Money and Banking Chapter 25 Inflation and Money

Chapter 25 Inflation and Money CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Describe the strongest evidence for the model that links money supply growth to inflation . Explain what the aggregate demand ( model , a structural model , says about money supply growth and the price level . Explain why central bankers allow inflation to occur year after year . Define lags and explain their importance . URL books 508

Empirical Evidence of a Link LEARNING OBJECTIVES . What is the strongest evidence for the model that links money supply growth to inflation ?

What does the model , a structural model , say about money supply growth and the price level ?

Milton claimed that is always and everywhere a monetary We know this isn entirely true because , as we saw in Chapter 23 Aggregate Supply and Demand , the Growth Diamond , and Financial Shocks , negative aggregate supply shocks and increases in aggregate demand due to stimulus can also cause the price level to increase . Large , sustained increases in the price level , however , are indeed caused by increases in the money supply and only by increases in the money supply . The evidence for this is overwhelming all periods of from and French Revolutions to the German World War I , to more recent episodes in Latin America and Zimbabwe , have been accompanied by high rates ofmoney supply ( growth . Moreover , the increases in some circumstances were exogenous , so those episodes were natural experiments that give us confidence that the model correctly considers money supply as the causal agent and that reverse causation or omitted variables are unlikely . Stop and Think Box During the American Civil War , the Confederate States of America ( or the South ) issued more than billion of fiat paper currency similar to today Federal Reserve notes , far more than the economy could support at the prewar price level . Confederate dollars fell in value from cents in specie in 1862 to cents in 1863 , to cents in 1865 , a level of currency depreciation ( that some economists think was simply too high to be accounted for by Confederate money supply growth alone . What other factors may have been at play ?

Hint Over the course of the war , the Union the North imposed a blockade of southern trade that increased in efficiency during the course of the war , especially as major Confederate like New Orleans and Norfolk fell under northern control . URL books 509

A negative supply shock , the almost complete cutoff of foreign trade , could well have hit poor Johnny Reb ( the South ) as well . That would have decreased output and driven prices higher , prices already raised to lofty heights by continual emissions of too much money . Economists also have a structural model showing a causal link between money supply growth and at their disposal , the model . Recall that an increase in causes curve to shift right . That , in turn , causes the AS curve to shift left , leading to a return to , but higher prices . If the grows and grows , prices will go up and up , as in Figure as a response to a continually increasing money supply . Figure as a to a continually increasing ( Aggregate Price Level , AD , Aggregate Output , Nothing else , it turns out , can keep prices rising , rising , ever rising like that because other variables are bounded . An increase in government expenditure will also cause AD to shift right and AS to shift left , leaving the economy with the same output but higher prices in the long run ( whatever that is ) But if stops growing , as it must , then stops rising and ( the change in ) goes to zero . Ditto with tax cuts , which can fall below zero ( or even get close to it ) So policy alone can create a sustained rise in prices . Or a sustained decrease either . URL books 510

Negative supply shocks are also events , not the of sustained increases in prices . An oil embargo or a wage push will cause the price level to increase ( and output to fall , ouch ! and negative shocks may even follow each other in rapid succession . But once the AS curve is done shifting , that stays put . Moreover , if falls below , in the long run ( again , whatever that is ) increased unemployment and other slack in the economy will cause AS to shift back to the right , restoring both output and the former price level ! So , again , was right , in the sense of continual increases in prices , is always a monetary phenomenon and only a monetary Stop and Think Box Figure US . and growth compares with two years . What does the data tell you ?

Now look at Figure Government ratio and Figure US . unemployment rates , What caused to grow during the 19605 ?

Figure and growth and Percent 1961 1962 1963 1965 1966 1967 1968 1970 1971 1972 Year I I ( Legged Vears ) URL books Figure ratio 75 70 Percentage 55 50 1964 1965 1967 1968 1970 1971 1972 Yea Figure . unemployment rates , URL books 512 Unemployment Rates . Percent Unemployed Year 1961 1962 1964 1966 1967 1968 1969 1971 Year The data clearly show that was growing over the period and likely causing with a lag . grew partly because federal increased faster than the economy , increasing the ratio , leading to debt monetization on the part of the Fed . Also , unemployment rates fell considerably below the natural rate of unemployment , suggesting that was taking place as well . KEY TAKEAWAYS Throughout history , exogenous increases in have led to increases in . Every hyperinflation has been preceded by rapid increases in money supply growth . The model shows that money supply growth is the only thing that can lead to inflation , that is , sustained increases in the price level . This happens because monetary stimulus in the short term shifts the AD curve to the right , increasing prices but also rendering , i . Unemployment drops , driving up wages , which shifts the AS curve to the left , back to , and yet higher . Unlike other variables , the can continue to grow , initiating round after round of this dynamic . URL books 513

Other variables are bounded and produce only changes in . A negative supply shock or wage push , for instance , increases the price level once , but then price increases stop . Similarly , increases in government expenditures can cause to rise by shifting AD to the right , but unlike increases in the , government expenditures can increase only so far politically and practically ( to 100 percent of ) A Monetary History of the United States , This is not to say , however , that negative demand shocks might not contribute to a general monetary inflation URL books 514

Why Have Central Bankers So Often Gotten It Wrong ?

LEARNING OBJECTIVES . Given the analysis in this chapter , why do central bankers sometimes allow inflation to occur year after year ?

What are lags and why are they important ?

