Category Archives: Inflation

AS Economics Revision – Inflation

Here are some revision notes on inflation and a diagram that I have found useful. As well as cost-push and demand-pull inflation remember:

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.

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.

The flattening of the Phillips Curve

Part 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 in London. 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.

Central Banks

Central banks have found that inflation has been the pest it has been in the past – most countries inflation rates have been short of its target rate. After the GFC the level of unemployment rose and inflation was quite subdues. However, with the post GFC recovery unemployment began to fall whilst the inflation rate was still showing no signs of accelerating which went against the original Phillips Curve. A further problem was that imported goods and services in one country have little relevance on the wages in another and the low levels of unemployment tempted people back into the labour force who hadn’t been counted as unemployed. This is particularly the case in Japan.

When there is an increase in job numbers, with a boom period, inflation may also be slow to rise. Although firms tend to be reluctant to lower wages when the economic climate slows as it is harmful to staff morale. The same could be said in good times as wages tend not to rise that quickly.

For many businesses changing the price of their goods or services can be costly especially for a small increase in price. Therefore the change in the business cycle tends not to be reflected in price changes as there needs to be major swings before prices will move at all. Central bank policy tends to manipulate interest rates to maintain a stable inflation causing unemployment to move up or down – unemployment is what changes not inflation.

The problem that central banks face today is that to keep the phillips curve flat they need to be able to cut interest rates to stimulate growth when inflation threatens to become deflation. However there is little room for further easing with rates so low. Central banks will need to work with the government’s fiscal policy to stimulate growth and spend the money that the central bank’s create.

Reduced inflation in New Zealand with Covid-19

The inflation rate in New Zealand, as in many countries, is on a downward trajectory – it will take a lot of stimulus form the Reserve Bank to meet its policy target agreement of maintaining the CPI between 1-3%. Westpac have forecast a drop to 0.2% in 2021 and to remain below 1% until the middle of 2022. There have been some obvious reasons for less pressure on inflation:

  • Demand for goods and services both in NZ and overseas has dropped significantly and tamed any inflation. Most notably there has been a major drop in oil prices.
  • The use of ecommerce and, without the overheads of rents / staff, prices are often much lower than the high street.
  • With zero net migration and as excess capacity in long term rental market prices haven’t moved. Add to this the Government’s rent freeze.
  • A lack of tourist dollars has meant a shift inwards of the aggregate demand curve as exports of services fall – AD = C+I+G+(X-M).
  • With people having the growing uncertainty of job security there has been little additional spending or borrowing with the threat of redundancy hanging over them.
  • The wage subsidy has kept some companies afloat but there has been no room for wages increases/negotiations for such uncertain times. Therefore consumer spending has been limited compared to previous years.

Important to note that inflation figures that are quoted are usually on a yearly basis so it is the change in prices from today to this time last year. It will be interesting to see what state the economy will be in this time next year.

Modern Monetary Theory – The Deficit Myth

I have blogged before about Modern Monetary Theory. Basically it says that you can print your own currency by having your own central bank, run large deficits, have full employment, have no inflationary pressure and do this year after year. However while large deficits and monetary stimulus make some sense during a short deflationary economic contraction, sustaining those policies for years, will lead to inflation and economic stagnation – stagflation. The video below is from BBC Reel where Stephanie Kelton, author of The Deficit Myth, argues that we need to rethink our attitudes towards government spending. Worth a look – great graphics.

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

Just covering this topic with my A2 class. Part 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.

Post coronavirus: putting more V in MV=PT

Governments around the world introduce unprecedented fiscal stimulus packages to compensate those who have been impacted by the enforced lockdown. In New Zealand Finance Minister Grant Robertson announced a $12.1 billion stimulus package to support New Zealanders and their jobs from the global impact of COVID-19 – the largest in the world on a per capita basis. The money is hopefully going to bring as many businesses back from the brink of closure but the crucial aspect of this injection is that it actually does stimulate demand and generate additional spending. Businesses that survive this pandemic and open their doors again will need the demand side of the economy to do its bit.

Demand side

The lockdown has badly affected the demand side of the economy and it won’t revert back to the way it away was overnight. Will people venture back into areas with large crowds – bars, restaurants, hotels etc? It is essential that demand makes a return in order to inject some inflation into the economy. But with such uncertainty consumers will want to put off a lot of non-essential purchases. Many economists are also concerned with the “output gap.” — the difference between what the economy could produce and what it was producing. The solution to this output gap, particularly one caused by collapsing economic demand, is to invest in infrastructure projects and give consumers cash. If consumers don’t spend then the government should step-in and spend on their behalf to create the demand necessary to return the economy to some sort of normality. One indicator that we shouldn’t be worried at present is inflation – in theory such a stimulus should create inflationary pressure – the 1970’s yes but today this is less likely when you look at the velocity of circulation.

Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:

M x V = P x T

M = Stock of money
V = Income Velocity of Circulation
P = Average Price level
T = Volume of Transactions or Output

For example if M=100 V=5 P=2 T=250.   Therefore MV=PT – 100×5 = 2×250. Both M x V and P x T are equivalent to TOTAL EXPENDITURE or NOMINAL INCOME in a given time period. To turn the equation into a theory, monetarists assume that V and T are constant, not being affected by changes in the money supply, so that a change in the money supply causes an equal percentage change in the price level.

However when the velocity of money is falling, monetary policy which would otherwise cause inflation doesn’t seem to do so. The velocity graph (USA) above shows that you need to go back to 1949 to find a time when it was lower than today, and it was actually rising rapidly after the postwar lows. Remember that this graph was before the Covid-19 lock down. Velocity needs to increase at rapid rate to cause any inflation.

We have no idea of how the future is going to unfold because we have never seen anything like this before – to quote Rogoff and Reinhart – This time it is definitely different.

Source: Thoughts from the from line by John Mauldin

Paul Volcker – 1929-2019 – the slayer of inflation.

I first came across Paul Volcker in the ‘Commanding Heights’ series produced by PBS. Appointed to the position of Chairman of the US Federal Reserve in 1979 by the then President Jimmy Carter, Paul Volcker understood the problems of the Great Inflation in the US economy which was at around 11.5%. Up to this point Carter had attempted to follow Keynes’s formula to spend his way out of trouble by dropping taxes and increasing government spending. However this was not working. Below is an extract from the PBS series.

It came to be considered part of Keynesian doctrine that a little bit of inflation is a good thing. And of course what happens then, you get a little bit of inflation, then you need a little more, because it peps up the economy. People get used to it, and it loses its effectiveness. Like an antibiotic, you need a new one; you need a new one. Well, I certainly thought that inflation was a dragon that was eating at our innards, so the need was to slay that dragon. Paul Volcker

Volcker’s policy to tighten the money supply with increasing interest rates, which peaked at 21.5% but was not popular with Jimmy Carter who lost the election to Ronald Reagan. But in order to get prices down the economy had to experience a recession and the longer the inflation was out of control the worse the recession would be. Unemployment did hit 10% but could have been much worse. As Ronald Reagan said referring to a recession – ‘if not now when? If not us who?’

He saw the primary focus of central banker was to control inflation and preserve the value of money whether is be keeping prices stable or ensuring that there is not easy access to credit. Below is a tribute from Paul Solman of PBS.

Monetary Policy in New Zealand – what the OCR means.

The Monetary Policy Committee of the Reserve Bank of New Zealand (RBNZ) operates monetary policy in New Zealand through adjusting the official cash rate (OCR). The OCR was introduced in March 1999, and is reviewed 7 – 8 times a year. The recent amendment to the Reserve Bank’s legislation sets up a Monetary Policy Committee that is responsible for a new dual mandate of keeping consumer price inflation low and stable, and supporting maximum sustainable employment. The agreement continues the requirement for the Reserve Bank to keep future annual CPI inflation between 1 and 3% over the medium-term, with a focus on keeping future inflation near the 2% mid-point.

Through adjusting the OCR, the Reserve Bank is able to substantially influence short-term interest rates in New Zealand, such as the 90-day bank bill rate. It also has an influence upon long-term interest rates and the exchange rate. In theory this is what the impact should be:

Higher interest rates = contractionary effect which leads to lower inflation and less employment growth

Lower interest rates = expansionary effect which can lead to higher inflation but more employment growth.

However the Reserve Bank of New Zealand acknowledge that it is a very complex mechanism as interest rates impact the aggregate demand through various channels – C+I+G+(X-M) – and over varying time periods.

On a normal day consumers, producers, government etc undertake financial transactions involving the commercial banking system. At the end of each day they need to ensure that their accounts balance but some registered banks may find that they are short of funds following the net aggregate result of these transactions, while others may find that they have substantial deposits.

Commercial banks that are have positive balances can leave this money with the Reserve Bank overnight. They receive the OCR on deposits up to a threshold level, and then receive the OCR less 1% for the remainder. Commercial banks that have a negative balance can borrow overnight from the Reserve Bank at an overnight rate of the OCR plus 0.5%. Therefore if you use the current OCR rate of 1% you get this situation. Remember that 50 basis point = 0.50% and 100 basis points = 1.00%.

Banks have the option (and incentive) of borrowing from each other, and using the Reserve Bank as a last resort. In doing so, both parties gain as the lending and borrowing rate tends to mirror the OCR (given the level of competition in the banking market). Those banks with excess deposits can then receive an overnight rate close to one percent (rather than a zero interest rate on any funds over the threshold level). Those banks who need to borrow funds can do so at around the OCR rate, rather than at 1.50 percent. The interest rate at which these transactions take place is called the overnight interbank cash rate see graph below.

Source: Grant Cleland – Parliamentary Monthly Economic Review – Special Topic – October 2019