Money and Inflation
Theory and Evidence
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.
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, 1921-1923
– 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.
Hyperinflation
1000 Mark
Note
Overstamped
as a million
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)
More from the German Hyperinflation
50 Marks, 1919
5,000 Marks, 1922
100 Billion Marks, 1924
1 Rentenmark, 1924
Money and Hyperinflation
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%
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.
Money and Inflation: Theory
SRAS3
LRAS
P4
SRAS2
SRAS1
P3
P2
AD3
P1
AD2
AD1
YP
Y2
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.
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.
Demand-Pull Inflation
SRAS3
LRAS
P5
SRAS2
SRAS1
P4
P3
P2
AD3
P1
AD2
AD1
YP
YT
Cost-Push Inflation
LRAS
P5
SRAS3
SRAS2
P4
SRAS1
P3
P2
AD3
P1
AD2
AD1
Y2
YP
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.
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.
US Inflation 1960-1980
• Budget Deficits (as a % of GDP) actually declined during
this period.
• Demand-Pull Inflation (1965-1973)
– Policymakers targeted a 4% unemployment rate
– Natural rate was closer to 5% or even 6%
• Cost-Push Inflation (1975-1980)
– 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.
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
Should we let the economy self-correct?
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.