economics_of_money_banking__financial_markets

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.

C H A P T E R 2 7 Money and Inflation 643

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.

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 MB and the change in government bonds held by the public B. Algebraically, this expression can be written as:

To see what the government budget constraint means in practice, letÕs 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 ( B $100 million) or by the change in the monetary base ( MB $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 publicÕs bond holdings do not increase. The simplest case is when the governmentÕs 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.

F I G U R E 7 Interest Rates and

the Government Budget Deficit

When the Treasury issues bonds to finance the budget deficit, the supply curve for bonds shifts rightward from B 1s to B 2s . Many economists take the position that the equilibrium moves to point 2 because the bond demand curve remains unchanged, with the result that the bond price falls from P1 to P2 and the interest rate rises from i1 to i2. Adherents of Ricardian equivalence, however, suggest that the demand curve for bonds also increases to B dR , moving the equilibrium to point 2 , where the interest rate is unchanged at i1. (Note that P and i increase in opposite directions. P on the left vertical axis increases as we go up the axis, whereas i on the right vertical axis increases as we go down the axis.)

Quantity of Bonds, B

ftp://ftp.bls.gov/pub/special

.requests/cpi/cpiai.txt

Download historical inflation statistics going back to 1913. This data can easily be moved into Microsoft Excel using the procedure discussed at the end

of Chapter 1.

that a change in money growth takes that long to affect the inflation rate.) The rise in inflation from 1960 to 1980 can be attributed to the rise in the money growth rate over this period. But you have probably noticed that in 1974Ð1975 and 1979Ð1980, the inflation rate is well above the money growth rate from two years earlier. You may recall from Chapter 25 that temporary upward bursts of the inflation rate in those years can be attributed to supply shocks from oil and food price increases that occurred in 1973Ð1975 and 1978Ð1980.

However, the linkage between money growth and inflation after 1980 is not at all evident in Figure 8, and this explains why in 1982 the Fed announced that it would no longer use M1 as a basis to set monetary policy (see Chapter 18). The breakdown of the relationship between money growth and inflation is the result of substantial gyrations in velocity in the 1980s and 1990s (documented in Chapter 22). For example, the early 1980s was a period of rapid disinflation (a substantial fall in the inflation rate), yet the money growth rates in Figure 8 do not display a visible downward trend until after the disinflation was over. (The disinflationary process in the 1980s will be discussed in another application later in this chapter.) Although some economists see the 1980s and 1990s as evidence against the moneyÐinflation link, others view this as an unusual period characterized by large fluctuations

http://w3.access.gpo.gov /usbudget/

The Economic Report of the President reports debt levels and gross domestic product, along with many other economic statistics.

in interest rates and by rapid financial innovation that made the correct measurement of money far more difficult (see Chapter 3). In their view, this period was an aberration, and the close correspondence of money and inflation is sure to reassert itself. However, this has not yet occurred.

What is the underlying cause of the increased rate of money growth that we see occurring from 1960 to 1980? We have identified two possible sources of inflationary monetary policy: government adherence to a high employment target and budget deficits. LetÕs see if budget deficits can explain the move to an inflationary monetary policy by plotting the ratio of government debt to GDP in Figure 9. This ratio provides a reasonable measure of whether government budget deficits put upward pressure on interest rates. Only if this ratio is rising might there be a tendency for budget deficits to raise interest rates because the public is then being asked to hold more government bonds relative to their capacity to buy them. Surprisingly, over the course of the 20-year period from 1960 to 1980, this ratio was falling, not rising. Thus U.S. budget deficits in this period did not raise interest rates and so could not have encouraged the Fed to expand the money supply by buying bonds. Therefore, Figure 9 tells us that we can rule out budget deficits as a source of the rise in inflation in this period.

