CHAPTER 16: INFLATION, DISINFLATION, AND DEFLATION Inflation tax -so far, we've only explored two possible

options for the financing of government spending: either raise taxes or borrow money -the government can also simply print more money -can be an important source of revenue for the government -seignorage: revenue generated by the government's right to print money -simplistic explanation: seignorage revenue is the difference between the value of money and the cost of printing that money -ex: cost 1 cent to print $1 ==> seignorage revenue = 98 cents -more realistic explanation: how the Fed and the Treasury work together -Treasury issues government debt (t-bills) to pay for government expenses -Fed buys that debt (t-bills) from banks, thus increasing the money supply -those t-bills that the Fed holds earn interest -once the Fed pays its operating expenses, any extra money gets transferred back to the Treasury as government revenue ==> seignorage revenue -what do we use? we go with a simplistic definition of seignorage -we assume that the cost of printing money is zero -seignorage revenue = delta(MS) -as weve seen in the classical AD-AS model, increasing the money supply causes the price level to rise (leads to inflation) -inflation erodes the purchasing power of money -inflation tax is the reduction in the value of money held by the public -ex: suppose inflation is 5% -a year from now $1 will only buy 0.95 of goods and services -this is like a tax of 5% -think about sales taxes: $1 in your hand will not buy $1 of goods because you must pay sales tax -sales tax = 10%, you can only buy about 91 cents of goods Hyperinflation: how might an economy find itself in hyperinflation? -lets go back to our seignorage revenue equation SEG = delta(MS) -in real terms Real SEG = delta(MS)/P -multiplying and dividing the RHS by MS Real SEG = [delta(MS)/M]x[M/P] Real SEG = money supply growth x real money holdings -what happens to this equation in the face of high inflation? -in the face of high inflation people will reduce their real money holdings (M/P decreases) -if the government needs to generate a given amount of seignorage revenue, it must increase the growth of the money supply -increasing the growth of the money supply further increases the inflation rate -increase in the inflation rate causes people to further reduce real money holdings -the cycle continues until the economy erupts in hyperinflation and people arent willing to hold any money (M/P ==> 0) Moderate Inflation/Disinflation -hyperinflation caused by excessive printing of money is not the norm -but most of the world has experienced periods of moderate inflation ==> why? -in general -expansionary policies lead to higher inflation -reducing inflation leads to an economic contraction Output gap and Okuns law -what is the output gap? -output gap: percentage difference between actual output and potential output -OG = (Y-Yp)/Yp

-relationship between the output gap and unemployment -first, recall what the natural rate of unemployment is -portion of unemployment that is unaffected by the business cycle -when Y = Yp -unemployment = natural rate of unemployment -when Y > Yp ==> positive output gap -unemployment < natural rate of unemployment -when Y < Yp ==> negative output gap -unemployment > natural rate of unemployment -what is Okuns law? -Okuns law represents the negative relationship between the output gap and unemployment increase output gap ==> decrease in cyclical unemployment decrease output gap ==> increase in cyclical unemployment -remember that cyclical unemployment is unemployment that arises due to fluctuations of the business cycle -tying this into the AD-AS model Short run Phillips curve -what is it: shows the negative short-run relationship between inflation and the unemployment rate -when inflation is high ==> unemployment is low -economy is booming, were producing more than Yp, low unemployment -when inflation is low ==> unemployment is high -economy isnt doing so hot, producing less than Yp, high unemployment -graph it! -shifts of the SRPC -the effect of supply shocks -negative supply shock shifts SRPC up -higher inflation at any rate of unemployment -positive supply shock shifts SRPC down -lower inflation at any rate of unemployment -ex: increased oil prices in the 1970s -the increased price of oil made everything more expensive at all levels of unemployment -the effect of expectations of inflation -peoples expectations of future inflation affect the current trade-off between inflation and unemployment today -increase expectations of future inflation ==> SRPC shifts up -decrease expectations of future inflation ==> SRPC shifts down -whats going on here? -the price that producers charge for goods is directly related to their marginal cost of producing that good -MC is positively related to the wage rate (higher wage ==> higher MC ==> higher price) -when workers and negotiating wage contracts, if they think inflation will be high in the future, they will demand higher wages today -locked into this wage for a while -demand a higher wage to account for expected future declines in purchasing power -higher wage ==> higher prices ==> higher inflation rate for a given unemployment rate Long run Phillips curve and NAIRU -short run and accelerating inflation (figure16-12) -if the fiscal/monetary authorities make a persistent attempt to keep unemployment low leads to accelerating inflation -graph it -to avoid accelerating inflation, the unemployment rate must be high enough such that actual

