THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 699

CHAPTER 26

Money and Inflation 667

MO NE Y AN D IN FL ATI O N: EV ID EN CE
The evidence for Friedman s statement is straightforward. Whenever a country s
inflation rate is extremely high for a sustained period of time, its rate of
money supply growth is also extremely high. Indeed, this is exactly what we
saw in Figure 1-5 (page 8), which shows that the countries with the highest inflation rates have also had the highest rates of money growth.
Evidence of this type seems to support the proposition that extremely high
inflation is the result of a high rate of money growth. Keep in mind, however, that
you are looking at reduced-form evidence, which focuses solely on the correlation
of two variables: money growth and the inflation rate. As with all reduced-form
evidence, reverse causation (inflation causing money supply growth) or an outside factor that drives both money growth and inflation could be involved.
How might you rule out these possibilities? First, you might look for historical
episodes in which an increase in money growth appears to be an exogenous event;
a high inflation rate for a sustained period following the increase in money growth
would provide strong evidence that high money growth is the driving force behind
the inflation. Luckily for our analysis, such clear-cut episodes hyperinflations
(extremely rapid inflations with inflation rates exceeding 50% per month) have
occurred, the most notorious being the German hyperinflation of 1921 1923.
In 1921, the need to make reparations and reconstruct the economy after World
German
Hyperinflation, War I caused the German government s expenditures to greatly exceed revenues. The government could have obtained revenues to cover these increased
1921 1923

expenditures by raising taxes, but that solution was, as always, politically
unpopular and would have taken much time to implement. The government
could also have financed the expenditure by borrowing from the public, but the
amount needed was far in excess of its capacity to borrow. There was only one
route left: the printing press. The government could pay for its expenditures

simply by printing more currency (increasing the money supply) and using it to
make payments to the individuals and companies that were providing it with
goods and services. As shown in Figure 26-1, this is exactly what the German
government did; in late 1921, the money supply began to increase rapidly, and
so did the price level.
In 1923, the budgetary situation of the German government deteriorated even
further. Early that year, the French invaded the Ruhr because Germany had failed to
make its scheduled reparations payments. A general strike in the region then ensued
to protest the French action, and the German government actively supported this
passive resistance by making payments to striking workers. As a result, government expenditures climbed dramatically, and the government printed currency at an
even faster rate to finance this spending. As displayed in Figure 26-1, the result of
the explosion in the money supply was that the price level blasted off, leading to an
inflation rate for 1923 that exceeded 1 million percent!
The invasion of the Ruhr and the printing of currency to pay striking workers
fit the characteristics of an exogenous event. Reverse causation (that the rise in the
price level caused the French to invade the Ruhr) is highly implausible, and it is
hard to imagine a third factor that could have been a driving force behind both
inflation and the explosion in the money supply. Therefore, the German hyperinflation qualifies as a controlled experiment that supports Friedman s proposition
that inflation is a monetary phenomenon.