SECTION 14

Monetary policy can affect economic welfare.

Monetary policy involves inflation and deflation.

Zimbabwe achieved the distinction of having the world's highest inflation rate in the summer of 2008.

In the late 1970s and early 1980s, consumer prices in the United States rose at an annual rate of as high as 15%. The deepest recession since the Great Depression was caused by the policies of the Federal Reserve. Moderate levels of inflation such as those experienced in the United States--even the double-digit inflation of the late 1970s--can have complex causes. The causes of moderate inflation in the United States are different from the causes of high inflation in Zimbabwe.

Changes in the money supply have an effect on the price level. We'll look at the reasons why governments increase the money supply rapidly.

In the short run, an increase in the money supply will increase GDP by lowering the interest rate and stimulating investment spending. Real GDP falls back to its original level as nominal wages and other sticky prices rise. In the long run, an increase in money supply doesn't change GDP. The prices of all goods and services in the economy, including nominal wages and the prices of intermediate goods, rise by the same percentage as the money supply. The aggregate price level rises when the overall price level rises.

There is no long-run effect on aggregate demand. Real GDP was unaffected by money.

The number of zeros in prices was the only change.

This is what happens in the long run.

Instead, they work with a real quantity of money fied model in which the effect of a change in the money supply on the aggregate price is always at its long run level, rather than over a long period of time. You could be at equilibrium level.

In the case of high inflation, this is a reasonable assumption to make.

Suppose there is an increase in money supply.

In the classical model, the effects of money supply changes are analyzed as if the short run and long run aggregate supply curves were vertical.

During periods of low infla tion, this is a poor assumption. It may take a while for workers and firms to respond to a monetary expansion by raising wages and prices.

The prices of some goods are sticky in the short run.

In the face of high inflation, economists have observed that nominal wages and prices tend to disappear. Workers and businesses are quick to raise their wages and prices in response to changes in the money supply. Under high inflation there is a quicker adjustment of wages and prices than under low inflation. It may take a while for workers to get used to a low inflation rate and for firms to adjust to a monetary expansion by raising wages and prices.

The classical model of the price level is more likely to be a good approximation of reality for economies experiencing persistently high inflation.

Changes in the money supply can be quickly translated into changes in the inflation rate in countries with persistently high inflation. Let's look at Zimbabwe. The surge in the growth rate of the money supply was very similar to the surge in the inflation rate. To fit these large percentage increases, we used a logarithmic scale to draw the vertical axis.

Zimbabwe's inflation rate reached 231 million percent in late 2008.

Modern economies use pieces of paper that have no value but are accepted as a medium of exchange. In the United States and most other wealthy countries, the decision about how many pieces of paper to issue is left to the central bank.

The U.S. government does it all the time. The answer is that the Treasury and Federal Reserve work together. The U.S. government can raise revenue by printing money.

In February 2010, the US monetary base was $559 billion larger than it had been a year earlier. Over the course of that year, the Federal Reserve issued $559 billion in money and put it into circulation through open market operations. The Fed created money out of thin air and used it to buy government securities in the private sector. It's true that the U.S. government pays interest on debt owned by the Federal Reserve--but the Fed hands the interest payments it receives on government debt back to the Treasury, keeping only enough to fund its own operations. The Federal Reserve's actions enabled the government to pay off $559 billion in debt by printing money.

It is possible to say that the right to print money is a source of revenue. Medieval lords in France charged a fee for the right to stamp gold and silver into coins.

Concerns about seignorage don't affect the Federal Reserve's decisions about how much money to print. In the United States, both sides relied on seignorage to help cover budget deficits during the Civil War. Governments have turned to their printing presses as a crucial source of revenue in the past.

Due to the fear that the government's weakness will leave it unable to repay its debts, potential lenders won't extend loans to cover the gap.

Governments end up printing money to cover the budget deficit.

A government increases the amount of money in circulation by printing money. Increases in the money supply translate into increases in the aggregate price level. Inflation is caused by printing money to cover a budget deficit.

People who hold money get paid. Inflation erodes the purchasing power of money holdings.

Think about what this tax means. If the inflation rate is less than 5%, a year from now $1 will buy goods and services worth less than a dollar. A tax rate of 5% on the value of money held by the public is imposed by a 5% inflation rate.

The process by which high inflation turns into hyperinflation is next.

Inflation imposes a tax on money. It will lead people to change their behavior. People have a strong incentive to spend money quickly when inflation is high. The goal is to reduce the burden of inflation tax by avoiding holding money. Eggs and coal were used as a medium of exchange during the German hyperinflation. Money did not keep up with the real value of coal over time. Paper money was less valuable than wood during the peak of German hyperinflation.

