What, If Any, Is the Link Between Inflation and Output - Essay Example

What, if any, is the link between inflation and output? In your discussion refer to both theoretical and empirical evidence. In economics the term ‘inflation’ generally describes the prevailing annual rate at which the prices of goods and services are increasing. However, it is a common lace that all prices tend to rise at broadly the same rate; thus, when prices of domestic goods and services are rising fast this will generally be true also of wages, of the prices of the imported goods, of the money supply and of the prices of assets. This is because inflation is one sector of the economy permeates rapidly into other sectors. The phrase “a high rate of inflation” therefore usually describes a situation in which the money values of all goods in an economy are rising at a fast rate1. The view commonly taken is that inflation should be kept close to zero; prices should rise at no more than about 2 to 3 percent a year on average. This is because high inflation affects the economy adversely in a number of ways. For example, it distorts the income distribution; because of the difficulty and risk associated with the complete index-linking of pensions tend to suffer. Also, it biases investment decisions: the cost of borrowing money rises making debt finance expensive in the early years of a project and reducing the incentive to invest. In theory inflation accounting could correct for this, but in practice this has proved difficult to implement. Further, because different prices are set at different times of year, high price inflation is associated with a volatility of relative prices. This can lead to an inefficient allocation of resources2 it is difficult for decision makers to interpret price signals correctly when relative prices are volatile. Thus, when inflation is high decisions may not be taken in a way that is consistent with the efficient allocation of scarce resources. The control of inflation is therefore an issue of primary concern in designing macroeconomic policy. In order to use policy instruments to prevent inflation from rising, or to reduce it where there has been an increase, it is necessary to understand as fully as possible the process that create it, the way in which it perpetuates itself, and the circumstances in which it declines. However, it is not an easy matter to discover the cause of a rise in inflation. It is a familiar fact that prices influence each other: wages follow prices of goods and services, prices follow wages; the currency tends to depreciate when domestic inflation is higher than that abroad, and to rise when it is lower, influencing the domestic currency price of imports. Import prices, in their turn, affect domestic prices. The ‘inflation spiral’ has a dynamic structure that results from the interaction of these markets. But it is not usually at all obvious which of the possible causes has been the initiating factor of any particular rise or fall in inflation. Indeed it is usually unclear in which market an inflationary pressure originates; for as soon as an inflationary shock impinges on any one market; its influence is spread across a wide range of other markets by the feed-backs in the inflation spiral and its origin becomes difficult to detect. Developments in the Modeling of Inflation: The two main strands of empirical work on modeling inflation relate to the Phillips curve ( the relation between inflation and unemployment) and the money supply ( the role of the monetary authorities in determining nominal values). In 1958 Phillips reported an apparent empirical trade-off between inflation and the rate of unemployment, subsequently known as the “Phillips curve”, with its implication that the level of employment could, in principle, be used as if it were a policy instrument to control the rate of inflation. In this version of the Phillips curve there is an inflation/unemployment trade-off. In the late 1960s this equation was criticized for implying that it is the nominal wage rather than the real wage that responds to excess supply or demand in the labor market. The Phillips curve equation was re-written by Phelps (1967) and by Friedman (1968) in terms of the (expected ) real wage to give the Expectations Augmented Phillips Curve (EAPC).  The Phillips curve and expectations : The historical starting point for most theoretical approaches to modeling the way wages are set has been the empirical observation of Phillips. He observed that the rate of wage inflation in the UK seemed to vary inversely with level of unemployment in such a way that equal falls in unemployment were associated with progressively larger increases in wage inflation. A theoretical justification for the relationship was produced afterwards, citing the pressure of excess demand in individual labor markets operating on the nominal wage (unemployment was seen as a proxy for labor market disequilibrium). This relationship suggested that there was a stable trade-off between inflation and unemployment. It has the implication that the government has a choice: it could gear fiscal and monetary policy towards having high unemployment with low price inflation or towards having a small number out of work but high inflation, or to some intermediate solution. However, the historical relationship was not robust to the large swings in the business cycle that began in the 1960s. In