Money and Prices

CHAPTER 112 Money and Prices Key Concepts Hyperinfl ation Monetarism Neutrality of Money Infl ation Money Multiplier Quantity Theory Infl ation Tax Money Supply Seignorage Overview This chapter focuses on the nominal side of the economy: money and prices. We examine the historical behaviour of prices and the surge in infl ation that occurred in the twentieth century. We consider how to measure the price level and the rate of infl ation and compare their different meanings. We discuss why policymakers want to control infl ation and the costs of infl ation. Money is intimately linked to prices – after all, we quote prices of goods and services in terms of money. We review the historical development of money – from commodity money to paper money – and examine how governments and the banking sector create money and credit. We then consider the interaction between money and inflation. We first discuss hyperinflations – inflations of more than 50% per month – and show that they really always originate in fiscal policy, when governments print money to finance their activities. We review the concepts of seignorage and the inflation tax and compare them across countries. We then discuss a more general link between money and inflation and outline the quantity theory, which forms the basis of monetarism: the idea that inflation can be controlled by controlling the money supply. 282 cc12.indd12.indd 228282 110/01/120/01/12 88:56:56 AAMM CHAPTER 12 MONEY AND PRICES 283 12.1 Rising Prices THE HISTORICAL RECORD Although historical evidence regarding the scale of economic activity is often obscure, we have much more evidence about the price of different items. The various receipts, invoices and advertising leafl ets that accumulate in pockets and wastepaper baskets amount to a substantial historical legacy. From these we can construct price indexes that refl ect the costs of buying a rep- resentative collection of consumer goods over time. For example, we could go to a supermarket on 1 January 2012 and buy a typical household’s weekly groceries for $120. When purchased on 1 January 2013, the same groceries might cost $125. With this information we can construct a price index that has a value of 120 in 2012 and 125 in 2013. This implies an infl ation rate (the annual percentage change in prices) of 4.2% [100 ϫ (125 – 120)/120]. Price indexes often are set at a value of 100 in a particular year – usually the year used to construct the average basket of goods. In our example, the index would have been 100 in 2012 and 104.2 in 2013. Figure 12.1 shows the behaviour of UK prices between 1264 and 2008.1 (A detailed examination and a cross-reference with UK history reveals many interesting events,2 but we want to see the broad characteristics of price behaviour.) Between 1264 and around 1930 prices showed no persistent trend, though there was a signifi cant increase in prices around the sixteenth century (primarily associated with the infl ux of gold and silver from the Americas). Prices sometimes rose sharply (e.g. during the Napoleonic Wars, 1790s to 1815 and the First World War, 1914–18), but then fell sharply. But after 1930 things changed and prices continued to increase – by 46-fold between 1930 and 2009. As Figure 12.2 shows, after 1945 annual infl ation was always positive. Before 1945 the United Kingdom had experienced extreme infl ation, large defl ations (falls in prices) and frequent small defl ations, which overall kept the price level reasonably constant over long periods. 256 64 16 4 1 0.25 1264 1291 1318 1345 1372 1399 1426 1453 1480 1507 1534 1561 1588 1615 1642 1669 1696 1723 1750 1777 1804 1831 1858 1885 1912 1939 1966 1993 FIGURE 12.1 UK prices, 1264–2010. Until the twentieth century, prices showed no upward trend, experiencing both increases and decreases. In the twentieth century prices increased sharply. Source: Lawrence H. Offi cer, What Were the UK Earnings and Prices Then?, MeasuringWorth (2009), http://www.measuringworth.com/ukearncpi/. cc12.indd12.indd 228383 110/01/120/01/12 88:56:56 AAMM 284 MACROECONOMICS 120 100 80 60 40 20 0 Ϫ20 Ϫ40 2010 1264 1288 1312 1336 1360 1384 1408 1432 1456 1480 1504 1528 1552 1576 1600 1624 1648 1672 1696 1720 1744 1768 1792 1816 1840 1864 1888 1912 1936 1960 1984 Ϫ60 FIGURE 12.2 UK infl ation, 1264–2010. Since 1945, infl ation has been consistently positive. Source: Authors’ calculations from Figure 12.1. Although not all countries experienced the United Kingdom’s overall price stability prior to 1930, most countries did see prices surge during the second half of the twentieth century. Figure 12.3 shows the same pattern for the United States. DEFINITIONKEY POINT Most countries have experienced continuously rising prices since the middle of the twentieth century. 