More Irritating Details About Inflation

The Phillips Curve & Accelerating Inflation

-We know what the Phillips curve is. I'm not explaining it again.
-At Y* and U*, there is no gap inflation
-When the economy is in an inflationary gap, the BoC must validate for wage inflation
-In the 1960s, the level of wage and price adjustment began to rise for any level of output (the whole phillips curve shifted to the right)
-Why? Because the original phillips curve included only gap inflation and ignored expectation inflation (which impacts wage changes, obviously)
-This newly-shifted phillips curve is called the expectations-augmented phillips curve. There is still an inverse relation between the unemployment rate and the rate of changes of nominal wages, but with the effect of expectation inflation built into the model.
-Expectation inflation is graphically represented by the height of the phillips curve above the X axis at U*

Using this new phillips curve, we can see than when there is gap inflation, and when there are expectations adding to inflation, the curve shifts up at Y*: expected inflation increases for all levels of inflation, and thus, inflation can accelerate.

THERE IS NOT A STABLE TRADEOFF BETWEEN INFLATION AND OUTPUT. TO MAINTAIN Y @ LEVELS GREATER THAN Y*, INFLATION MUST ACCELERATE.

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Is inflation a monetary phenomenon? Was Milton Friedman correct when he said "Inflation is everywhere, and always a monetary problem"?

Does inflation have purely monetary consequences? What about its consequences- are they purely monetary?

Well... inflation on its own can be caused by either an increase in AD or a decrease in A. However, unless monetary validation is continuous, inflation will only be temporary. As such inflation is not necessarily caused by monetary issues, but continuous inflation IS.

The consequences of inflation:
1: Short run gap inflation caused by output being higher than Y*
2: Short run supply inflation caused by Y being less than Y*
3: In the long run, output will always eventually return to Y*, so inflation will only cause a change in the price level.

so... SUSTAINED inflation is everywhere, and is always a monetary problem.

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REDUCING INFLATION: The process of disinflation

Accelerating Inflation is inflation. There is a positive change in the price level.
Constant Inflation is inflation. There is a positive change in the price level.
Decelerating Inflation is disinflation. There is a positive change in the price level, but at a decreasing rate.
Stopped Inflation is zero inflation. There is no change in the price level.
Reverse Inflation is deflation. There is a negative change in the price level.

How do we reduce constant inflation from occurring at Y*??? by STOPPING EXPECTATIONS
How do we reduce accelerating inflation? By NO LONGER VALIDATING CHANGES IN THE ECONOMY

both of these measures may cause short-term economic pain (recessionary gaps cause unemployment, which is both depressing for individuals, and unproductive for economies in general). However, this will eliminate sustained accelerating inflation.

But is this a good thing?

There is often questions over whether the benefits of reducing inflation outweigh the costs.

How it works:
1: remove monetary validation to eliminate the inflationary gap (which allow the SRAS to return GDP to Y*)
2: stagflation: the SRAS decreases to the point where it actually overshoots Y* due to the intensity of wage momentum. As a result, there will be a period of rising unemployment accompanied by inflation
3: recovery: wage adjustments can bring SRAS back to Y* the slow way, or the BoC can use expansionary monetary policy to bring it there faster (at the cost in inflation)

The cost of disinflation:
-Disinflation is caused by a recessionary gap
-The cost of disinflation is equal to the loss of output caused by the required recessionary gap.

The SACRIFICE RATIO is the cumulative loss of output as a percentage of potential output divided by the percentage reduction in the inflation rate.

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THE COSTS OF INFLATION: Why is this bad, again?

1: Unanticipated Inflation
-Affected the distribution of income (redistributes income from creditors to debtors)
-Wage contracts: redistributes income from employers to employees if inflation is less than expected, and vice versa if inflation is higher than expected
-Pension contracts: redistributes income away from pensioners (although this can be solved by indexing pensions for inflation)

1970s: Trudeau indexed public pensions, and they have remained indexed as thus until..
1980s: Mulroney de-indexed tax brackets
2000: Chretian fully indexed tax brackets

Low versus Moderate Inflation: BC advocates low inflation
-The price signal distortion hypothesis suggests that inflation interferes with the information conveyed by price changes. As a result, market participants can have a difficult time distinguishing absolute prices from relative prices. This extra confusions created by inflation reduces market efficiency
-In PLANNING DISRUPTION, inflation interferes with retirement plans and long term contracts

With moderate inflation...
-The downward nominal wage rigidity hypothesis claims that low levels if inflation reduce economic efficiency, because real wage cuts will require nominal wage cuts, which will be resisted. Basically, if inflation is zero, a 2% cut in real wages required a 2% cut in nominal wages: workers will resist a drop in their nominal wages. However, if inflation were high enough, nominal wages could simply be maintained to the effect of reducing real wages, and this is met with much less resistance. In this way, this theory suggests that high inflation facilitates more efficient economies, because it makes it easier for employers to "trick" their employees into accepting real wage cuts.