Because politicians were frequently bemoaning the budget deficits in this period, why did deficits not lead to an increase in the debtÐGDP ratio? The reason is that in this period, U.S. budget deficits were sufficiently small that the increase in the stock of government debt was still slower than the growth in nominal GDP, and the ratio of debt to GDP declined. You can see that interpreting budget deficit numbers is a tricky business.6

We have ruled out budget deficits as the instigator; what else could be the underlying cause of the higher rate of money growth and more rapid inflation in the 1960s and 1970s? Figure 10, which compares the actual unemployment rate to the natural rate of unemployment, shows that the economy was experiencing unemployment below the natural rate in all but one year between 1965 and 1973. This suggests that in 1965Ð1973, the American economy was experiencing the demand-pull inflation described in Figure 6.

Policymakers apparently pursued policies that continually shifted the aggregate demand curve to the right in trying to achieve an output target that was too high, thus causing the continual rise in the price level outlined in Figure 6. This occurred because policymakers, economists, and politicians had become committed in the mid-1960s to a target unemployment rate of 4%, the level of unemployment they thought was consistent with price stability. In hindsight, most economists today agree that the natural rate of unemployment was substantially higher in this period, on the order of 5 to 6%, as shown in Figure 10. The result of the inappropriate 4% unemployment

6Another way of understanding the decline in the debtÐGDP ratio is to recognize that a rise in the price level reduces the value of the outstanding government debt in real termsÑthat is, in terms of the goods and services it can buy. So even though budget deficits did lead to a somewhat higher nominal amount of debt in this period, the continually rising price level (inflation) produced a lower real value of the government debt. The decline in the real amount of debt at the same time that real GDP was rising in this period then resulted in the decline in the debtÐGDP ratio. For a fascinating discussion of how tricky it is to interpret deficit numbers, see Robert Eisner and Paul J. Pieper, ÒA New View of the Federal Debt and Budget Deficits,Ó American Economic Review 74 (1984): 11Ð29.

Responses to High Unemployment

All economists have similar policy goalsÑthey want to promote high employment and price stabilityÑand yet they often have very different views on how policy should be conducted. Activists regard the self-correcting mechanism through wage and price adjustment (see Chapter 25) as very slow and hence see the need for the government to pursue active, accommodating, discretionary policy to eliminate high unemployment whenever it develops. Nonactivists, by contrast, believe that the performance of the economy would be improved if the government avoided active policy to eliminate unemployment. We will explore the activist/nonactivist policy debate by first looking at what the policy responses might be when the economy experiences high unemployment.

Suppose that policymakers confront an economy that has moved to point 1 in Figure 11. At this point, aggregate output Y1 is lower than the natural rate level, and the economy is suffering from high unemployment. Policymakers have two viable choices: If they are nonactivists and do nothing, the aggregate supply curve will eventually shift rightward over time, driving the economy from point 1 to point 1, where full employment is restored. The accommodating, activist alternative is to try to eliminate the high unemployment by attempting to shift the aggregate demand curve rightward to AD2 by pursuing expansionary policy (an increase in the money supply, increase in government spending, or lowering of taxes). If policymakers could shift the aggregate demand curve to AD2 instantaneously, the economy would immediately move to point 2, where there is full employment. However, several types of lags prevent this immediate movement from occurring.

1.The data lag is the time it takes for policymakers to obtain the data that tell them what is happening in the economy. Accurate data on GDP, for example, are not available until several months after a given quarter is over.

2.The recognition lag is the time it takes for policymakers to be sure of what the data are signaling about the future course of the economy. For example, to minimize errors, the National Bureau of Economic Research (the organization that officially

F I G U R E 1 1 The Choice

Between Activist and Nonactivist

Policy

When the economy has moved to point 1 , the policymaker has two choices of policy: the nonactivist policy of doing nothing and letting the economy return to point 1 or the activist policy of shifting the aggregate demand curve to AD2 to move the economy to point 2.

Activist and

Nonactivist

Positions

dates business cycles) will not declare the economy to be in recession until at least six months after it has determined that one has begun.

3.The legislative lag represents the time it takes to pass legislation to implement a particular policy. The legislative lag does not exist for most monetary policy actions such as open market operations. It can, however, be quite important for the implementation of fiscal policy, when it can sometimes take six months to a year to get legislation passed to change taxes or government spending.