inflation is equal to the expected inflation -this level of unemployment is the NAIRU (non-accelerating inflation rate of unemployment) -when unemployment is kept below the NAIRU (via monetary or fiscal policy) inflation is accelerating because actual inflation > expected inflation -when unemployment is above the NAIRU inflation is decelerating because actual inflation < expected inflation -long run Phillips curve (LRPC): relationship between unemployment and the inflation rate after expectations of inflation have had time to adjust to experience -vertical line at the NAIRU ==> no trade off in the long run! -why no trade off? -anywhere below the NAIRU leads to accelerating inflation because of the mismatch between expectations and realized inflation (and the same for anywhere above NAIRU) -in the LR, expected inflation = actual inflation ==> no accelerating or decelerating inflation! -a closer look at NAIRU -the natural rate of unemployment = NAIRU -remember in the LR we produce Yp, which corresponds to unemployment being equal to the natural rate of unemployment -but in the LR we are also on the LRPC and at the NAIRU -therefore, it is the case that the natural rate of unemployment = NAIRU Deflation versus disinflation (they are different!) -disinflation: the process of bringing down the inflation rate -inflation is still positive! -deflation: when the inflation rate is negative (aggregate prices are falling) Liquidity trap -nominal interest rates cannot go below zero -a negative nominal interest rate would be akin to lenders paying borrowers to loan money from them! the lender would be better off just holding that money as cash -a liquidity trap can occur when the monetary authority finds its nominal interest rate approaching this zero bound -if the economy is in a slump, the typical action of the Fed is to cut interest rates and increase the money supply ==> increase AD ==> improve the economy -if the interest rate is hitting this zero lower bound, the Fed will not be able to reduce interest rates further the way they normally do -when can this occur? -sudden massive decrease in the demand for loanable funds -expectations of deflation -if people expect deflation (expect aggregate price level to decline), banks wont lend money, firms and consumers wont spend money -holding cash yields a positive real interest rate when the inflation rate is negative -any increase in the money supply will simply sit in bank reserves or peoples pockets -wont get spent! -this sort of outcome could occur for other reasons beside expectations of deflation...could be due to pessimism of the economys future CHAPTER 18: Balance of payments: summary of a countrys transactions with other countries -current account: balance of payments on goods and services, net international transfer payments, and factor income -BOP on goods and services = exports of goods and services - imports of goods and services -merchandise trade balance = exports of goods - imports of goods -ignores exports and imports of services -consists of transactions that do not create liabilities

-financial (capital) account: sales of assets to foreigners - purchase of assets from foreigners -net capital flows -transactions that create liabilities -how are the two accounts related? CA + FA = 0 ==> CA = -FA -a country that has positive capital inflows (FA>0) must run a matching current account deficit (CA < 0) Loanable funds model revisited: determining the financial account -the financial account measures the volume of net capital flows==> what determines capital flows? -suppose we start in financial autarky (no international capital flows) in a world with two countries (US and Germany) -the equilibrium interest rate in the US is 6%; the equilibrium interest rate in Germany is 2% -what happens if we allow for international capital flows? -German lenders attracted by the high interest rate in the US will send some of their loanable funds to the US -what happens to the interest rates? -as German loanable funds enter the US, the total supply of funds in US increases ==> pushing the equilibrium interest rate down in the US -as German loanable funds leave Germany, the total supply of funds in Germany decreases ==> pushes the equilibrium interest rate up in Germany -interest rates are pushed closer together -if people do not delineate between German and US loans the two domestic interest rates will eventually coincide somewhere in the middle (this is the international interest rate) -in general, when does a country have net capital inflows? net capital outflows? -graph it! -at a given world interest rate if -Qs>Qd ==> net outflow (export excess loanable funds) -Qs<Qd ==> net inflow (import loanable funds) -Qs=Qd ==> no inflow or outflow Exchange Rates: determining the current account -what are exchange rates? prices at which currencies trade -how many pesos can I get for $1US? -appreciation: when dollars become more valuable in terms of other currencies -depreciation: when dollars become less valuable in terms of other currencies -why do exchange rates matter? -exchange rates determine the relative prices of goods and services in different countries -these relative prices play a very important role in determining the balance of payments (net exports) -appreciation of the dollar -from US POV, foreign goods are cheaper ==> increase in imports -from foreign POV, US goods are more expensive ==> decrease in exports -effects on aggregate demand? -appreciation ==> decrease in net exports ==> lower AD -depreciation of the dollar -from US POV, foreign goods are more expensive ==> decrease in imports -from foreign POV, US goods are cheaper==> increase in exports -effects on aggregate demand? -depreciation ==> net exports increase ==> higher AD Equilibrium: the supply and demand for US currency -these demand and supply curves represent the international demand and supply for US dollars -why is the demand curve downward sloping? -when the exchange rate is high, US goods are expensive relative to foreign goods -relative few US goods are bought, thus few dollars are demanded -when the exchange rate is low, US goods are cheap relative to foreign goods

