Category Archives: Inflation

Modern Monetary Theory vs Mainstream Monetary Theory

Although not in the A2 syllabus we have had some great discussions in my A2 class on Modern Monetary Theory – MMT. It has its roots in the theory of John Maynard Keynes who during the Great Depression created the field of macroeconomics. He stated that the fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. When you get this situation it is the government that can get the economy moving again by putting money in people’s pockets.

MMT states that a government that can create its own money therefore:

1. Cannot default on debt denominated in its own currency;
2. Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
3. Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
4. Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
5. Does not need to compete with the private sector for scarce savings by issuing bonds.

Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

How does it differ from more mainstream monetary policy – see table below.

Those against MMT are dubious of the idea that the treasury and central bank should work together and also concerned about the jobs guarantee. They argue that if the government’s wage for guaranteed jobs is too low it won’t do much to help unemployed workers or the economy, while if it’s too high it will undermine private employment. They also say that trying to use fiscal policy to steer the economy is a proven failure because politicians rarely act quickly enough to respond to a downturn. They can’t be relied upon to impose pain on the public through higher taxes or lower spending to quell rising inflation.

Below is a video from Stephanie Kelton, an MMTer who was the economic adviser on Vermont Independent Senator Bernie Sanders’s presidential campaign in 2016.


The Economist – Free Exchange – March 16th 2019

Wikipedia – Modern Monetary Theory

A2 Economics – Quantity Theory of Money

Just covered MV = PT with my A2 class and produced some notes followed by a video from Marginal Revolution which I got from the Economics Teacher group.

Quantity Theory of Money

The Monetarist explanation of inflation operates through the Fisher equation.

M x V = P x T

M = Stock of money

V = Income Velocity of Circulation

P = Average Price level

T = Volume of Transactions or Output

For example if M=100 V=5 P=2 T=250.   Therefore MV=PT – 100×5 = 2×250

Both M x V and P x T are equivalent to TOTAL EXPENDITURE or NOMINAL INCOME in a given time period. The Quantity Theory is the familiar monetarist interpretation of the Equation and is based on the following assumptions:

  1. T is broadly equivalent to total output and is fixed in the short run
  2. V is broadly stable (i.e. the demand to hold money is relatively uninfluenced by the change in interest rates that arises from changes in the money stock).
  3. Causality runs from the left hand side to the right hand side of the equation

On these assumptions, increases in the money supply (after a suitable time lag) cause equivalent increases in the price level.

Critics argue that:

  1. V is not stable and responsive to interest rate changes.
  2. T is not fixed and is responsive to increases in the money supply below full employment.
  3. Change is P tend to cause changes in M (and not v.v.). In other words, changes in the money supply accommodate inflation and do not cause it.

Calculation using MV = PT

Since MV=PT (by definition), if M=$60, V=4 and T=12, then P can be found.

P =   MV /T  =  (60 x 4)/12  =  $20 

Hyperinflation – can be controlled with a different government.

Venezuela has been in the news for sometime with its economy spiralling out of control with the inflation rate last year at 100,000% – doubling roughly once a month. The occurrence of hyperinflation in economies has become more common with governments now printing money rather than that money being backed by the amount of gold that they held – gold standard. Because the gold supply is quite inelastic, being on the gold standard would theoretically stop government overspending and keep inflation under control. The country effectively abandoned the gold standard in 1933, and completely severed the link between the dollar and gold in 1971 – this was around the time of the Vietnam War.

The more recent hyperinflation in Zimbabwe, Bolivia, Argentina etc have come about through government’s not been able to control the printing presses and succumbing to the desire to stay in power at the expense of crippling the economy. Huge fiscal deficits and excessive borrowing are the common denominator here – see flow chart below:

