Money and Inflation in Colonial Massachusetts

By Smith, Bruce D. | Federal Reserve Bank of Minneapolis Quarterly Review, Fall 2002 | Go to article overview

Money and Inflation in Colonial Massachusetts


Smith, Bruce D., Federal Reserve Bank of Minneapolis Quarterly Review


A view common to nearly all economists is that, over a sufficiently long period of time, the rate of growth of the money supply is the key determinant of the rate of inflation. An extreme (but not uncommon) version of this view is that inflation can be controlled merely by preventing rapid growth of money, independently of other forces at work in an economy. The idea that rates of money growth and inflation are intimately related is based, at least in part, on what might be called a naive version of the quantity theory of money. This theory suggests that, in some long-run average sense, the rate of inflation will roughly equal the rate of money growth less the growth rate of real output. The purpose of this paper is to call into question the existence of any direct link between the rate of growth of the money supply and inflation. More specifically, the paper suggests that the growth of the money supply, taken by itself, is of little significance in determining the rate of inflation an economy experiences.

The point of departure for this argument is a relatively recent body of theoretical developments in monetary economics associated with the work of Thomas Sargent (1981) and Neil Wallace (1981). These developments suggest that the effects of changes in the money supply cannot correctly be analyzed without simultaneously considering prevailing fiscal policy. In order to make the argument simple, it is helpful to begin by considering monetary systems which are not fiat in nature, or in which money is backed. All this means is that when money is injected into an economy, it is either a direct claim on some commodity (such as gold or silver) or the government is committed to retire money at some future dates. In the latter case, where the government is committed to retire money, this must be done by running future budget surpluses. Under such circumstances, money is said to be backed by future tax receipts.

In either case, it is easy to see that the value placed on money in the marketplace must be closely related to the government's current and future balance sheets. In the first case, where money is backed by commodities, the ability of the government to honor claims against it depends directly on its current position and its anticipated future income stream. Then, since the value of any claim is determined in part by the issuer's ability to honor it, the value of money will depend in a direct way on the government's outstanding debt, current assets, and on expected surpluses or deficits. In the second case, where money is backed by a commitment to run future surpluses, the reasoning is similar. Here money is injected into the economy with the commitment that it will eventually be withdrawn. If this commitment is not honored, the economy will be left with a permanently higher stock of unbacked money. Few would dispute that this is a stimulus to inflation.

Thus, when money is backed, its value depends on the government's balance sheet--that is, on the course of government surpluses and deficits. But all that backing necessarily means here is that increases in the money supply are accompanied by a government commitment to increase future income streams. Even if there is no explicit commitment to back currency, then, in a regime with fiat money (where no explicit promise of backing is made), appropriate fiscal policy can implicitly back money. In short, the view espoused here is that it is inadequate to look only at rates of growth of the money supply in considering the inflationary impact of monetary changes; the time path of fiscal policy must also be taken into consideration.

This view, which for the purposes of this paper will be called the Sargent-Wallace view, can also be thought of as follows: the value of government liabilities (including money) is determined in exactly the same way as the value of liabilities issued by private agents (such as firms). In order to see the force of this comparison, it is useful to consider what might be expected to happen to the price of a given firm's shares if the number of its shares outstanding doubles. …

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