Applied Macroeconomics: Employment, Growth and Inflation

by Vivek Moorthy

From the central bank’s view point, although the cost of printing a given note is less than that of minting a coin, overall notes are more expensive to issue than coins because they have to be replaced.

notes in India have a life of less than one year.

Although coins are physically durable, they fail to withstand inflation. They tend to disappear rapidly with higher inflation due to one of two reasons. First, it becomes profitable to melt down the coins, because the metallic value has risen above its face value. The higher the price level, the more the ...

Second, at the other extreme when inflation is high, the coins themselves may become worthless and are thrown away, since one has to accumulate a stash of coins (or a ward of small notes) to pay for the lowest value transactions. This is too much of a nuisance to both customers and sellers and so they are compelled to switch to higher value denominations and thereby notes. In short, coins disappear because either they become too valuable relative to face value, or else because they lose their value for transactions. As notes proliferate relative to coins, the risks of counterfeiting currency goes up. To avoid counterfeiting, the RBI issues notes with various security features, but these are expensive.

one neglected component of the cost of inflation – that of minting and printing and preventing counterfeiting – is quite high.

Hayek emphasized that individual agents have limited knowledge, i.e., specific to their domain. Their decisions are based on the price and other market conditions of their product. For a centralized planning agency to coordinate and allocate resources efficiently (which the invisible hand does, according to classical economics), it would need to have precise information about all prices in the economy. This is an utter impossibility.

Microeconomics deals with relative prices, i.e., the absolute price of item j relative to the price level or Pj/P. If the aggregate price level P is unchanging, this can be conveniently set equal to one, and thereby, the absolute price of any item becomes the relative price. When demand for an item goes up, its relative price goes up. A rise in the (relative) price is a signal to the firms to produce more of that product and vice versa. Based on these signals, the decisions of firms release resources, including labour, from the sectors that are shrinking to those that are growing.

Inflation greatly complicates the assessment of price changes. When the price level is stable, the entire price change is a relative price signal that can be unambiguously responded to. When there is inflation of say 10%, declining sectors with weak demand will register inflation below 10% while those with strong demand will register inflation above 10%. Individual firms will need to decipher absolute versus relative prices and extract the price signal from the noise.

high inflation raises the ratio of noise to signal in the prices that economic agents encounter and have to respond to.

One of the functions of money as a means of payment is that it performs the role of what is called as a numeraire: all prices are quoted in terms of money. By contrast, when there are N items in a barter economy, there are N (N− 1)/2 relative prices in any given period.

The menu costs we have discussed are a large part of transaction costs.

customer markets and auction markets for products (He also made a similar distinction between casual and career labour markets). For instance, washing machines and doctor visits will come under the former, while oil and wheat traded on the commodities exchange market will come under the latter. This distinction somewhat corresponds to branded, differentiated products with different prices and unbranded homogenous products with a uniform price.13 In auction markets, prices are based on current demand and supply conditions and respond fairly quickly to changes in demand. There are no price tags and hence no major menu costs. Menu costs are one part of transactions costs. However, the informational costs of sorting out absolute versus relative price changes from quoted prices will still be there in auction markets.

in customer markets, prices are not set so as to maximize current period profits. Instead they are based on multi-period considerations. Prices are based on implicit contracts, largely formed based on notions of trust and fairness. These implicit contracts are made between retailers and consumers, and also between workers and firms.

a profit maximizing firm sets price equal to marginal cost to maximize current period profits. But in reality firms often set price as some mark up over some measure of average cost, even when marginal cost is rising, and often do not change it even when demand rises in subsequent periods.

transaction costs and implicit contracts play a far greater role in price formation. Prices are not sticky per se. It is more accurate to say that, in customer markets, prices respond quickly to changing costs, but not to changing demand,

One way to signal to the buyer the reliability and quality of a product is by maintaining the price. Firms selling a branded product will make deliberate efforts to continue selling at the same price to retain loyal customers.

Fast Moving Consumer Goods firms would often resort to shrinking the product size to avoid raising prices.17 We can call this the ‘shrinkage’ effect of inflation, i.e., less quantity for the same price.

The shrinkage effect is a hidden cost and indicates that actual inflation is higher than reported inflation.

LIFO valuation comes as close as possible to the economists’ concept of opportunity cost, while still being based on actual shipments.

