1. © 2008 Pearson Education Canada26.1 Chapter 26 Money and Inflation

2. © 2008 Pearson Education Canada26.2 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. © 2008 Pearson Education Canada26.3 German Hyperinflation 1921-1923

4. © 2008 Pearson Education Canada26.4 Views of Inflation Monetarist View Fiscal Policy Supply Shocks Always a monetary phenomenon

5. © 2008 Pearson Education Canada26.5 Response to a Continually Rising Money Supply

6. © 2008 Pearson Education Canada26.6 Can Fiscal Policy Produce Inflation?

7. © 2008 Pearson Education Canada26.7 Can Supply-Side Phenomena Produce Inflation?

8. © 2008 Pearson Education Canada26.8 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. © 2008 Pearson Education Canada26.9 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. © 2008 Pearson Education Canada26.10 High Employment Targets and Inflation

11. © 2008 Pearson Education Canada26.11 Demand-Pull Inflation

12. © 2008 Pearson Education Canada26.12 Budget Deficits and Inflation 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 M s Deficit not financed by bonds, MB and M s 

13. © 2008 Pearson Education Canada26.13 Budget Deficits and Inflation (Cont’d) Financing persistent budget deficit by money 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

14. © 2008 Pearson Education Canada26.14 Budget Deficits and Money Creation in Canada 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 rates by buying increasing amounts of bonds, the net result is open market operations This can increase the monetary base and the money supply, resulting in inflation

15. © 2008 Pearson Education Canada26.15 Budget Deficits and Money Creation in Canada (Cont’d) 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 now need for the Bank of Canada to purchase bonds to keep interest rates from rising

16. © 2008 Pearson Education Canada26.16 Interest Rates and Government Deficits

17. © 2008 Pearson Education Canada26.17 Inflation and Monetary Growth in Canada 1960-2005

18. © 2008 Pearson Education Canada26.18 Government Debt to GDP Ratio Canada 1960-2005

19. © 2008 Pearson Education Canada26.19 Unemployment and the Natural Rate of Unemployment, Canada 1960-2005

20. © 2008 Pearson Education Canada26.20 Activist/Nonactivist Policy Debate Activists view self-correcting mechanism as slow Relevant lags slow activist policy –Data lag –Recognition lag –Legislative lag –Implementation lag –Effectiveness lag

21. © 2008 Pearson Education Canada26.21 Activist/Nonactivist Policy Debate (Cont’d) Non-activists believe government should not get involved –Activist accommodating policy produces volatility in both the price level and output

22. © 2008 Pearson Education Canada26.22 The Choice Between Activist and Non-Activist

23. © 2008 Pearson Education Canada26.23 Expectations and the Activist/Nonactivist 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 that lead to excessive unemployment –Must be credible Constant-money-growth-rate rule