AP Economics

Mr. Bernstein

Module 33: Types of Inflation, Disinflation and

DeflationFebruary 2, 2015

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AP EconomicsMr. Bernstein

The Classical Model of Money and Prices• Change in nominal

money supply (M)leads to change inaggregate price level(P) so real quantityof money (M/P)remains unch’d

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AP EconomicsMr. Bernstein

The Classical Model of Money and Prices• Assumes adjustment is automatic and

instantaneous• Holds true during periods of high inflation but

not in times of slower inflation• So in countries with persistently high inflation,

increase in M are quickly turned into changes in P (inflation) but in other countries, changes in M may actually boost real GDP in short run

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AP EconomicsMr. Bernstein

The Inflation Tax• Independent Central Banks create fiat currency• Treasury issues debt (borrows money) to fund government operations• The Fed prints money to buy Treasury debt• The Fed turns over interest earned back to Tsy• So the Fed effectively pays off debt by printing money• Revenue generated by the right to print money is known as

seignorage• When the printing of money leads to inflation, eroding the purchasing

power of currency held, they are said to be imposing an inflation tax on holders of the currency

• An inflation tax is implicit, not explicit

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AP EconomicsMr. Bernstein

The Logic of Hyperinflation• Gov’t decides to print money and collect seignorage,

to cover a budget deficit• The public, fearing erosion in purchasing power of

currency, avoids inflation tax by reducing holdings of money

• Gov’t responds by printing more money to collect targeted real seignorage to cover deficit

• People respond by reducing holdings of money again• Result: An inflationary spiral

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AP EconomicsMr. Bernstein

Moderate Inflation and Disinflation• Cost-push inflation results from an increase in the

price of resources, ie an increase in the price of steel will increase the price of cars and many other items

• Demand-pull inflation results from an increase in demand for goods and services• Usually coupled with expansionary monetary or fiscal

policy• Politicians may use fiscal policy such as tax cuts or public

works during election years, leaving the costs of inflation until after they win the election