learning objectives
- Given the analysis in this chapter, why do central bankers
sometimes allow inflation to occur year after year?
- What are lags and why are they important?
If the link between money supply growth and inflation is so
clear, and if nobody (except perhaps inveterate debtors) has
anything but contempt for inflation, why have central bankers
allowed it to occur so frequently? Not all central banks are
independent of the fiscal authority and may simply print money on
its behalf to finance budget deficits, the stuff of
hyperinflations. In addition, central bankers might be more
privately interested than publicly interested and somehow benefit
personally from inflation. (They might score points with
politicians for stimulating the economy just before an election or
they might take out big loans and repay them after the inflationary
period in nearly worthless currency.) Assuming central bankers are
publicly interested but far from prescient, what might cause them
to err so often? In short, lags and high-employment policies.
A lag is an amount of time that passes between a cause and its
eventual effect. Lags in monetary policy, Friedman showed, were
“long and variable.” Data lag is the time it takes for policymakers
to get important information, like GDP (Y) and unemployment.
Recognition lag is the time it takes them to become convinced that
the data is accurate and indicative of a trend and not just a
random perturbation. Legislative lag is the time it takes
legislators to react to economic changes. (This is short for
monetary policy, but it can be a year or more for fiscal policy.)
Implementation lag refers to the time between policy decision and
implementation. (Again, for modern central banks using open market
purchases [OMPs], this lag is minimal, but for changes in taxes, it
can take a long time indeed.) The most important lag of all is the
so-called effectiveness lag, the period between policy
implementation and real-world results. Business investments, after
all, typically take months or even years to plan, approve, and
implement.
All told, lags can add up to years and add considerable
complexity to monetary policy analysis because they cloud
cause-effect relationships. Lags also put policymakers perpetually
behind the eight-ball, constantly playing catch-up. Lags force
policymakers to forecast the future with accuracy, something (as
we’ve seen) that is not easily done. As noted in earlier chapters,
economists don’t even know when the short run becomes the long
run!
Consider a case of so-called cost-push inflation brought about
by a negative supply shock or wage push. That moves the AS curve to
the left, reducing output and raising prices and, in all
likelihood, causing unemployment and political angst. Policymakers
unable to await the long term (the rightward shift in AS because Y*
has fallen below Ynrl, causing unemployment and wages to
decline) may well respond with what’s called accommodative monetary
policy. In other words, they engage in expansionary monetary
policies (EMPs), which shift the AD curve to the right, causing
output to increase (with a lag) but prices to rise. Because
prices are higher and they’ve been recently rewarded for their wage
push with accommodative monetary policy, workers may well initiate
another wage push, starting a vicious cycle of wage pushes followed
by increases in P* and yet more wage pushes. Monetarists and
other nonactivists shake their heads at this dynamic, arguing that
if workers’ wage pushes were met by periods of higher unemployment,
they would soon learn to stop. (After all, even 2-year-olds and
rats eventually learn to stop pushing buttons if they are not
rewarded for doing so. They learn even faster to stop pushing if
they get a little shock.)
An episode of demand-pull inflation can also touch off
accommodative monetary policy and a bout of inflation. If the
government sets its full employment target too high, above the
natural rate, it will always look like there is too much
unemployment. That will eventually tempt policymakers into thinking
that Y* is < Ynrl, inducing them to implement an EMP.
Output will rise, temporarily, but so too will prices. Prices will
go up again when the AS curve shifts left, back to Ynrl,
as it will do in a hurry given the low level of unemployment. The
shift, however, will again increase unemployment over the
government’s unreasonably low target, inducing another round of EMP
and price increases.
Another source of inflation is government budget
deficits. To cover their expenditures, governments can tax,
borrow at interest, or borrow for free by issuing money. (Which
would you choose?) Taxation is politically costly. Borrowing at
interest can be costly too, especially if the government is a
default risk. Therefore, many governments pay their bills by
printing money or by issuing bonds that their respective central
banks then buy with money. Either way, the monetary base increases,
leading to some multiple increases in the MS, which leads to
inflation. Effectively a tax on money balances called a currency
tax, inflation is easier to disguise and much easier to collect
than other forms of taxes. Governments get as addicted to the
currency tax as individuals get addicted to crack or meth. This is
especially true in developing countries with weak (not independent)
central banks.
Stop and Think Box
Why is central bank independence
important in keeping inflation at bay?
Independent central banks are better
able to withstand political pressures to monetize the debt, to
follow accommodative policies, or to respond to (seemingly) “high”
levels of unemployment with an EMP. They can also make a more
believable or credible commitment to stop inflation, which is an
important consideration as well.
key takeaways
- Private-interest scenarios aside, publicly interested central
bankers might pursue high employment too vigorously, leading to
inflation via cost-push and demand-pull mechanisms.
- If workers make a successful wage push, for example, the AS
curve will shift left, increasing P*, decreasing Y*, and increasing
unemployment.
- If policymakers are anxious to get out of recession, they might
respond with an expansionary monetary policy (EMP).
- That will increase Y* but also P* yet again. Such an
accommodative policy might induce workers to try another wage push.
The price level is higher after all, and they were rewarded for
their last wage push.
- The longer this dynamic occurs, the higher prices will go.
- Policymakers might fall into this trap themselves if they
underestimate full employment at, say, 97 percent (3 percent
unemployment) when in fact it is 95 percent (5 percent
unemployment).
- Therefore, unemployment of 4 percent looks too high and output
appears to be < Ynrl, suggesting that an EMP is in
order.
- The rightward shift of the AD curve causes prices and output to
rise, but the latter rises only temporarily as the already tight
labor market gets tighter, leading to higher wages and a leftward
shift of the AS curve, with its concomitant increase in P* and
decrease in Y*.
- If policymakers’ original and flawed estimate of full
employment is maintained, another round of AD is sure to come, as
is higher prices.
- Budget deficits can also lead to sustained inflation if the
government monetizes its debt directly by printing money (and
deposits) or indirectly via central bank open market purchases
(OMPs) of government bonds.
- Lags are the amount of time it takes between a change in the
economy to take place and policymakers to effectively do something
about it.
- That includes lags for gathering data, making sure the data
show a trend and are not mere noise, making a legislative decision
(if applicable), implementing policy (if applicable), and waiting
for the policy to affect the economy.
- Lags are important because they are long and variable, thus
complicating monetary policy by making central bankers play
constant catch-up and also by clouding cause-effect
relationships.