1. Copyright  2011 Pearson Canada Inc. 26 - 1 Chapter 26 Money and Inflation

2. Copyright  2011 Pearson Canada Inc. 26 - 2 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

3. Copyright  2011 Pearson Canada Inc. 26 - 3 German Hyperinflation 1921-1923

4. Copyright  2011 Pearson Canada Inc. 26 - 4 Views of Inflation The Continuous Money Growth Produced Inflation Three kinds of an increase in money supply: 1) once-for-all increase in money supply 2) continuous and constant increase in money supply 3) continuous and accelerating increase in money supply One and for all increase in Price Level is not ‘(Permanent) Inflation’ Only 2) and 3) can cause permanent inflation Inflation is always and everywhere a monetary phenomenon

5. Copyright  2011 Pearson Canada Inc. 26 - 5 Response to a Unexpected Continually Rising Money Supply 1->1’->2->2’->3->3’->4

6. Copyright  2011 Pearson Canada Inc. 26 - 6 Response to a Anticipated and Continually Rising Money Supply: 1->2->3->4

7. Copyright  2011 Pearson Canada Inc. 26 - 7

8. Can Fiscal Policy alone Produce Inflation?: Can Expansionary Fiscal Policy or Government Deficits lead to an increase in Price Level? Only when the deficits are financed by Money Creation or an Increase in Money Supply? That happens only when Bonds are sold to the Central Bank and the proceeds are spent on domestically produced goods. Thus a ‘permanent inflation’ is only possible when persistent deficits are continuously funded by money creation. Copyright  2011 Pearson Canada Inc. 26 - 8

9. Copyright  2011 Pearson Canada Inc. 26 - 9 Budget Deficits and Inflation I Government Budget Constraint DEF = G – T =  MB +  B Where: G = government spending T = tax revenues MB = Bonds sold to the central bank = monetary base *Just printing money for G is unconstitutional in most developed countries; At least on surface this takes the form of the Ministry of Finance selling the bonds to the Central Bank B = Bonds sold to the general public Deficit financed by B, no effect on MB and M s Deficit not financed by B, MB and M s 

10. Hypothesis of Ricardian Equivalence This is the case where government expenditures are completely financed by bond sales to the general public(dG = dDeficits =d Bonds). The public are far-sighted and concerned about the welfare of the future generation; and behave responsibly by buying the bonds and bequeathing the bonds for the next generation (dBonds = d Savings) Nothing would happen to Money Supply (MS) or interest rate(i). Copyright  2011 Pearson Canada Inc. 26 - 10

11. Copyright  2011 Pearson Canada Inc. 26 - 11 Can Fiscal Policy alone Produce Inflation?: (Only one time increase in Price Level is not Inflation)

12. Copyright  2011 Pearson Canada Inc. 26 - 12 Can Supply-Side Phenomena alone Produce Inflation? No.

13. Copyright  2011 Pearson Canada Inc. 26 - 13 Origins of Inflationary Monetary Policy I Inflation occurs only when money supply keeps increasing (over and again): When does the continuous increase in money supply occur? 1) Cost-push inflation –Cannot occur without monetary authorities pursuing an accommodating policy 2)Demand-pull inflation 3) Budget deficits –Can be the source only if the deficit is persistent and is financed by creating money or selling bonds to the central bank.

14. Copyright  2011 Pearson Canada Inc. 26 - 14 Origins of Inflationary Monetary Policy II Two underlying reasons –Adherence of policymakers to a high employment target –Presence of persistent government budget deficits

15. Copyright  2011 Pearson Canada Inc. 26 - 15 High Employment Targets and Inflation

16. Copyright  2011 Pearson Canada Inc. 26 - 16 The Choice Between Activist and Non-Activist Policy

17. Copyright  2011 Pearson Canada Inc. 26 - 17 Demand-Pull Inflation

18. Copyright  2011 Pearson Canada Inc. 26 - 18 Budget Deficits and Inflation I Government Budget Constraint DEF = G – T =  MB +  B Where: G = government spending T = tax revenues MB = Bonds sold to the central bank = monetary base *Just printing money for G is unconstitutional in most developed countries; At least on surface this takes the form of the Ministry of Finance selling the bonds to the Central Bank B = Bonds sold to the general public Deficit financed by B, no effect on MB and M s Deficit not financed by B, MB and M s 

19. Copyright  2011 Pearson Canada Inc. 26 - 19 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(bonds sold to the central bank) rather than by bonds sold to the general public

20. Copyright  2011 Pearson Canada Inc. 26 - 20 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

21. Copyright  2011 Pearson Canada Inc. 26 - 21 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 no need for the Bank of Canada to purchase bonds to keep interest rates from rising

22. Copyright  2011 Pearson Canada Inc. 26 - 22 Interest Rates and Government Deficits

23. Copyright  2011 Pearson Canada Inc. 26 - 23 Inflation and Monetary Growth in Canada 1960-2008

24. Copyright  2011 Pearson Canada Inc. 26 - 24 Government Debt to GDP Ratio Canada 1960-2007

25. Copyright  2011 Pearson Canada Inc. 26 - 25 Unemployment and the Natural Rate of Unemployment, Canada 1960-2008

26. Copyright  2011 Pearson Canada Inc. 26 - 26 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

27. Copyright  2011 Pearson Canada Inc. 26 - 27 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

28. Copyright  2011 Pearson Canada Inc. 26 - 28 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