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Money and Inflation Theory and Evidence.

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1 Money and Inflation Theory and Evidence

2 Monetary Policy and Inflation
“Inflation is always and everywhere a monetary phenomenon.” – Milton Friedman Historical evidence suggests a strong link between high growth rates in the money supply and high inflation Does 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 goods When the number of dollars increases, but the number of goods does not, then prices must rise.

3 Hyperinflation A period of abnormally high growth in the cost of living is a hyperinflation Behind 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 day In 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 issued Pretty much just dropped nine zeros off a billion mark note, but the psychological effect mattered.

4 Overstamped as a million Mark note
Hyperinflation Overstamped as a million Mark note 1000 Mark Note In Germany in 1923, prices were rising by 40% per day $100  $140 (1 day). $100  $753 (1 week). $100  $1.7 million (1 month)

5 More from the German Hyperinflation
50 Marks, 1919 100 Billion Marks, 1924 5,000 Marks, 1922 1 Rentenmark, 1924

6 Money and Hyperinflation

7 Hyperinflations Between August 1945 and July 1946, prices in Hungary rose by 19,000% per month. This translates into a 39% increase in prices every day Bolivia 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%

8 Inflation and Money: Theory
Empirical evidence suggests a causal relationship between money growth and inflation A theoretical link may be established using the AD-AS model The basic intuition is that increasing the money supply will give people more spending power, but does not actually increase productive capacity As a result, prices must eventually rise to account for increased demand without any increase in supply Increasing 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.

9 Money and Inflation: Theory

10 Inflation is Purely a Monetary Phenomenon
Recall that we define inflation as the percentage change in the cost of living from one year to the next A 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 increase Suppose government spending increases by 20% next year Prices 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.



13 So 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 Inflation The 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 Inflation Worker 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 Deficits The government finances its budget deficit by printing more money or getting the central bank to buy government bonds which it then retires.

14 Demand-Pull Inflation

15 Cost-Push Inflation SRAS3 LRAS P5 SRAS2 P4 SRAS1 P3 P2 AD3 P1 AD2 AD1

16 Budget Deficits and Inflation
There are three ways a government can pay for its purchases With money from tax revenue With money borrowed from the public in the form of bonds With 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 + ΔB If 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 hold Budget deficits are notable causes of inflation in countries with shallow credit markets.

17 Why 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.

18 US Inflation Budget Deficits (as a % of GDP) actually declined during this period. Demand-Pull Inflation ( ) Policymakers targeted a 4% unemployment rate Natural 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 policy Workers pushed for higher wages, raising costs and prices. Fed’s continued intervention encouraged more workers to push for higher wages.


20 How 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 lag Recognition lag Legislative lag Implementation lag Effectiveness lag

21 Should we let the economy self-correct?

22 How 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 matter Suppose 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.

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