678 PA R T V I I Monetary Theory A critical element in this process is that the deficit is persistent If temporary, it would not produce inflation because the situation would then be similar to that shown in Figure 26-3 (page 671), in which there is a one-shot increase in government expenditure In the period when the deficit occurs, there will be an increase in money to finance it, and the resulting rightward shift of the aggregate demand curve will raise the price level If the deficit disappears next period, there is no longer a need to print money The aggregate demand curve will not shift further, and the price level will not continue to rise Hence the one-shot increase in the money supply from the temporary deficit generates only a one-shot increase in the price level, and persistent inflation does not develop To summarize, a deficit can be the source of sustained inflation only if it is persistent rather than temporary and if the government finances it by creating money rather than by issuing bonds to the public If inflation is the result, why governments frequently finance persistent deficits by creating money? The answer is the key to understanding how budget deficits may lead to inflation Although Canada has well-developed money and capital markets in which huge quantities of its government bonds, both short- and long-term, can be sold, this is not the situation in many developing countries If developing countries run budget deficits, they cannot finance them by issuing bonds and must resort to their only other alternative, printing money As a result, when they run large deficits relative to GDP, the money supply grows at substantial rates, and persistent inflation results Earlier we cited Germany in the 1920s, and Zimbabwe more recently, which had high inflation rates and high money growth as evidence that inflation is a monetary phenomenon The countries that had high money growth are precisely the ones that had persistent and extremely large budget deficits relative to GDP The only way to finance the deficits was to print more money, so the ultimate source of their high inflation rates was their large budget deficits In all episodes of hyperinflation, huge government budget deficits are also the ultimate source of inflationary monetary policies The budget deficits during hyperinflations are so large that even if a capital market exists to issue government bonds, it does not have sufficient capacity to handle the quantity of bonds that the government wishes to sell In this situation, the government must also resort to the printing press to finance the deficits BUDGET DEFICITS AND MONEY CREATION IN OTHER COUNTRIES So far we have seen why budget deficits in some countries must lead to money creation and inflation Either the deficit is huge, or the country does not have sufficient access to capital markets in which it can sell government bonds But neither of these scenarios seems to describe the situation in Canada True, Canada s deficits were large in the 1980s and early 1990s, but even so, the magnitude of these deficits relative to GDP was small compared to the deficits of countries that have experienced hyperinflations The federal government deficit as a percentage of GDP reached a peak of 6.5% in 1985, whereas Argentina s budget deficit, for example, sometimes exceeded 15% of GDP Furthermore, since Canada has a well-developed government bond market, it can issue large quantities of bonds when it needs to finance its deficit Whether the budget deficit can influence the monetary base and the money supply or not depends critically on how the Bank of Canada chooses to conduct BUDGET DEFICITS AND MONEY CREATION IN CANADA