© 2008 pearson education canada26.1 chapter 26 money and inflation

© 2008 Pearson Education Canada26.1

Chapter 26Chapter 26Money and Inflation


Money and Inflation: Money and Inflation: EvidenceEvidence

• 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


German Hyperinflation 1921-German Hyperinflation 1921-19231923


Views of InflationViews of Inflation

• Monetarist View

• Fiscal Policy

• Supply Shocks

• Always a monetary phenomenon


Response to a Continually Response to a Continually Rising Money SupplyRising Money Supply


Can Fiscal Policy Produce Inflation?Can Fiscal Policy Produce Inflation?


Can Supply-Side Phenomena Produce Can Supply-Side Phenomena Produce Inflation?Inflation?


Origins of Origins of Inflationary Monetary PolicyInflationary 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


Origins of InflationaryOrigins of Inflationary Monetary Policy Monetary Policy (Cont’d)(Cont’d)

• Two underlying reasons

– Adherence of policymakers to a high employment target

– Presence of persistent government budget deficits


High Employment Targets High Employment Targets and Inflationand Inflation


Demand-Pull InflationDemand-Pull Inflation


Budget Deficits and InflationBudget Deficits and Inflation

Government Budget Constraint

DEF = G – T = MB + BWhere: 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 Budget Deficits and Inflation (Cont’d)(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.Persistent2.Financed by money creation rather than by bonds


Budget Deficits and Money Budget Deficits and Money Creation in CanadaCreation 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


Budget Deficits and Money Budget Deficits and Money Creation in Canada Creation in Canada (Cont’d)(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


Interest Rates and Interest Rates and Government DeficitsGovernment Deficits


Inflation and Monetary Growth in Inflation and Monetary Growth in Canada 1960-2005Canada 1960-2005


Government Debt to GDP Ratio Government Debt to GDP Ratio Canada 1960-2005Canada 1960-2005


Unemployment and the Natural Rate of Unemployment and the Natural Rate of Unemployment, Canada 1960-2005Unemployment, Canada 1960-2005


Activist/Nonactivist Policy Activist/Nonactivist Policy DebateDebate

• Activists view self-correcting mechanism as slow

• Relevant lags slow activist policy– Data lag– Recognition lag– Legislative lag– Implementation lag– Effectiveness lag


Activist/Nonactivist Policy Activist/Nonactivist Policy Debate Debate (Cont’d)(Cont’d)

• Non-activists believe government should not get involved

– Activist accommodating policy produces volatility in both the price level and output


The Choice Between Activist The Choice Between Activist and Non-Activistand Non-Activist


Expectations and the Expectations and the Activist/Nonactivist DebateActivist/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

© 2008 pearson education canada26.1 chapter 26 money and inflation

Documents

pearson education canada26

money supply slide

government deficits

rising slide

monetary phenomenon

evidence inflation

supply of bonds

money creation