money and inflation

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Chapter 26
Money and Inflation
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Money and Inflation: Evidence
•
Inflation is always and everywhere a monetary
phenomenon
•
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
•
Reduced-form evidence
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German Hyperinflation 1921-1923
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Views of Inflation

•
The Money Growth Produced Inflation
•
Fiscal Policy
•
Supply Shocks
•
Always a monetary phenomenon
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Response to a Continually Rising Money
Supply
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Can Fiscal Policy Produce Inflation?
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Can Supply-Side Phenomena Produce Inflation?
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Origins of Inflationary Monetary Policy I
•

Cost-push inflation
–
Cannot occur without monetary authorities
pursuing an accommodating policy
•
Demand-pull inflation
•
Budget deficits
–
Can be the source only if the deficit is persistent
and is financed by creating money rather than by
issuing bonds
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Origins of Inflationary Monetary Policy II
•
Two underlying reasons
–
Adherence of policymakers to a high employment
target
–
Presence of persistent government
budget deficits
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High Employment Targets and Inflation

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Demand-Pull Inflation
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Budget Deficits and Inflation I
Government Budget Constraint
DEF = G – T = ∆MB + ∆B
Where: G = government spending
T = tax revenues
MB = monetary base
B = Bonds
•
Deficit financed by bonds, no effect on MB and M
s
•
Deficit not financed by bonds, MB and M
s
↑
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Budget Deficits and Inflation II
Financing persistent budget deficit by money creation
(monetizing debt – printing money) leads to sustained

inflation
Government Deficit is inflationary only if it is:
1. Persistent
2. Financed by money creation rather than by
bonds
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Budget Deficits and Money Creation
in Canada I
•
Financing persistent deficits by selling bonds
increases the supply of bonds, drives bond prices
down and interest rates up
•
If the Bank of Canada prevents higher interest rates
by buying increasing amounts of bonds, the net
result is open market operations
•
This can increase the monetary base and the money
supply, resulting in inflation
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Budget Deficits and Money Creation
in Canada II
•
The Ricardian Equivalence contends (given

government deficits) the public will increase savings
in anticipation of higher future taxes
•
Increased savings take the form of increased demand
for bonds, matching the increased supply
•
This leaves bond prices and interest rates unchanged
and there is now need for the Bank of Canada to
purchase bonds to keep interest rates from rising
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Interest Rates and Government Deficits
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Inflation and Monetary Growth in Canada
1960-2008
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Government Debt to GDP Ratio Canada
1960-2007
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Unemployment and the Natural Rate of
Unemployment, Canada 1960-2008
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Discretionary/Nondiscretionary
Policy Debate I
•
Discretionary policy advocates view self-
correcting mechanism as slow
•
Relevant lags slow activist policy
–
Data lag
–
Recognition lag
–
Legislative lag
–
Implementation lag
–
Effectiveness lag
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Discretionary/Nondiscretionary
Policy Debate II
•

Nondiscretionary advocates believe
government should not get involved
–
Activist accommodating policy produces volatility
in both the price level and output
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The Choice Between Activist and
Non-Activist Policy
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Expectations and
Discretionary/Nondiscretionary Debate
•
If expectations about policy matter, then
accommodating activist policy with high employment
targets may lead to inflation
•
Nonactivist policy may prevent inflation and
discourage leftward shifts in short-run aggregate
supply that lead to excessive unemployment
–
Must be credible
•
Constant-money-growth-rate rule