The zero bound on nominal interest rates hypothesis claims that the BoC cannot run expansionary money policy.

AS A GENERAL RULE, healthy economies have moderate inflation (this is caused naturally by economic growth and increases in aggregate demand).

High and accelerating inflation leads to prediction problems, and arbitrary redistribution of income. It may also lead to hyperinflation. Politics, however, is usually the entity to blame for these problems.

HYPERINFLATION: This is associated with low economic growth. Why? Because hyperinflation increases transaction costs (ie: menus must be changed constantly, and holding money for transactions is risky, because that money's purchasing power can rapidly decrease)

DISINFLATION: Governments can try to use wage or price controls, but usually this doesn't work.
-Two recessions in Canada have been caused by the government of Canada attempting to slow the rate of disinflation. As such, the costs of disinflation probably outweigh the benefits unless inflation is getting seriously out of control.

DEFLATION: Like disinflation, is not a good idea.

THAT'S ALL

Monetary Policy in Canada

This is the last piece of the puzzle! This chapter is all about how the government of Canada uses policy instruments to change the money supply!

The central bank can set the money supply and let the market determine the interest rate

OR

The central bank can set the interest rate and the money supply will adjust to this interest rate

PROBLEMS WITH ADJUSTING THE MONEY SUPPLY DIRECTLY:
-The Bank of Canada (BoC) cannot directly control the money supply through the currency ratio and the reserve ratio (they can't control minds and make banks hold more or less assets and make people hold more or less money)
-Also, it's sometimes confusing as to which definition of the money supply should be used: H? M1? M2? Know know...

SO, the BoC sets the interest rate instead, and then accommodates for fluctuations and changes by using open market operations. (The US directly changes the money supply by printing more or less money, while Canada simply changes the bank rate)

There are 5 Different Policy Instruments The BoC Uses:
1: The Overnight Target Rate (Which is changes by changing the Bank Rate)
2: Buyback Operations (Specials and Reverses)
3: Shifting Government of Canada Accounts
4: Moral Suasion
5: The Announcement Effect

NOTE** It's important to know the difference between operational targets: usually, governments can only target one factor, so they have to choose between targeting

a) The Exchange Rate (from 1962-1970, Canada targeted the exchange rate and tried to keep its external value at 92.5)
b) The Interest Rate/Money Supply (from 1975-1982, the BoC would adjust interest rates to affect the money supply through the liquidity preference system. The problem was that interest rates became extremely volatile, and the government had no way of controlling the price level)
c) The Inflation Rate (the BoC uses interest rates and money supply as a policy instrument to affect the inflation rate, so the operational target is currently PRICES. The BoC tries to keep inflation at about 2%, because a little bit of inflation is healthy

Policy Variables: These are the ultimate targets for policy changes
Y - stable economic growth
U - low unemployment
P - Low Inflation !!! THIS IS THE PRESENT GOAL OF THE BoC

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THE 5 POLICY INSTRUMENTS

1: THE OVERNIGHT RATE

Note* the interest rates on borrowing increase as the term of the loan grows longer (as a compensation for leaving money inaccessible for a longer amount of time)

The Overnight Rate: This is the daily interest rate which chartered banks charge each other for borrowing money (or that investment dealers charge to banks for borrowing money) in cases where they have insufficient funds to clear cheques. These loans have a very short maturity (the term is extremely short) and the interest rates are MARKET DRIVEN

The BoC is the LENDER OF LAST RESORT

The Bank Rate is the rate which the BoC charges to lend to money to chartered banks. This is the upper limit of the overnight rate. Because the bank rate is so high, most chartered banks will not borrow from the bank of Canada unless all other sources refuse to loan them money

The Overnight Rate Operational Band: This is the difference between the highest overnight rate (the bank rate) and the lowest overnight rate (the rate the BoC pays to borrow for depoits)
-It is measured in basis points (each basis point is worth 0.01%, so an operational band of 50 basis points would mean a difference of 0.5% between the highest and lowest overnight rates)

Overnight Rate Target: the midpoint of the operational band for overnight rates, as set by the BoC
-THIS is the policy instrument used by the BoC to affect the interest rate
-There are fixed announcement dates: the BoC announces the overnight rate target 8 times per year

The USA uses a slightly different system...


