TYPES OF INFLATION, DISINFLATION, AND DEFLATION MODULE 33
MONEY AND INFLATIONInflation may have complex causes.Very high inflation is associated with rapid increases in the money supply.To understand what causes inflation, we must understand the effect of changes in the money supply on the overall price level.
THE CLASSICAL MODEL OF MONEY AND PRICESRemember: in the long run, an increase in the money supply does not change GDP.Other things equal, an increase in the money supply leads to an equal percentage rise in the overall price level (the prices of all goods and services in the economy, including nominal wages and the prices of intermediate goods, rise by the same percentage as the money supply.
THE CLASSICAL MODEL OF THE PRICE LEVELThe classical model of the price level ignores the short run movements, and assumes that the economy moves directly from one equilibrium at full-employment to the next equilibrium at full-employment, as if the short-run as well as the long-run aggregate supply curves were vertical.
THE CLASSICAL MODEL OF THE PRICE LEVELUnder periods of low inflation, this model makes a poor assumption, as nominal wages and prices are sticky in the short run.As a result, in periods of low inflation, there is an upward sloping SRAS curves, and changes in the money supply can change real GDP in the short-run.
THE CLASSICAL MODEL OF THE PRICE LEVELHowever, in periods of high inflation the short- run stickiness of nominal wages and prices tends to disappear.Workers and businesses are quick to raise their wages and prices in response to changes in the money supply. This makes for a more rapid return to long-run equilibrium under high inflation.Therefore, the classical model of the price level is more likely to be a good approximation of realities for economies experiencing persistently high inflation.
HOW DOES THE GOVERNMENT RAISE REVENUE BY PRINTING MONEY?The Treasury and the Federal Reserve work together to raise revenue by printing money.1. The Treasury issues debt to finance the government’s purchases of goods and services.2. The Fed monetizes the debt by creating money and buying the debt back from the public through the open-market purchases of Treasury bills.
HOW DOES THE GOVERNMENT RAISE REVENUE BY PRINTING MONEY?The Fed creates money “out of thin air” and uses it to buy valuable government securities from the public sector.The US government does have to pay interest on the debt owned by the Federal Reserve, but, by law, the interest payments it receives on government debt go right back to the Treasury, as it only can keep what it needs to fund its own operations.
SEIGNORAGESeignorage refers to the amount of real purchasing power that a government can extract from the public by printing money.This means that the right to print money is itself a source of revenue, as it refers to the revenue generated by a government’s right to print money.
SEIGNORAGEConcerns about seignorage don’t affect the Fed’s decisions about how much money to print, as the Fed is worried about inflation and unemployment, not revenue.A government may find itself with a large budget deficit and may not want or be able to eliminate this deficit through contractionary measures or added borrowing.
WHAT ARE THE EFFECTS OF PRINTING MONEY TO PAY FOR DEBT?In these cases a government may end up printing money to cover the budget deficit.However, when printing money to pay for its bills, a government increases the quantity of money in circulation.These increases in the money supply translate into equal increases in the aggregate price level.So, printing money to cover a budget deficit leads to inflation.
INFLATION TAXThe ones who end up paying for the goods and services the government purchases with newly printed money are the people who hold money.The inflation decreases their purchasing power. Therefore, the government imposes a form of tax on the people.This reduction in the value of the money held by the people, by printing money to cover its budget deficit and creating inflation, is referred to as an inflation tax.
INFLATION TAXIf the inflation rate is 3%, then in a year, $1 will buy only about $0.97 worth of goods and services today.So this 3% inflation rate imposes a tax of 3% on the value of the money held by the public (because they lose 3% of their purchasing power).
HOW DOES HYPERINFLATION OCCUR?Because inflation imposes a tax on individuals who hold money, it leads people to change their behavior.If inflation is high, people prefer to hold real goods or interest bearing assets for money.They cut the amount of money they hold so much that it actually has less purchasing power than the amount of money they would hold if inflation were low, because, the more real money holdings they have, the greater real amount of resources the government captures from them through the inflation tax.
HOW DOES HYPERINFLATION OCCUR?Countries can get into situations of extreme inflation when they print a large quantity of money, imposing a large inflation tax, to cover a large budget deficit.
HOW DOES HYPERINFLATION OCCUR? This cycle progressively leads to an even higher rate of inflation, which leads people to hold even less money, and so on. Although the amount of real seignorage does not change, the inflation rate the government needs to impose to collect that amount rises. So, the government is forced to increase the money supply more rapidly, leading to an even higher rate of inflation, and so on. This self-reinforcing process can easily spiral out of control, creating hyperinflation. When this happens people are unwilling to hold any money at all, so the government is forced to abandon its use of the inflation tax, and stops printing money.
MODERATE INFLATIO AND DISINFLATION There are two possible changes that can lead to an increase in the aggregate price level:1. A decrease in aggregate supply, or2. An increase in aggregate demand. Cost-push inflation is caused by a significant increase in the price of an input that has economy-wide importance. This increases the costs of production through the economy, which drive prices up. Demand-pull inflation is inflation that is caused by an increase in aggregate demand, which means that the aggregate demand for goods and services is outpacing the aggregate supply and driving up the prices of goods.
MODERATE INFLATION AND DISINFLATION In the short run, policies that promote growth also tend to lead to inflation, and policies that reduce inflation tend to depress the economy. Politicians face a dilemma: inflationary policies often produce short-term political gains, but policies to bring inflation down carry short-term political costs. What to do? This political asymmetry may explain why some countries that do not need to impose an inflation tax sometimes end up with inflation problems.
THE OUTPUT GAP AND THE UNEMPLOYMENT RATE Potential output typically grows steadily over time, reflecting long-run growth. However, in the short run, actual output fluctuates around potential output, creating recessionary or inflationary gaps. Remember: The output gap is the percentage difference between the actual level of GDP and potential output. This positive or negative output gap occurs when an economy is producing more or less than what is expected because the prices and wages.have not adjusted.
THE OUTPUT GAP AND THE UNEMPLOYMENT RATE Remember: the unemployment rate is composed of cyclical unemployment and natural unemployment. The relationship between the unemployment gap and the output gap is defined by two rules:1. When actual aggregate output is equal to potential output, the actual unemployment rate is equal to the natural rate of unemployment.2. When the output gap is positive (inflationary gap), the unemployment rate is below the natural rate. When the output gap is negative (recessionary gap), the unemployment rate is above the natural rate .
THE OUTPUT GAP AND THE UNEMPLOYMENT RATE This means that the fluctuations of aggregate output around the long-run trend of potential output correspond to fluctuations of the unemployment rate around the natural rate.:1. when output is lower than potential, there is an unusually high unemployment rate.2. When output is higher than potential, there is a lower-than-normal unemployment rate.