This is the final money and inflation post. Then I’ll do one post on money and business cycles, and conclude the mini-course with a post on money and asset prices (including interest rates.) Nine posts in all.
In the previous post we saw that increases in the rate of money growth lead to higher inflation, which leads to higher velocity and lower real money demand. This means that in the long run an increase in the money supply growth rate will cause prices to rise by even more than the money supply increased. Conversely if money growth slows, inflation will slow, the opportunity cost of holding base money will fall, money demand will rise, and prices will rise by less than the increase in the money supply. That’s one way that expectations play a role in the money inflation equation.
The more interesting examples occur when there is a change in the expected future level of the monetary base, but no current change in the base. Consider the following two examples:
1. A new government is elected and is expected to print lots of money (perhaps to juice the economy.) Prices will rise in anticipation of that increase in the money supply. A good example occurred between March 1933 and February 1934, when the Wholesale Price Index rose by over 20%, despite no increase in the monetary base. The public anticipated (correctly) that the devaluation of the dollar would lead to a higher money supply in future years. That increased current base velocity, reduced real money demand, and increased prices almost immediately.
2. The opposite situation occurs when a government injects large quantities of money into the economy, but tells the public that it will be removed as soon as there is any sign of inflation. In that case the interest rate will fall to zero, and the public will willingly hold much larger real cash balances. This occurred in Japan between the early 2000s, when lots of base money was injected, and 2006, when the monetary base was reduced by 20% in order to prevent inflation from occurring.
(It’s not clear the extent to which the recent low inflation in the US reflects this factor, and how much reflects the 2008 decision to pay interest on reserves.)
So the current path of inflation is very heavily influenced by expectations. But expectations must be about something, and in this case they are about future changes in the monetary base (and future changes in the demand for base money.) If we ignore expectations, then we can say the “hot potato effect” drives the long run relationship between changes in the money supply and changes in the price level. Once we bring expectations into the picture, then it’s the expected future hot potato effect that mostly explains current inflation.
Unfortunately the role of expectations makes monetary economics much more complex, potentially introducing an “indeterminacy problem,” or what might better be called “solution multiplicity.” A number of different future paths for the money supply can be associated with any given price level. Alternatively, there are many different price levels (including infinity) that are consistent with any current money supply. Thus if the public believes money will be declared null and void next week, it may have no value today (think Confederate money toward the end of the Civil War.) So lurking in the background there must be some sort of confidence that money will have purchasing power in the future. There is much debate over what sort of implied promise is embedded in money. My best guess is that the public (correctly) believes that if and when currency is replaced by electronic money, the government will redeem the currency they pull out of circulation for some sort of alternative asset with roughly the same purchasing power.
The next step is to explain why monetary policy does not just affect prices, but also has real effects. It turns out that this is pretty easy to do, and I’ll cover that in the next post.