Macroeconomics in the World Economy: Theory and Applications Topic 7: Unemployment & Inflation: Policy in Action

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1 Macroeconomics in the World Economy: Theory and Applications Topic 7: Unemployment & Inflation: Policy in Action Dennis Plott University of Illinois at Chicago Department of Economics Spring 2014 Plott (ECON 221) Spring / 50

2 Outline 1 Topic 7: Unemployment & Inflation: Policy in Action Monetary Policy: Rules vs. Discretion The Problems with Unemployment The Problems with Inflation Plott (ECON 221) Spring / 50

3 Non Sequitur Slemrod, Blumenthal, and Christian (2001) analyze the results of a randomized controlled experiment conducted by the State of Minnesota Department of Revenue. Random taxpayers received a letter notifying them that they were to be audited. Low and middle income taxpayers receiving the letters reported slightly more income than those who did not receive such a letter. High income taxpayers receiving an audit threat reported lower income. Can you explain this result? Plott (ECON 221) Spring / 50

4 Outline 1 Topic 7: Unemployment & Inflation: Policy in Action Monetary Policy: Rules vs. Discretion The Problems with Unemployment The Problems with Inflation Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

5 Goals of the Fed (Revisited) The Fed s primary goals are to foster economic growth and job creation and restrain inflationary pressure. The Fed wants to set r so that r = r (the target real interest rate),y = Y,u = u,n = N (Note: these are equivalent). π = π where π is the target inflation rate, approximately 0 2% inflation) The Fed wants to raise r when r < r,y > Y,u < u,n > N π > π The Fed wants to lower r when the opposite conditions hold. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

6 U.S. Inflation: 1970Q1 2013Q4 Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

7 The Fed s Timing Recession Begins December 1969 November 1973 July 1981 July 1990 March 2001 December 2007 First Fed nominal rate cut 11 months later 13 months later 4 months later 5 months later 3 months before 4 months before Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

8 Rules vs. Discretion Should a central bank have a specific policy rule? Rules are explicit and may be mandated by law Money should grow at 4% per year (Friedman preferred rule). Explicit inflation target: U.K. has an inflation target of 2% (± 1%) See main web page Rules may be implicit and known by all economic agents The Fed will target the inflation rate at 2 4% per year. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

9 Benefits of Rules Commits central bank to some policy. Removes inflation temptation; recall not all central banks are equally independent from political pressure. Creates a more stable economic situation: individuals and firms can anticipate the central bank actions. No surprises! Prevents central bank from thinking too much the economy is so complex that Fed policy can have delayed impact and is usually initiated too late! Central Bank actions can often be "destabilizing". (Freidman and Lucas both prefer simple rules). More on Lucas later. Potential problem: rules often assume that key economic variables are constant, when often they are not. With respect to the Taylor rule, it is possible that the equilibrium real interest rate changes over time in response to technological change and other factors that affect the economy s long-run equilibrium. In those circumstances, the Fed s strict adherence to the Taylor rule could increase fluctuations in unemployment and inflation. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

10 Benefits of Discretion Central bank uses all information possible to make the best decision at the time. The Fed uses a discretionary rule. The members of the bank vote on a monetary policy at each FOMC meeting. The policy is not dictated by some explicit rule. Benefits of discretion: Allows central bank to choose from competing policy goals; sometimes inflation targeting is not best for the economy. The fundamentals of an economy may change or evolve over time the rule becomes outdated. How do we know where the economy is relative to Y and target inflation rate? Information flows slowly and is complex to analyze. Potential problem: Nobel Laureates Finn Kydland and Edward Prescott argue that central banks face a time-inconsistency problem. A policy rule avoids the time-inconsistency problem the tendency of policymakers to announce one policy in advance in order to change the expectations of households and firms and then to follow another policy after households and firms have made economic decisions based on the announced policy. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