160 80 40 20 10 5 1774 1804 1834 1864 1894 1784 1794 1814 1824 1844 1854 1874 1884 1904 1914 1924 1934 1944 1954 1964 1984 1994 2004 1974 FIGURE 12.3 US prices, 1774–2010. US infl ation shows a familiar pattern: while prices rose and fell during the 1800s, infl ation has been consistently positive since 1950. Source: Lawrence H. Offi cer, The Annual Consumer Price Index for the United States, 1774–2010, MeasuringWorth (2010), http:// www.measuringworth.com/uscpi/ cc12.indd12.indd 228484 110/01/120/01/12 88:56:56 AAMM CHAPTER 12 MONEY AND PRICES 285 THE RECENT EXPERIENCE Figure 12.4 shows the infl ation experience among the seven leading industrialized nations over the past four decades. We can note fi ve distinct periods. The fi rst covers 1973–76, when infl ation increased in all countries. Economists refer to this period as OPEC I. In October 1973 Arab nations, through a cartel of oil producers known as the Organization of Petroleum Exporting Countries (OPEC), embargoed oil sales at the time of the Yom Kippur War with Israel. As a result, oil prices increased from $3 a barrel to $11.65 (see Figure 12.5 for the history of oil prices over this period). Industrialized nations were heavy importers of oil and had low oil stocks in the early 1970s, so the increase in oil prices led to a rapid increase in infl ation. By 1977 most countries had stabilized their infl ation in response to OPEC I, but in 1979 OPEC again raised oil prices (OPEC II), which peaked at over $36 a barrel in 1980. Infl ation surged again, although, as Figure 12.4 shows, the increase was more restrained. The increase in oil prices and the associated rise in interest rates led to a global reces- sion. This slowdown in the economy and a sharp fall in oil prices produced the third stage in Figure 12.4: lower infl ation among the industrialized nations in the 1980s. Infl ation fell and economic growth increased signifi cantly in the industrialized world in the 1980s. The strength of this boom and the strong growth in all countries led to another increase in infl a- tion by the end of the decade, so that governments again raised interest rates and economic growth slowed. In the 1990s infl ation continued to fall until, by 2000, it was at its lowest level since the 1970s. Since then infl ation has remained low despite a signifi cant rise in oil (and other commodity) prices recently. 25 Canada France 20 Germany Italy 15 Japan United Kingdom United States 10 5 0 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 Ϫ5 FIGURE 12.4 G7 infl ation, 1974–2010. Infl ation surged after increases in oil prices in 1973 and 1979 and after high global growth in the late 1980s, but it was subdued by the end-of-the-century infl ation. Source: OECD. cc12.indd12.indd 228585 110/01/120/01/12 88:56:56 AAMM 286 MACROECONOMICS 120 dollars 100 2010 dollars 80 60 40 20 0 1871 1881 1891 1901 1911 1921 1931 1941 1951 1971 1981 1991 2001 2011 1861 1961 FIGURE 12.5 Oil prices, 1861–2011. In recent decades high-infl ation periods have followed big rises in oil prices. Source: BP Statistical Review (2011). 1600 Canada 1400 France 1200 Germany Italy 1000 Japan United Kingdom 800 United States 600 400 200 0 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 FIGURE 12.6 G7 price levels, 1974–2010. Persistent differences in average infl ation rates have led to big differences cross-country in how the level of prices has changed over time. Source: OECD. We have stressed the co-movements in infl ation across countries, but differences are also signifi cant. High infl ation means something different to an Italian than to a German. These differences in annual infl ation rates lead to big differences in price changes over long periods. Figure 12.6 shows how prices have changed across countries. Prices are set equal to 100 in each country in 1974, so that an index of 500 in 2004 means that prices have risen fi vefold over that 30-year period. Japan has had the lowest infl ation over this time period, so goods that used to cost ¥100 now cost the equivalent of around ¥250. By comparison, Italy has seen large increases in prices: a commodity that used to cost 100 lira now typically costs the equivalent of around 1300 lira (though prices are now quoted in euros). cc12.indd12.indd 228686 110/01/120/01/12 88:56:56 AAMM CHAPTER 12 MONEY AND PRICES 287 DEFINITIONKEY POINT Global events, particularly changing prices of oil, have caused developed nations to experience similar patterns of infl ation.

Load more