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1、CHAPTER 22INFLATION AND HYPERINFLATIONChapter Outline Money and inflation Monetarism and the rational expectations approach The effects of hyperinflation Disinflation and the sacrifice ratio Credibility The Feds dilemma Deficits and money growth The inflation tax SeignoriageChanges from the Previous
2、 EditionMuch of the material in this chapter comes from Sections 19-4, 19-5, and 19-6 in former Chapter 19. These sections, including Figures 22-1 and 22-3 (former Figures 19-2 and 19-3), and Table 22-2 (former Table 19-5) have been updated. Figure 22-2 is new and shows growth in M-l and M-2 and the
3、 inflation rate from 2005-13. Box 19-4, which described the Bolivian hyperinflation, has been eliminated.Introduction to the MaterialInflation is often defined as too much money chasing too few foods. Clearly, many factors, such as a supply shock or an increase in aggregate demand can lead to more i
4、nflation In the short run; however, in the long run, the link between a sustained increase in the inflation rate and an increase in monetary growth can easily be derived. The quantity theory of money equation (in terms of percentage changes) serves well to explain this link:MV = PY = %AM + %AV = %AP
5、 + %AY = m + v = n + y = n = m - y + vIn other words, the rate of inflation (%AP =兀)is determined by the difference between the growth rate of nominal money supply (%AM = m) and the growth rate of real output (%AY = y), adjusted for the percentage change in the income velocity of money (%AV = v).Fig
6、ure 22-1 shows that trends in the rate of inflation and the growth of money supply (M2) tracked similarly until about the mid-1990s, when the close relationship between M2 growth and the inflation rate had largely broken down, even for the long run. Nonetheless, there has never been sustained inflat
7、ion without a rapid growth in money supply.There is plenty of evidence to support the notion that in the long run, inflation is a monetary phenomenon here in the U.S. and in other countries. However, there are short-run variations, indicating that changes in velocity and output growth have also affe
8、cted the inflation rate.5 .a. During the hyperinflation of 1922-23, the German government financed almost all of its spending through the creation of money. The excessive monetary expansion caused in nation to skyrocket, reaching an average monthly inflation rate of 322 percent.6 .b. The revenue tha
9、t the government can gain through the inflation tax is defined as:inflation tax revenue = (inHation rate)*(real money base).Figure 22-4 shows that it is possible for the government to increase the inflation tax revenue temporarily as long as money is printed faster than people expect. But excessive
10、monetary growth causes inflation to increase rapidly and people will start to reduce their money holdings in an attempt to avoid the inflation tax. Eventually, the monetary base will decline, and the whole process will break down.At the end of a hyperinflation, nominal interest rates tend to decline
11、 and thus the demand for money balances increases. In this situation, the government is able to increase money supply without creating more inflationat least for a short while.7 . Russia was burdened with a huge budget deficit and a large external debt as it tried to transform its centrally planned
12、economy to a free market economy. Real output decreased substantially as much of the economic activity occurred on the black market, so collecting tax revenues was difficult. With government spending far outpacing tax revenues, the government budget got totally out of balance and hyperinflation resu
13、lted as the central bank created money to allow for more government spending. Inflation peaked at 2,600% in 1993. The ruble totally collapsed in value and the Russian economy became burdened with a huge foreign debt that it was unable to service. In this situation, subsidies to loss-making state ent
14、erprises had to be cut and tax collections had to be strictly enforced in order to bring the budget back into balance. To bring inflation under control, Russia introduced a new line of ruble notes in January, 1998. The old 1,000-ruble bills were replaced with new one-ruble notes in an effort to curt
15、ail money growth.Technical ProblemsWith real output remaining constant, the additional tax revenue gained from inflation is: inflation tax revenue = (inflation rate)*(real monetary base).If the real money base is 10% of GDP and the inflation rate increases from 0% to 10%, we should expect an increas
16、e in government tax revenues of 1%, as long as the real monetary base remains constant. However, as inflation increases, people reduce their money holdings and banks reduce their excess reserves since it becomes more costly to hold money. In countries that have sophisticated banking systems, money h