11 Hawks vs. Doves How does the Fed balance price stability (π = π ) and full-employment (u = u) when they conflict? For example, when π > π and u > u at the same time. Hawks put more weight on π and have lower values for it. U.K., Canada, New Zealand Bundesbank before euro-zone; European Central Bank (ECB) now Doves put more weight on staying near u and have higher π. Bernanke tended to put the same "weight" on each. FOMC Hawk vs. Dove Composition Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

12 The Fed s Policy Behavior: The Taylor Rule Question: can we approximate the Fed s decisions in a simple, synthetic way? John Taylor: the Fed s behavior under Alan Greenspan (August 1987 to 2006) and Ben Bernanke (2006 to 2014) are well described by: ( ) Taylor Rule : i FF = r + π e + β π (π e π Y Y ) + β y Y i FF = the nominal federal funds rate. r = the real fed funds rate target (this is the r consistent with Y = Y ) π e = expected inflation, π = target inflation, and Y = real GDP Y = equilibrium real GDP β is the respective weight; e.g., if a central bank only cares about inflation, then β y = 0. Y Y is the output gap or GDP gap. A positive output gap means overheating and Y potentially rising inflation (labor markets will demand higher wages) Taylor used r = 2% and π = 2%. The Taylor Rule explains about two-thirds of quarterly variation in the fed funds rate since 1987; i.e. a lot. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

13 John B. Taylor Taylor s Blog Likely a (near) future winner of the Nobel Prize in Economics Taylor s work "has affected the way policymakers and economists analyze the economy and approach monetary policy." Janet Yellen Contributions: Taylor rule; Taylor principle: the nominal interest rate should increase by more than one percentage point for each one-percent rise in inflation; help develop and apply methods for solving macroeconomic models under rational expectations. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

14 Notes on the Taylor Rule Fed economists find an even better fit with 1 on the GDP gap term. This does NOT mean that the Fed uses this "rule", it is just that Fed behavior looks very similar to this rule. Furthermore, the Fed tends to smooth interest rates relative to the rule: This quarter s actual i = 0.6(Last quarter s actual i) + 0.4(Taylor Rule s i) Studies have found that other G7 central banks (e.g., the Bundesbank (previously), ECB) have also followed versions of a smoothed Taylor Rule. G7 countries: Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

15 Did the Fed Do Something Wrong? During the expansion after 2001, the economy did not seem to overheat, output was around potential Y and inflation was stable However, at the same time, housing prices were rising steadily... Greenspan did not do anything, according to the Taylor Rule: i should not change if output and inflation are around target. Should the Fed have reacted to the housing bubble? Should the Taylor rule include asset prices (ω)? Taylor Rule : i FF = r + π e + β π (π e π ) + β y ( Y Y Bernanke and Gertler answer: NO! Y ) + β ω (ω ω ) Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

16 Housing Bubble Bernanke and Gertler argument: the Fed should care about asset prices only if they have macroeconomic effects if the housing bubble had macro effects you should see output or inflation react (standard demand shock) BUT then standard Taylor rule would suffice However, it seems that the housing bubble had macro impact when it burst! It could be that asset price bubbles are problematic because agents tend to leverage too much and then a crisis can occur if the bubble bursts Is monetary policy the right tool to control a bubble? Can you even do it? Is this relevant? Should you care? Haven t people, firms, and policy makers learned from relatively recent events? See The Economist "Housing Markets: Double Bubble Trouble" 22 nd March 2014! Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

17 Other Limitations of Monetary and Fiscal Policy Not an exact science: How much stimulus is necessary to move the economy to Y? Where is Y? Policy creates uncertainty as economic agents try to anticipate Fed and/or Government rules Long and variable lags Some argue avoid using stabilization policy (just a simple Quantity Theory representation) or suggest using very simple rules. Some research says that every sustained period of large inflation is due to the Fed! Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

