2Monetary Policy and Inflation “Inflation is always and everywhere a monetary phenomenon.” – Milton FriedmanHistorical evidence suggests a strong link between high growth rates in the money supply and high inflationDoes correlation imply causality here?Could some other variable be driving both inflation and money growth in the same direction?Why would money growth and inflation be related?Inflation is the result of too many dollars chasing too few goodsWhen the number of dollars increases, but the number of goods does not, then prices must rise.
3HyperinflationA period of abnormally high growth in the cost of living is a hyperinflationBehind every hyperinflation is an extremely high rate of growth in money.The German Hyperinflation,Costs of rebuilding and reparations payments induced the Weimar government to print more money.As the pace of money supply growth increased, so too did inflation.At one point prices were rising by 41% per dayIn 1921, a newspaper sold for 0.3 marks. By 1923, that same newspaper cost 70 million marks.Inflation became a self-fulfilling prophecy as people rushed to make purchases as soon as they received any money.Inflation only ended when confidence was restored in the value of the currency after the Rentenmark was issuedPretty much just dropped nine zeros off a billion mark note, but the psychological effect mattered.
4Overstamped as a million Mark note HyperinflationOverstamped as a million Mark note1000 Mark NoteIn Germany in 1923, prices were rising by 40% per day$100 $140 (1 day). $100 $753 (1 week). $100 $1.7 million (1 month)
5More from the German Hyperinflation 50 Marks, 1919100 Billion Marks, 19245,000 Marks, 19221 Rentenmark, 1924
7HyperinflationsBetween August 1945 and July 1946, prices in Hungary rose by 19,000% per month. This translates into a 39% increase in prices every dayBolivia in 1985 saw prices rise by 12,000%One story tells of a man who did just this. On his payday, he received 50 million pesos, and a dollar cost 500,000 pesos (the exchange rate). He was able to exchange his pay for $50. A few days later, a dollar cost 900,000 pesos, and he would only have been able to get $27 for his efforts. The value of his wage had essentially been cut in half over the course of two days.A less severe, but still high level of inflation occurred between 1970 and 1987 in Argentina, Bolivia, Brazil, Chile, Peru, and Uruguay, who collectively experienced an average annual inflation rate of 120%
8Inflation and Money: Theory Empirical evidence suggests a causal relationship between money growth and inflationA theoretical link may be established using the AD-AS modelThe basic intuition is that increasing the money supply will give people more spending power, but does not actually increase productive capacityAs a result, prices must eventually rise to account for increased demand without any increase in supplyIncreasing the money supply shifts the AD curve right. This expands output in the short run, but only prices in the long run.A sustained increase in the rate of money supply growth will lead to a sustained increase in the rate of inflation.
9Money and Inflation: Theory SRAS3LRASP4SRAS2SRAS1P3P2AD3P1AD2AD1YPY2
10Inflation is Purely a Monetary Phenomenon Recall that we define inflation as the percentage change in the cost of living from one year to the nextA one time increase in the money supply will cause prices to rise (positive inflation)An increase in the growth rate of the money supply will cause the rate at which prices rise (inflation) to increaseSuppose government spending increases by 20% next yearPrices will rise next year, but the increase in the level of government spending is only enough to increase prices once.A permanent increase in the growth rate of government spending could increase inflation, but there is an upper limit on how much the government can spend (no more than 100% of GDP)Similarly, temporary supply shocks can cause prices to change, but cannot cause changes in the rate of inflation.
13So why do we see inflationary monetary policy? If we agree that high inflation is bad and that high inflation can only be caused by expansionary monetary policy, why would the central bank ever choose to expand the growth rate of money?Demand-Pull InflationThe central bank is committed to an unemployment target below the natural rate, leading to a continual expansion of the money supply to push output above full employment.Cost-Push InflationWorker demands (or expectations of inflation) for higher salaries raise costs, leading to more unemployment. The central bank expands the money supply to restore full employment.Government Budget DeficitsThe government finances its budget deficit by printing more money or getting the central bank to buy government bonds which it then retires.
16Budget Deficits and Inflation There are three ways a government can pay for its purchasesWith money from tax revenueWith money borrowed from the public in the form of bondsWith money borrowed from the central bank (i.e. money printed up for the government).This is operationalized with the government budget constraint:DEF = G – T = ΔMB + ΔBIf the government finances a deficit through tax increases or borrowing directly from the public, there is no change in the money supply.If the government borrows from the central bank, it will cause the money supply to increase by m*ΔMB.A sustained budget deficit could lead to inflation if Ricardian Equivalence does not holdBudget deficits are notable causes of inflation in countries with shallow credit markets.
17Why did US Inflation Rise between 1960 and 1980? Inflation rose from about 1% per year in 1960 to over 10% per year toward the end of this period.Three candidates for why monetary policy was so expansionist during this period.
18US InflationBudget Deficits (as a % of GDP) actually declined during this period.Demand-Pull Inflation ( )Policymakers targeted a 4% unemployment rateNatural rate was closer to 5% or even 6%Cost-Push Inflation ( )Workers had gotten used to expansionary monetary policy.The expectation was that any unemployment caused by a strike for higher wages would be met by expansionary monetary policyWorkers pushed for higher wages, raising costs and prices.Fed’s continued intervention encouraged more workers to push for higher wages.
20How Active should Monetary Policy be? If the economy moves into recession, should the central bank intervene?If they do nothing, eventually the economy will self correct with full-employment output restored.How long does this self correction take?How much of a lag time is there before policy has an effect?Data lagRecognition lagLegislative lagImplementation lagEffectiveness lag
22How Active should Monetary Policy be? If the SRAS curve reacts more quickly to policy and economic conditions than the AD curve, then the best policy may be to do nothing.Expectations matterSuppose workers expected that the central bank would step in to eliminate any unemployment gaps.They will then push for higher wages, knowing that unemployment will be eliminated by expansionary monetary policy.AD shift right until full employment output is restored at a higher price.The accommodation by the central bank simply invites more wage demands.If the central bank had taken a non-activist stance, then eventually full employment output would be restored at the original price level.The central bank could have averted cost-push inflation by standing firm on non-intervention, sacrificing some unemployment now for lower inflation in the long run.