Inflation pushes up nominal income and people move into higher tax brackets with the same real income. This is called ‘bracket creep’, and occurs whether or not inflation is anticipated. Changing the tax brackets every period to tackle the problem of bracket creep makes financial planning difficult for firms and individuals.

Inflation has other side effects. It leads to output disruptions as workers strike for higher wages, sometimes due to higher inflation.

at low to moderate inflation rates, although MEW falls as in our IAPC model, the evidence tends to suggest that there is no solid negative impact of inflation on growth.

Disinflation is a fall in the inflation rate, after which the price level is stable or keeps rising slowly. By contrast, deflation refers to a fall in the price level. While the former is considered desirable, the latter involves huge costs.

economies can cope far more easily with inflation than with deflation. “For the mechanism of the modern business world is even less adapted to fluctuations in the value of money upwards than it is to fluctuations downwards

The benefits of low inflation versus the costs of a stable price level involve the process of relative price adjustment.

When inflation is very high, a currency reform (an administrative decision to knock off a few zeroes from the currency and thereby, from all prices) will lower the price level.22 Currency reforms are a dramatic change: they tend to get done only with very high inflation rates. However, this need not lead to a strict vertical downward movement on the Phillips Curve, which relates to the inflation rate. By knocking off the zeroes, the currency reform wills slightly lower the menu costs and enhance the value of small currency that had disappeared from circulation. However, despite the lower price level, inflation is likely to continue if wage and prices agreements continue to increase at the ongoing inflation rate. Both conceptually and practically, lowering the inflation rate is different from lowering the price level. The former involves the prolonged period of economic slack and hardship that lowers inflation and expected inflation via the EAPC process. The latter requires a re-engineering of the payment system replacing old currency with new currency ones.

Most disinflations in practice involve the EAPC process and a policy of pushing up unemployment and creating a corresponding (negative) ADSGAP such that inflation comes down.

Based on this output version of the EAPC, we can define what is called the ‘Sacrifice Ratio’ – the cumulative percentage loss of a year’s GDP that needs to be reduced to reduce inflation by one percentage point. This ratio is calculated as follows: in any given year, take the percentage loss in output, measured by the ADSGAP. Add the cumulative losses and divide by the sustained drop in inflation, i.e., the difference between the starting and ending values of inflation corresponding to L.R.E.

gradualist strategy, where the URATE is slowly raised and then lowered.

a ‘cold turkey’ strategy, inducing a huge rise in URATE and a drop in GDP for a shorter period.

“Volcker disinflation”

To calculate the sacrifice ratio, let us take 5.5% as the value of the U* (assumed unchanging) over this period. Also, let us take the starting (LRE) value of inflation to be 11.5% (3 year average of 1978 to 1980), which fell by 7 percentage points. The cumulative excess of U above U* over the decade was 18 percentage points. Thus, we can calculate the sacrifice ratio for URATE as 18 / 7, about 2.5. With an inverse lokun coefficient of 2.5, that implies a sacrifice ratio of 1 for GDP with regard to inflation.

General Form: p = p expected + θ [ADSGAP] Specific Function: p = pt–1 + 0.5 [ADSGAP] What are the factors that determine θ, the slope of the short run Phillips Curve? From the ‘transaction costs’ angle, as in Okun, the value of θ will depend on the structure of the economy. If the share of auction/commodity markets in the economy is high, the expansion of nominal GNP demand will mostly go into prices and will not go into output. Vice versa, if the manufacturing and services sectors, which have customer markets with sticky prices, are large. Similarly, if the share of workers locked into predetermined wage contracts is high, then the short run wage Phillips Curve will be flat. Note that these two approaches need not be mutually exclusive. Suppose all the products in the economy is produced in customer markets and all the workers are in career markets, i.e., inflation rates for prices and wages are predetermined in the previous periods. This is a case of lagged inflation (backward looking) adjustment rather than forward looking expected inflation.

Cold turkey policy seeks to reduce inflation very quickly by pushing up unemployment very high compared to gradualist policy. For a given Phillips curve coefficient, total output loss (or rise in unemployment) is the same but takes place over fewer years. So sacrifice ratio is the same. But if the disinflation is credible, in a cold turkey policy expected inflation will fall more sharply than inflation falls. Hence, the economy returns to long run equilibrium even quicker than predicted by the numerical values in the existing EAPC. Hence the total sacrifice and the sacrifice ratio turns out to be lower, as during the Volcker disinflation.