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11.6 End-of-Chapter Material

In Conclusion

We have studied some severe and extreme cases of inflation to reveal the sources of rapid price increases. The quantity equation and the data both clearly indicate that inflation is linked to money supply growth. During periods of rapid inflation, the money supply is growing as well. The velocity of money also increases in times of rapid inflation, reflecting the collapse of confidence in the monetary system.

Money supply growth, in turn, comes about because money creation can help finance government budget deficits. Instead of using taxes to finance government spending, governments just print money. This increases prices and thus acts like a tax on those holding money and other nominal assets. Like all taxes, the inflation tax is distortionary. Used in moderation, there is an argument for using this tax along with others. But for some countries in some time periods, the use of the inflation tax has been excessive and there have been very costly hyperinflations.

The way to avoid excessive inflation is to create fiscal balance and monetary discipline. The big inflations between World War I and World War II ended when fiscal balance was restored. Monetary discipline comes in many forms. It requires an independent central bank, immune from political pressures. It may also require a central bank focused on an inflation target, paying less attention to other macroeconomic issues.

Key Links

Exercises

  1. What is the difference between the quantity equation and the quantity theory of money?
  2. According to the classical dichotomy, what happens to the real money supply if the nominal money supply grows at 10 percent?
  3. If you were to draw a line through the points in Figure 11.6 "Inflation and Money Growth in Different Countries", it would not pass through the origin. Can you explain why? (Hint: examine the equation for the quantity equation, expressed in growth rates.)
  4. Looking at Figure 11.10 "The Price Level in Argentina", you might be fooled into thinking that the inflation between 2002 and 2003 was almost as bad as that between 1990 and 1991. Why would this reasoning be a mistake?
  5. The chapter contains two perspectives on Germany. The first is the hyperinflation in Germany during the 1920s, and the second is current Germany with low inflation and an independent central bank. How would you describe the differences in economic achievement (inflation, output growth, and unemployment) between these two versions of Germany? What were the institutional differences between these two versions of Germany?
  6. Looking at Table 11.2 "The Start of the Hyperinflation in Zimbabwe", what happened to the velocity of money in Zimbabwe during the hyperinflation?
  7. If the central bank takes the view that producing at potential GDP is efficient, then does it face a commitment problem?
  8. In 2010, the state of California faced severe budgetary problems. If the state could print dollars, how would that relieve its budget problems? Who would pay the inflation tax?

Economics Detective

  1. In the United States, how many central banks are there?
  2. In note 5, we mention a measure of the money supply called “M2.” There are other measures of the money supply. For example, “M1” refers to currency and other assets that are immediately available for spending purposes. Find the most recent measure of the stocks of M1 and M2 for the United States.
  3. Calculate the velocity of money for a country other than the United States.
  4. The chapter did not present data on other recent periods of high inflation in countries such as Argentina, Brazil, Israel, and others. Search the Internet to find data on the inflation experiences of these countries. Create a graph of the growth rates of inflation and money in one of these countries.
  5. It might be that countries have high money growth and thus high inflation because these are the goals of their monetary authority. See whether you can find a monetary authority with a stated goal of high inflation. If not, then think about why countries experience inflation if that is not the objective of the monetary authority?
  6. What countries are dollarized in the world economy? Try to find out how dollarization influenced the inflation rate in that country.
  7. Try to find a statement of the objectives of the Central Bank of Argentina. Part of independence is the way in which the decision makers at the central bank are appointed. How are these appointments made in Argentina?
  8. Go to the web page for the Bank of Australia to learn about inflation targeting. What is their inflation target? How is it determined? What happens if they miss the target? Compare this to the objective and policy decisions of the Fed in the United States. What other central banks follow an inflation-targeting rule?
  9. Is monetary policy in the United States guided by an inflation target? Does the European Central Bank use an inflation target?

Spreadsheet Exercise

  1. Create a version of Table 11.1 "Prices in Germany" using a spreadsheet. Examine quarterly data for the United States or another country for the years 2007 to 2009. For prices, use the GDP implicit price deflator. Use the spreadsheet to calculate the inflation rate. Then put in a measure of the money supply and real GDP. Use the spreadsheet to calculate the velocity of money. Is the velocity of money approximately constant?