Self-Fulfilling Inflationary Expectations

Transcription

1 Self-Fulfilling Inflationary Expectations The public s rational expectations may cause inflation. If people expect that the government wishes to inflate away the national debt, they will anticipate the inflation by demanding higher nominal interest rate, R x pe / p ). = ( t 1 t t 1 People cannot distinguish between truthful and deceitful governments. Although the government does not wish to inflate away the national debt, people still expect inflation and demand a high interest rate. The real burden of the national debt will increase. Consider an economy with n = 1, x = 1.1, p t = $1, and real debt (B t ) = 1 million goods. Suppose people expect the government to double the fiat money stock, z e = 2.

2 To convince people to hold bonds, the government must offer a nominal interest rate of R = x( pe / p ) = x( ze / n) = 1.1(2/1) = t t t This means that at time t+1 the government will owe $2.2 million. If the government does not inflate, the actual price at time t+1, p t+1 = 1, and the pt 1 real value of the national debt is R B = (2.2) (1) = million goods. t t pt + If the government inflates as expected, the actual price at time t+1, p t+1 = 2, and pt 1 the real value of the national debt only is R B = (2.2) (1) = million t t pt + goods. The honest government that meant to end the inflation will find itself with a real debt twice size of the real debt if it had inflated as expected. Therefore, although the government does not wish to inflate the national debt, it may choose to inflate as expected.

3 Hyperinflation Hyperinflation is the inflation rate that is extremely high and out of control. Most countries have inflation rates below 20 percent a year, but countries that experience hyperinflation can have inflation rates accelerate to a thousand or million percent a year. Hyperinflation causes fiscal difficulty. Suppose the government has an enormous national debt that its interest payment cannot be financed through taxes or government expenditure cuts. The government must now turn to inflation in hope of reducing the real value of the debt.

4 People will anticipate this inflation by demanding high rates of nominal interest. An increase in nominal interest obligations requires the government to print money at a faster rate. How can hyperinflation be stopped? The government cannot just announce that it will stop inflating because nobody will believe. To stop hyperinflation, the government must solve its fiscal problems and then reduce the need to inflate. The end of hyperinflation can be done by fiscal reforms that reduce government spending or increase government revenue.

5 Commitment in Monetary Policy A binding commitment is the best way to convince people that the government will not try to inflate away the debt. One way is to index the national debt to changes in price level so that the real value of the debt does not change. Another way is to keep the central bank independent of the government and free from political pressure. A more direct way is to have a constitutional amendment prohibiting expansion of the money stock.

6 Example 16.3 Consider the overlapping generations economy with a constant population of two-period-lived people endowed only when young. Suppose the real net rate of return from capital is always 4 percent and young people always save a total of 5,000 goods, including fiat money, worth 1,000 goods. Last period the price of a good was $1, people expected a 10 percent net rate of inflation, the fiat money stock was worth $1,000, and the national debt (of one-period bonds) was worth $2,000. In this period the government will issue bonds equal to the principal and interest on the old debt. Find the current real values of the old debt (principal plus interest), the capital stock, and next period s output from capital for the following three cases: (a) The government inflates at a net rate of 10 percent, as expected. (b) The government unexpectedly inflates at a net rate of 20 percent. (c) The government unexpectedly refuses to inflate.