Chapter 27 Money and Inflation

27-2 Money and Inflation: The Evidence “Inflation is always and everywhere a monetary phenomenon” (Milton Friedman) Evidence In every case when inflation is high for sustained period, money growth is high. Meaning of “inflation” Friedman’s defines inflation as a rapid and continuing increase in the price level.

27-3 Monetarist and Keynesian Views of Inflation Monetarist View The only source of AD shifts and Inflation is money growth. Keynesian View Allows for other sources of AD shifts, but agrees that the only source of sustained, high inflation is money growth.

27-4 Response to Monetary Policy Monetarist and Keynesian View 1.M  continually → AD shifts right from AD 1 to AD 2 to AD 3 to AD 4 2.Y > Y n → wages  → SRAS shifts left from SRAS 1 to SRAS 2 to SRAS 3 SRAS 4 3.P continually rises from P 1 to P 2 to P 3 to P 4 → inflation

27-5 Response to Fiscal Policy 1.G  → AD 1 shifts right to AD 2 2.Y > Y n → wages  → SRAS 1 shifts left to SRAS 2 3.P  to P 2, but no inflation 4.Fiscal policy without money growth only causes P , but not sustained inflation

© 2006 Pearson Addison-Wesley. All rights reserved 27-6 Response to Supply Shocks 1. Negative Supply Shock → SRAS 1 shifts left to SRAS 2 2.Y < Y n → wages  → SRAS 2 shifts back to SRAS 1 3.P unchanged and no inflation

27-7 Employment Target and Inflation: Cost-Push Inflation Employment Target at Y n 1. Expected inflation ↑ → SRAS shifts left 2.Y < Y n → Employment ↓ → Government shifts AD right 3.Expected inflation ↑ → go through steps 1 and 2 again 4.P  continually → inflation

© 2006 Pearson Addison-Wesley. All rights reserved 27-8 Employment Target and Inflation: Demand-Pull Inflation High Employment Target at Y T > Y n 1.Y = Y n < Y T → government shifts AD right 2.Y = Y T > Y n → wages ↑ → SRAS shifts left 3.Y = Y n < Y T → government shifts AD right, and repeat steps 2 and 3 again 4.P  continually → inflation

© 2006 Pearson Addison-Wesley. All rights reserved 27-9 Budget Deficits and Inflation Government Budget Deficit = G - T =  MB +  B 1. Deficit financed by bonds → no effect on MB and M S 2. Deficit financed by money → MB  and M S  →  AD shifts right 3. If persistent budget deficit → M S  continually → P  continually → Inflation Only persistent budget deficit financed by money creation rather than by bonds leads to sustained inflation.

© 2006 Pearson Addison-Wesley. All rights reserved Budget Deficits and Inflation Budget deficits developing countries 1.Bond finance is hard. 2.Deficit likely to lead to money creation and inflation  Budget deficits developed countries 1.Large capital market → bond finance is possible 2.Fed has choice whether to monetize the deficit, but may be pressured to do so. 3.Ricardian equivalence may mean no effect of budget deficits on interest rates. Conclusion: Deficits do not necessarily lead to inflation

27-11 Activist/Non-Activist Debate in Response to High Unemployment Case for Activist Policy If self-correcting mechanism is slow, 1. U > U n for long time 2.Doing nothing has high cost 3.SRAS shift little, even after long lags in shifting AD 4. Should shift AD 1 to AD 2 to get to point 2 Case for Non-activist Policy If self-correcting mechanism is fast, 1. Lags in shifting AD 2. Doing nothing has low cost 3.SRAS 1 shifts to SRAS 2 before AD 1 shifts to AD 2 4.The economy moves from point 1’ to 1 to 2’ to 2 → Y and P are highly variable

27-12 Activist/Non-Activist Debate in Response to High Unemployment If expectations about policy matter, 1.Economy won’t stop at point 2 2.Wages  → SRAS shifts left → Y < Y n → AD shifts right → inflation Rules vs. Discretion 1.Non-activists advocate policy rule to keep AD from fluctuating and avoid the time-consistency problem. Example: Monetarists advocate a constant-money- growth-rate rule 2.Credibility of non-accommodating policy helps avoid wage push and helps prevent inflation and unemployment in the future.

© 2006 Pearson Addison-Wesley. All rights reserved Activist/Non-Activist Debate in Response to High Unemployment