18 When Does Policy Not Work? Vertical IS curve: what if firms don t respond to interest rate changes (they think future economic conditions are going to be bad or interest rates will be lower in the future or the banking system has problems making loans)? Monetary policy becomes dampened or muted Central banks become powerless because nominal interest rates are already so low (Keynesian) liquidity trap Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

19 Demand Side Effects of Deflation Deflation can make borrowers either consumers or firms, worse off. As we saw earlier in the course, unexpected inflation makes borrowers better off. They expected to pay a certain real rate and when inflation is higher and the nominal rate is fixed, the real rate they pay is lower (in terms of lost purchasing power). If the economy experiences unexpected deflation, the opposite happens: borrowers are paying more in terms of lost real purchasing power when there is unexpected deflation. Borrowers, both consumers and firms, will essentially be poorer. Even though, there is another side of the market somebody has to lend to them, this could still have large effects on consumption and investment. This demand side effect of deflation is called "debt overhang" or "debt deflation". Note: even the government is paying higher than expected real rates on their debt. Even if the deflation is expected, large transfers can occur from borrowers to lenders because nominal interest rates are bounded by zero (shuts down lending channels). Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

20 Change in Prices versus Inflation Labor Markets are forward looking If the purchasing power of workers nominal wages is systematically eroded by unexpected changes in prices, workers will try not to lose systematically. Change in prices become dynamic Two Examples: Cost-Push Inflation: Consider an increase in production costs. Accommodating supply shocks can lead to persistent inflation (the Fed in the mid and late 1970s). Workers see this, and adjust. They ask for higher nominal wages in anticipation, this shifts up the SRAS, and this pushes prices up. Demand-Pull Inflation: Policy makers try to permanently keep the economy above its potential level by stimulating demand. Wages will keep adjusting then (you cannot fool all the people all the time). Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

21 The Fed in the 1970s: Cost-Push Inflation After the negative supply shocks in the mid- and late 1970s, the Fed adopted a policy mainly based on fighting the recession by increasing M; i.e., an expansionary monetary policy. The Fed believed that the potential level of output was still Y 1 The Fed tried to bring Y back to the wrong potential, Y 1 instead of Y 2! This pushed prices up and then, through the adjustment of the labor market, wages even higher! This pushed the SRAS in, pushing inflation up! Say back to Y 2. But the Fed wants to go to Y 1, so increases M again... Amplifying mechanism: if workers expect high inflation they will try to get higher nominal wages! Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

22 Graphing Accommodation of Inflation P LRAS 1 AS 1 (W 1,Oil 1 ) P 1 a AD 1 (M 1 ) Y 1 = Y 1 Y Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

23 How Do We Get Out of Cost-Push Inflation? The Fed can break the inflation by resetting expected inflation rates. The 1982 Volker Recession (Paul Volcker, an underrated Fed Chair). Through a cold-turkey cut of money supply and with a substantial effort to modify the market s perception of the Fed he managed to cut inflation from double digits to 4%. It did cost the economy a short but deep recession though. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

24 Paul Volcker Fed Chair from 1979 to 1987 Volcker rule: bars banks from speculating in the markets a practice known as proprietary trading and from operating and investing in hedge funds and private-equity funds. The Volcker rule separates investment banking, private equity, and hedge funds from their consumer lending arms. Banks are not allowed to simultaneously enter into an advisory and creditor role with clients with the aim to minimize conflicts of interest between banks and their clients. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

25 Graphing Demand-Pull Inflation P LRAS 1 AS 1 (W 1 ) P 1 a AD 1 (M 1 ) Y 1 = Y 1 Y Graph of a sustained policy to keep Y above Y. May induce an upward spiral in P. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

26 The Business Cycle and Inflation What can we say about the relationship between output and prices in light of our analysis of shocks and the possible stabilization through policy? We know that in recessions labor supply is higher than labor demand (disequilibrium in the labor market), hence we have unemployment. In booms labor supply is lower than labor demand (disequilibrium in the labor market again), hence we have an utilization rate of labor that is higher or some story for being able to extract more labor (see discussion of efficiency wages in the textbook ch. 11 if you would like more information). We also know that prices change. Positively after a positive demand shock such as an increase in money supply or an expansionary fiscal policy is implemented (increase in G). Can we see a pattern between unemployment and inflation? Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

