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CHAPTER 26 Money and Inflation 667 MO NE Y AN D IN FL ATI O N: EV ID EN CE The evidence for Friedman s statement is straightforward Whenever a country s inflation rate is extremely high for a sustained period of time, its rate of money supply growth is also extremely high Indeed, this is exactly what we saw in Figure 1-5 (page 8), which shows that the countries with the highest inflation rates have also had the highest rates of money growth Evidence of this type seems to support the proposition that extremely high inflation is the result of a high rate of money growth Keep in mind, however, that you are looking at reduced-form evidence, which focuses solely on the correlation of two variables: money growth and the inflation rate As with all reduced-form evidence, reverse causation (inflation causing money supply growth) or an outside factor that drives both money growth and inflation could be involved How might you rule out these possibilities? First, you might look for historical episodes in which an increase in money growth appears to be an exogenous event; a high inflation rate for a sustained period following the increase in money growth would provide strong evidence that high money growth is the driving force behind the inflation Luckily for our analysis, such clear-cut episodes hyperinflations (extremely rapid inflations with inflation rates exceeding 50% per month) have occurred, the most notorious being the German hyperinflation of 1921 1923 In 1921, the need to make reparations and reconstruct the economy after World German Hyperinflation, War I caused the German government s expenditures to greatly exceed revenues The government could have obtained revenues to cover these increased 1921 1923 expenditures by raising taxes, but that solution was, as always, politically unpopular and would have taken much time to implement The government could also have financed the expenditure by borrowing from the public, but the amount needed was far in excess of its capacity to borrow There was only one route left: the printing press The government could pay for its expenditures simply by printing more currency (increasing the money supply) and using it to make payments to the individuals and companies that were providing it with goods and services As shown in Figure 26-1, this is exactly what the German government did; in late 1921, the money supply began to increase rapidly, and so did the price level In 1923, the budgetary situation of the German government deteriorated even further Early that year, the French invaded the Ruhr because Germany had failed to make its scheduled reparations payments A general strike in the region then ensued to protest the French action, and the German government actively supported this passive resistance by making payments to striking workers As a result, government expenditures climbed dramatically, and the government printed currency at an even faster rate to finance this spending As displayed in Figure 26-1, the result of the explosion in the money supply was that the price level blasted off, leading to an inflation rate for 1923 that exceeded million percent! The invasion of the Ruhr and the printing of currency to pay striking workers fit the characteristics of an exogenous event Reverse causation (that the rise in the price level caused the French to invade the Ruhr) is highly implausible, and it is hard to imagine a third factor that could have been a driving force behind both inflation and the explosion in the money supply Therefore, the German hyperinflation qualifies as a controlled experiment that supports Friedman s proposition that inflation is a monetary phenomenon
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