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Supply-side phenomena that alter the natural rate level of output (and shift the long-run aggregate supply curve at Yn) 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.
FIGURE 4 Response to a Supply Shock
A negative supply shock (or a wage push) shifts the aggregate supply curve leftward to A52 and results in high unemployment at point 1'. As a result, the aggregate supply curve shifts back to the right to A51, and the economy returns to point 1, where the price level has returned to P1
FIGURE 4 Response to a Supply Shock
A negative supply shock (or a wage push) shifts the aggregate supply curve leftward to A52 and results in high unemployment at point 1'. As a result, the aggregate supply curve shifts back to the right to A51, and the economy returns to point 1, where the price
do governments pursue inflationary monetary policies? Since there is nothing intrinsically desirable about inflation and since we know that a high rate of money growth doesn't happen of its own accord, it must follow that in trying to achieve other goals, governments end up with a high money growth rate and high inflation. In this section, we will examine the government policies that are the most common sources of inflation.
High Employment The first goal most governments pursue that often results in inflation is high employ-
Targets and ment. The U.S. government is committed by law (the Employment Act of 1946 and
Inflation the Humphrey-Hawkins Act of 1978) to promoting high employment. Though it is true that both laws require a commitment to a high level of employment consistent with a stable price level, in practice our government has often pursued a high employment target with little concern about the inflationary consequences of its policies. This was true especially in the mid-1960s and 1970s, when the government began to take a more active role in attempting to stabilize unemployment.
Two types of inflation can result from an activist stabilization policy to promote high employment: cost-push inflation, which occurs because of negative supply shocks or a push by workers to get higher wages, and demand-pull inflation, which results when policymakers pursue policies that shift the aggregate demand curve to the right. We will now use aggregate demand and supply analysis to examine how a high employment target can lead to both types of inflation.
Cost-Push Inflation. In Figure 5, the economy is initially at point 1, the intersection of the aggregate demand curve AD1 and the aggregate supply curve A5X. Suppose that workers decide to seek higher wages, either because they want to increase their real wages (wages in terms of the goods and services they can buy) or because they expect inflation to be high and wish to keep up with inflation. The effect of such an increase
- FIGURE 5 Cost-Push Inflation with an Activist Policy to Promote High Employment
In a cost-push inflation, the leftward shifts of the aggregate supply curve from ASj to AS2 to AS3 and so on cause a government with a high employment target to shift the aggregate demand curve to the right continually to keep unemployment and output at their natural rate levels. The result is a continuing rise in the price level from P1 to P2 to P3 and so on.
(similar to a negative supply shock) is to shift the aggregate supply curve leftward to AS2.5 If government fiscal and monetary policy remains unchanged, the economy would move to point 1' at the intersection of the new aggregate supply curve AS2 and the aggregate demand curve AD1. Output would decline to below its natural rate level Yn, and the price level would rise to P1'.
What would activist policymakers with a high employment target do if this situation developed? Because of the drop in output and resulting increase in unemployment, they would implement policies to raise the aggregate demand curve to AD2, so that we would return to the natural rate level of output at point 2 and price level P2. The workers who have increased their wages have not fared too badly. The government has stepped in to make sure that there is no excessive unemployment, and they have achieved their goal of higher wages. Because the government has, in effect, given in to the demands of workers for higher wages, an activist policy with a high employment target is often referred to as an accommodating policy.
The workers, having eaten their cake and had it too, might be encouraged to seek even higher wages. In addition, other workers might now realize that their wages have fallen relative to their fellow workers', and because they don't want to be left behind, these workers will seek to increase their wages. The result is that the aggregate supply curve shifts leftward again, to AS3. Unemployment develops again when we move
5The cost-push inflation we describe here might also occur as a result either of firms' attempts to obtain higher prices or of negative supply shocks.
to point 2', and the activist policies will once more be used to shift the aggregate demand curve rightward to AD3 and return the economy to full employment at a price level of P3. If this process continues, the result will be a continuing increase in the price level—a cost-push inflation.
What role does monetary policy play in a cost-push inflation? A cost-push inflation can occur only if the aggregate demand curve is shifted continually to the right. In Keynesian analysis, the first shift of the aggregate demand curve to AD2 could be achieved by a one-shot increase in government expenditure or a one-shot decrease in taxes. But what about the next required rightward shift of the aggregate demand curve to AD3, and the next, and the next? The limits on the maximum level of government expenditure and the minimum level of taxes would prevent the use of this expansionary fiscal policy for very long. Hence it cannot be used continually to shift the aggregate demand curve to the right. But the aggregate demand curve can be shifted continually rightward by continually increasing the money supply, that is, by going to a higher rate of money growth. Therefore, a cost-push inflation is a monetary phenomenon because it cannot occur without the monetary authorities pursuing an accommodating policy of a higher rate of money growth.