each upswing the rate of inflation increased, but there was a little fall in the level of unemployment. In the downswings unemployment increased with little effect of inflation. Thus, the Phillips curve was unstable during this period. Fig : Phillips Curve The Foreign Exchange Market : Unlike most other empirical analyses of inflation (for example, Gordon 1985), we treat the exchange rate as an integral part of the inflation spiral3.We do this because the effect on domestic inflation of shocks to the economic system depends on the dynamic reaction of the exchange rate to differential rates of price inflation at home and abroad. Given the way in which the market in currencies works, a policy requirement that the nominal exchange rate remains unchanged may have profound implications for policy instruments and could indeed prove untenable. Theoretical Approaches : The exchange rate is the price (or rate) at which one currency is exchanged for another. It may be defined either way up, in relation to one other currency ( the bilateral exchange rate) or in relation to a basket of currencies and in real or in nominal terms. The trade-off between credibility and flexibility has induced a game-theoretic foundation of central bank independence. Here two approaches can be differentiated:4 on the one hand Rogoff’s (1985a) proposal to delegate monetary policy to an independent “conservative” central banker and the contracting or targeting approach on the other hand. What the theories have in common is that they propose the establishment of central bank structures which permit monetary policy to react to economic disturbances independently without interference from the government. However, they differ in their policy advices regarding the determination of central bank’s objectives. Barro – Gordon Model : This model uses the same structure as the new classical model. It adds, one twist, that is, that the monetary authorities should be modeled as players in a game with private agents acting rationally. The model has a very simple graphical interpretation, shown in figure. The downward sloping lines U1, U2.., are the familiar expectations augmented Phillips curves. The vertical lines are the long – run Phillips curve corresponding with NAIRU. The curves I1, I2.. are the indifference curves representing the preferences of the authorities with respect to inflation and unemployment. A time consistent equilibrium is obtained in point E. In this point, two conditions necessary for rational expectations equilibrium are satisfied. First, the economy is on the long-run Phillips curve. Second, the authorities have no incentives to create surprise inflation. Any other point on the long run Phillips curve suffers from the fact that it is not time consistent; that is the authorities have an incentives to depart from it. Since economic agents know this, they will adjust their expectations. \ Fig : Barro – Gordon Model In the Barro – Gordon model a monetary authority determines the inflation rate which maximizes a social objective functions in inflation and output. The economy is represented by a simple Phillips Curve, in which output deviates from the potential output if inflation is different from expected inflation (which is the variable that the workers use to fix wages). Workers, at the beginning of the period, try to predict correctly the future inflation and fix wages accordingly. The central finding of the Barro-Gordon model, the inferiority of discretion to rules because of a time consistency problem continues to be present, however: if inflation expectations and, hence, wage growth were constantly equal to zero, a discretionary monetary authority would be tempted to produce positive inflation on average, thus contradicting rational expectations. The emphasis placed in the Barro-Gordon Model on the need for credibility to control inflation has also given a new impetus to research studying the institutions that are conducive to create this credibility and that therefore promote price stability. In sum, theoretical studies show that central bank independence by itself does not improve the social welfare in a discretionary regime. Aggregate Demand and Inflation : When output is initially at its full- employment level and aggregate supply is vertical, an increase in aggregate demand has no effect on output; and the increase in the price level is proportional to the increase in aggregate demand. Thus, when output is at its full-employment level, the Price level increases over time only when there are repeated increases in aggregate demand. For example when aggregate supply is vertical and output is $100, 5% increases in aggregate demand from $100 to $ 105 to $110.25 to $115.76 cause the price level to rise 5% in successive periods and there is a 5% rate of inflation. A dynamic aggregate demand (DAD) schedule displays an inverse relationship between the rate of inflation and output. When money supply growth and fiscal expansion are the sources of demand growth, increases in the growth rate of the nominal money supply and/or additional fiscal stimuli shift dynamic aggregate demand rightward, while decreases shift in leftward. Schedule of Dynamic Aggregate Demand : The equation for dynamic demand derived is 5 An increase in autonomous spending and/or the nominal money supply, with the price level held constant, shifts aggregate demand rightward by ∆y = [hk/(h+kbk)] ∆ A + [bk/ (h+kbk)] (∆ M/p). Growth is the level of aggregate demand (the dynamic aggregate demand schedule) is y = y – 1 + ∆y, where y is current period aggregate demand, y – 1 is the previous period aggregate demand, and ∆ y is the change in aggregate demand between the current and previous period. When growth in aggregate demand is due to an increase in the nominal money supply and/or a fiscal expansion, the equation for dynamic aggregate demand is y = y -1 + β( M – Л ) + α f. Where β is the multiplier for an increase in the money supply and α for fiscal expansion. M is the growth rate for nominal money supply; Л is the current inflation rate. (M – Л) is the rate of increase in the real money supply and f is the fiscal stimulus. Holding M and f constant there is an inverse relationship between the rate of inflation and aggregate demand depicted by DAD in below figure. (Since we are now analyzing the growth of aggregate demand, the inflation rate replaces the price level p on the vertical axis.) An increase in the growth rate of nominal money supply, ceteris paribux, shifts DAD rightward, and n decrease shifts in leftward. Schedule of Dynamic Aggregate Supply: The dynamic aggregate supply schedule displays a positive relationship between the rate of inflation and output; it exists when the growth rate of the nominal wage is less than that of inflation. When the percentage change in the nominal wage always equals that of the price level, equilibrium in the labor market is unaffected by the price level, as is output, and aggregate supply is vertical. When the nominal wage lags a change in the price level, the real wage deviates from the market- clearing real wage, and aggregate supply can be higher or lower than full-employment output. Wages can increase at a slower rate than inflation when labor’s inflationary expectation lags the actual rate of inflation. When labor expects a higher rate of inflation, dynamic aggregates supply shifts leftward; dynamic aggregate supply shifts rightwards when labor expects a lower rate of inflation. The dynamic aggregate supply schedule is positively sloped when the location of the labor supply schedule depends upon expectations about the rate of inflation [L = f (x²)], the location of the demand for labor schedule depends on the actual rate of inflation [L = f (x²)], and the actual rate of inflation is not the same as the expected rate of inflation. Economists disagree on how labor arrives at inflationary expectations. The adaptive expectations hypothesis is a backward-looking approach, contending that Л² is derived from the past economic behavior. A rational expectations approach suggests that inflationary expectations are formed from all current, available information. Inflation and Output: An economy can be in inflationary equilibrium at full employment. For example, output is at full-employment level y, at a 5% inflation rate for schedules DAD and DAS (Л² = 5%) in Fig (1). The 5% inflation rate continues into successive periods when the variables affecting DAD and DAS are unchanged. A change in the rate of money supply growth and/or fiscal stimuli shifts the dynamic aggregate demand schedule, impacting output and inflation in successive periods. Equilibrium is restored over time as changing inflation rates are incorporated into the dynamic aggregate supply schedule. Fig (2) traces the path of inflation and output which results from an increase in the growth rate of the nominal money supply; there is an eventual return to full-employment output, but at a higher inflation rate. Fig (3) traces the path of inflation and output due to fiscal stimulus; note that both the output and inflation return to their initial levels. Fig 1 Fig 2 Fig 3  Optimum Output and the Trade-Off : The most perplexing problem for macroeconomic policy and social welfare in modern industrial economies is the balancing of the benefits of higher output and employment on the one hand with the costs of inflation on the other. As is often the case, the essential features of the problem are best understood by considering the condition under which the problem would not exist. Optimization in an Auction Economy Let’s consider a hypothetical economy in which all products and factors are traded on fully competitive frictionless auction markets. Then all prices equal marginal costs or, strictly speaking, equal the seller’s estimates of marginal costs. Wages, natural resource depletion, and the user cost of capital enter into the marginal costs of goods. In the labor market the auction process ensures that wages are equated on the margin with the opportunity cost of leisure or other forms of non working activity. Then clearly full competitive equilibrium generates an output that can be regarded as ideal. Any output for which buyers are willing to pay a price that exceeds the value of the required inputs to produce it is in fact produced; and no output of lesser value than its input costs is produced.  New Investment and the Inflation-Output Trade off : Just as strong employment growth tends to push up wage inflation, high rates of utilization of industrial capacity tends to push up price inflation. New research, suggests that the non accelerating inflation rate of capacity utilization (NAIRCU) is just as important a concept For understanding the dynamic of the relationship between price inflation and output growth as the NAIRCU concept is for labor, the other major input to the production process.6 Some analysts have held in recent years that too much investments in plant and equipment has been undertaken around the world. To be sure, when economies in much of the world are growing at rates well below what they are capable of, it will appear that there is too much capacity.  