MiltonFriedman once said, "inflation is always and everywhere a monetary phenomenon." And amazing, Keynesians and Monetarist agree that persistent, continual increases in the price level can only be caused by persistent, continual increases in the money supply. In this chapter we use the AD/AS model of chapter 24 to analyze the impact of monetary policy on inflation and to examine how inflationary monetary policy comes about in the first place.

In general, inflation is defined as the percentage increase in the price level. However in this chapter we will define inflation as a continuing and rapid rise in the price level, not just a one-shot increase.

I.  Evidence on Money and Inflation

Box 1, page 665 provides some striking evidence about the relationship between money growth and inflation. For these Latin American countries, high money growth is associated with high inflation. However, this relationship is reduced-form evidence. How can we be sure it is money growth that is causing the inflation and not a third variable?

To determine causation, it helps to use historical evidence where the increase in money supply growth is exogenous and not due to inflation. One example of this is the German Hyperinflation 1921-23. After WWI, Germany was forced to pay heavy war reparations. The German government financed these huge expenditures through printing money. This of course increased the money supply. In 1923 their expenditures and printing of money accelerated. As a result we see in figure 1, page 667, that the price level took off with the money supply. This is strong evidence of the link between money and inflation.

We can find similar more recent episodes in Latin America where Argentina, Brazil, and Peru financed there large government deficits through money creation.

II.  Views on Inflation

We can use the AD/AS model to understand why Monetarists and Keynesians both agree that inflation is a monetary phenomenon.

Monetarist View

Recall that, for monetarists, changes in the money supply are the only factor that shift the AD curve. If the money supply increases AD shifts right and the short-run equilibrium moves from 1 to 1':

However, since output is now above the natural rate level, wages will rise, causing the AS curve to shift left. Equilibrium will now be at 2, at the natural rate level of output with a higher price level:

If the increases in money supply continue, we will see the AD curve shifting to the right, but the economy self-correcting and the AS shifting left. The result is that the economy moves to higher and higher price levels and inflation will occur:

Again, since money supply increases are the only factor that increases AD for monetarists, money supply increases must be behind this escalating price level.

Keynesian View

Keynesian agree that money supply increases will have the same effect on AD and AS as monetarist do. However, recall that Keynesians also believe that other factors affect the AD curve, including

• changes in government expenditure
• changes in taxes
• changes in investment
• changes in consumption
• changes in net exports

Also, negative supply shocks that shift AS left could also cause one-time temporary increases in the price level, but not inflation.

III.  Inflationary Monetary Policy

So if inflation has its origins in monetary policy, how does inflationary monetary policy occur? There are two government policies that lead to inflationary monetary policy.

High Employment Targets

In 1946 and 1978, the U.S. government made laws making it responsible for promoting low unemployment and a stable price level. However, the government has favored the low employment part of the deal, especially during the 1960s and 1970s. In using policies to minimize unemployment the government can trigger either cost-push inflation or demand-pull inflation.

Cost-push inflation begins with workers making demands for higher wages. This shifts the AS curve to the left. But this results in lower output and thus higher unemployment:

Seeing this, the government undertakes some policy to shift the AD curve right to restore employment to its previous levels. This is known as an accommodating policy since the government is accommodating the wage demands of workers rather than allowing wages to fall for self-correction:

The inflationary spiral continues if workers keep pushing for higher wages (likely due to rising price levels) and the government keeps accommodating this by shifting the AD curve:

Cost-push inflation can continue only if the government is using money supply growth to shift the AD curve.

Demand-pull inflation occurs when the government sets an unemployment target that is too low. That is, the target is below the natural rate of unemployment. The government shifts the AD curve right to increase output and lower unemployment:

However, since the new equilibrium is above the natural rate level of output, wages will rise and AS will shift left:

If the government keeps pursuing the too-low target, they keep shifting AD right, and the cycle continues. The result can be seen in figure 6, page 675.

How do we tell the difference between demand-pull and cost-push inflation? One way to do so is to see if the unemployment rates has been above or below the natural rate of unemployment. If above, then we are experiencing cost-push inflation. If below, then we are experiencing demand-pull inflation. However, in practice, if we do not know the natural rate, it is hard to distinguish between the two.

Budget Deficits

If the government runs a budget deficit, they have 3 choices in how they finance it:

• raise taxes, which is never popular
• borrow the money through issuing bonds
• create the money to buy goods and services

The last choice can happen one of two ways. If the government treasury has the power to issue currency, they just print more money and use to pay for the expenditures that exceed tax revenue. Off course, this puts more money in circulation and increases the money supply.

If the government is like the U.S., however, the treasury does not issue currency (the Federal Reserve does). In this case the government issues bonds, and the Federal Reserve conducts an open market purchase to buy them. Again, this open market purchase increases the money supply. This is called monetizing the debt.

If the budget deficit persists, then the increases in the money supply persist, and we have inflation.

Why would countries choose this option if it is inflationary? For developing countries, there may be no choice. The is not sufficient demand for the bonds of developing country governments, nor is their a sufficient tax base. So they have no choice but to print money to finance the deficit. This has been the source of the hyperinflations in Latin American countries.

The U.S. ran large deficits in the 1980s and early 1990s, but these were not inflationary. Why? First, U.S. Treasury bonds are popular securities, so our government has no trouble borrowing the money. Also, our debt-to-GDP ratio is much smaller than other countries, so are true debt burden is modest.

U.S. Inflation 1960-80

Let's use our knowledge of the causes of inflationary monetary policy to evaluate the U.S. inflation experience. Figure 8, page 681, shows inflation and the rate of money growth (M1) two years prior during this period. From 1960-80 we see a striking relationship between inflation and money growth. But what is the source of rising money growth during this period?

Budget deficits are not the culprit here. Looking at figure 9, page 682, we see that the debt-to-GDP ratio actually fell during this period, so the debt burden was not an issue.

Looking at unemployment relative to its estimated natural rate (figure 10, page 683), we get a clearer picture of what happened. Between 1965-73, unemployment was below its natural rate, suggesting that demand-pull inflation was occurring. After 1975, unemployment was consistently above its natural rate, suggesting that cost-push inflation was occurring. With the government pursuing low unemployment targets, workers began to expect inflation and demand higher wages. The government accommodated these demands, and inflation rose during the period.

Activist/Nonactivist Policy Debate

The relationship between monetary policy and inflation gives us a new dimension to the debate between using government intervention to achieve economic goals (activist policy) and waiting for the economy to self-correct (nonactivist policy). Nonactivists have more ammunition for waiting, since government intervention could trigger inflationary expectations and cost-push inflation. In fact, many nonactivists favor a constant-money-growth-rate rule to prevent inflation.

Activists still argue that without government intervention, the self-correction process is slow and that the economy will experience long periods of high unemployment and lost output.

FYI: Related Links

Federal Reserve Credibility: What's the Big Deal? An article about the importance that the Fed's commitment to price stability is credible, that is, people believe it.

Inflation and the Time Value of Money CPI Calculator This is another Dismal Scientist calculator that allows you to compare the values of money across time, adjusting for the effects of inflation.