OKAY: so basically, the bank rate is FIXED by the BoC
-Money's liquidity (the demand for money) is given
-The BoC accommodates the money supply to ensure equilibrium in the money market
-The money supply is thus endogenous, and becomes determined from the interest rates and the demand for money!

1: BoC increases the overnight rate (i goes up)
2: Banks increase their target reserves to buffer against this higher opportunity cost of borrowing from the BoC
3: The money supply decreases (because the reserve ratio is higher)
4: The market interest rate goes up!

This is a long-about way of showing how the market interest rate (which includes the prime rate, the 5-year mortgage rate, and commercial lines of credit) is related to the overnight interest rate!

NOTE* A change in the overnight rate target and other market interest rates usually happens very quickly BUT the demand for loans changes gradually (so the first step of the overall transmission mechanism is much faster than then subsequent steps)

As the demand for money changes, the BoC accommodates by using open market operations!

2: BUYBACK OPERATIONS (INCLUDING OPEN MARKET OPERATIONS)
-The BoC Uses Specials and Reverses to stabilize the overnight rate inside the operational band
-Buyback operations are used to fine-tune the overnight rate target within one basis point of the target

SPECIALS (Specials purchase and resale agreement):
-This is a transaction in which the BoC offers to purchase government of Canada securities from major financial players with an agreement to sell them back at a predetermined price the next business day
-This allows the BoC to put money into the system for one day
-This OFFSETS UPWARD PRESSURES on the overnight rate (by adding a bit to the money supply, the BoC decreases the interest rate a little bit)
-The BoC initiates SPRAs daily if overnight funds are generally trading above the target rate
-Differences between the purchase and the sale price determines the overnight rate

REVERSES (Sale and repurchase agreement)
-This is a transaction in which the BoC offers to SELL government securities to major financial parties with an agreement to buy them back at predetermined prices the next business day (this sale is called a reverse)
-Basically, this let's the BoC take cash out of the system for a day (by coaxing investors to temporarily store wealth in bonds instead of money)
-Reverses are used to offset downward pressures on the overnight rate
-The BoC initiates reverses daily if overnight funds are generally trading below the target rate

OPEN MARKET OPERATIONS (OMO): LONG RUN MONETARY ACCOMMODATION
-An OMO is the purchase/sale of government securities by the BoC in the open market for long run monetary accommodation
-Government securities are long run loans to the government
-Treasury bills are short term loans to the government
-These are auctioned off every Thursday, just like stocks, in a market

The BoC BUYS securities to increase excess reserves and attempt to increase the money supply
The BoC SELLS securities to decrease excess reserves and attempt to decrease the money supply

This analysis assumes that there are no cash drains, and that the reserve ratio remains constant in the long run (neither of which may be true)

3: SHIFTING GOVERNMENT OF CANADA DEPOSITS

Cash Management: The Bank of Canada shifts Government of Canada deposits to and from the Bank of Canada and the chartered banks. This is the major day-to-day instrument which the BoC uses to reinforce overnight rate targets within the operational band

Transferring money to a chartered bank increases their reserves, which allows the chartered bank to safely lend out more money, thus increasing the money supply
Transferring money from a chartered bank back to the BoC decreases chartered banks' reserves, which forces the chartered bank to lend out a smaller proportion of money, thus decreasing the money supply

4: MORAL SUASION

-The BoC enlists the cooperation of commercial banks
-This is possible because there is such a small number of banks in Canada
-Since there are not required reserves in Canada (required reserves are not legislated), this tool is more important
-For an example, the BoC may require an increase in settlement balances held at the BoC

5: THE ANNOUNCEMENT EFFECT

-There are fixed announcement dates where the BoC announces the bank rate (8 times per year)
-Like moral suasion, an increase in the bank rate sends a signal to the economy of the government's intentions, which can affect private investment (due to changed expectations)

CONCLUSION: The BoC fixes the overnight rate target, then uses buyback operations and shifting to reinforce it and open market operation to accommodate the demand for money in the long run

1: Policy instruments: The BoC sets the bank rate
2: The Money Market which defines reserves determines the money supply and the equilibrium interest rate
3: Transmission to real sector through the investment and net export effects

GAPBUSTING GUIDE

TO FIX A RECESSIONARY GAP (CREATE EASY MONEY)
-Decrease the target rate
-Increase the money supply
-Decrease interest rates
-Increase Investment and net exports
-Increase Aggregate Demand
-Y moves to the right, back to Y*

TO FIX AN INFLATIONARY GAP (TIGHTEN MONEY)
-Increase the target rate
-Decrease the money supply
-Increase interest
-Decrease investment and net exports
-Decrease aggregate demand
-Y moves left to Y*

The Transmission Mechanism

So... what happens when the money supply changes? How does this affect things? That's what we're going to figure out today!