Ifthe link between money supply growth and is so clear , and ( inveterate debtors ) has anything but , why have central bankers allowed it to occur so frequently ?

Central bankers might be more privately interested than publicly interested and somehow personally from . They might score points with politicians for stimulating the economy just before an election or they might take out big loans and repay them after the period in nearly worthless currency . Assuming central bankers are publicly interested but far from prescient , what might cause them to err so often ?

In short , lags and policies . A lag is an amount of time that passes between a cause and its eventual effect . Lags in monetary policy , showed , were long and Data lag is the time it takes for to get important information , like ( and unemployment . Recognition lag is the time it takes them to become convinced that the data is accurate and indicative of a trend and not just a random perturbation . Legislative lag is the time it takes legislators to react to economic changes . This is short for monetary policy , but it can be a year or more for policy . Implementation lag refers to the time between policy decision and implementation . Again , for modern central banks using open market purchases ( this lag is minimal , but for changes in taxes , it can take a long time indeed . The most important lag of all is the effectiveness lag , the period between policy implementation and results . All told , lags can add up to years and add considerable complexity to monetary policy analysis because they cloud relationships . Lags also put perpetually behind the , constantly playing . Lags force to forecast the future with accuracy , something ( as we ve seen ) that is not easily done . As noted in earlier chapters , economists don even know when the short run becomes the long run ! books 515

Consider a case of brought about by a negative supply shock or wage push . That moves the AS curve to the left , reducing output and raising prices and , in all likelihood , causing unemployment and political angst . unable to await the long term ( the rightward shift in AS because has fallen below i , causing unemployment and wages to decline ) may well respond with what called accommodative monetary policy . In other words , they engage in expansionary monetary policies ( which shift the AD curve to the right , causing output to increase ( with a lag ) but prices to rise . Because prices are higher and they ve been recently rewarded for their with accommodative monetary policy , workers may well initiate another wage push , starting a vicious cycle by increases in and yet more wage pushes . and other shake their heads at this dynamic , arguing that if workers wage pushes were met by periods of higher unemployment , they would soon learn to stop . After all , even and rats eventually learn to stop pushing buttons if they are not rewarded for doing so . They learn even faster to stop pushing if they get a little shock . An episode can also touch monetary policy and a bout of . If the government sets its full employment target too high , above the natural rate , it will always look like there is too much unemployment . That will eventually tempt into thinking that is , inducing them to implement an EMP . Output will rise , temporarily , but so too will prices . Prices will go up again when the AS curve shifts left , back to , as it will do in a hurry given the low level of unemployment . The shift , however , will again increase unemployment over the government unreasonably low target , inducing another round of EMP and price increases . Another source of is government budget . To cover their expenditures , governments can tax , borrow at interest , or borrow for free by issuing money . Which would you choose ?

Taxation is politically costly . Borrowing at interest can be costly too , especially if the government is a default risk . Therefore , many governments pay their bills by printing money or by issuing bonds that their respective central banks then buy with money . Either way , the monetary base increases , leading to some multiple increases in the , which leads to . Effectively a tax on money balances called a currency tax , is easier to disguise and much easier to collect than other forms of URL books 516

taxes . Governments get as addicted to the currency tax as individuals get addicted to crack or meth . This is especially true in developing countries with weak ( not independent ) central banks . Stop and Think Box Why is central bank independence important in keeping at bay ?

Independent central banks are better able to withstand political pressures to monetize the debt , to follow accommodative policies , or to respond to ( seemingly ) high levels of unemployment with an EMP . They can also make a more believable or credible commitment to stop , which ( as well see in Chapter 26 Rational Expectations Redux Monetary Policy Implications ) is an important consideration as well . KEY TAKEAWAYS scenarios aside , publicly interested central bankers might pursue high employment too vigorously , leading to inflation via and mechanisms . If workers make a successful wage push , for example , the AS curve will shift left , increasing , decreasing , and increasing unemployment . If are anxious to get out of recession , they might respond with an expansionary monetary policy ( EMP ) That will increase but also yet again . Such an accommodative policy might induce workers to try another wage push . The price level is higher after all , and they were rewarded for their last wage push . The longer this dynamic occurs , the higher prices will go . might fall into this trap themselves if they underestimate full employment at , say , 97 percent ( percent unemployment ) when in fact it is 95 percent ( percent unemployment ) Therefore , unemployment of percent looks too high and output appears to be Ym , suggesting that an EMP is in order . The rightward shift of the AD curve causes prices and output to rise , but the latter rises only temporarily as the already tight labor market gets tighter , leading to higher wages and a leftward shift of the AS curve , with its concomitant increase in and decrease in . If original and flawed estimate of full employment is maintained , another round of AD is sure to come , as is higher prices . URL books 517

Budget deficits can also lead to sustained inflation if the government its debt directly by printing money ( and deposits ) or indirectly via central bank open market purchases ( of government bonds . Lags are the amount of time it takes between a change in the economy to take place and to effectively do something about it . That includes lags for gathering data , making sure the data show a trend and are not mere noise , making a legislative decision ( implementing policy ( if applicable ) and waiting for the policy to affect the economy . Lags are important because they are long and variable , thus complicating monetary policy by making central bankers play constant and also by clouding relationships . URL books , 518

Suggested Reading Ball , and the Theory of Money . Aldine Transaction , 2007 . Economics of . Auburn , AL Ludwig Von Institute , 2007 . Robert . The and Its Aftermath The Past and Future . New York Random House , 2008 . URL books 0791 ) 519