Chapter 27

1. Chapter 27 Money and Inflation

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.

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.

4. Monetarist and Keynesian View 1. M continually → AD shifts right from AD1 to AD2 to AD3 to AD4 2. Y > Yn→ wages  → SRAS shifts left from SRAS1 to SRAS2 to SRAS3 SRAS4 3. P continually rises from P1 to P2 to P3 to P4→ inflation Response to Monetary Policy

5. 1. G→ AD1 shifts right to AD2 2. Y > Yn→ wages  → SRAS1 shifts left to SRAS2 P to P2, but no inflation Fiscal policy without money growth only causes P, but not sustained inflation Response to Fiscal Policy

6. Response to Supply Shocks 1. Negative Supply Shock→ SRAS1 shifts left to SRAS2 2. Y < Yn→ wages  → SRAS2 shifts back to SRAS1 3. P unchanged and no inflation © 2006 Pearson Addison-Wesley. All rights reserved

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

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

9. Budget Deficits and Inflation Government Budget Deficit= G - T = MB + B 1. Deficit financed by bonds → no effect on MB and MS 2. Deficit financed by money → MB and MS →AD shifts right 3. If persistent budget deficit → MS 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

10. 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 © 2006 Pearson Addison-Wesley. All rights reserved

11. Activist/Non-Activist Debate in Response to High Unemployment Case for Activist Policy • If self-correcting mechanism is slow, 1. U > Un for long time 2. Doing nothing has high cost 3. SRAS shift little, even after long lags in shifting AD 4. Should shift AD1 to AD2 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. SRAS1 shifts to SRAS2 before AD1 shifts to AD2 4. The economy moves from point 1’ to 1 to 2’ to 2 → Y and P are highly variable

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 < Yn→ 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.

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