Should Anyone really Worry about Inflation - PowerPoint Presentation

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Should Anyone reallyWorry about Inflation?

Andrew K Rose

NUS-Business

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Motivation: large government fiscal support for pandemic

COVID-19 pandemic has caused an enormous expansion of government support in many rich countries, including Singapore, the United States, Germany. Even ignoring targeting of support …

How are governments paying for these expansions?

What are the monetary authorities doing? Should we be worried about massive increases in government debt? What do the financial markets indicate? Will inflation return?

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Most Governments were Running Deficits

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Deficits and Debt Data (IMF WEO, 6/’20)

%GDP

2018 Deficit

2019 Deficit

2020 Deficit

2018 Debt

2019 Debt

2020 Debt

World

-3.1

-3.9

-13.981.282.8101.5US-5.8-6.3-23.8111.6113.2131.2EMU-.5-.6-11.785.884.1105.1Japan-2.5-3.3-14.7236.6238.0268.0UK-2.2-2.1-12.785.785.4101.6China-4.7-6.3-12.147.052.064.1India-6.3-7.9-12.169.672.284.0Russia2.91.9-5.513.513.918.5Brazil-7.2-6.0-16.087.189.5102.3S Africa-4.1-6.3-14.856.762.279.9S Arabia-5.9-4.5-11.419.022.835.2

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Whence Debt? Fiscal PolicyGovernment does four macro things:

Spends directly (G)

Makes transfers

Collects taxesIssues or retires treasuries (bonds)5

Andrew Rose, Global Macroeconomics 8

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Recall: Direct Government Spending (G)Approximately 20% of typical economy

Health

Education

Defense, Infrastructure, …6Andrew Rose, Global Macroeconomics 8

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Reminder: Indirect Government SpendingGovernment often makes Transfers (Tr) to groups

Often bigger than direct government spending

Old

PoorUnemployedDebt-HoldersAgriculture, …7

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Government Spending (G)

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Government Revenue

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The Government has a Budget ConstraintTotal Spending = Total Revenues

Transfers + G = taxes + debt issuance + seigniorage

Ignore seigniorage for now

Typically model taxes simply as proportional to income Taxes = tYIncome and VAT are big taxes for rich countriesEmpirically, Taxes >> Debt Issuance ( >> Seigniorage)

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Tangent: Don’t Forget the Business Cycle

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“Automatic Stabilizers”Taxes lower value of multiplierTransfers (e.g., to unemployed) raise spending during bad times, lower them during good

Both are “Automatic Stabilizers” that are

counter-cyclic

(reduce the volatility of business cycles)Note: no discretionary (fiscal) policy necessaryNote: most shocks are good, so automatic stabilizers are also “fiscal drag”Weaker in Asia, America; stronger in EuropeAndrew Rose, Global Macroeconomics 8

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So Government Budget Naturally CyclicAs income changes (for whatever reason), budget deficit/surplus changes automatically

tax revenues fall in recessions; transfers rise

Hence can “cyclically adjust” budget deficit: deficit reflects both “structural” and “cyclic” components

For balance over the cycle, should run surplus during boomsOtherwise “pro-cyclic” fiscal policy; fiscal contraction during recessions exacerbates recessionsEx: EMU and “Growth and Stability Pact”Ex: most sub-national governments have balanced budget requirements

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Graphically14

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Long-run trend, balanced budget

Bad shock hits (recession)

Gov’t transfers rise, revenues fall: deficit

Cut gov’t spending or raise taxes, or both

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So, can Adjust Government Budget for Cycle

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But Deficits and Debts Remain Large!

End of Cyclic-Adjustment Tangent

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Government Deficits add to Debt

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But the Government Also Has Assets…

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How Much (Net) Debt is Too Much?

EMU guideline: 60%

Blanchard: compare nominal interest rate to growth rate

Ongoing concern: will debts be monetized?High inflations historically fall high debt burdens (wars)Hence: fear of inflation!What are the causes of inflation?