27 The Phillips Curve Discoverer: British economist A.W. Phillips. Discovery: a negative correlation between the unemployment rate and the inflation rate across years within a country in the 1950s. Corr(π,u) < 0 The correlation was also negative in the U.S. and other countries through the 1960s. Old Keynesians in the 1960s: we have found a stable, exploitable trade-off between the rate of inflation and the rate of unemployment. We can permanently lower the rate of unemployment at the cost of a permanently higher inflation rate. No! The negative relation is only between unexpected inflation and cyclical unemployment. Expectations-augmented Phillips Curve (Friedman): π = π e h(u u) u is the natural unemployment rate (structural and frictional unemployment only). Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

28 The Phillips Curve: Graph π LRPC 1 (u) π 1 = π e 1 a SRPC 1 (u,π e ) u 1 = u 1 u Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

29 The Short-Run Phillips Curve: Shifters The Phillips curve shows the relationship between unemployment and inflation for a given expected rate of inflation and natural rate of unemployment Changes in the expected rate of inflation For a given expected rate of inflation, the Phillips curve shows the trade-off between cyclical unemployment and actual inflation Higher expected inflation implies a higher Phillips curve Changes in the natural rate of unemployment For a given natural rate of unemployment, the Phillips curve shows the trade-off between unemployment and unanticipated inflation A higher natural rate of unemployment shifts the Phillips curve to the right Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

30 Friedman and Phelps: Expectations Matter You cannot exploit the trade-off between inflation and unemployment unless you constantly surprise people. That is, if workers and firms are rational they will incorporate the economic policy that exploits the trade off in their decisions and will not allow the government to fool them systematically by increasing M s or G. Milton Friedman in 1968: the Long-Run Phillips Curve is vertical. Vindicating evidence: The Phillips Curve broke down after 1970s. Over time in the U.S., higher money growth just leads to more inflation and no higher real GDP. Across countries, higher money growth just leads to more inflation and no higher real GDP. [Note: our model is consistent with this observation. See Problem Set 6 and Exam II] Real GDP actually appears to be hindered by high levels of inflation. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

31 Why is the Long-Run Phillips Curve Vertical? The self-correcting mechanism You Cannot Sustain Y > Y forever Quantity Theory of Money Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

32 Is There a Short-Run Trade Off? Short-Run trade-off between the unemployment rate and inflation rate changes: Inflation tends to fall in years following u > u. The cost of a permanently lower inflation rate is a temporarily higher unemployment rate. Inflation tends to rise in years following u < u. The cost of temporarily lowering the unemployment rate is a permanently higher inflation rate. This is why Fed is currently worried about inflation. Demand shocks cause a negative relationship between the price level and unemployment (early 1980s). Supply shocks cause a positive relationship between the price level and unemployment (the 1970s and the late 1990s). Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

33 The Lucas Critique When the rules of the game change, behavior changes For example, if batters in baseball were called out after two strikes instead of three, they would swing more often when they have one strike than they do now. Lucas applied this idea to macroeconomics, arguing that historical relationships between variables will not hold up if there has been a major policy change. The Phillips curve is a good example it fell apart as soon as policymakers tried to exploit it. Evaluating policy requires an understanding of how behavior will change under the new policy, so both economic theory and empirical analysis are necessary. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

34 The Sacrifice Ratio To reduce inflation, policymakers can contract aggregate demand, causing unemployment to rise above the natural rate. The sacrifice ratio measures the percentage of a year s real GDP that must be forgone to reduce inflation by 1 percentage point. A typical estimate of the ratio is 5. Example: to reduce inflation from 6 to 2 percent, must sacrifice 20 percent of one year s GDP: GDP loss = inflation reduction sacrifice ratio GDP loss = 4 5 This loss could be incurred in one year or spread over several; e.g., 5% loss for each of four years. The cost of disinflation is lost GDP. One could use Okun s law to translate this cost into unemployment. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

