wk11- inflation, phillips curve and rational expectations

• Inflation rate- percentage rise in general price level per annum
• RPI- retail price index representative of the items brought by an average household in the UK 
• CPI- consumer price index covers all expenditure on consumer goods and services in UK by households, residents of institutions and tourists
• New good bias- goods that were not available in base year appear, if more expensive than goods they replace price level might be biassed, higher likewise if they are cheaper. Often new goods like mobile phones take time before included in price indices but tend to fall in price rapidly after, so the actual rate is overstated 
• Quality change bias- quality improvements are generally neglected thereby improvements that lead to higher price are considered purely inflationary 
• Substitution bias- market basket used to calculate RPI is fixed and does not account consumers substitutions away from goods who relative prices increase
• Why inflation must be correctly measured 

  Index linking of social security- pensions and other government benefits are linked to RPI. upward bias could end up swelling government spending while underestimating would unfairly lower living standards.

  Inflation targeting- bank of england uses price index as target for monetary policy so choosing an accurate measure of inflation becomes necessity 

  Tax thresholds- usually raised in line with inflation rate every year, so if government underestimates inflation we overpay tax
• Cost of inflation 

  Anticipated inflation- is anticipated and has relatively small costs 

  Unanticipated inflation- unforeseen by market participants and hence more costly can be negative or positive 
• Costs of anticipated inflation 

  Menu costs- real economic resources and time used up adjusting prices of goods and services to notify customers of higher prices 

  Shoe leather costs- when inflation rate rises interest rates will also rise and economic agents will economise money holdings spending more time going to banks to collect cash. Velocity of money increases and people rush to shops to spend money before its purchasing power falls in value.

  Increased uncertainty-  high rates of anticipated inflation there is more uncertainty 
• Costs of unanticipated inflation 

  Arbitrary redistribution of income

  Borrowers gain at expense of lenders- if fixed rate of interest 

  Governments gain at expense of taxpayers due to fiscal drag

  Young gain at expenses of old- some older people live on fixed incomes whereas workers can ask for pay rise 

  Monopolistic firms gain at expenses of competitive firms- as inflation rises, firms that face competition find it hard to pass to consumers 

  Some workers gain others lose- workers in monopolistic firms relatively easy to secure a wage rise
• Costs of unanticipated inflation

  Property owners gain at expenses of those who do not own property 

  Increased uncertainty and reduction in investment

  Increased resource usage- when inflation is high and difficult to predict more economic resources must be diverted to cope with it

  Loss of competitiveness, balance of payment problem and reduced trade- if country has fixed exchange rate a higher inflation rate will lead to a loss of competitiveness and a balance of payment problems as exports decline and imports rise
• Demand push pull inflation 

  Results from an initial increase in aggregate demand. Such as an increase in quantity of money and lower interest rates, increase in government expenditures or tax cuts, changes in consumer and investment demand, increase in export demand due to global economic growth.
• Cost push inflation 

  Results from an initial increase in costs. Such as increase in money wage rate, increase in money price of a raw material, depreciation of exchange rate which raises import costs
• Fisher hypothesis 

  r = i + Pe 

  r is nominal rate of interest, i is real rate of interest an Pe is expected rate of inflation 

  In practice expected inflation rate is difficult to observe so when calculating the real interest rate we deduct annual inflation as a proxy
• Quantity theory of money 

  Changes in nominal money supply leads to equivalent changes in price level but have no effects on real output and employment

  MV=Py

   Where V is velocity of circulation, y is level of real GDP, P is the price level and M is nominal money supply 

  If velocity of money is constant and level of real output is constant then an increase in nominal money supply leads to an equivalent increase in prices 

  Backbone of this theory and monetarism is that money supply growth greater than the  rate of growth of real output causes inflation 
• Hyperinflation

   price rises of 50% or more a month are used as a benchmark, during periods of hyperinflation people tend to try and hold as little cash as possible 
• hyperinflation

  General population prefers to keep its wealth in non-monetary assets or in relatively stable foreign currency, regards monetary amounts in terms of a relatively stable foreign currency, prices may be in that currency too, sales and purchases on credit take place at prices expected to compensate for loss of purchasing power, interest rates wages and prices are linked to price index and cumulative inflation rate over three years approaches or exceeds 100%
• Phillips curve 

  Demand side explanation- explained by fluctuations in aggregate demand, when high inflation and unemployment low since demand for goods and services is high 

  Supply side explanation- explained by looking at the labour market and influence on trade unions. If unemployment is low and labour market conditions tight then workers and trade unions that represented them would make higher wage demands and employers would tend to give in, so higher wages and price inflation
• Milton Friedman's vertical phillips curve argument- Keynasians were suggesting we could get unemployment down by increasing inflation rate, seems to rely on money illusion on part of the workforce. Might be possible in short run but is unsustainable in long run as a hypothesis. 

  Non- accelerating inflation rate of unemployment- where the long run phillips curve cuts the horizontal axis, an unemployment rate at with inflation can remain constant
• DAD/DAS model

  Advantages over IS/MP- can observe effects of economic shocks on inflation (as well as output), can directly model supply shock, more straightforwardly model the adjustment of macroeconomic outcomes across time periods and therefore dynamic response of economies to demand and/or supply shocks

  Horizontal axis measures real national income (Y) and the vertical axis measures rate of inflation, and horizontal line of target inflation
• DAD curve is downward sloping because if rate of inflation goes above target, central bank will raise real rate of interest, higher the rate of interest will then reduce real aggregate demand through interest rate and exchange rate mechanisms

  Slope of DAD curve depends on how fast the central bank wants to get inflation back to target level, the less concerned about cutting back on aggregate demand the greater the interest rate changes, the more interest-rate sensitive aggregate demand and stronger the interaction of the multiplier and amplifier process(the flatter the IS curve)
• The DAS curve like the AS curve is upward sloping, in short run will be relatively flat, mirroring expectations of phillips curve. In long run will be relatively steep if not vertical at potential level of national income. Is an alternative representation of the phillips curve