Inflation

What Causes Long-Term Inflation?

The inflation rate equals the rate of change of the price level and is equal to the rate of growth of AD minus the rate of growth of real GDP.

sources of short-run increases in the price level

• • increase in the money supply

  • other increases in AD

  • supply shocks

Long-term inflation (repeated increases in the price level over a long period of time) are the result of persistent growth in the money supply.

Budget Deficits and Inflation

Expansionary fiscal policy by itself leads to a one-time jump in the price level. The only way for sustained inflation to occur is for there to be sustained growth in the money supply.

If government deficits are monetized they can lead to ongoing increases in the money supply. The Treasury borrows by issuing government bonds which the central bank buys with newly printed money.

Seignorage is the revenue the government raises by printing money. Developed countries rarely use seignorage because it does not raise enough revenue ($20 billion in U.S.). But war-torn or developed countries are unable to raise sufficient tax revenue to cover government spending and may not be able to borrow from the public.

The real revenue the government gets from seignorage is related to the inflation rate.

Consider an all-currency economy with a fixed Y and r and so a fixed money demand. The inflation rate is equal to the percentage increase in the money supply. Real seignorage revenue is equal to the inflation rate times real money balances.

Seignorage is a tax on real money balances. The government collects its revenue when it buys goods with the newly printed money. This inflation tax is paid by everyone who holds money.

Will a rise in money growth increase seignorage revenue? As the money growth rate rises, inflation rises, but as the inflation rate rises people may hold less real money balances.

Costs of Inflation

The costs of inflation differ depending on whether the inflation was anticipated or not, and on whether the economy's institutions have adapted to the presence of inflation.

expected inflation

• • shoe leather costs

  • bracket creep

  • distorts financial decisions

  • menu costs

unexpected inflation

• redistributes income from lenders to borrowers

  • misperceptions theory

Why Policymakers Allow Inflation to Occur

• • cost push inflation - higher costs shift up SRAS

  • demand pull inflation - increases in total spending

Costs of Reducing Inflation

• • cold turkey vs. gradual disinflation