1. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 24 Money and Inflation

2. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-2 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

3. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-3 FIGURE 1 Money Supply and Price Level in the German Hyperinflation Source: Frank D. Graham, Exchange, Prices and Production in Hyperinflation: Germany, 1920–25 (Princeton, NJ: Princeton University Press, 1930), pp. 105–106.

4. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-4 Views of Inflation Money Growth –High money growth produces high inflation Fiscal Policy –Persistent high inflation cannot be driven by fiscal policy alone Supply Shocks –Supply-side phenomena cannot be the source of persistent high inflation Conclusion: always a monetary phenomenon

5. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-5 FIGURE 2 Response to a Continually Growing Money Supply

6. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-6 FIGURE 3 Response to a One-Shot Permanent Increase in Government Expenditure

7. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-7 FIGURE 4 Response to a Supply Shock

8. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-8 Origins of Inflationary Monetary Policy 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

9. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-9 Origins of Inflationary Monetary Policy (cont’d) Two underlying reasons –Adherence of policymakers to a high employment target –Presence of persistent government budget deficits

10. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-10 FIGURE 5 Cost-Push Inflation with an Activist Policy to Promote High Employment

11. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-11 FIGURE 6 Demand-Pull Inflation: The Consequence of Setting Too Low an Unemployment Target

12. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-12 FIGURE 7 Interest Rates and the Government Budget Deficit

13. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-13 FIGURE 8 Inflation and Money Growth, 1960–2008 Source: Economic Report of the President; www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

14. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-14 FIGURE 9 Government Debt-to- GDP Ratio, 1960–2008 Source: Economic Report of the President.

15. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-15 FIGURE 10 Unemployment and the Natural Rate of Unemployment, 1960–2008 Sources: Economic Report of the President and Congressional Budget Office.

16. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-16 The Discretionary/Nondiscretionary Policy Debate Advocates of discretionary policy regard the self-correcting mechanism as slow Policy lags slow activist policy –Data lag –Recognition lag –Legislative lag –Implementation lag –Effectiveness lag

17. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-17 The Discretionary/Nondiscretionary Policy Debate (cont’d) Advocates of nondiscretionary policy believe government should not get involved –Discretionary policy produces volatility in both the price level and output

18. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-18 FIGURE 11 The Choice Between Discretionary and Nondiscretionary Policy

19. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 24-19 Expectations and the Discretionary/Nondiscretionary Debate If expectations about policy matter, discretionary policy with high employment targets may lead to inflation Nondiscretionary 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