Demand-Pull Inflation. The goal of high employment can lead to inflationary monetary policy in another way. Even at full employment, unemployment is always present because of frictions in the labor market, which make it difficult to match workers with employers. An unemployed autoworker in Detroit may not know about a job opening in the electronics industry in California or, even if he or she did, may not want to move or be retrained. So the unemployment rate when there is full employment (the natural rate of unemployment) will be greater than zero. If policymakers set a target for unemployment that is too low because it is less than the natural rate of unemployment, this can set the stage for a higher rate of money growth and a resulting inflation. Again we can show how this can happen using an aggregate supply and demand diagram (see Figure 6).
If policymakers have an unemployment target (say, 4%) that is below the natural rate (estimated to be between 4j and 52% currently), they will try to achieve an output target greater than the natural rate level of output. This target level of output is marked YT in Figure 6. Suppose that we are initially at point 1; the economy is at the natural rate level of output but below the target level of output YT. To hit the unemployment target of 4%, policymakers enact policies to increase aggregate demand, and the effects of these policies shift the aggregate demand curve until it reaches AD2 and the economy moves to point 1'. Output is at YT, and the 4% unemployment rate goal has been reached.
If the targeted unemployment rate was at the natural rate level between 4j and 5^%, there would be no problem. However, because at YT the 4% unemployment rate is below the natural rate level, wages will rise and the aggregate supply curve will shift in to A52, moving the economy from point 1' to point 2. The economy is back at the natural rate of unemployment, but at a higher price level of P2. We could stop there, but because unemployment is again higher than the target level, policymakers would again shift the aggregate demand curve rightward to AD3 to hit the output target at point 2', and the whole process would continue to drive the economy to point 3 and beyond. The overall result is a steadily rising price level—an inflation.
How can policymakers continually shift the aggregate demand curve rightward? We have already seen that they cannot do it through fiscal policy, because of the limits on raising government expenditures and reducing taxes. Instead they will have to
FIGURE 6 Demand-Pull Inflation: The Consequence of Setting Too Low an Unemployment Target
Too low an unemployment target (too high an output target of YT) causes the government to shift the aggregate demand curve rightward from AD1 to AD2 to AD3 and so on, while the aggregate supply curve shifts leftward from A51 to A52 to A53 and so on. The result is a continuing rise in the price level known as a demand-pull inflation.
FIGURE 6 Demand-Pull Inflation: The Consequence of Setting Too Low an Unemployment Target
Too low an unemployment target (too high an output target of YT) causes the government to shift the aggregate demand curve rightward from AD1 to AD2 to AD3 and so on, while the aggregate supply curve shifts leftward from A51 to A52 to A53 and so on. The result is a continuing rise in the price level known as a demand-pull inflation.
resort to expansionary monetary policy: a continuing increase in the money supply and hence a high money growth rate.
Pursuing too high an output target or, equivalently, too low an unemployment rate is the source of inflationary monetary policy in this situation, but it seems senseless for policymakers to do this. They have not gained the benefit of a permanently higher level of output but have generated the burden of an inflation. If, however, they do not realize that the target rate of unemployment is below the natural rate, the process that we see in Figure 6 will be well under way before they realize their mistake.
Because the inflation described results from policymakers' pursuing policies that shift the aggregate demand curve to the right, it is called a demand-pull inflation. In contrast, a cost-push inflation occurs when workers push their wages up. Is it easy to distinguish between them in practice? The answer is no. We have seen that both types of inflation will be associated with higher money growth, so we cannot distinguish them on this basis. Yet as Figures 5 and 6 demonstrate, demand-pull inflation will be associated with periods when unemployment is below the natural rate level, whereas cost-push inflation is associated with periods when unemployment is above the natural rate level. To decide which type of inflation has occurred, we can look at whether unemployment has been above or below its natural rate level. This would be easy if economists and policymakers actually knew how to measure the natural rate of unemployment; unfortunately, this very difficult research question is still not fully resolved by the economics profession. In addition, the distinction between cost-push and demand-pull inflation is blurred, because a cost-push inflation can be initiated by a demand-pull inflation: When a demand-pull inflation produces higher inflation rates, expected inflation will eventually rise and cause workers to demand higher wages so that their real wages do not fall. In this way, demand-pull inflation can eventually trigger cost-push inflation.