-relatively high amount of US goods are bough, thus lots of dollars are demanded -the supply curve is upward sloping by the same logic -strong dollar, buy lots of foreign goods, supply lots of dollars to buy those goods -and vice versa -the equilibrium exchange rate is given by the intersection of the supply and demand curves -shifts of demand -capital inflow ==> increase in demand for $ -as foreign investors send their funds to the US, the funds must be converted into dollars before they can be used to fund investment, buy assets, etc. -this increases the demand for dollars ==> increase the exchange rate/dollar appreciates -the appreciation of the dollar causes demand for US goods to drop and demand for foreign goods to rise ==> BOP falls -the capital inflow (increase in financial account) ==> dollar appreciation ==> offsetting decrease in BOP (decrease in current account) -capital outflow (financial account decreases) ==> decrease in demand for $ ==> dollar depreciates ==> BOP increases (current account increases) Real exchange rate: taking international differences in price levels into account -how to calculate -RER = nominal exchange rate (pesos/$) x PUS/PMEX -the real exchange rate is what determines the BOP -the current account responds only to changes in the RER -people care about what their money can buy them (purchasing power), not simply to amount of money they have Purchasing power parity: nominal exchange rate at which a given basket of goods would cost the same amount in each country -how to calculate? PPP = PMEX/PUS -actual nominal exchange rates and purchasing power parity rarely coincide in the short run -does a better job over the longer haul Exchange Rate Policy -rule governing policy towards the exchange rate -two broad categories of exchange rate policies -fixed exchange rate: when the government intervene to keep the exchange rate against some particular currency (often the euro or dollar) at a particular rate -ex: -flexible/floating exchange rate: let's market forces (the S and D model we just presented) decide the exchange rate -ex: How do countries maintain fixed exchange rates? -if the fixed exchange rate coincides with the market equilibrium, then this isn't a very interesting story -however, if the equilibrium exchange rate is above or below the market equilibrium, the government must act to maintain their fixed rate -fixed rate above the equilibrium ==> surplus supply of dollars -exchange market intervention: government can soak up the extra supply of currency by buying it's own currency on the foreign exchange market -country must hold foreign exchange reserves (usually euros or dollars) to buy it's own currency in the market -monetary policy: lower the interest rate ==> attracts capital inflows ==> increases demand for currency -eliminate the surplus -all else equal, higher interest rates ==> increase value of currency -foreign exchange controls: limit the amount of foreign currency domestic residents can buy -keep demand for currency higher by preventing domestic resident from

exchanging their currency for something else -all else equal, foreign exchange controls ==> increase value of currency -pros and cons of a fixed exchange rate -pros -by committing to a fixed exchange rate the government is also committing itself to not engage in inflationary policy for the sake of generating seignorage revenue -a stable exchange rate reduces uncertainty which is good for business (promotes trade between countries) -cons -must keep large quantities of reserves on hand -these are generally low interest assets -can be depleted quickly when there are large capital outflows from the country -if uses monetary policy, it must divert monetary policy from other goals like output or inflation stabilization -foreign exchange controls distort incentives for importing and exporting activities Monetary policy under floating exchange rates -in a closed economy, changes in the interest rate caused by monetary policy affect only investment spending and consumer spending -in an open economy, changes in the interest rate will also affect the exchange rate, and thus net exports -expansionary monetary policy ==> decrease in the interest rate -normal effects on I and C (both increase in response to the lower interest rate) ==> increase in AD -let's look closer at the effects on the exchange rate -lower interest rate ==> foreigners have less of an incentive to send their funds to the US ==> decrease in the demand for dollars as less foreign currency is sent to the US -decrease in D for dollars ==> depreciates the exchange rate -a depreciation of the exchange rate increases net exports -US goods relatively cheaper ==> increase exports, decrease imports -increase in net exports further increases AD -contractionary monetary policy ==> increase in the interest rate -I and C fall ==> AD decreases -demand for dollars rise ==> currency appreciates ==> net exports falls ==> AD decreases further