recognize several circumstances in which a central bank could lose control of the money supply; and
understand the concept of seigniorage.
13.1 Losing Control of The Money Supply
If we know that excessive money-supply growth causes inflation, and if the money supply is under the control of the central bank, why does inflation rise? Why would the monetary authorities allow the money supply to grow too quickly? Although it is true that monetary authorities have known for some time that in the long run inflation is due to excessive money growth, this fact was not always given the prominence it deserved. On occasion, central banks pursued a policy that at first appeared not to involve a loss of control of the money supply, but in retrospect clearly did. We have encountered several examples of such situations in earlier chapters of this book.
Underestimating the NRU
Suppose the central bank has chosen to target monetary policy on the NRU, so that whenever unemployment departs from its natural rate, monetary policy reacts by pushing it back. A problem with this approach is that the NRU is never known. It must be estimated, and it can easily be underestimated. One reason for underestimation is that many politicians find it difficult to believe that the natural rate can be so high and, consequently, continually bring pressure to bear on the central bank to lower unemployment.
Suppose the economy is at the NRU, but the central bank does not realize that it is and thinks that the NRU is lower. An expansionary monetary policy will be undertaken to push down unemployment, creating some unexpected inflation. The unexpected inflation causes the real wage to fall, either because workers are slow to realize what has happened or because of contract obligation s that prevent immediate adjustment of wages. The fall in the real wage induces firms to increase output. After a time, however, inflation expectations increase and contracts are renegotiated, restoring the real wage to its original level and moving the economy back to the true natural rate. This situation prompts the central bank to increase its stimulation in order to keep the economy below the NRU, thereby accelerating the inflationary forces and causing this process to be repeated. The economy is prevented from moving back to its actual NRU, but at a cost of an accelerating inflation. By targeting on an underestimate of the NRU, the central bank could lose control of the money supply.
