Chapter 26 Money and Inflation

Milton Friedman stated “inflation is always and everywhere a monetary phenomenon” We will perform some thought experiment and empirical investigation.

Thought experiment In an economy, if money supply doubles and real economy remains the same, will there be inflation? In an economy, if money supply remains the same and real economy shrinks by half, will there be inflation?

Thought experiment (Continued) If a country is an oil consumer and the market price of oil increases, can a monetary policy be applied to maintain zero inflation rate without affecting the living standard?

Empirical evidences In the textbook, several historical examples were used to support Friedman’s view. We will reinvestigate these examples. –Germany –Latin America

Germany ( ) Keynes, in his The economic consequences of the peace, had warned explicitly the disastrous impact of the reparations imposed on Germany

Germany ( ) In the textbook, it stated, The invasion of the Ruhr and the printing of currency to pay striking workers fit the characteristics of an exogenous event. However, the invasion of the Ruhr by the French can hardly be classified as an exogenous event. It is an integral part of the enforcement of the reparations that put great burden over German people and the German government.

Germany ( ) The reparations were explicitly designed to permanently weaken German economy. It is a little more than disingenuous to blame the resulting economic disaster in Germany on the victims themselves.

Latin America In the textbook, it states The explanation for the high rates of money growth in these countries is similar to the explanation for Germany during its hyperinflation. The unwillingness of Argentina, Brazil, and Peru to finance government expenditures by raising taxes led to large budget deficits, which were financed by money creation.

It is interesting to note that economists, who usually promote low tax rates to stimulate incentives in domestic politics, rarely shy away from advocating high tax burden on already impoverished people in foreign countries. Why?

What are government expenditures in these countries exactly? They include paying heavy interest on foreign debt. This is very similar to Germany after WWI. All these rapid inflations have the common property of huge foreign debts, which greatly crippled their domestic economy and impoversihed local people.

from Stiglitz But it soon became obvious that this was not what the IMF was all about at all … That was not their mindset. They were interested in one thing. They looked at the country and thought, “they need to repay the loans they owe to Western banks. How do they get that happen? So they would never ask, “should we give this developing country a bankruptcy procedure so they can have a fresh start?” They thought that bankruptcy was a violation of the sanctity of contracts, even though every democracy has a bankruptcy law for people who have persistently failed. They were interested in milking money out of the country quickly, not rebuilding it for the long term.

Can monetary policy alone insure good economic performance, as claimed by many monetarists? Slashing government program and raising taxes will hurt living standard. Can you resolve your personal financial deficit by borrowing alone? There is no painless way out of a persistent deficit, whether at a personal level or country level.

From the textbook, To sum up, although high inflation is “always and everyewhere a monetary phenomenon” in the sense that it cannot occur without high rate of monetary growth, there are reasons why this inflationary monetary policy might come about. The two underlying reasons are the ahdherence of policymakers to a high employment target and the presence of persistent government budget deficits. (p. 654)

If we look at today’s BC and Alberta economy, it is difficult not to have a high employment rate and to run government deficit. Therefore, underlying economic condition is the most important factor affecting inflation and other monetary phenomena. Simply put, living beyond one’s mean, whether at personal and scale bigger, is unsustainable.

Some empirical evidence However, the linkage between money growth and inflation after 1980 is not at evident in Figure (p. 656) It would to better to combine the economic output and money output to understand inflation.

HOmework 4, 6, 10.

Extra homework Inflation rate is calculated from the weighted average of price increase from the various economic products. Since people tend to decrease spending on products whose prices increases substantially and increase spending on products whose prices decline or increase less, the change of weights of consumer spending often highly correlated with price changes. This may make CPI a less reliable measure of inflation over a long period of time. We will use a numerical example to illustrate this. Suppose there are two products in an economy. Initially, product A is weighted 30% in economy and product B is weighted 70%. In the first period of time, product B’s price increased by 20% and product A’s price remains the same. In period 1, product A is weighted 70% in economy and product B is weighted 30%. Calculate the CPI of the economy is period 1. In the second period of time, product A’s price increased by 20% and product B’s price remains the same. In period 2, product B is weighted 70% in economy and product A is weighted 30%. Calculate the CPI of the economy is period 2. What is the average of inflation rate in the two time periods calculated from the average of CPI? If we calculate the average inflation rate from the price data from the beginning to end, what will be the average inflation rate? Which number reflect the reality more truthfully? Why? In an economy, if money supply doubles and real economy remains the same, will there be inflation? In an economy, if money supply remains the same and real economy shrinks by half, will there be inflation? Milton Friedman stated that “inflation is always and everywhere a monetary phenomenon”. Do you agree or not? Why?