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Money DemandQ: Why hold money instead of bonds? (Portfolio choice)

Demand for

real

purchasing power (prices matter 1:1)Positively related to real income/consumption (facilitate transactions), big effect empirically (≈1)Negatively related to opportunity cost (bonds earn nominal interest rate), small effect empirically

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Money SupplyHow does government set money supply; exogenously?

Assume

central bank

sets money supplyCentral Banks often now independent of finance ministry/government for rich countries, some LDCsA recent innovation for mostMonetary independence akin to judicial independenceGoals of Central Bank: set monetary policy

to hit targets, typically:Inflation targets (often explicit, but only recently)Smooth business cycles

Maintain integrity of financial system (avoid bank runs, financial crises)

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EquilibriumMoney Supply equals Money Demand

Algebraically M

s

= PL(y,i)“Walras’ Law” states this is also bonds market equilibrium (with two assets, money & bonds)[Hence can ignore bonds market, focus only on money market]22

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Quantity Theory: A Long Run Theory of Inflation

 

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Recall equilibrium: M

s

= P*L(y, i)

Assume y effect =1

, where V is velocity of money

In rates of change,

 

Excessive money growth causes inflationMoney growth which exceeds difference between “velocity drift” and growth (both exogenous) is inflationary

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Notes on Quantity TheoryDoes not

fit well in the short run

Friedman: “inflation is always and everywhere a monetary phenomenon”

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Quantity Theory Works Badly in Short Run

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Quantity Theory Works Well in Long Run

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More on Monetary PolicyMoney (M1) is defined as currency held by public and demand deposits

But central bank doesn’t control deposits and hence money (directly)

Instead, it directly controls a more narrow monetary aggregate

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More on Money SupplyMs =



HPM

 is “money multiplier” a function of two ratios (Currency/Deposits), (Commercial Bank Reserves/DD)Usually exogenous, moves slowlyFinancial crisis may lead to “reserve hoarding” (2008-9)HPM is “high-powered money” or “monetary base” controlled by Central Bank28

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High-Powered MoneyLiabilities of central bank: Currency in circulation held by public

Commercial bank reserves (CBR)

Asset side:

International Reserves (IR=FX + gold + SDRs)Central Bank Credit (CBC=government debt held by central bank – not all treasuries, just those held by central bank)Usually not private bonds/equity except in crisisThat is, HPM  IR + CBC = Currency + CBR

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How Does Central Bank Actually Change Monetary Policy?An expansionary “open market operation” consists of central bank sale of Currency/CBR to the public in exchange for increase in CBC (government debt)

Purchases of government debt raise their price, lower interest rates

“Provide liquidity” to markets

Traditionally at short-maturity end of debt marketIn US, this is done through “Federal Funds” marketCan also do unconventional “Quantitative Easing” at longer maturities – direct central bank purchases of other assets … if short interest rates low/0/negativeAndrew Rose, Global Macroeconomics 9

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Short Nominal Interest Rate

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Quantitative Easing needed for low/0 rates

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Still Inflation Has Been Low

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(1-yr ahead) Expected Inflation also low

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What do the Financial Markets say About Expected Inflation?

“Fisher Effect” states

nominal

interest rate is the sum of expected inflation and expected real interest rate: i = %pe + reFisher Effect works reasonably in long run, not in short run (except during hyperinflations)

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Short Real Interest Rate

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There are Real (and Nominal) Long Bonds

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Long Term Expected American Inflation

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Long (10y) Government Bond Yields, 7/’20

Australia

0.92

Israel

0.71

Canada

0.56

Japan

0.03

Brazil

2.43

Korea1.39China4.07South Africa9.96France-0.20Switzerland-0.44Germany-0.54UK0.28India5.84USA0.73

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Takeaways

Government deficits are big

Government debts are big

Monetary growth is highNominal interest rates are low… but …Inflation is lowReal interest rates are lowExpected inflation rates and bond rates are low …Inflation is not an issue for any major country right now!

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