Throughout history many governments have financed government operations with the printing press, and paying government bills by increasing the money supply. The United States followed this path during the Civil War, approximately doubling the U.S. money

Question

supply between 1860 and 1865 using paper fiat money called Greenbacks. What do you think this rapid increase in the money supply did to inflation and inflationary expectations? Suppose the economy was in long-run equilibrium by the end of the war and the government began to remove Greenbacks and reduce the money supply. Use your understanding of the Phillips curve relationship to explain the effect on the economy.

Answer 1

Increases in the money supply that are more rapid than the increase in productive capacity will cause inflation. The increased inflation would more than likely increase expected and anticipated inflation rates and results in the short-run Phillips curve shifting up (to the right).

Reducing the money supply after the Civil War is contractionary monetary policy. It would cause aggregate demand to decrease and the price level to fall. Real wages, if it were unexpected, would increase and firms would reduce output and hire fewer workers. Unemployment would rise; the economy would move down along the short-run Phillips curve to the right. Eventually wages would decline, real wages would fall, and firms would hire more workers until the natural rate of unemployment was once again achieved. People would also reduce their anticipated rate of inflation as a result.