price pf labour – wages. With increasing costs for the firm it is usual for them to increase their prices for the consumer and therefore increasing the CPI. However many labour markets around the world (especially Japan and the USA) have been very tight but there is little sign of inflation. This assumes that the Phillips curve (trade-off between inflation and unemployment) has become less steep. Research by Olivier Blanchard found that a drop in the unemployment rate in the US has less than a third as much power to raise inflation as it did in the mid 1970’s.

This flatter Phillips curve suggests that the cost for central banks in higher inflation of delaying interest-rate rises is rather low.

Don’t cry for me Argentina – collapsing peso and 40% interest rates

To avoid a run on the peso the Argentinian Central Bank has increased interest rates from 27.5% on 27th April to 40% on 4th May. Argentina’s peso has lost 20% of its value against the US dollar since the start of the year making it the worst performing emerging-market currency.
The problems began in January when the central bank wanted to ease interest rates by increasing the inflation target from 12% to 15% – the government were concerned that the high interest rates were having a detrimental effect on economic growth. However when the Central Bank eased interest rates by 0.75% expectations about inflation started to rise and then investors began to question what the Argentinian Central Bank and Government were trying to achieve with economic policy.

In order to prop up the peso the Argentinian Central Bank sold $4.3bn of its dollar reserves over 5 days and it raised interest rates by 6%. But the peso lost 7.8% of its value during trading on 3rd May so inevitably came an interest hike to 40%. However if inflation figures continue to disappoint the peso will continue its downward slide.

Interest rates are set to continue at high levels and if the central bank cuts rates too early they run the risk of a rerun of the crisis. Fitch (credit rating agency) recently downgraded their outlook for Argentina from positive to stable citing high inflation and economic instability.

But high interest rates are damaging to an economy. By increasing the borrowing costs you make it very difficult for business grow and the economy slows with the threat of a recession and higher unemployment. The key for Argentina will be to keep rates high just long enough to inspire confidence that policymakers have halted the currency run, but not so long that the increase drains the economy.