Remember the marginal efficiency of investment function?

There are two reasons why interest rates and desire for investment are negatively related
-lower interest rates mean that there is a lower opportunity cost for investing (it costs less to borrow money)
-when interest rates are lower, investing in capital becomes more attractive than keeping money in bonds (so if buying a new mixmaster will have a 4% yield, my friend the baker is much more likely to buy one when an equivalently-priced bond would only give him a 2% yield)
-Investment is determined by the REAL interest rate: for simplicity's sake, just assume that there is no inflation in this model for now

SO: There is an investment transmission mechanism

Let's do this in steps

1: The government changes the money supply (we'll learn how in the next little while)
2: The change in the money supply, thanks to the way the money market works, causes interest rates to fall (this is liquidity preference theory)
3: Lower interest rates cause investment to increase (this is marginal efficiency of investment theory)
4: Increased investment causes the family of aggregate expenditure curves for this economy to shift up
5: A shift up in aggregate expenditure causes aggregate demand to shift to the right, indicating an increasing in GDP, a decrease in unemployment, and an increase in the price level

BE SURE THAT YOU CAN REPRESENT EACH OF THESE STEPS GRAPHICALLY! If you have any questions about that, just send me an email and I will spell it out for you! =D

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THERE IS ALSO AN EXCHANGE RATE TRANSMISSION EFFECT:

In open economies, consumers are not restricted to buying domestic bonds- they can also buy bonds sold by foreign governments. Thus, when the interest rate falls for one country in comparison with other countries, this makes that particular country's bonds less attractive for investors (if China's interest rate is 25% and Canada's is 4%, why the hell would you put your money in Canadian bonds [assuming the Chinese bonds were relative risk-free]). As a result, when domestic interest rates fall, investors tend to pull money OUT of the domestic economy and into foreign economies. This DEVALUES domestic currencies.

We know that when domestic currencies are devalued, this makes it more attractive for foreign economies to import domestic goods, and less attractive for local consumers to import foreign goods (for price-related reasons). Thus, net exports increases. This leads to an increase in aggregate expenditure, and subsequently, an rightward shift in the aggregate demand curve!

SO! There are 2 different pathways through which changes in the money supply can affect aggregate demand in an economy (and by association, Y, U, and P)

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THE LONG RUN NEUTRALITY OF MONEY

Classical economists divided the economy into real and monetary sectors: they believed that changes in the money supply only affected the price level, but would not impact GDP in the long run
MV = PY where V and Y are constant (money has a constant velocity, and GDP tends to return to its potential leve in the long run)

Modern economist now understand that in the short run, changes in the money supply CAN impact GDP through the monetary transmission mechanism. At the same time, they state that in the long run, the "anchor and chain" mechanism will bring GDP back to its potential level (through wage adjustment)

Pretend this graph indicated that the increase in AD was due to an increase in the money supply. In the long run, inflationary pressures cause wages to increase, which effectively raises costs for firms. This shifts aggregate supply to the left until the real GDP is back at Y*, but at a higher price level

Hysteresis: some economists debate that Y* can be affected by short run trends in Y, not just factors and productivity (for an example, a long-lasting recessionary gap may cause worker skills to depreciate, thus bringing productivity down, and consequently lowering potential GDP as well)

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SOME OTHER COOL THINGS
-Changes in the money supply cause larger changes in the interest rate when the money-demand curve is STEEP
-Changes in the interest rate cause larger changes in investment when the MEI curve is very FLAT

MONETARISTS: believe that the LPF is steep and the MEI is flat- they think that monetary changes can cause LARGE changes in GDP and price levels
KEYNESIANS: believe that the LPF is very flat and that the MEI is very steep- they think that monetary changes are much less effective than fiscal changes in affecting GDP and the price level

That's all for now. Only one more bit to cover for the midterm! =D