4.The implementation lag is the time it takes for policymakers to change policy instruments once they have decided on the new policy. Again, this lag is unimportant for the conduct of open market operations because the FedÕs trading desk can purchase or sell bonds almost immediately upon being told to do so by the Federal Open Market Committee. Actually implementing fiscal policy may take time, however; for example, getting government agencies to change their spending habits takes time, as does changing tax tables.

5.The effectiveness lag is the time it takes for the policy actually to have an impact on the economy. An important element of the monetarist viewpoint is that the effectiveness lag for changes in the money supply is long and variable (from several months to several years). Keynesians usually view fiscal policy as having a shorter effectiveness lag than monetary policy (fiscal policy takes approximately a year until its full effect is felt), but there is substantial uncertainty about how long this lag is.

Now that we understand the considerations that affect decisions by policymakers on whether to pursue an activist or nonactivist policy, we can examine when each of these policies would be preferable.

Expectations and

the Activist/

Nonactivist

Debate

Case for an Activist Policy. Activists, such as the Keynesians, view the wage and price adjustment process as extremely slow. They consider a nonactivist policy costly, because the slow movement of the economy back to full employment results in a large loss of output. However, even though the five lags described result in delay of a year or two before the aggregate demand curve shifts to AD2, the aggregate supply curve likewise moves very little during this time. The appropriate path for policymakers to pursue is thus an activist policy of moving the economy to point 2 in Figure 11.

Case for a Nonactivist Policy. Nonactivists, such as the monetarists, view the wage and price adjustment process as more rapid than activists do and consider nonactivist policy less costly because output is soon back at the natural rate level. They suggest that an activist, accommodating policy of shifting the aggregate demand curve to AD2 is costly, because it produces more volatility in both the price level and output. The reason for this volatility is that the time it takes to shift the aggregate demand curve to AD2 is substantial, whereas the wage and price adjustment process is more rapid. Hence before the aggregate demand curve shifts to the right, the aggregate supply curve will have shifted rightward to AS2, and the economy will have moved from point 1 to point 1, where it has returned to the natural rate level of output Yn. After adjustment to the AS2 curve is complete, the shift of the aggregate demand curve to AD2 finally takes effect, leading the economy to point 2 at the intersection of AD2 and AS2. Aggregate output at Y2 is now greater than the natural rate level (Y2 > Yn) , so the aggregate supply curve will now shift leftward back to AS1, moving the economy to point 2, where output is again at the natural rate level.

Although the activist policy eventually moves the economy to point 2 as policymakers intended, it leads to a sequence of equilibrium pointsÑ1 , 1, 2 , and 2Ñat which both output and the price level have been highly variable: Output overshoots its target level of Yn, and the price level falls from P1 to P1 and then rises to P2 and eventually to P2. Because this variability is undesirable, policymakers would be better off pursuing the nonactivist policy, which moved the economy to point 1 and left it there.

Our analysis of inflation in the 1970s demonstrated that expectations about policy can be an important element in the inflation process. Allowing for expectations about policy to affect how wages are set (the wage-setting process) provides an additional reason for pursuing a nonactivist policy.

Do Expectations Favor a Nonactivist Approach? Does the possibility that expectations about policy matter to the wage-setting process strengthen the case for a nonactivist policy? The case for an activist policy states that with slow wage and price adjustment, the activist policy returns the economy to full employment at point 2 far more quickly than it takes to get to full employment at point 1 under nonactivist policy. However, the activist argument does not allow for the possibility (1) that expectations about policy matter to the wage-setting process and (2) that the economy might initially have moved from point 1 to point 1 because an attempt by workers to raise their wages or a negative supply shock shifted the aggregate supply curve from AS2 to AS1. We must therefore ask the following question about activist policy: Will the aggregate supply curve continue to shift to the left after the economy has reached point 2, leading to cost-push inflation?

The answer to this question is yes if expectations about policy matter. Our discussion of cost-push inflation in Figure 5 suggested that if workers know that policy will be accommodating in the future, they will continue to push their wages up, and