Back to Basics, Pt. 4: The role of expectations

In theĀ previous post, we examined the Quantity Theory of Money. We have seen that increases in money growth rate lead to high inflation leading to higher speed and lower real money demand. This indicates that when it comes to a rise in the money supply growth rate, in the long run, the price increase will be more than the increase in the money supply. Conversely, when it comes to slow money growth, inflation slows down, which lowers the opportunity cost of holding the base money, so the demand for money increases and the price increase is less than the money supply. This is one of the ways expectations play a role in the money and inflation equation.

There are a few more interesting examples. These happen when there is a change in the monetary base’s expected future level but no change in the current base. Here are two examples of this:

  1. A new government is elected, and there is an expectation that a lot of money will be printed. This expectation of an increase in the money supply raises prices. A clear example of this occurred between March 1933 and February 1934, when the Wholesale Price Index rose more than 20%, but there was no increase in its monetary base. People correctly expected that the dollar’s devaluation would lead to a higher money supply in the coming years. The increasing current base velocity reduced real money demand, and prices increased.
  2. The opposite is also remarkable. This happens when a government injects large amounts of money into the economy but tells the public that it will end as soon as there is a sign of inflation. In this case, the interest rate will drop to zero and the public will hold much larger real cash balances. The best example of this situation occurred in Japan in the early 2000s. By 2006, too much base money was injected, and in 2006 the monetary base was lowered by 20% to prevent inflation from occurring.

The conclusion to be drawn here is that the current path of inflation is affected by expectations too much. But of course, the expectations must be about something, and in this case, they are about the monetary base and the changes in its demand in the future. If we completely ignore the expectations, we can conclude that the “hot potato effect” drives the long-term relationship between money supply changes and changes in the price level. However, current inflation will be more likely to affect the expected future hot potato effect when expectations come into line.

Unfortunately, the role of expectations makes the monetary economy much more complex. This situation causes us to experience a problem that can be called a kind of “indeterminacy problem” or “multiplicity of solutions”. Several different future pathways for the money supply can be associated with any price level. Alternatively, there are many different price levels (including infinity) consistent with any available money supply. Therefore, if the public believes that the money will be declared null and void next week, it may have no value today. Confederate money towards the end of the Civil War is a perfect example of this. So there must be some kind of confidence in the background that money will have purchasing power in the future.

In the next step, we will see that monetary policy affects prices and has real effects, and we will examine the reasons for this.

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