International Forces and Inflation – Output Trade off: Other international factors have contributed to falling inflation rates in recent years. Currency has appreciated in many countries, contributing to downward pressures on input costs as well as on final good prices. Finally, the growing market clout of imports has increased competition in the domestic market place, further keeping prices in check. And the drive to expand into markets abroad has made exporters acutely conscious of pricing. Some of these international forces should be temporary and others may be more lasting. The falling import prices in different countries and the falling commodity prices have slowed the rate of price inflation. Different measures of price inflation have slowed to differing degrees with the different behavior directly related to international trade exposure and competition. Inflation has come down the most in those sectors with the greatest exposure to international competition.  Globalization and Inflation – Output Trade- off : Globalization is a widely used term, but is in fact rather vague. It refers to the growing economic interdependence of countries worldwide through the increasing volume and variety of cross-border transactions in goods and services and of international capital flows, and also through the more rapid and widespread diffusion of technology7. Every economy aims at price stabilization; stabilization policy is often directed towards fighting or preventing both inflation and unemployment. The main problem for this, however, is the well known short run trade-off between inflation and unemployment and the phenomenon of an inflation bias which is based on the credibility. Moreover, the increasing intense debate on globalization is addressing several aspects of growing interdependence of countries worldwide. The most striking resume, concluded by many economists is that globalization reduces inflation worldwide. It lowers the inflationary bias as well as the politician’s preferred rate of inflation because of increasing costs of inflation due to international capital movements. The effects of increasing costs of inflation can be analyses within a Barro-Gordon model as discussed earlier. In short, within the design of an economy, effects of an inflation-reduction are shown for changes in behavior, a higher aversion to inflation and a lower price-elasticity of output are assumed. And the effects are shown for changes within the loss functions of the central bank and of the society, thus the preferred rate of inflation is lowered and a linear inflation rate term as an additional cost factor is added. The (relative) shock structure of a country is invariant neither to time nor to the country’s degree of internationalization. It goes without saying; there are processes of convergence and demarcation at work simultaneously. The national central banks’ optimal governance structure and degree of discretion (flexibility) depend on the economic stage of a country, including its degree of monetization respectively its (relative) transaction costs. These institutions, which are in game and process-theory normally given with the framework and are characterized as being exogenous or extremely slow-moving variables, these institutions are becoming more and more endogenous through globalization. CONCLUSION: An economy can be in a state of inflationary equilibrium, where output remains at its full-employment level and the inflation rate is unchanged. An increase in nominal money supply growth and or an additional fiscal stimulus shift dynamic aggregate demand rightward, and output is pushed beyond its full-employment level number for a number of periods when demand aggregate supply is positively sloped. Output returns to its full-employment level over time as a result of further shifts of dynamic aggregate demand and dynamic aggregate supply. An increase in the growth rate of the nominal money supply results in a higher rate of inflation when output returns to its full-employment level. Inflation and output return to their initial position when the rightward shift of DAD is caused by a fiscal stimulus. Output falls below its full-employment level when dynamic aggregate supply is positively sloped- and policy maker s implements measures that will lower the rate of inflation. A large decrease in nominal money supply growth results in a large decrease in inflation and output in the short run. A slow down of nominal money supply growth over time results in a less severe decrease in output but output remains below its full-employment level for a longer period of time, and the inflation rate falls more slowly. REFERENCE:  Rowlatt, Penelope. 1993: Inflation. Springer Publishers.  Solvator, Dominic & Fratiani, Michelle. 1997: Macro Economic Policies in Open Economy. Greenwood Press Publishers.  Frankel, Jeffrey. 2003: Economies of Exchange Rates. Cambridge University Press.  Wagner, Helmut. 2000: Globalization and Unemployment. Springer Publishers  Phelps, E.S. 1967. : Phillips Curves, Expectations of Inflation, and Optimal Unemployment over Time. Read More