Money and Inflation

In light of comments on my post about inflation, e.g. that deficits and supply shocks cannot produce a long-term inflation, etc., let me try to convince you that at least one member of the Fed thinks about inflation exactly as I wrote. This is from chapter 24 of Federal Reserve Governor Frederic S. Mishkin's textbook The Economics of Money, Banking, and Financial Markets (8th ed.), graphs and all. The chapter is called "Money and Inflation":

Meaning of 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 indicates only 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 a 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.

Accordingly, Milton Friedman's proposition actually says that upward movements in the price level are a monetary phenomena only if this is a sustained process. When inflation is define as a continuing and rapid rise in the price level, almost all economists agree with Friedman's proposition that money alone is to blame.

Views of Inflation

Now that we understand what Friedman's proposition means, we can use the aggregate supply and demand analysis learned in Chapter 22 to show that large and persistent upward movements in the price level (high inflation) can occur only if there is a continually growing money supply.

How Money Growth Produces Inflation

First, let's look at the outcome of a continually growing money supply (see Figure 2). Initially the economy is at point 1, with output at the natural rate level and the price level at P₁ (the intersection of the aggregate demand curve AD₁, and the short-run aggregate supply curve AS₁). If the money supply increases steadily over the course of the year, the aggregate demand curve shifts rightward to AD₂. At first, for a very brief time, the economy may move to point 1' and output may increase above the natural rate level to Y', but the resulting decline in unemployment below the natural rate level will cause wages to rise, and the short-run aggregate supply curve will quickly begin to shift leftward. It will stop shifting only when it reaches AS₂, at which time the economy has returned to the natural rate level of output on the long-run aggregate supply curve.¹ At the new equilibrium, point 2, the price level has increased from  P₁ to P₂.

click on figure to enlarge

If the money supply increases the next year, the aggregate demand curve will shift to the right again to AD₃, and the short-run aggregate supply curve will shift from  AS₂ to AS₃; the economy will move to point 2' and then to point 3, where the price level has risen to P₃. If the money supply continues to grow in subsequent years, the economy will continue to move to higher and higher price levels. As long as the money supply grows, this process will continue, and inflation will occur. High money growth produces high inflation.

Can Other Factors Besides Money Growth Produce a Sustained Inflation?

In the aggregate demand and supply analysis in Chapter 22, you learned that other factors besides changes in the money Supply (such as fiscal policy and supply shocks) can affect the aggregate demand and supply curves. Doesn't this suggest that these other factors can generate high inflation? The answer, surprisingly, is no. To see why high inflation is always a monetary phenomenon, let's dig a little deeper into aggregate demand and supply analysis to see whether other factors can generate high inflation in the absence of a high rate of money growth.

Can Fiscal Policy by Itself Produce Inflation? To examine this question, let's look at Figure 3, which demonstrates the effect of a one-shot permanent increase in government expenditure (say, from $500 billion to $600 billion) on aggregate output and the price level. Initially, we are at point 1, where output is at the natural rate level and the price level is P₁. The increase in government expenditure shifts the aggregate demand curve to AD₂, and we move to point 1', where output is above the natural rate level at Y_1'. Because of this, the short-run aggregate supply curve will begin to shift leftward, eventually reaching AS₂, where it intersects the aggregate demand curve AD₂, at point 2, at which output is again at the natural rate level and the price level has risen to P₂.

click on figure to enlarge

The net result of a one-shot permanent increase in government expenditure is a one-shot permanent increase in the price level. What happens to the inflation rate? When we move from point 1 to 1' to 2, the price level rises, and we have a positive inflation rate. But when we finally get to point 2, the inflation rate returns to zero. We see that the one-shot increase in government expenditure leads to only a temporary increase in the inflation rate, not to an inflation in which the price level is continually rising.

If government spending increases continually, however, we could get a continuing rise in the price level. It appears, then, that aggregate demand and supply analysis could reject Friedman's proposition that inflation is always the result of money growth. The problem with this argument is that a continually increasing level of government expen­diture is not a feasible policy. There is a limit on the total amount of possible govern­ment expenditure; the government cannot spend more than 100%, of GDP. In fact, well before this limit is reached, the political process would stop the increases in government spending. As revealed in the continual debates in Congress over balanced budgets and government spending, both the public and politicians have a particular target level of government spending they deem appropriate; although small deviations from this level might be tolerated, large deviations would not. Indeed, public and political perceptions impose tight limits on the degree to which government expenditures can increase.

What about the other side of fiscal policy-taxes? Could continual tax cuts generate an inflation? Again the answer is no. The analysis in Figure 3 also describes the price and output response to a one-shot decrease in taxes. There will be a one-shot increase in the price level, but the increase in the inflation rate will be only temporary We can increase the price level by cutting taxes even more, but this process would have to stop-once taxes reach zero, they can't be reduced further. We must conclude, then, that high inflation cannot be driven by fiscal policy alone.²

Supply-Side Phenomena by Themselves Produce Inflation?

Because supply shocks and workers' attempts to increase their wages can shift the short-run aggregate supply curve leftward, you might suspect that these supply-side phenomena by themselves could stimulate inflation. Again, we can show that this suspicion is incorrect.

click on figure to enlarge

Suppose that a negative supply shock -- for example, an oil embargo -- raises oil prices (or workers could have successfully pushed up their wages). As displayed in Figure 4, the negative supply shock shifts the short-run aggregate supply curve from AS₁ to AS₂. If the money supply remains unchanged, leaving the aggregate demand curve at AD₁, we move to point 1', where output Y_1' is below the natural rate level and the price level P_1' is higher. The short-run aggregate supply curve will now shift back to AS₁, because unemployment is above the natural rate, and the economy slides down AD₁ from point 1' to point 1. The net result of the supply shock is that we return to full employment at the initial price level, and there is no continuing inflation. Additional negative supply shocks that again shift the short-run aggregate supply curve leftward will lead to the same outcome: The price level will rise temporarily, but inflation will not result. The conclusion that we have reached is the following: Supply-side phenomena cannot be the source of high inflation.³

Summary

Our aggregate demand and supply analysis shows that high inflation can occur only with a high rate of money growth. As long as we recognize that inflation refers to a continuing increase in the price level at a rapid rate, we now see why Milton Friedman was correct when he said that "Inflation is always and everywhere a monetary phenomenon."

---

¹There is a possibility that the short-run aggregate supply curve may immediately shift in toward AS₂, because workers and firms may expect the increase in the money supply, so expected inflation will be higher. In this case, the movement to point 2 will he very rapid, and output need not rise above the natural rate level. (Some support for this scenario from the theory of rational expectations is discussed in Chapter 25.)

²The argument here demonstrates that "animal spirits" also cannot be the source of inflation. Although consumer and business optimism, which stimulates these groups' spending, can produce a one-shot shift in the aggregate demand curve and a temporary inflation, it cannot produce continuing shifts in the aggregate demand curve and inflation in which the price level rises continually. The reasoning is the same as before: Consumers and businesses cannot continue to raise their spending without limit because their spending cannot exceed 100% of GDP.

³Supply-side phenomena that alter the natural rate level of output (and shift the long-run aggregate supply curve at Y_n) can produce a permanent one-shot change in the price level. However, this resulting one-shot change results in only a temporary inflation, not a continuing rise in the price level.