Download Week 15 (Chapter 26)

Week 15
Chapter 26
Money and Inflation
Relative price changes versus general increases in the price level
Suppose that the public decides buy more vegetable products and fewer meat
products. This will cause the prices for vegetable products to rise and those for
mean products to fall. This is not inflation—this is a change in relative prices.
Relative price increases are good things. They are necessary to get farmers to
produce more vegetables and less meat. Changes in relative prices is the
mechanism by which a capitalist society allocates resources between competing
uses (here the production of vegetables and meat).
Inflation is a sustained increase in all prices. Milton Friedman has stated that
“inflation is always and everywhere a monetary phenomenon.” Friedman means
that inflation can only be caused by sustained increases in the money supply.
Here we will look at some potential causes of inflation that have been suggested
by various economists in the past. By and large, however, these days most
economists tend to agree with Friedman.
The evidence from Latin America
Your text has a graph on page 665 showing the relationship between the
average inflation rate in the average money growth rate for a number of Latin
American countries from 1989 to 1999. The graph is almost a straight line.
Those countries with extremely high money growth rates all experience
extremely high inflation rates.
The German hyperinflation 1921—1923
The allies (Britain, France, and the U.S.) defeated Germany in World War I. After
the war the allies required that Germany pay for the damage created by the war
(“reparations”). Further they required that Germany pay in gold. The German
government was broke. Any reserves it had were needed to pay for the war
debt. The German government did not have any money left over to pay for its
own operations. Further no one would lend the government money because they
knew the government could not pay them back.
The government printed money to pay for its purchases and to pay its workers.
The German money supply started increasing rapidly in 1921. This meant that
prices started to increase and the Government had to print yet more money, and
so on, and so on… The inflation rate for 1923 exceeded one million percent.
Views of inflation
The monetarist view
Figure 26—1. Attempts to move the economy to a higher level of output than the
natural rate.
Suppose that the economy is in equilibrium at the natural rate level of output
where Y1D and Y1S intersect. Now suppose that policy maker want to drive the
economy to a higher level of output, say Y f . The Humphrey—Hawkins Act
defined a full employment level of unemployment to be 4%. This act requires the
government to try to obtain this level of unemployment (consistent with price
stability). The problem is that this level of unemployment may be lower than the
natural rate of unemployment so that the full employment level of output will be
higher than the natural rate level of output. We will call Y f the full employment
level of output.
Suppose that the government tried to shift aggregate demand from Y1D to Y2D by
lowering taxes or increasing government spending. A monetarist would claim
this attempt will fail because the government deficit must be financed either by
increased taxes or by borrowing. If a spending increase is financed by a tax
increase these will offset one another will no net increase in spending. If the
deficit is financed by borrowing, then the attempt to shift the aggregate demand
curve to the right will be frustrated by crowding out. Recall from a monetarist
point of view fiscal policy is ineffective.
Monetary policy would be successful in shifting the curve to the right, but then
this will start forcing up the price of inputs such as the wage rate and the price of
raw materials. This will start the aggregate supply curve shifting to the left. The
monetarists believe this adjustment would be very rapid. While the government
policy makers might succeed in driving the economy to the full employment level
for a short period of time, it could not keep the economy there unless there is a
continuing increase in the money supply.
The Keynesian view
The Keynesians will agree with the monetarists that using monetary policy to
continually push the aggregate demand curve to the left will be inflationary. They
would also agree that the aggregate supply curve will always return the economy
to the natural rate level of output.
Unlike the monetarists, Keynesians do believe that fiscal policy could shift the
aggregate demand curve. Might it not be the case that fiscal policy could be
inflationary? There is little doubt in the Keynesian view that a government
spending increase will shift the aggregate demand curve to the right. The
subsequent shift of the aggregate supply curve to the left will return the economy
to the natural rate level of output and unemployment. This would also increase
the price level. This would be a onetime increase in the price level which would
not be inflationary. Inflation requires sustained increases in the price level. This
could not occur unless the government continually increased spending. However
there must be a limit to how much spending the government can complete. The
government can’t purchase more output than the economy can produce. But the
limit of how much the electorate will tolerate will be reached long before that.
The same sort of thing would hold for tax decreases. The government cannot
continually decrease taxes. Eventually the tax rate would be zero and can’t be
reduced further.
This does not mean that Keynesians think that either monetary or fiscal policies
are useless. They would suggest that fiscal policy, aided by monetary policy are
useful in returning the economy to a natural rate level when there has been a
leftward shift in the aggregate demand curve.
Can shifts in the aggregate supply curve create inflation?
Recall that a negative supply side shock shifts the aggregate supply curve to the
left reducing output and raising prices. Such a shock occurred with oil prices in
the 1970s. The aggregate supply curve will gradually shift back to its original
position. This latter shift occurs because wages will decline if the economy is
producing to the left of the natural rate level of output.
