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In simple words, inflation leads to a decline in the real value of money. Inflation has never been viewed as favourable for an economy. Amongst several harmful effects highlighted by various economists Gwartney et. al (2000) argued that inflation distorted the information delivered by prices. They further stated that people responded to high and variable rates of inflation by spending less time producing and more time trying to protect themselves from inflation.
The following paper will analyse and evaluate whether inflation is a monetary or a fiscal phenomenon. It is general belief that inflation is a monetary phenomenon which can be controlled by monetary policy. The belief became stronger when supported by the Milton Freidman's statement that inflation was always and everywhere a monetary phenomenon. It however came under severe criticism when in the 1980s empirical evidence suggested that there was no correlation between money growth and inflation. Counter arguments suggested that inflation could not be considered as he sole province of the central bank as it was controlled by fiscal authority. This viewpoint of inflation being a fiscal policy has been termed as fiscal theory of the price level (FT).
The weak form of FT suggests that there is an obvious link between monetary and fiscal policy and makes the assumption that the central bank responds and generates seignorage generated to avoid default.
The weak form of FT is a theory about the determinants of monetary movements. It further states that monetary policy is dictated by fiscal policy. One of the most important implication of this theory is the possibility that tight money today could increase today's price level. A low money supply today necessitates increased inflation tomorrow, implying - if money demand is sufficiently elastic - a high price level today. Low money today directly lowers current prices. The higher future inflation necessary for budget balance increases the nominal interest rate lowering real money demand today.
Thus based on the above explanation it can be said hat fiscal theory predicts future inflation as well. It must be highlighted that, that the prediction only happens by determining future money growth. Thus the traditional FT is not opposed to the quantity theory of money, whereby the prices are driven by current or future money growth. Thus the theory postulates that fiscal policy is endogenous while money supply movements are endogenous.
The strong form of FT states that whilst fiscal policy determines future inflation, it does it independent of the future monetary growth. In the strong form of FT the key assumption is that the fiscal budget constraint, and thus the fiscal policy, pins down the initial price level. In most monetary models, a fixed money stock implies that prices are uniquely determined by the public's willingness to hold real demand for cash balances cash, which is in stark contrast to strong for of FT, which eliminates the multiplicity and pins down prices by assuming that in the long run government's budget must balance.
Strong form of FT has experienced several empirical problems. According to Carlstrom and Fuerst (1999), in order for this self-fulfilling circle to occur, unrealistically large elasticities are requiredan increase in current prices will, with other things being constant, lower expected inflation between this period and the next.
They argue that either version of the FT fail to explain the lack of correlation between money and prices since the early 1980s. They state that while using FT would have predicted a sharp increase in inflation during the 1980s, in reality there was a sharp fall in inflation. Besides, the reduction of money growth after the huge increases in budget deficits has cast further doubts on the assumption tat fiscal authorities are a dominant force. This has led to doubting the credibility of the weak form of fiscal theory as well. Despite the criticisms, fiscal price theory does provide caution, where the weak form of FT is predicted on the assumption of fiscal dominance. Thus if the FT belies the central bank's ability to achieve inflation targeting then it can only happen because the central bank does not have the credibility to follow through on an objective of this nature.
It must be highlighted that long run monetary and fiscal policy are jointly determined by the fiscal budget constraint.
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From the preceding paragraphs it can be said that inflation is not only a monetary but also a fiscal phenomenon. Whilst traditionally it was argued that inflation was affected by monetary policy only, evidence has suggested that there is fiscal dominance. Fiscal theory of price level does not negate the effect of monetary growth on price levels. Both the weak and strong form of fiscal theory of price level have tried to establish the link between fiscal and monetary policy and have attempted to explain how both influence inflation. Needless to say, FT has also been subject to severe criticism.
Thus both forms of FT suggest that a central bank cannot target the inflation rate, as that would suggest that central bank is targeting something which is not under its control. Thus, inflation can said to be influenced by both monetary and fiscal phenomenon rather than just a monetary or a fiscal phenomenon. Thus, Friedman's belief of inflation being a monetary phenomenon can be considered true only when the fact that inflation is a fiscal phenomenon is considered to be true as well.
Dornbusch, R., Fisher, S., Macroeconomics, (2000), Eighth Edition, Mc-Graw Hill Education
Griffiths, A. and Wall, S., Applied Economics, (2001), Ninth edition, FT Prentice Hall
Gwartney, James D., Stroup, Richard L., and Sobel, Russell S., Economics Private and Public Choice, (2000), Ninth Edition, The Dryden Press.
Sloman, J., Essentials of Economics, (2004), Third edition, FT Prentice Hall
Howells, P and Bain, K, The Economics of Money, Banking and Finance, (2002), Prentice Hall
Carlstrom, Charles., Money Growth and Inflation: Does Fiscal Policy matter?, Federal Reserve Bank of Cleveland, April 15, 1999