17、oldings (and therefore the inflation tax revenue) decrease to a much larger extent than in countries where there are fewer alternatives to cash holdings. But if the real monetary base decreases, so does the inflation tax revenue.1. The inflation-adjusted budget deficit is 1.9% of GDP, which can be c
18、alculated as follows:inflation-adjusted deficit = total deficit - (inflation rate)*(national debt)=4% - (7%)(30%) = 4%-2.1% = 1.9%2. From the equation MV = PY = %AM + %AV = %AP + %AY= %AP = %AM - %AY + %AV = 7t = m-y + v.In other words, the rate of inflation (%AP =兀)is equal to the difference betwee
19、n M2 growth (%AM = m) and economic growth (%AY = y) adjusted for changes in the income velocity of M2 (%AV = v). If we subtract the second column (output growth) from the first column (money growth) in Table 22-5, we get the inflation rate minus the change in the velocity. In other words, Column 3 (
20、the inflation rate) would only be equal to the difference of the first two columns if velocity remained constant. The numbers in this table imply that the changes in velocity varied from - 6.3% in 1880-1889 to + 3.3% in 1920 - 1929. From I960 to 1989, changes in velocity were very close to 0%. In th
21、ese three decades, the rate of inflation can be explained very well by the difference between M2 growth and economic growth. In the periods after 1990, changes in velocity again differed significantly from 0%.Empirical ProblemsWhen the average percent error (MV - PY)/PY is calculated (using Excel) f
22、or the years 1959 to 2012, the results for each year are extremely close to zero. Therefore one can conclude that equation (1), that is, MV = PY, is supported by actual data.Additional ProblemsComment on the following statement:“Higher monetary growth is generally followed by higher wage demands.The
23、 equation %AP = %AM - %AY + %AV implies that in the long run the rate of inflation (%AP) is determined by the growth rate of money supply (%AM) adjusted for the growth rate of income (%AY) and changes in velocity (%AV). In addition, from the equation w = W/P, that is, real wages equal nominal wages
24、divided by the price level, we can calculate that(%Aw) = (%AW) - (%AP). Assuming in a competitive labor market in which w = MPN, that is, the real wage rate is equal to the marginal product of labor, this can be reformulated into the equation (%AP) = (%AW) - (%AMPN). Thus we can see that inflation i
25、ncreases if nominal wages increase more than labor productivity. Since workers base their wage demands on their inflationary expectations (which are largely based on the growth rate of money supply), increases in money supply are likely to be followed by demand for higher nominal wages.1. Comment on
26、 the following statement:“An increase in the growth rate of money supply by 2% will lead to an increase in interest rates of 2%.”From the equation %AP = %AM - %AY + % AV, or 兀=m - y + v, it follows that, in the long run, the rate of inflation (%AP =兀)will go up by 2% as a result of an increase in th
27、e rate of money growth (%AM = m) by 2%. However, this assumes that the rate of economic growth (%AY = y) and the growth of velocity (%AV = v) do not change. According to the Fisher equation, in = r + 兀，the nominal interest rate (in) is equal to the real interest rate (r) plus the rate of inflation (
28、兀).If【he rate of inflation goes up by 2%, nominal interest rates will do so as well, since monetary policy is neutral in the long run. In other words, in the long run only the nominal interest rate is affected by monetary expansion, but the real interest rate remains constant. However, this is not t
29、rue in the short run. After an increase in monetary growth, the increase in the rate of inflation and the interest rate will be less than 2%, since the AS-curve is not vertical but upward-sloping in the short run.2. “The most important factor in a central banks fight against inflation is credibility
30、.” Comment on this statement and explain the concept of time inconsistency.If a policy measure designed to reduce inflation has credibility, labor unions are more likely to adjust their inflationary expectations and their wage demands downwards in contract negotiations. The likely outcome will be lo
31、w inflation and low unemployment. Restrictive monetary policy will shift the AD-curve to the left, lowering inflation but at the cost of increasing unemployment. If inflationary expectations, wages, and prices adjust quickly, the short-run AS-curve will shift quickly to the right and the economy wil
32、l return rapidly to the full-employment level of output at a lower inflation rate. A central banks credibility is an important factor in this process, but so are long-term contracts. If long-term wage contracts exist, then wages cannot adjust quickly to their market-clearing level, and it will take
33、a longer time to return to the full-employment level of output.While the credibility of the central bank is very important in the fight against inflation, it is not easily earned. If the central bank has not consistently adhered to its announced policies in the past, il will encounter the problem of