Budget Deficits and Inflation
The requirement that the government budget deficit equal the sum of the change in the monetary base and the change in government bonds held by the public.
Our discussion of the evidence on money and inflation suggested that budget deficits are another possible source of inflationary monetary policy. To see if this could be the case, we need to look at how a government finances its budget deficits.
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.
Methods of financing government spending are described by an expression called the government budget constraint, which states the following: The government budget deficit DEF, which equals the excess of government spending G over tax revenue T, must equal the sum of the change in the monetary base AMB and the change in government bonds held by the public AB. Algebraically, this expression can be written as:
To see what the government budget constraint means in practice, let's look at the case in which the only government purchase is a $100 million supercomputer. If the government convinces the electorate that such a computer is worth paying for, it will probably be able to raise the $100 million in taxes to pay for it, and the budget deficit will equal zero. The government budget constraint then tells us that no issue of money or bonds is needed to pay for the computer, because the budget is balanced. If taxpayers think that supercomputers are too expensive and refuse to pay taxes for them, the budget constraint indicates that the government must pay for it by selling $100 million of new bonds to the public or by printing $100 million of currency to pay for the computer. In either case, the budget constraint is satisfied; the $100 million deficit is balanced by the change in the stock of government bonds held by the public (AB = $100 million) or by the change in the monetary base (AMB = $100 million).
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.
There are several ways to understand why a deficit leads to an increase in the monetary base when the publics bond holdings do not increase. The simplest case is when the government's treasury has the legal right to issue currency to finance its deficit. Financing the deficit is then very straightforward: The government just pays for the spending that is in excess of its tax revenues with new currency. Because this increase in currency adds directly to the monetary base, the monetary base rises and the money supply with it through the process of multiple deposit creation described in Chapters 15 and 16.
In the United States, however, and in many other countries, the government does not have the right to issue currency to pay for its bills. In this case, the government must finance its deficit by first issuing bonds to the public to acquire the extra funds to pay its bills. Yet if these bonds do not end up in the hands of the public, the only alternative is that they are purchased by the central bank. For the government bonds not to end up in the hands of the public, the central bank must conduct an open market purchase, which, as we saw in Chapters 15 and 16, leads to an increase in the monetary base and in the money supply. This method of financing government spending is called monetizing the debt because, as the two-step process described indicates, government debt issued to finance government spending has been removed from the hands of the public and has been replaced by high-powered money. This method of financing, or the more direct method when a government just issues the currency directly, is also, somewhat inaccurately, referred to as printing money because high-powered money (the monetary base) is created in the process. The use of the word printing is misleading because what is essential to this method of financing government spending is not the actual printing of money but rather the issuing of monetary liabilities to the public after the money has been printed.
We thus see that a budget deficit can lead to an increase in the money supply if it is financed by the creation of high-powered money. However, earlier in this chapter you have seen that inflation can develop only when the stock of money grows continually. Can a budget deficit financed by printing money do this? The answer is yes, if the budget deficit persists for a substantial period of time. In the first period, if the deficit is financed by money creation, the money supply will rise, shifting the aggregate demand curve to the right and leading to a rise in the price level (see Figure 2). If the budget deficit is still present in the next period, it has to be financed all over again. The money supply will rise again, and the aggregate demand curve will again shift to the right, causing the price level to rise further. As long as the deficit persists and the government resorts to printing money to pay for it, this process will continue. Financing a persistent deficit by money creation will lead to a sustained inflation.
A critical element in this process is that the deficit is persistent. If temporary, it would not produce an inflation because the situation would then be similar to that shown in Figure 3, in which there is a one-shot increase in government expenditure. In the period when the deficit occurs, there will be an increase in money to finance it, and the resulting rightward shift of the aggregate demand curve will raise the price level. If the deficit disappears in the next period, there is no longer a need to print money. The aggregate demand curve will not shift further, and the price level will not continue to rise. Hence the one-shot increase in the money supply from the temporary deficit generates only a one-shot increase in the price level, and no inflation develops.
To summarize, 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.
If inflation is the result, why do governments frequently finance persistent deficits by creating money? The answer is the key to understanding how budget deficits may lead to inflation.
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