Hyperinflation usually happens amongst chaotic domestic conditions, whether social unrest or that country being involved in conflict – e.g. post war Germany. However as reported by The Economist hyperinflation can occur under more mundane circumstances. For instance in Bolivia’s inflation reached 60,000% which was started by a commodity boom which allowed them to borrow heavily from overseas but once resource prices tumbled there was a significant reduction in government revenue. The  government under Hugo Banzer increased spending to satisfy the voters who supported them in the election and this created further inflationary pressure. In a way this is similar to the Venezuela experience with high oil prices generating significant revenue for the government but once the oil prices fell the printing presses started to work overtime. And once inflation starts to accelerate Inflationary expectations kick in and then it becomes very difficult to control. However these inflationary expectations could reflect the lack of seriousness of government policy to rectify the problem as a change of government which is focused on prices can end hyperinflation in weeks. This reflects the trust in the incoming regime and was true of Bolivia (see video below).  Here the incoming government under Gonzalo (Goni) Sánchez de Lozada were serious about the ravages of inflation and to deal with it  didn’t use highly sophisticated economic theory.  See below:

  • Government spending was slashed
  • Price controls were scrapped
  • Import tariffs were cut
  • Government budgets were balanced.
  • No borrowing from the Central Bank

As Jeff Sachs – advisor to the Bolivian government –  said:

“All this gradualist stuff just doesn’t work. When it really gets out of control you’ve got to stop it, like in medicine. You’ve got to take some radical steps; otherwise your patient is going to die.”


The Economist – February 2nd 2019

Commanding Heights – PBS Video

Turkey’s economy – stuffed

Inflation at 25%, Central Bank interest rates at 24%, Lira down 30% in value since the start of the year. What hope is there for the Turkish economy?

Wages and salaries haven’t kept pace with inflation and the reduction in demand has led to higher unemployment. There is pressure on the central bank to keep interest rates to avoid the lira collapsing. However this makes it expensive for businesses to borrow money and thereby reducing investment and ultimately growth.

No pain no gain – there is no alternative for Turkey other than undertaking painful and unpopular economic reforms. Remember what Reagan said in the 1980’s “If not now, when? If not us, who?”  He was referring to the stagflation conditions in the US economy at the time and how spending your way out of a recession, which had been the previous administration’s policy, didn’t work.

In order to the economy back on track things will need to get worse but President Erdogan has the time on his hands as there is neither parliamentary nor presidential elections in the next five years. This longer period should allow him the time to make painful adjustments without the pressure of elections which usually mean more short-term policies for political gain. Beyond stabilising the lira, which helped to ease the dollar-debt burden weighing on the country’s banks and corporate sectors, the 24 per cent interest rate level the central bank imposed also brought about a long-overdue economic adjustment. A cut in interest rates discourage net inflows of investment from foreigners and the resulting depreciation would accelerate the concerns about financial stability and deteriorating business and consumer confidence. Below is a mind map as to why a rise in the exchange rate maybe useful in reducing inflation.

A2 Economics – Wage Price Spiral and the Long Run Phillips Curve

Phillips CurvePart of the CIE A2 macro syllabus focuses on the wage price spiral which relates to the Phillips Curve. Here are some excellent notes that I picked up from Russell Tillson in my early days teaching at Epsom College. As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve.

During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

AS Economics – Hyperinflation causes and ends

Starting with a definition. In 1956 Phillip Cagan, an economist working at America’s National Bureau of Economic Research, published a seminal study of hyperinflation, which he defined as a period in which prices rise by more than 50% a month.

There seems to be common patterns when hyperinflation occurs in an economy. These include:

  1. Fiscal pressure – cost of funding a war, increased social welfare payments, corrupt officials taking money from the budget.
  2. Dependence of a particular resource – the resource curse. Some economies rely on exports of oil, iron ore or other resources to fund its spending. This has the effect of increasing the value of the currency and although this will make imports cheaper once the resource runs out or global prices start to drop the overvalued currency falls causing a large increase in imported prices. Furthermore governments come to depend on revenue from oil and a sudden drop in prices saw a massive drop in tax revenue – 90% of Venezuela’s revenue came from oil.
  3. Printing money – like Bolivia in the 1980’s, Venezuela overcame their shortfall in income by printing more money. The increase in the supply of money pushes up inflation. But what makes it worse is, as the inflation rate impacts the real value of government revenue, they continue to print money to finance the budget deficit which in turn exacerbates the problem – bigger budget deficit and further inflation.
  4. Exchange rate – at some stage the exchange rate will collapse as people lose confidence in the currency. Imports become ever increasingly expensive and feed into the inflation calculation.
  5. Inflationary expectations – In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue. This is evident in Venezuela as people become accustomed to higher prices and expect them to continue which makes inflation likely to continue.Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves.

