money and inflation

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

Chapter 26

Money and Inflation

Money and Inflation: Evidence

e Inflation is always and everywhere a monetary phenomenon

e 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

FIGURE 26-1 Money Supply and Price Level in the German Hyperinflation

Source: Frank D Graham, Exchange, Prices and Production in Hyperinflation: Germany, 1920-25

(Princeton, N.J.: Princeton University Press, 1930), pp 105-106

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Response to a Continually Rising Money

FIGURE 26-2 _ Response to a Continually Rising Money Supply

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Can Fiscal Policy Produce Inflation?

LRAS Aggregate

Price Level, P

Aggregate Output, Y

FIGURE 26-3 _ Response to a One-Shot Permanent Increase in Government Expenditure

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Can Supply-Side Phenomena Produce Inflation?

LHAS

Aggregate Price Level, P

FIGURE 26-4 _ Response to a Supply Shock

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Origins of Inflationary Monetary Policy |

¢ Cost-push inflation

— Cannot occur without monetary authorities

pursuing an accommodating policy

¢ Demand-pull inflation

e Budget deficits

— Can be the source only if the deficit is persistent

and is financed by creating money rather than by issuing bonds

Origins of Inflationary Monetary Policy I

® Two underlying reasons

— Adherence of policymakers to a high employment target

— Presence of persistent government

budget deficits

High Employment Targets and Inflation

FIGURE 26-5 Cost-Push Inflation with an Activist Policy to Promote High

Employment

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Demand-Pull Inflation

Budget Deficits and Inflation |

Government Budget Constraint

DEF=G—T=AMB+ AB Where: G = government spending

T = tax revenues

MB = monetary base

B = Bonds

° Deficit financed by bonds, no effect on MB and Ms

° Deficit not financed by bonds, MB and Ms T

Budget Deficits and Inflation I

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

Budget Deficits and Money Creation

in Canada |

e Financing persistent deficits by selling bonds

increases the supply of bonds, drives bond prices

down and interest rates up

e If the Bank of Canada prevents higher interest rates

by buying increasing amounts of bonds, the net

result is open market operations

e This can increase the monetary base and the money supply, resulting in inflation

Budget Deficits and Money Creation

in Canada II

e The Ricardian Equivalence contends (given

government deficits) the public will increase savings

in anticipation of higher future taxes

e Increased savings take the form of increased demand for bonds, matching the increased supply

e 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

Interest Rates and Government Deficits

Price of Bonds, P

Quantity of Bonds, B

FIGURE 26-7 Interest Rates and the Government Budget Deficit

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Inflation and Monetary Growth in Canada

0002022020010 010.1010100 06.1.0.0.(.ỏ

FIGURE 26-8 Inflation and Money Growth, 1960—2007

Source: IMF, International Financial Statistics

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Government Debt to GDP Ratio Canada

1960-2007

90r- 80[- 70Ƒ 60[Ƒ 50[—

40}- 30Ƒ 20Ƒ-

FIGURE 26-9 Government Debt-to-GDP Ratio, 1960—2007

Source: Statistics Canada, CANSIM II Series V34441 and V498086

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Unemployment and the Natural Rate of

Unemployment, Canada 1960-2008

FIGURE 26-10 Unemployment and the Natural Rate of Unemployment, 1960—2008

Source: Historical Statistics of Canada, Second Edition, Catalogue 11-516, 1983; Statistics Canada,

CANSIM II Series V2062815; and authors’ calculations

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Discretionary/Nondiscretionary

Policy Debate |

e Discretionary policy advocates view self-

correcting mechanism as slow

e Relevant lags slow activist policy

Discretionary/Nondiscretionary

Policy Debate II

e Nondiscretionary advocates believe

government should not get involved

— Activist accommodating policy produces volatility

in both the price level and output

The Choice Between Activist and

Aggregate LRAS AS,

Price Level, P

Yụ, Yn Yo Aggregate Output, Y

FIGURE 26-11 _ The Choice Between Discretionary and Nondiscretionary 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

e 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