34、 time inconsistency. For example, if labor unions settle for lower wage increases, the central bank may be tempted to create additional jobs by increasing monetary growth, knowing that wages are locked in for the time being. The outcome is lower unemployment but a higher than expected rate of inHati
35、on, and workers real wages will be lower than expected. If the central bank abandoned its announced anti- inflation policy after wages have been settled in the past, any future policy announcement will suffer from time inconsistency. In that case, labor unions will always expect faster monetary grow
36、th and demand higher wages in upcoming wage negotiations regardless of what the central bank announces. As a result, inflation will not be reduced.3. What are the factors that would make an anti-inflation policy less costly in terms of increased unemployment and subsequent loss of output?A more grad
37、ual approach to reducing inflation is generally less costly than other options because it causes less unemployment. But such an approach can only be successful if it has a high degree of credibility. In other words, the central bank must be generally viewed as likely to adhere to announced policy ch
38、anges. Furtheimore, the faster inflationary expectations adjust and the more flexible wages and prices are, the more successful an anti-inflation policy will be.4. Hyperinflation requires a cold-turkey approach. Comment on this statement.An economy experiencing hyperinflation needs to implement dras
39、tic measures to reduce inflationary expectations enough to stabilize at a lower rate of inflation. In the 1980s, the governments of Israel and Bolivia used the cold-turkey approach and succeeded in ending periods of hyperinflation. Israel used wage and price controls to avoid a large increase in the
40、 unemployment rate, but supplemented them with large budget cuts and credit rationing. Bolivia sharply reduced its budget deficit, curtailed monetary growth, stabilized exchange rates, and stopped external debt service. As a result, the rates of inflation in these countries declined rapidly and shar
41、ply.5. Comment on the following statement:“There is a limit to how much additional tax revenue a government can create through an increase in inflation.”The financing of government spending through the creation of high-powered money is an alternative to explicit taxation. The additional tax revenue
42、that can be created by an increase in inHation is defined as follows:inflation tax revenue = (inflation rate)*(real money base).Inflation acts just like a tax since the government is able to finance a spending increase by printing money while people must hold increasing amounts of nominal money bala
43、nces to maintain the purchasing power of their real balances. However, holding money becomes more costly with increased inflation and there is a limit to how much revenue the government can raise through this inflation tax. People start to reduce their real currency holdings and banks begin to hold
44、as little in excess reserves as possible. Eventually the real monetary base falls so much that the governments inflation tax revenue begins to decrease again.6. Monetarists and the rational expectations school share the belief that active government stabilization policy usually makes things worse an
45、d that the central bank should adopt a monetary growth rule. But they disagree on how the economy reacts to monetary policy changes. Explain this disagreement.Both monetarists and the rational expectations school believe that credibility is important in the fight against inflation and that credibili
46、ty can best be established through policy rules. Thus they prefer a monetary growth rule over discretionary policies. However, they disagree on how the economy adjusts to a change in money supply growth. Monetarists believe that the economy reacts to monetary policy change with long and variable lag
47、s. Since markets do not clear rapidly, an increase in unemployment will follow a significant reduction in money supply growth. The rational expectations approach, however, states that markets do clear rapidly and that inflation can therefore be reduced fairly rapidly through monetary restriction wit
48、hout great costs in terms of higher unemployment.7. Comment on the following statement:“The rational expectations approach and the monetarist approach to macroeconomics both assert that expansionary monetary policy simply increases inflation without any significant effect on output or the unemployme
49、nt rate.”The rational expectations approach asserts that all individuals and firms have access to all the necessary information and consistently make optimal decisions based on rationally formed expectations. Wages and prices are assumed to be flexible, so markets always clear rapidly. When a policy change is anticipated, people try to immediately adjust to the long-run outcome. As a result, any announced expansionary monetary policy will almost immediately res