Download Economics “Ask the Instructor” Clip 69 Transcript

Economics “Ask the Instructor” Clip 69 Transcript
Why should we care if the money supply is large or small or whether it is increasing at 20 percent per
year or 4 percent? After all, if aggregate supply is the main determinant of real Gross Domestic
Product, who cares about the money supply?
To answer this, we first need to consider some history. Society’s concept of money has evolved,
and we now have only fiat money. Fiat money is money that has no intrinsic value nor is it redeemable in
anything that has use as a commodity. In most respects, fiat money is good news. Why? Because it is
very wasteful of scarce resources to dig gold and silver to use it as money. It is equally wasteful to dig gold
and silver and then bury it at Fort Knox, Kentucky. However, this was done years ago because we believed
that currency and checking accounts had to be backed by gold or silver in order for them to function as
money. So what’s the bad news about fiat money?
Once we began using fiat money, there was no limit on the quantity. History shows that there is a
great temptation for society, through whatever institution controls money, to increase the supply of money
too much.
What do we mean by “grows too much”? Generally, the money supply is growing too fast if the
growth rate of money exceeds the growth rate of real output. Suppose, for example, that the economy is
operating at its potential rate of output; that is, we are at full employment. In other words, we are assuming
that the economy is on its long-run aggregate supply curve. How much would you guess output could
increase over the next 12 months? The labor supply can be expected to increase somewhat. Maybe the
nation’s capital stock will increase a little, allowing the average worker to have more or improved capital
goods. Maybe some better production methods might be adopted, but output cannot grow by a lot. What
happens if the money supply grows by 20 percent?
One way to summarize the sequence of events is as follows: The money supply grows, interest
rates fall, business investment increases, aggregate expenditure increases, and the aggregate demand curve
shifts to the right. The economy is operating in the upward-sloping segment of its short-run aggregate
supply curve. If aggregate supply can grow by only 2 or 3 percent, but aggregate demand has shifted
rightward by 20 percent, demand-pull inflation is bound to occur.
Is there any evidence that too much money causes inflation? Indeed there is. Between 1980 and
1990, the money supply in Bolivia grew on average at an annual rate of about 500 percent. The Bolivian
inflation rate averaged almost 300 percent per year over this period. The most dramatic example of
hyperinflation occurred in Germany following World War I. Historians report that the inflation rate
averaged more than 300 percent per month during many months in 1922 and 1923. The deutsche mark
pretty much ceased performing the functions of money, especially the store of value function. Inflation
was brought under control in Germany, but only after the government created an independent monetary
authority that issued a new currency.
We all have a lot at stake if the money supply grows too fast. This is especially true for people
who are net creditors and own assets denominated in dollars, like bonds and CDs. However, high inflation
harms everyone by increasing uncertainty and the cost of doing business, inducing consumers to resort to
barter exchange. The net result is lower living standards.