35 Expectations Ways of modeling the formation of expectations: Adaptive expectations: people base their expectations of future variables (e.g. inflation) on recently observed behavior of that variable. Rational expectations: people base their expectations on all available information, including information about current and prospective future policies. A more recent formulation is natural expectations. We may return to this in Topic 9. The idea is to formalize the "this time is different" logic that often characterizes boom and bust cycles in markets. In other words, people mistake temporary changes in the economy for permanent changes. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

36 Rational Expectations First proposed by John F. Muth in 1961 supposedly to annoy another economist. Robert Lucas is the intellectual founder of the rational expectations equilibrium approach to macroeconomics. Rational expectations from an ex-wife Rational expectations is the assumption that people make forecasts using all available information. Many economists believe that rational expectations is better than adaptive expectations at describing how households and firms make decisions. If expectations are rational, which means they are statistically the best predictions of the future that can be made using the available information. Note: this does NOT mean they are always correct; it simply implies that they will not be wrong in a consistent way. Rational expectations imply that people will eventually come to understand whatever policy is being used, and thus that it is not possible to fool most of the people all the time or even most of the time. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

37 Robert Lucas Robert Lucas "The most influential macroeconomist of the last quarter of the 20 th century." Greg Mankiw Awarded Nobel Prize in Economics (1995) Contributions: incorporated rational expectations into macroeconomic models; Lucas critique; Lucas paradox: why more capital does not flow from developed countries to developing countries. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

38 Painless Disinflation? Proponents of rational expectations believe that the sacrifice ratio may be very small. Suppose u = u and π = π e = 6%, and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6 to 2 percent as soon as possible. If the announcement is credible, then π e will fall, perhaps by the full 4 points. Then, π can fall without an increase in u. This means there is no trade-off between inflation and unemployment even in the short-run when expectations are rational and policy changes are anticipated. This result is called the policy ineffectiveness proposition and implies that announced and credible changes in monetary policy, for example, affect only the inflation rate and do not affect real GDP. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

39 Calculating the Sacrifice Ratio for the Volcker Disinflation } 1981 : π = 9.7% Total disinflation = 6.7% 1985 : π = 3.0% Year u u u u % 6.0% 3.5% % 6.0% 3.5% % 6.0% 1.4% % 6.0% 1.1% Total 9.5% Okun s law: 1% of unemployment = 2% of lost output. Thus, 9.5% cyclical unemployment = 19.0% of a year s real GDP. lost GDP Sacrifice ratio = total disinflation) = 19.0% = 2.8 percentage points of GDP were 6.7% lost for each 1 percentage point reduction in inflation. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

40 The Natural-Rate Hypothesis & Hysteresis Our analysis of the costs of disinflation and of economic fluctuations is based on the natural-rate hypothesis: changes in aggregate demand affect output and employment only in the short-run. In the long-run, the economy returns to the levels of output, employment, and unemployment corresponding to their respective natural-rate levels. Hysteresis: the long-lasting influence of history on variables such as the natural-rate of unemployment. Negative shocks may increase u, so economy may not fully recover. Hysteresis Why negative shocks may increase the natural-rate: The skills of cyclically unemployed workers may deteriorate while unemployed, and they may not find a job when the recession ends. Cyclically unemployed workers may lose their influence on wage setting; then, insiders (employed workers) may bargain for higher wages for themselves. Insiders vs. Outsiders Theory Result: the cyclically unemployed "outsiders" may become structurally unemployed when the recession ends. Plott (ECON 221) Monetary Policy: Rules vs. Discretion Spring / 50

41 Outline 1 Topic 7: Unemployment & Inflation: Policy in Action Monetary Policy: Rules vs. Discretion The Problems with Unemployment The Problems with Inflation Plott (ECON 221) The Problems with Unemployment Spring / 50

