Inflation and Yield Curve

By:
Irfan Siddiqui
 Introduction
Inflation. In simplest terms, the tendency
of prices to go up.

It is usually defined as a sustained

increase in the general price level.

We measure it as the annual percentage

increase in prices. It can be measured as
a monthly change, but the most often
quoted figure is the annual change.
 Inflation
The prices usually measured are retail prices
that is RPI or you may say customer price index
that is CPI

The CPI is measured by taking a large number

of prices, working out how much each price has
changed and then weighting the price changes
according to their importance.

This is because some price changes have a

much bigger impact on people than others.
 Inflation
For example, a 5% increase in food prices is
likely to affect people much more than a
100% increase in the price of matches
Food therefore gets a much bigger weighting
than matches, and changes in the price of
food will have a bigger effect on the CPI.
 But Why Can’t we ignore it
Yes , question is can we ignore inflation ?

Why to bother about inflation?

Because…………..
Ignoring inflation is like ignoring
elephant in a room !
 Inflation
Now, before analyzing inflation

Lets review long term and short term

effect
of inflation on the economy
Inflation and GDP in Long run
In the long run when prices are fully flexible ,
the level of GDP is determined by the
demand and supply for
Labor
Stock of capital
And technological progress
The economy operates at full employment
With the supply of output fixed at full
employment , increase in government
spending must come at the expense of other
use of outputs
Inflation and GDP in Short Run
In the short run when prices are sticky ,
the level of GDP is determined by the total
level of demand for goods and services.
Increase in supply of Money lower interest
rates, stimulate investment and increase
GDP.
Increases in govt. spending or cuts in
taxes will also lead to increase in GDP
 Transition between long and
short run
It is easy to understand by golden rule

When GDP is higher than its potential

output , the economy starts to overheat
and wages and prices increase.
But this increase in wages and prices will
push the economy back to full
employment.
Aggregate Demand , Aggregate
Supply and Adjustment
Before illustrating transition between the
short run and long run, lets review

Aggregate Demand : it is plotted

with the price on the vertical axis and real
out put on horizontal axis.
It shows the total level of demand for
goods and services for any level of prices.
 Aggregate Demand , Aggregate
Supply and Adjustment
Aggregate Supply (by supply we mean
work force and not product)
We will discuss two aggregate supply curve
1. Classical Aggregate Supply curve (for long
run) , it is vertical line at full employment level
of output.
2. The Keynesian aggregate supply curve (for
short run) is a horizontal line at the current
level of prices. It is horizontal because , as
economists typically find, changes in demand
lead to very small chances in prices over short
periods of time.
Unemployment
era in long run
ILLUSTRATION
At point D , there is a full
. Classical AS
employment in long run ,
where aggregate
demand and supply of
work force intersects,
D
Price , P

PF

A
P0 Keynesian AS

P’0 O AD of labor force

In short run at point A , economy is

yF
At y F , economy is producing
output at full employment level
at point D in long run, with
maximum possible wages at
level of PF
y0 producing at full employment level
and wages are very low , so people
Output , y are over employed at point O, thus
unemployment rate is below its
normal level and so is the wage level.
 Transition from point A to D
This transition gives us an idea that when
economy is over employed :
Wages are at lowest level , output is in access
and prices are also at lower level in short term
But wages demand would rise gradually and
prices of products would also rise
As a result production level will reduce , prices
will get high until full employment level at point
D is achieved, after that unemployment era
would start and would show natural rate of
unemployment in long run.
 In short run agg. supply curve moves
Transition horizontally b/w ASo to AS 3 and gets
from point A to D higher wages , however in long run agg.
supply curve meets production level and
Classical AS
is at vertical axis.Thus, economy
achieves maximum output at Y F With full
. employment level at point D, after that era
of unemployment starts

