Money and Inflation

In this section we develop the basic link between the nominal money supply and the price level. In turn, this provides a link between the rate of growth of the nominal money supply and inflation, or the rate of growth of the price level.

The analysis focuses on the market for money which we discussed in Chapters 24 and 25.

The real money supply M/P is the nominal money supply M divided by the price level P.

People demand money because of its purchasing power in terms of goods. In Chapter 24 we explained that the demand for money will be a demand for real money balances. Because Keynes happened to use the term liquidity preference to mean the demand for money, economists often use the symbol L to denote the demand for real money balances. We use the symbol L (Y, r) to denote the quantity of real balances demanded when real income is Y and the interest rate is r. An increase in real income increases the quantity of real balances demanded since people are undertaking more transactions. By increasing the opportunity cost of holding money rather than bonds or other interest-bearing assets, an increase in the interest rate r will reduce the quantity of real balances demanded.

If the money market is in equilibrium, the supply of real balances M/P must equal the quantity of real balances demanded. Equation (1) summarizes this equilibrium condition.

M/P = L (Y, r) (1)

Throughout this chapter we shall assume that interest rates are very flexible. Whenever there is excess demand for money, interest rates are bid up until the quantity of real money demanded is sufficiently reduced that it is brought into line with the supply of real balances. Conversely, an excess supply of money reduces interest rates and immediately increases the quantity of real balances demanded. Thus we assume that flexible interest rates keep the money market continuously in equilibrium. Equation (1) holds at all points in time.

Suppose, as we have previously assumed, that nominal wages and prices are slow to adjust in the short run. An increase in the nominal money supply M leads initially to an increase in the real money supply M/P since prices P have not yet had time to adjust fully. There is now an excess supply of real money balances which bids interest rates down until the demand for real balances has increased enough to restore money market equilibrium. Lower interest rates boost aggregate demand for goods. Gradually this excess demand for goods bids up goods prices, and in the labour market the increased demand for employment starts to bid up money wages. In Chapter 26 we saw that, when wages and prices have fully adjusted, a once-and-for-all increase in the nominal money supply leads to an equivalent once-and-for-all increase in wages and prices. Output, employment, interest rates, and the real money supply are restored to their original levels.

Equation (1) allows us to state this argument succinctly. When adjustment is complete and long-run equilibrium has been restored, real income, interest rates, and hence the demand for real balances are all unchanged. Hence the price level must have changed in proportion to the original increase in the nominal money supply. Only then will the real money supply be unchanged and the money, market have returned to its long-run equilibrium position. This result is the essence of the quantity theory of money.

The quantity theory of money says that changes in the nominal money supply lead to equivalent changes in the price level (and money wages) but do not have effects on output and employment.

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Nationalization and Privatization

'In every great monarchy in Europe the sale of the Crown lands would deliver a much greater revenue than any which these lands ever afforded to the Crown… When the Crown lands had become private property, they would, in the course of a few years, become well improved and well cultivated.'   Adam Smith, The Wealth of Nations (1776)

This chapter deals with the boundary between the public sector and the private sector. As suggested by the quotation above from Adam Smith, the father of modern economics, the controversy is more than 200 years old.

Scale intervention can take many forms. In previous chapters we have discussed tax incentives, competition policy, and industrial policy. The main focus of this chapter is whether these policies are sufficient, or whether it is necessary for the state to have direct control of certain industries through public ownership. Conversely, if public ownership has in the past been tried and found wanting, should the government now return these public sector corporations to private ownership?

Nationalization is the acquisition of private companies by the public sector. Privatization is the sale of public sector companies to the private sector.

In the UK, the great wave of nationalizations - industries such as rail and steel - occurred during the Attlee government elected in 1945. By the 1960s, most countries in Europe had a significant sector of industrial production under public ownership and control. The tide has truly turned. Major privatization programmes are under way not only in the UK but also in countries as different as France, Japan, Taiwan, Mexico, Poland, and Hungary.

In this chapter we analyse the nationalized industries, explain how they have been run, and assess their performance. Then we discuss the case for privatization. Finally, we examine the UK privatization programme m practice.