42 The Costs of Unemployment Loss in output from idle resources Workers lose income Society pays for unemployment benefits and makes up lost tax revenue Using Okun s Law (each percentage point of cyclical unemployment is associated with a loss equal to 2% of full-employment output), if full-employment output is $17 trillion, each percentage point of unemployment sustained for one year costs $340 billion Personal or psychological cost to workers and their families Especially important for those with long spells of unemployment There are some offsetting factors Unemployment leads to increased job search and acquiring new skills, which may lead to increased future output Unemployed workers have increased leisure time, though most would not feel that the increased leisure compensated them for being unemployed Plott (ECON 221) The Problems with Unemployment Spring / 50

43 A Common Misperception Common misperception: inflation reduces real wages This is true only in the short-run, when nominal wages are fixed by contracts, for example. In the long-run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate. Consider the data... Plott (ECON 221) The Problems with Unemployment Spring / 50

44 The CPI and Average Hourly Earnings, Plott (ECON 221) The Problems with Unemployment Spring / 50

45 Outline 1 Topic 7: Unemployment & Inflation: Policy in Action Monetary Policy: Rules vs. Discretion The Problems with Unemployment The Problems with Inflation Plott (ECON 221) The Problems with Inflation Spring / 50

46 The Social Costs of Inflation... fall into two categories: 1 Costs when inflation is expected 2 Costs when inflation is different than people had expected Plott (ECON 221) The Problems with Inflation Spring / 50

47 The Costs of Expected Inflation Shoe leather cost: the costs and inconveniences of reducing money balances to avoid the inflation tax. Remember: in the long-run, inflation does not affect real income or real spending. So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash. Menu costs: the costs of changing prices. Examples: cost of printing new menus cost of printing & mailing new catalogs The higher is inflation, the more frequently firms must change their prices and incur these costs. General inconvenience Inflation makes it harder to compare nominal values from different time periods. This complicates long-range financial planning. Plott (ECON 221) The Problems with Inflation Spring / 50

48 The Costs of Expected Inflation (Continued) Relative price distortions Firms facing menu costs change prices infrequently. Example: A firm issues new catalog each January. As the general price level rises throughout the year, the firm s relative price will fall. Different firms change their prices at different times, leading to relative price distortions... causing microeconomic inefficiencies in the allocation of resources (frictions). "Unfair" tax treatment Some taxes are not adjusted to account for inflation, such as the capital gains tax. Example: January 1: you buy $10,000 worth of Apple stock December 31: you sell the stock for $11,000, so your nominal capital gain is $1,000 (10%). Suppose π = 10% during the year. Your real capital gain is $0. But the government requires you to pay taxes on your $1,000 nominal gain! Plott (ECON 221) The Problems with Inflation Spring / 50

49 The Costs of Unexpected Inflation Arbitrary redistribution of purchasing power Many long-term contracts not indexed, but based on π e. If π turns out different from π e, then some gain at others expense. Example: borrowers & lenders If π > π e, then (i π) < (i π e ) and purchasing power is transferred from lenders to borrowers. If π < π e, then purchasing power is transferred from borrowers to lenders. Additional cost of high inflation: increased uncertainty When inflation is high, it s more variable and unpredictable: π turns out different from π e more often, and the differences tend to be larger (though not systematically positive or negative) So, arbitrary redistributions of wealth more likely. This creates higher uncertainty, making risk-averse people worse off. Plott (ECON 221) The Problems with Inflation Spring / 50

50 One Benefit of Inflation Nominal wages are rarely reduced, even when the equilibrium real wage falls. This hinders labor market clearing. Inflation allows the real wages to reach equilibrium levels without nominal wage cuts. Therefore, moderate inflation improves the functioning of labor markets. Plott (ECON 221) The Problems with Inflation Spring / 50