D
Price , P

PF AS3
AS2

A AS 1
P0 AS 0
AD

yF y0
Output , y
Long Run Neutrality of Money
In Short run increase in Money supply will
Increase Output above full employment and
wages and price of products will reduce
Reduction in interest rate in short run will
increase investment and will help in reducing
unemployment rate
But, ……….
Money supply increase in long run has neutral
effect at economy , thus excess supply of money
will not stay longer and would create inflation
and reverse cycle of neutrality of money will be
in action.
 Neutrality of Money
.
Interest Rate

M0 M1

rF

ro
Md 0
Unemployment rate

I I’ I
Money

Investment
When there is a shift in Money supply (from Mo to M1) money demand would decrease
, thus interest rate will decreases and investment in Economy will increases which will
bring rate of unemployment at lower side.
 Neutrality of Money
A shift in Money demand from Mdo to
Md 1 will raise interest rate and
.
Interest Rate

economy will see lack of investment in

M0 M1 process.

rF
Md 1

ro
Md 0
Unemployment rate

I I’ I
Money
Investment
but , after reaching certain level labor cost will become unbearable, cost of production
would be higher and Price hike will start due to surplus money supply, this surplus
money supply will cause inflation , as a result invt. will reduce and unemployment level
will rise .
 Neutrality of Money
.
Interest Rate

M0 M1

rF
Md 1

ro
Md 0
Unemployment rate

I I’ I
Money Investment
Now, at the time of inflation, unemployment would rise, hoarding of commodities would
start. People will change their spending habits, savings would be preferred rather than
investment and above all , SBP will raise discount rate or CRR ratio to tighten up
monetary system. Thus, a shift in demand of Money would occur , which will reduce
investments .
 Money Growth , Inflation and
Interest Rates
Now , we know when economy operates
at full employment in long run , money is
neutral .
Suppose SBP increases money supply at
5% a year, so inflation will grow by 5% a
year
However , wages are also rising at 5% ,
now ; there will be no inflation as wages
are also rising at the same %.
 Money Growth , Inflation and
Interest Rates
But inflation is measured in two ways
One the existing one and other is
expectation of inflation
Now, lets say on basis of 5% increase in
inflation , automobile producers will on
average expect their prices to be 5%
higher next year.
 Expected inflation
When the public expect inflation , nominal interest rate
would differ from real interest rate
Expected Real
Rate of interest = Nominal rate – expectations of
inflation
10% - 6%
Expected Real Rate of interest = 4%
Thus if you invest Rs 100 at the end of year you
will get
Rs 110 , but with expectation of 6% inflation , real
gain is only Rs 4 not 10.
 Expected inflation
Therefore, when inflation grows it hurts
your purchasing power
Instead of Rs 10 gain , it is expected that
your gain would be Rs 4, thus to maintain
purchasing power , you require extra Rs 6.
If two countries have identical real interest
rate and one has higher level of inflation
would also have a higher nominal interest
rate.
 Credibility and Inflation
Why SBP Governor is very conservative and
constantly warning about the dangers of inflation?
Because these policy makers do influence
expected inflation rate and it does effect actual
behavior of the economy.
The Creditability of Central bank plays very
important role fighting against inflation
When Credibility
is lost
 Credibility and Inflation
Full employment but at higher
Recessio
cost , higher wages
n
. F AS1
PF 1 A Full employment
at PF price level
and AS0 , Wages level ,
D
Price , P

PF point D
AS0

A
P0
AD 1
AD 0
ym yF
Output , y
In era of expected inflation, producers and lenders are not sure about profit
margin, so unexpected price hike would occur with a fear of inflation which will
create panic , excess margin would be taken , as long as selling items are
unavoidable this shift would sustain like petrol and basic food items
 Credibility and Inflation
Full employment but at higher
Recessio
cost , higher wages
n
. F AS1
PF 1 A Full employment
at PF price level
and AS0 , Wages level ,
D
Price , P

PF point D
AS0

A
P0
AD 1
AD 0
ym yF Output , y
but economy would slow down in shape of minimum usage and if appropriate
actions to control inflation would not be taken price hike would continue but
investments will fall, unemployment would occur , agg. Demand would shift
backward and output level will also reduce , thus Recession will emerge and
would provide new point of equilibrium that is A which will soon decline towards
unemployment.
 Credibility and Inflation
Full employment but at higher
Recessio
cost , higher wages
n
. F AS1
PF 1 A Full employment
at PF price level
and AS0 , Wages level ,
D
Price , P

