Monetary Policy and Central Banking

16
Monetary Theory II

Module 016 Money and Inflation

Objectives
1. To use aggregate demand and supply analysis to reveal the role of
monetary policy in creating inflation
2. To explore the activist/non-activist policy debate by first looking
at what the policy responses might be when the economy
experiences high unemployment.

Introduction
The evidence for Friedman’s statement is straightforward. 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. Countries with the highest inflation
rates have also had the highest rates of money growth.
Evidence of this type seems to support the proposition that extremely high
inflation is the result of a high rate of money growth. Keep in mind, however, that
you are looking at reduced-form evidence, which focuses solely on the correlation
of two variables: money growth and the inflation rate. As with all reduced-form
evidence, reverse causation (inflation causing money supply growth) or an outside
factor that drives both money growth and inflation could be involved.
What is Inflation?
You may have noticed that all the empirical evidence on the relationship of
money growth and inflation discussed so far looks only at cases in which the price
level is continually rising at a rapid rate. It is this definition of inflation that
Friedman and other economists use when they make statements such as “Inflation
is always and everywhere a monetary phenomenon.” This is not what your friendly
newscaster means when reporting the monthly inflation rate on the nightly news.
The newscaster is only telling you how much, in percentage terms, the price level
has changed from the previous month.
For example, when you hear that the monthly inflation rate is 1% (12% annual
rate), this merely indicates that the price level has risen by 1% in that month. This
could be a one-shot change, in which the high inflation rate is merely temporary,
not sustained. Only if the inflation rate remains high for a substantial period of time
(greater than 1% per month for several years) will economists say that inflation
has been high.

Course Module
Views of Inflation
1. Monetarist view- Monetarist analysis indicates that rapid inflation must be driven
by high money supply growth.
Do monetarists believe that a continually rising price level can be due to any source
other than money supply growth? The answer is no. In monetarist analysis, the
money supply is viewed as the sole source of shifts in the aggregate demand curve.
2. Keynesian View- Keynesian analysis indicates that high inflation cannot be driven
by fiscal policy alone
Keynesian analysis indicates that the continually increasing money supply
will have the same effect on the aggregate demand and supply curves. The
aggregate demand curve will keep on shifting to the right, and the aggregate supply
curve will keep shifting to the left. The conclusion is the same one that the
monetarists reach: A rapidly growing money supply will cause the price level to
rise continually at a high rate, thus generating inflation
Could a factor other than money generate high inflation in the Keynesian
analysis? The answer is no. This result probably surprises you, for you learned that
Keynesian analysis allows other factors besides changes in the money supply (such
as fiscal policy and supply shocks) to affect the aggregate demand and supply
curves. To see why Keynesians also view high inflation as a monetary phenomenon

Two types of inflation can result from an activist stabilization policy to promote
high employment

1. Cost-push inflation
-a monetary phenomenon because it cannot occur without the monetary
authorities pursuing an accommodating policy of a higher rate of money growth.
- occurs because of negative supply shocks or a push by workers to get higher
wages

2. Demand-pull inflation
- Results when policymakers pursue policies that shift the aggregate demand curve
to the right
-Produces higher inflation rates, expected inflation will eventually rise and cause
workers to demand higher wages so that their real wages do not fall

Budget Deficits and Inflation

Government Budget Constraint.
Because the government has to pay its bills just as we do, it has a budget
constraint. There are two ways we can pay for our spending: raise revenue (by
working) or borrow. The government also enjoys these two options: raise revenue
by levying taxes or go into debt by issuing government bonds. Unlike us, however,
it has a third option: The government can create money and use it to pay for the
goods and services it buys.
The government budget constraint thus reveals two important facts: If the
government deficit is financed by an increase in bond holdings by the public, there
is no effect on the monetary base and hence on the money supply. But, if the deficit
is not financed by increased bond holdings by the public, the monetary base and
the money supply increase.
 Monetary Policy and Central Banking
16
Monetary Theory II

A deficit can be the source of a sustained inflation only if it is persistent

rather than temporary and if the government finances it by creating money rather
than by issuing bonds to the public

Activist/Non activist Policy Debate

Activists regard the self-correcting mechanism through wage and price
adjustment as very slow and hence see the need for the government to pursue
active, accommodating, discretionary policy to eliminate high unemployment
whenever it develops.
Non-activists, by contrast, believe that the performance of the economy
would be improved if the government avoided active policy to eliminate
unemployment

