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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.