This will result in a temporary increase in the price level. But the price level will
return to its original value over a period of time. Supply side shocks won’t be
inflationary.
Cost push inflation
The theory of cost--push inflation held some prominence at one time. The idea
was that workers would start inflation by demanding large real wage increases.
This is a negative supply side shock and shifts the aggregate supply curve to the
left. This would lead to unemployment and a slack labor market which would
drive down wage rates and shift the aggregate supply curve back to the right.
Suppose however, that the government used monetary or fiscal policy to shift the
aggregate demand curve to the right (which would occur if the government policy
makers were of the Keynesian persuasion). Both of these shifts would tend to
make prices rise, at least temporarily. But the price increase will lower real
wages, so workers will try again to increase real wages shifting the aggregate
supply curve to the left. Now if policy makers shift the aggregate demand curve
to the right by using monetary or fiscal policy then higher prices result and the
cycle will continue.
As we discussed earlier, fiscal policy tools are not adequate to continually shift
the aggregate demand curve to the right. Only monetary policy can do this. So
again, even if the cost—push story is true continual increases in the money
supply are necessary to sustain the inflation.
Demand—pull inflation
Actually we have already discussed demand—pull inflation, we just didn’t call it
that. Demand pull inflation would occur if the government tried to achieve a full
employment level of output, Y f , when the full employment level out output is
greater than the natural rate level of output Yn . This was illustrated in Figure
26—1. We concluded earlier that fiscal policy could not cause sustained
inflation, only continuous increases in the money supply could do that.
The government budget deficit
We discussed financing a government spending increase (by increasing taxes or
by Treasury borrowing from the public) in Chapter 24. There is another
possibility. Suppose the government does not want to raise taxes and finances
by borrowing. The public (banks and people) can lend the funds. The Fed could
decide to buy the bonds as well.
Assets
Securities
Discount loans
Gold and SDRs
Coin
Items in process of
collection
Other assets
490.7
0.2
18.2
0.3
6.0
528
15.5
4.5
0.2
4.9
56.8
19.1
Total
572.2 572.2
Liabilities + Net Worth
Federal Reserve Notes
outstanding
Bank deposits (reserves)
U.S Treasury deposits
Foreign deposits
Deferred availability cash
items
Other liabilities and
capital
Total
Figure 26—2. The Fed’s balance sheet (end of 1999)
If the public (anybody other than the Fed) buys these bonds this will not change
the monetary base. If a bank buys the security its reserves will decrease. But the
Treasury will deposits the proceeds in a bank which will increase that banks
deposits by an identical amount. So total reserves in the banking system remain
unchanged. This operation, however, is likely to lower bond prices and raise
interest rates. The Fed may decide to offset this by conducting an open market
operation to raise bond prices and lower interest rates.
If the Fed buys bonds this will increase reserves and increase the Feds holding
of securities. This will increase the monetary base and hence reserves.
Here we have discussed banks and the intermediary, but the same holds true for
the non--bank public. If the non--bank public purchases the bonds and pays the
Treasury by check this will reduce deposits and reserves. The Treasury will
deposit the check in a commercial bank which will increase that banks reserves.
Reserves for the entire banking system are unchanged. If the Fed now buys
securities from the non—bank public it does so by writing a check that will be
deposited and thus increase reserves and the monetary base. The non—bank
public could also increase its holdings of currency which would also increase the
monetary base.
The Fed could buy the issue from the Treasury. The Treasury will deposit the
proceeds with a commercial bank which will increase reserves. Note these are
not the same thing as Treasury deposits with the Fed. When the Treasury
spends it withdraws deposits from the commercial bank and deposits it with the
Fed. This reduces reserves in the banking system. The Treasury then will write
a check on its deposit with the Fed.
This process is called monetizing the debt. In countries where the government
can create money to pay for things the operation would be to increase currency
and pay bills. This would be printing money. The Fed does not actually print
money and give it to the treasury, but the effect is the same. Monetizing the debt
is often time called printing money.
This process will be inflationary if the Fed continually monetizes the debt. This
will require the Fed accommodate the Treasury for substantial time. If the Fed
does not monetize the debt, then inflation will not occur. Again inflation requires
a sustained increase in the money supply.
Questions
1) Monetarists and Keynesians both agree with Milton Friedman that
A) the demand for money is insensitive to changes in the interest rate.
B) velocity is predictable and fairly constant.
C) inflation is a monetary phenomenon.
D) the price level and the money supply are unrelated. all of the above are
true.
2) Evidence strongly supports the view that countries with high inflation also
have
A) the lowest nominal interest rates. B) the highest rates of money growth.