Types of lags
1. The data lag is the time it takes for policymakers to obtain the data that
tell them what is happening in the economy. Accurate data on GDP, for example,
are not available until several months after a given quarter is over.
2. The recognition lag is the time it takes for policymakers to be sure of
what the data are signaling about the future course of the economy. For example, to
minimize errors, the National Bureau of Economic Research (the organization that
officially months after it has determined that one has begun.
3. The legislative lag represents the time it takes to pass legislation to
implement a particular policy. The legislative lag does not exist for most monetary
policy actions such as open market operations. It can, however, be quite important
for the implementation of fiscal policy, when it can sometimes take six months to a
year to get legislation passed to change taxes or government spending.
4. The implementation lag is the time it takes for policymakers to change
policy instruments once they have decided on the new policy. Again, this lag is
unimportant for the conduct of open market operations because the Fed’s trading
desk can purchase or sell bonds almost immediately upon being told to do so by
the Federal Open Market Committee. Actually implementing fiscal policy may take
time, however; for example, getting government agencies to change their spending
habits takes time, as does changing tax tables.
5. The effectiveness lag is the time it takes for the policy actually to have an
impact on the economy. An important element of the monetarist viewpoint is that
the effectiveness lag for changes in the money supply is long and variable (from
several months to several years). Keynesians usually view fiscal policy as having a
shorter effectiveness lag than monetary policy (fiscal policy takes approximately a
year until its full effect is felt), but there is substantial uncertainty about how long
this lag is.

Course Module
Activist and Non-activist Position
1. Case for an Activist Policy- Activists, such as the Keynesians, view the wage and
price adjustment process as extremely slow. They consider a non-activist policy
costly, because the slow movement of the economy back to full employment results
in a large loss of output
2. Case for a Non-activist Policy- Non- activists, such as the monetarists, view the
wage and price adjustment process as more rapid than activists do and consider
non-activist policy less costly because output is soon back at the natural rate level.
 Monetary Policy and Central Banking
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Monetary Theory II

Books and Journals

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Policy: A Factor-Augmented Vector Autoregressive (FAVAR) Approach’, The
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Brischetto A and G Voss (1999), ‘A Structural Vector Autoregression Model of
Monetary Policy in Australia’, RBA Research Discussion Paper No 1999-11.
Castelnuovo E (2012), ‘Testing the Structural Interpretation of the Price
Puzzle with a Cost-Channel Model’, Oxford Bulletin Of Economics And
Statistics, 74(3), pp 425–452.
Castelnuovo E and P Surico (2010), ‘Monetary Policy, Inflation Expectations
and the Price Puzzle’, The Economic Journal, 120(549), pp 1262–1283.
Cloyne J and P Hürtgen (2016), ‘The Macroeconomic Effects of Monetary
Policy: A New Measure for the United Kingdom’, American Economic Journal:
Macroeconomics, 8(4), pp 75–102.
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Small?’, American Economic Journal: Macroeconomics, 4(2), pp 1–32.
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Frequency Futures Data’, Journal of Monetary Economics, 51(6), pp 1107–
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Incorporated) Luncheon, Perth, 24 September.
Jääskelä J and D Jennings (2010), ‘Monetary Policy and the Exchange Rate:
Evaluation of VAR Models’, RBA Research Discussion Paper No 2010-07.

Course Module
Jacobs D and V Rayner (2012), ‘The Role of Credit Supply in the Australian
Economy’, RBA Research Discussion Paper No 2012-02.
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Exchange Rate: A Study Using Intraday Data’, International Journal of Central
Banking, 2(4), pp 157–183.
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Mechanism: Is Australia Different?’, Economic Record, 90(290), pp 382–399.
RBA (Reserve Bank of Australia) (2015), ‘Domestic Market Operations’,
viewed December 2016.
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Monetary Policy, and the Macroeconomy: The FRB/US Perspective’, Federal
Reserve Bulletin, 85(1), pp 1–19.
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Behavior of Interest Rates’, The American Economic Review, 90(3), pp 429–
457.
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Monetary Policymakers Add Value?’, The American Economic Review, 98(2),
pp 230–235.
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Australia?’, Economic Record, 80(249), pp 145–156.