1. TYPES OF INFLATION,
DISINFLATION, AND
DEFLATION
MODULE 33

2. MONEY AND INFLATION
Inflation 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.

3. THE CLASSICAL MODEL
OF MONEY AND PRICES
Remember: 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.

4. THE CLASSICAL MODEL
OF MONEY AND PRICES


5. THE CLASSICAL MODEL
OF THE PRICE LEVEL


6. THE CLASSICAL MODEL
OF THE PRICE LEVEL
The 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.

7. THE CLASSICAL MODEL
OF THE PRICE LEVEL
Under 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.

8. THE CLASSICAL MODEL
OF THE PRICE LEVEL
However, 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.

9. 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.

10. 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.

11. SEIGNORAGE
Seignorage 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.

12. SEIGNORAGE
Concerns 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.

13. 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.

14. INFLATION TAX
The 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.

15. INFLATION TAX
If 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).

16. 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.

17. 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.

18. HOW DOES HYPERINFLATION OCCUR?


19. HOW DOES HYPERINFLATION OCCUR?


20. 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.

21. 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, or
2. 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.

22. 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.

23. 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.

24. 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 .

25. 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.