Module 33
Types of Inflation,
Disinflation and Deflation
Objectives:
• Examine the classical model of price level.
• Examine why efforts to collect an inflation
tax can lead to high rates of inflation and
hyperinflation
• Identify cost-push and demand- pull
inflation.
Money and Inflation
• What is it good for?
• Why would governments increase the money
supply so rapidly?
• What are the effects on price levels?
Remember:
• In the short run, increasing the money supply
increases real GDP by lowering interest rates
•
In the long run, it leads to an equal percentage
rise in overall prices and real GDP is unchanged
A change in the nominal money supply (M) leads,
in the long run, to a change in the aggregate
price level (P).
This leaves the real quantity of money (M/P) at
its original level.
When analyzing large changes in aggregate price
level, economists like to look at the short – run
and not the long –run.
Classical Economics
• The model we are going to use doesn’t worry
about short or long run when analyzing large
changes in aggregate price level
• This is called the classical model of the price
level.
• According to the classical model of the
price level- the real quantity of money is
always at is long run equilibrium level.
We’ve seen this before.
Classical Model
• Effects of changes in the money supply are
analyzed as if the short-run as well as the long –
run aggregate supply curves were vertical
• because it assumes we go basically from E1 to E3
• Problem: poor assumption during periods of low
inflation because may take time to respond to
rise in prices (sticky in the SR) and GDP can rise
• High inflation: stickiness of wages and prices
disappears; people are sensitive to inflation
High Inflation is what drives the
model.
• In high inflation- there is a quicker adjustment
of wages and prices of intermediate goods.
• So the classical model is much more likely to be
a good approximation of reality for economies
experiencing persistently high inflation.
• For countries that fact this problem like
Zimbabwe- changes in the money supply are
quickly translated into changes in the inflation
rate.
How can government make more
money?
• Tax?!
• -not quick enough?!
• Sell government bonds to public
(crowding out)
• Hmmm….
Inflation Tax
• Remember, the government can and does raise
revenue by printing money
• called seignorage
• When this occurs, people holding money pay an
inflation tax, or a reduction is the value of money
• real inflation tax: a reduction in the value of money
held by the public caused by inflation
• Seignorage = ∆M
• Real seignorage = ∆M/P
• Real seignorage = (∆M/M) x (M/P)
• RS= Rate of growth of the money supply x Real
money supply
• the inflation rate times the real money supply.
Hyperinflation
• In order to avoid paying the inflation tax, people
reduce their real money holdings and force the
government to increase inflation to capture the
same amount of real inflation tax.
• In some cases, this leads to a vicious circle of a
shrinking real money supply and a rising rate of
inflation.
• This leads to hyperinflation and a fiscal crisis.
Inflation Spiral
• As people hold smaller amounts of money, the
government responds by accelerating the rate of
growth of money= higher inflation etc. . .
Inflation
• The price level is the absolute level of a price
index.
• Measures of the price level include:
• Consumer Price Index (retail prices).
• Producer Price Index (wholesale prices).
• GDP Deflator (average price of all items in
GDP).
• The rate of inflation is the annual rate of
increase in the price level.
Your attitude toward inflation will depend in part on whether you live on a
fixed income, whether you are a creditor or debtor, and whether you have
properly anticipated inflation.
Creditors may be harmed by unanticipated inflation because both the
principal on loans and interest payments are usually fixed.
The Treasury and the Federal Reserve work together. Treasury
issues debt to finance the government’s purchases of goods
and services, and the Fed monetizes the debt by creating
money and buying the debt back from the public through
open - market purchases of Treasury bills.
The Fed creates money out of thin air and uses it to buy
government securities from the private sector.
The Treasury pays interest on debt owned by the Federal
Reserve—but the Fed, by law, hands the interest payments it
receives on government debt back to the Treasury, keeping
only enough to fund its own operations.
An alternative way to look at this is to say that the right to print
money is itself a source of revenue. Economists refer to the
revenue generated by the government’s right to print money
as seignorage.
DEMAND-PULL INFLATION
“Too many dollars chasing too few goods”
DEMAND PULLS UP PRICES!!!
• Demand increases but supply stays the
same. What is the result?
• A Shortage driving prices up
• An overheated economy with
excessive spending but same amount
of goods.
Cost – Push Inflation
• Higher production costs increase prices
• A negative supply shock increases the costs of
production and forces producers to increase
prices.
• Examples:
• Hurricane Katrina destroyed oil refineries and
causes gas prices to go up. Companies that use
gas increase their prices.
Cost-Push Inflation
Sample Question
• According to the classical model of the price
level, an increase in the money supply will
create:
A) inflation with no long –run increase in real GDP
B) inflation and a long-run increase in real GDP
C) no inflation and a long-run increase in real GDP
D) deflation with no long-run increase in real GDP
E) disinflation with no long-run increase in real GDP
Sample Question
• According to the classical model of the price
level, an increase in the money supply will
create:
A) inflation with no long –run increase in real GDP
B) inflation and a long-run increase in real GDP
C) no inflation and a long-run increase in real GDP
D) deflation with no long-run increase in real GDP
E) disinflation with no long-run increase in real GDP
Sample Question
• The Fed monetizes the debt when it:
A) prints money and buys government debt from
the public
B) sells bonds
C) decreases the money supply
D) targets interest rates
E) increases taxes and reduces government
spending
Sample Question
• The Fed monetizes the debt when it:
A) prints money and buys government debt from
the public
B) sells bonds
C) decreases the money supply
D) targets interest rates
E) increases taxes and reduces government
spending
Sample Question
• Seignorage is:
A) the government’s cost of printing and coining $
B) the revenue generated by the government’s right
to print $
C) the money financial institutions make selling
government bonds to the FED when the FED
creates $
D) the revenue the government generates in tax
receipts
E) the revenue the government generates in interest
on lending to the public
Sample Question
• The inflation tax refers to
A) moving into higher income tax brackets
B) the reduction in the real value of money when
inflation falls
C) the reduction in the real value of money when
inflation rises
D) the tax placed on inflation by the government
E) the increase in income tax revenues from a
growing economy
Sample Question
• The inflation tax refers to
A) moving into higher income tax brackets
B) the reduction in the real value of money when
inflation falls
C) the reduction in the real value of money when
inflation rises
D) the tax placed on inflation by the government
E) the increase in income tax revenues from a
growing economy