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Inflation is always and everywhere a monetary phenomenon Whenever a country’s inflation rate is extremely high for a sustained period of time, its rate of money supply growth is also extremely high Reduced-form evidence
Copyright 2011 Pearson Canada Inc. 26 - 1 Chapter 26 Money and Inflation Copyright 2011 Pearson Canada Inc. 26 - 2 Money and Inflation: Evidence • Inflation is always and everywhere a monetary phenomenon • Whenever a country’s inflation rate is extremely high for a sustained period of time, its rate of money supply growth is also extremely high • Reduced-form evidence Copyright 2011 Pearson Canada Inc. 26 - 3 German Hyperinflation 1921-1923 Copyright 2011 Pearson Canada Inc. 26 - 4 Views of Inflation • The Money Growth Produced Inflation • Fiscal Policy • Supply Shocks • Always a monetary phenomenon Copyright 2011 Pearson Canada Inc. 26 - 5 Response to a Continually Rising Money Supply Copyright 2011 Pearson Canada Inc. 26 - 6 Can Fiscal Policy Produce Inflation? Copyright 2011 Pearson Canada Inc. 26 - 7 Can Supply-Side Phenomena Produce Inflation? Copyright 2011 Pearson Canada Inc. 26 - 8 Origins of Inflationary Monetary Policy I • Cost-push inflation – Cannot occur without monetary authorities pursuing an accommodating policy • Demand-pull inflation • Budget deficits – Can be the source only if the deficit is persistent and is financed by creating money rather than by issuing bonds Copyright 2011 Pearson Canada Inc. 26 - 9 Origins of Inflationary Monetary Policy II • Two underlying reasons – Adherence of policymakers to a high employment target – Presence of persistent government budget deficits Copyright 2011 Pearson Canada Inc. 26 - 10 High Employment Targets and Inflation [...]...Demand-Pull Inflation Budget Deficits and Inflation I Government Budget Constraint DEF = G – T = ∆MB + ∆B Where: G = government spending T = tax revenues MB = monetary base B = Bonds • Deficit financed by bonds, no effect on MB and Ms • Deficit not financed by bonds, MB and Ms ↑ Budget Deficits and Inflation II Financing persistent budget deficit by money creation (monetizing debt – printing money) ... monetary base and the money supply, resulting in inflation Budget Deficits and Money Creation in Canada II • The Ricardian Equivalence contends (given government deficits) the public will increase savings in anticipation of higher future taxes • Increased savings take the form of increased demand for bonds, matching the increased supply • This leaves bond prices and interest rates unchanged and there is... creation (monetizing debt – printing money) leads to sustained inflation Government Deficit is inflationary only if it is: 1 Persistent 2 Financed by money creation rather than by bonds Budget Deficits and Money Creation in Canada I • Financing persistent deficits by selling bonds increases the supply of bonds, drives bond prices down and interest rates up • If the Bank of Canada prevents higher interest... accommodating policy produces volatility in both the price level and output The Choice Between Activist and Non-Activist Policy Expectations and Discretionary/Nondiscretionary Debate • If expectations about policy matter, then accommodating activist policy with high employment targets may lead to inflation • Nonactivist policy may prevent inflation and discourage leftward shifts in short-run aggregate supply... interest rates unchanged and there is now need for the Bank of Canada to purchase bonds to keep interest rates from rising Interest Rates and Government Deficits Inflation and Monetary Growth in Canada 1960-2008 Government Debt to GDP Ratio Canada 1960-2007 Unemployment and the Natural Rate of Unemployment, Canada 1960-2008 Discretionary/Nondiscretionary Policy Debate I • Discretionary policy advocates... targets may lead to inflation • Nonactivist policy may prevent inflation and discourage leftward shifts in short-run aggregate supply that lead to excessive unemployment – Must be credible • Constant -money- growth-rate rule . Canada Inc. 26 - 1 Chapter 26 Money and Inflation Copyright 2011 Pearson Canada Inc. 26 - 2 Money and Inflation: Evidence • Inflation is always and everywhere. Canada Inc. 26 - 3 German Hyperinflation 1921-1923 Copyright 2011 Pearson Canada Inc. 26 - 4 Views of Inflation • The Money Growth Produced Inflation