Hyperinflation tends to end in two ways.

  1. The paper currency becomes so utterly worthless that it is supplanted by a hard currency. This is what happened in Zimbabwe at the end of 2008, when the American dollar took over, in effect. Prices will stabilise, but other problems emerge. The country loses control of its banking system and its industry may lose competitiveness.
  2. The second, hyperinflation ends through a reform programme. This was very much the case in Bolivia in the 1980’s – Government spending was slashed. Price controls were scrapped. Import tariffs were cut. Government budgets were balanced. Therefore this typically involves a commitment to control the budget, a new issue of banknotes and a stabilisation of the exchange rate—ideally all backed with confidence-inspiring foreign loans. Without such reform, Venezuela’s leaders, though scornful of America, may find that its people are forced eventually to adopt its dollar anyway.


  • The Economist “The half-life of a currency” September 15th 2018
  • The Economist “The roots of hyperinflation” February 12th 2018

Global Monetary Policy – why are US rates on the rise?

With the A2 mock exam next week here is a post on the theory and applied aspects of monetary policy. Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.

Further goals of a monetary policy are usually to contribute to economic growth and stability, to lower unemployment, and to maintain predictable exchange rates with other currencies.

Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values. See  mind map of Monetary Policy below.

What have caused US interest rates to increase?

The US economy has been at the forefront of the global upswing in the last couple of years and compared to other countries they are imposing a contractionary monetary policy – see graph.

The central bank in the USA, the Federal Reserve, are confident that the economy is nearly at full capacity and that inflationary pressures are starting to become evident. The main factors behind this are as follows and they all point towards an increase in aggregate demand.

  • Higher GDP growth
  • Rising investment in oil and gas industry
  • Strong consumer spending
  • Tax cuts
  • Strong employment growth
  • Tight labour market
  • Higher wages

The US is the only major economy to impose a significant contractionary monetary policy and the Fed has increased its interest rate six times in the last two years, and four more rate hikes are expected over the next 12 months. The UK and Canada have raised their policy rates tentatively, while Europe and Japan are still in the midst of unconventional easing programmes and interest rate hikes are a distant prospect. Whilst the Reserve Bank in New Zealand don’t expect rates to rise until early 2020.

Money as a store of value: Post-War Germany to present day Venezuela

If you have studied any economics course you will no doubt have come across the functions of money. One of the four functions of money is the store of value.

Store of value
Once a commodity becomes universally acceptable in exchange for goods and services, it is possible to store wealth by holding a stock of this commodity. It is a great convenience to hold wealth in the form of money. Consider the problems holding wealth in the form of wheat. It may deteriorate, it is costly to store, must be insured, and there will be significant handling costs in accumulating and distributing it.

However in a country which is being ravaged by hyperinflation money as a store value is rather inadvisable due to the fact that the return for putting in the bank will not be greater than the inflation which reduces its value. So what do people do to preserve their savings from hyperinflation? The importance of the function of money is dramatically illustrated by the experience of Germany just after World War II, when paper money was rendered largely useless because, despite inflationary conditions, price controls were effectively enforced by the American, French, and British armies of occupation. People had to resort to barter or to inefficient money substitutes – cigarettes and cognac – as these became stores of real wealth.

Venezuela is a current example of a country which has this problem. Some of the examples of wealth preservation can be seen on the Caracas skyline with the building boom that is taking place. This would usually be indicative of a growing economy but businesses are so worried about preserving their earnings that they are prepared to build white elephants as they see it as a better alternative that all their income being whipped out by inflation. On a smaller scale, eggs seem to be holding their value and are also a useful medium of exchange – it is easier to pay people in eggs as it has value and is much more portable (a characteristic of money) remember post-war Germany with wheel barrows of bank notes. In fact people are more likely to be accepting of eggs than banknotes.

