Module 33Types 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 GDPB) inflation and a long-run increase in real GDPC) no inflation and a long-run increase in real GDPD) deflation with no long-run increase in real GDPE) 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 GDPB) inflation and a long-run increase in real GDPC) no inflation and a long-run increase in real GDPD) deflation with no long-run increase in real GDPE) 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 publicB) sells bondsC) decreases the money supplyD) targets interest ratesE) increases taxes and reduces government spending

Sample Question

• The Fed monetizes the debt when it:A) prints money and buys government debt from

the publicB) sells bondsC) decreases the money supplyD) targets interest ratesE) 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 bracketsB) the reduction in the real value of money when

inflation fallsC) the reduction in the real value of money when

inflation risesD) the tax placed on inflation by the governmentE) the increase in income tax revenues from a

growing economy

Sample Question• The inflation tax refers to

A) moving into higher income tax bracketsB) the reduction in the real value of money when

inflation fallsC) the reduction in the real value of money when

inflation risesD) the tax placed on inflation by the governmentE) the increase in income tax revenues from a

growing economy