C) the smallest budget deficits.
D) the lowest interest rates.
3) The proposition that inflation is the result of a high rate of money growth is
A) not supported by evidence from Latin American countries.
B) held only by sociologists and is no longer believed by economists.
C) supported by evidence from inflationary episodes throughout the world.
D) largely a political fabrication designed to make the Fed a scapegoat for
poor fiscal policy.
4) The German authorities in the early 1920s appear to have resorted to
increasing the money supply as a way of raising revenues because
A) raising taxes would have been politically unpopular.
B) raising taxes would have been unconstitutional.
C) there was no way to collect taxes in those days.
D) none of the above.
5) A one-time increase in the money supply
A) is synonymous with inflation.
B) cannot cause inflation.
C) leads to an increase in the price level.
D) results in both (a) and (c) of the above.
E) results in both (b) and (c) of the above.
6) Factors other than money growth that can generate an inflation in monetarist
analysis include:
A) an increase in government spending.
B) a tax reduction.
C) an increase in net exports.
D) none of the above.
7) Factors other than money growth that can generate an inflation in Keynesian
analysis include
A) an increase in government spending.
B) a tax reduction.
C) an increase in net exports.
D) none of the above.
8) A one-shot increase in government expenditure causes
A) continual inflation.
B) continual wage increase.
C) a one-shot increase in the price level.
D) a one-shot increase in unemployment.
9) A one-shot increase in wages due to a successful wage push by labor unions
causes
A) continual inflation.
B) a one-shot increase in the price level.
C) a one-shot increase in real output
D) both (a) and (c) of the above to occur.
10) Which of the following help explain inflationary money growth?
A) The federal government's commitment to high employment since 1946
B) One-shot supply shocks
C) One-shot tax cuts
D) All of the above
11) Which of the following help explain inflationary money growth?
A) The federal government's commitment to high employment since 1946
B) Successful wage push by workers
C) Politicians unwillingness to raise taxes to finance increased government
expenditures
D) All of the above
14) If workers continually demand higher wages, which are accommodated by
expansionary monetary policy, the resulting inflation is known as
A) demand-pull inflation.
B) cost-push inflation.
C) not enough information to distinguish.
D) none of the above.
15) If budget deficits lead to a sustained inflation, it is true that the deficit can be
regarded as an initiating factor, but
A) money creation is the sustaining factor.
B) fiscal policy is the sustaining factor.
C) deficits cannot persist for long, so the type of inflation cannot last long.
D) none of the above are true.
16) For budget deficits to be inflationary, they must be
A) persistent.
B) financed by the creation of high-powered money.
C) financed by issuing bonds.
D) both (a) and (b) of the above.
E) both (a) and (c) of the above.
17) Evidence from episodes of hyperinflation indicates that
A) wage-push demands have been the ultimate source of inflationary
monetary policies.
B) supply shocks have been the ultimate source of inflationary monetary
policies.
C) huge government budget deficits have been the ultimate source of
inflationary monetary policies.
D) there is no common source of inflationary monetary policies.
18. If the government tried to drive output to a level greater than the natural
rate level, this could cause
a. cost—push inflation
b. demand—pull inflation
c. hyperinflation
d. disinflation
19. If workers tried to raise the real wage rate this could lead to
a. cost—push inflation
b. demand—pull inflation
c. hyperinflation
d. disinflation
20) According to the monetarist view of inflation, a continually increasing money
supply
A) causes the aggregate demand curve to shift continually to the right.
B) causes the aggregate demand curve to shift continually to the left.
C) is shown as a movement along the aggregate demand curve.
D) does none of the above.
21) Financing government spending by selling bonds to the public, which pays
for the bonds with currency,
A) leads to a permanent decline in the monetary base.
B) leads to a permanent increase in the monetary base.
C) leads to a temporary increase in the monetary base.
D) has no net effect on the monetary base.
22) Financing government spending with taxes
A) causes both reserves and the monetary base to rise.
B) causes both reserves and the monetary base to decline.
C) causes reserves to rise, but the monetary base to decline.
D) has no net effect on the monetary base.
23) The finance of government spending through a Treasury sale of bonds
which are then purchased by the Fed
A) causes both reserves and the monetary base to rise.
B) causes both reserves and the monetary base to decline.
C) causes reserves to rise, but the monetary base to decline.
D) has no net effect on the monetary base.
24) This method of financing government spending is frequently called printing
money because high-powered money (the monetary base) is created in the
process.
A) Financing government spending with taxes.
B) The finance of government spending through a Treasury sale of bonds
which are then purchased by the Fed.
C) Financing government spending by selling bonds to the public, which
pays for the bonds with currency.
D) Financing government spending by selling bonds to the public, which
pays for the bonds with checks.