Causes of hyperinflation

As with hyperinflation in Bolivia in the 1980’s, the weaknesses in public finances is the main cause of Venezuela’s hyperinflation. The reliance on a single source of income – oil export revenue – as well as increased social welfare spending left the government short of cash. Their solution was to go to the printers and print more money to pay its bills. This feeds inflation which in turn means that the government has to print more money as tax receipts are eroded by hyperinflation. Therefore more money is created to fill the gap in revenue = inflation increasing.


In the 1980’s and 90’s a lot of the middle class in Venezuela kept their money offshore in US dollar accounts. But with capital controls making it hard to transfer large amounts of cash, property seemed to be a viable hedging option. However property was too valuable as an inflation hedge. Car ownership became a store of value in that as well as getting you from A to B it was possible to sell the car for more than it was bought for. Some bought shares so as to deposit money and then sell them for larger amounts of cash. For the low incomes the options are limited but they also lack financial acumen as they tend not to act quickly enough to invest in a broader range of assets and refinance debt when interest rates are low. With hyperinflation the long term becomes the next week.

Source: The Economist – A trunkful of bolivares – July 21st 2018

Venezuela – can’t print money quickly enough

The extent of the inflation crisis in Venezuela has led to people to make origami objects out of 2, 5 and 100 bolivares bank notes as they are worth more sold as souvenir items than their face value. The free market exchange rate is 3.5 million bolivares = 1US$.

Venezuela’s problems started when oil prices collapsed – 95% of Venezuela’s export revenue is from oil. With falling oil revenue and therefore foreign currency the government has less money to buy imports. The inflation figure is due to hit 1,000,000% by the end of the year and this has been mainly caused by the printing of money to finance the deficit which amounts to 30% of GDP. But there is another problem in that they don’t have enough bank notes to go around. Like a lot of things in Venezuela bank notes are imported and the central bank printer produces less than 5% of cash in circulation. Since 2016 there have been major problems with note denominations.

December 2016 – President Maduro decrees that 100 Bolivar note will be withdrawn from circulation but the larger denominations never turned up. 500-bolivar notes turn up on emergency flights but too few came and inflation had eroded the value to 20 cents.

November 2017 – 100,000 bolivar notes arrive but not enough too meet demand. Traders sell bundles of assorted banknotes for up to three times their face value – needed for small budget items such as bus fares, coffee etc.

Much of the economy runs on debit cards and bank transfers but the checkout computers cannot cope with such large denominations. Maduro’s solution here was to create a ‘sovereign bolivar’ worth a thousand times more and it will fit more easily on screens. However this will do nothing for the stemming inflation. But again they place the order with the printers too late and they will be nearly worthless when they arrive. However the overseas printers are doing well out of it.

Below is a very informative video from CNN about the on-going crisis.

Looks like inflation might hit 2% in New Zealand

The ASB Bank produce a very good Economic Report and below are some of the points they make with regard to inflationary pressures – useful for NCEA Level 2 and 3 as well as CIE AS and A2 level. The CPI will be on the rise with higher global commodity prices (see graph below) as well as the weakening NZ dollar which in turn makes imports more expensive.

  • Commodity-price related influences are expected to directly contribute around 1 percentage point to annual CPI inflation over 2018. The direct impact is expected to wane.
  • The period of retail deflation looks like it might be coming to an end. The lower NZD and pending increases in wage costs could see this component add to inflation. The extent to which prices will firm will depend on retail margins.
  • Administered price increases will add roughly half a percentage point to annual inflation despite the impact of the free tertiary fees policy. Higher prices for tobacco and local authority rates seem to be a fact of life: one driven by health objectives, the other by perennial infrastructure demand and a lack of competitive pressure.
  • The labour market is likely to become more of a source of price increases. We note that higher wages need not impact on consumer prices if they are offset by a corresponding increase in labour productivity/trimming in producer margins.
  • Price increases from the housing group are expected to subside. It is no longer a sellers’ market for existing dwellings. The balance of power for building work looks to be increasingly shifting towards the customer and away from the provider. Rental dwelling inflation is expected to remain moderate.

Breakdown of CPI Weighting

Source: ASB Bank – Economic Note – Inflation Watch 26 July 2018