PF point D
AS0

A
P0
AD 1
AD 0
ym yF Output , y
To avoid recession , central bank plays its role and control inflation at the mid level
and tries to control money supply by tightening up the money market.. Thus , in a
successful economy equilibrium at point D would be tried to achieve rather than at
point A , which is a point of no return or could be said point of depression.
Inflation and the Velocity of Money

Countries some times experience

extremely dramatic inflation rates.
To provide more significant link between
Money growth and inflation , lets see a
concept of Velocity of Money
Velocity of Money = nominal GDP
money supply
Inflation and the Velocity of Money

Suppose a nominal GDP in country were

5 trillion per year and the money supply
were 1 trillion , then

Velocity = 5 trillion per year

1 trillion
V = 5 per year
 Inflation and the Velocity of Money

That is in this economy 1 trillion has to

turn around 5 times in a year to purchase
the 5 trillion of nominal GDP.
Which means holding power of people is
365 / 5 = 73 days a year
We can re write this equation as
money supply x velocity of money = nominal GDP
 Inflation and the Velocity of Money
money supply x velocity of money = nominal GDP

Where M = money supply

V = velocity of money
P = measure of the average price level
y = Real GDP

We can also say that

nominal GDP = Real GDP x measure of average price level

M x V = p x v -------------- is called Quantity equation

 Inflation and the Velocity of Money

This basic quantity equation can be used to

derive a closely related formula that is useful for
understanding inflation in the Long run =

Growth rate + growth rate = growth rate + growth rate

of money of velocity of prices of real output
= 10% + 0% = ? + 3%
(we assume that growth rate of velocity is ZERO)
 Inflation and the Velocity of Money
= 10% + 0% = ? + 3%

= 10% + 0% - 3% = 7% = Growth rate of Prices

Thus inflation in long run in this case = Growth rate of

prices
Now, assume that Growth rate of velocity grew by 1%
inflation rate would be
= 10% +1% - 3% = 8% = inflation in long run = Growth rate of prices
 Cost of Inflation
Expected Inflation is also divided in two category :
Anticipated inflation
Unanticipated inflation
Anticipated inflation
 Lets say anticipated inflation rate is 4%
 In this case 7% increase in wages means only 3%
increase in wages due to inflation factor
 Real income = nominal income - inflation
 Anticipated inflation
 Menu costs would be charged , menu cost is
that cost which restaurant owners, catalog
producers and other post price business men to
charge by increasing their retail price
considering anticipated inflation margin.
 However tax is imposed on nominal income and
not on real income thus inflation factor is 4% and
nominal income is 7% , but tax would not be
charged on 3% (real income) but on 7% nominal
income.
 Anticipated inflation
People would hold less money in there
hand and thus will only withdraw limited
amount for spending with a threat of loss
spending incase of cash
This accelerates different other costs like
ATM charges, more usage of ATMs and
cheque book , trying to holding less cash
in pocket is called Shoe – leather costs
 Unanticipated inflation
 It causes different problems like
 Reduction in long term investment
 Acceleration in current market exposure
 High lending rates asked by lenders
 Loans for longer fixed terms would not be available
resulting in less economic growth
 Increase in un employment, freeze on new hiring
 Higher cost of necessary food items
Inflation and economic , political
barriers
Inflation on food items and necessary items would
hurt not only people of the society but also may be
the cause of government change before due time,
revolution and other political benefits could be
achieved by opposition
Domestic inflation may cause
Food inflation, non food items inflation
International Inflation may cause
Petrol , sugar and other necessary items price hike
Inflation and economic , political
barriers
We have already seen all kind of inflationary
problems in our country some may be recalled
here as
Un employment
Price hike
Theft
Robbery
Inventory hoarding
Undue charges
Thank You