We're prepared to understand how countries can get into situations of extreme inflation. Suppose the government prints enough money to pay for a certain amount of goods and services. The increase in money supply causes the inflation rate to go up, so the government has to print more money to buy the same amount of goods and services. If the desire to reduce money holdings causes people to spend money faster than the government prints money, prices increase faster than the money.

The rate of inflation went up in the 1920s because of hyperinflation.

German currency is worth so little that it can easily spiral out of control.

Imagine a city government that tries to raise a lot of money with a special fee on taxi rides. The fee will cause people to use alternatives, such as walking or taking the bus, because it will raise the cost of taxi rides. The government has to impose a higher fee to raise the same amount of revenue as before as taxi use declines. The government imposes fees on taxi rides, which leads to less taxi use, which causes the government to raise the fee on taxi rides, which leads to even less taxi use, and so on.

You have the story of hyperinflation if you substitute the real money supply for taxi rides and the infla tion rate for the increase in the fee on taxi rides.

Zimbabwe has farms in world markets. It is very high in the hands of whites.

100,000,000,000 June 2008, with the 2000 level set to undermine equal to 100.

At some point the inflation rate explodes into hyperinflation, and people are unwilling to hold any money at all, so they resort to trading in eggs and coal. The printing presses are shut down after the government abandons its use of the inflation tax.

The governments of the United States and Britain don't have to print money to pay their bills. Over the past 40 years, both countries and a number of other nations have experienced uncomfortable episodes of inflation. The inflation rate in the United States peaked in 1980. In 1975, the inflation rate in Britain was 26%.

There are two possible changes that can lead to an increase in the aggregate price level: a decrease in aggregate supply or an increase in aggregate demand. It is argued that the oil crisis in the 1970s caused a leftward shift of the aggregate supply increase in the price of an curve, increasing the aggregate price level. It is difficult to think of examples of inputs with economy-wide importance.

An increase demand can be caused by a rightward shift of the aggregate demand curve.

Make sure you can graph and create temptations for governments.

Expansionary policies that will push the unemployment rate down as a way to please voters are both tested frequently on the AP(r) policies. Your advisers warn that cost-push will lead to higher inflation.

Imagine yourself as a politician in an economy with inflation.

The only way to bring inflation down is to push the economy into a recession, which will lead to higher unemployment, according to your economic advisers.

Inflationary policies can produce short-term political gains, but they can also carry short-term political costs. The British government's decision in 1971 to pursue highly expansionary monetary and fiscal policies resulted in a 26% rate of inflation in Britain. Politicians ignored warnings that the policies would be inflationary and were unwilling to reverse course even when it was clear that the warnings had been correct.

We need to look at the relationship between output and unemployment first. Inflation will be added to the story in Module 34.

Over time potential output grows, reflecting long-run growth. A recessionary gap arises when aggregate output falls short of potential output, and an inflationary gap arises when aggregate output exceeds potential output, as we learned from the aggregate demand-aggregate supply model. A positive or negative output gap occurs when an economy is producing more or less than expected because prices have not been adjusted. Wages are the prices in the labor market.

The portion of the unemployment rate unaffected by the business cycle is called thecyclic unem ployment. There is a relationship between the unemployment rate and the output gap. The unemployment rate is equal to the natural rate of unemployment when aggregate output is equal to potential output.

This makes sense. When the output gap is negative, the economy isn't making full use of its resources.

The economy's most important resource is labor. We would expect a negative output gap to be associated with high unemployment. When the economy is producing more than potential output, it temporarily uses resources at higher than normal rates. We would expect to see a lower unemployment rate with this positive output gap.

The actual and natural rates of unem ployment are estimated by the CBO. Two series are shown in the panel. There is a difference between the CBO estimate of the natural rate of unemployment and the actual unemployment rate.

The CBO estimate of the output gap is on the right. The output gap series is inverted so that the line goes down if actual output rises above potential output and up if actual output falls below potential output. The two series show a strong relationship between the output gap and unemployment.

The years of high unemployment were also years of a negative output gap. The late 1960s and 2000s were years of low unemployment and a positive output gap.

The actual U.S. is shown in Panel (a).

If all wages and prices in an economy increase at the same rate as the price level, it means that they have had low inflation in the past and should increase at the same rate as the price level. Is there still high inflation?

Revenue from the government's right to print curves is vertical.

The potential output is labeled at the intercept supply graph.