Inflation and Recessions

Inflation Temptation

• Inflation is caused primarily by governments’ printing more paper money or producing a large amount of cheap-metal coins, which vastly increases the supply of money and makes each piece of money less precious.

• As sellers demand higher prices to make up for the fact that each piece of money is worth less, you get inflation.

Inflation Temptation

• So why in the world would governments print too much money?

• Historically, governments circulate more money in three circumstances:– When governments can’t raise enough tax revenue to pay

their obligations.– When governments feel pressure from debtors who want

inflation so they can repay their debts using less valuable money.

– When governments want to try to stimulate the economy during a recession or depression.

Paying Bills by Printing Bills

• Governments almost always have debts, and printing extra money can be a tempting way to pay them.– Quite often, a government may want to spend

more money than it’s collecting in tax revenue.– One solution is to borrow the shortfall, but

another is to simply print new bills to cover the difference.

Paying Bills by Printing Bills

• The trouble with allowing a government to pay its debts and obligations by printing money is that as soon as the newly printed money begins to circulate, people spend it, drive up prices, and cause inflation.

• And if the government keeps printing money, you end up with people offering shopkeepers and producers successively more case for the same amount of goods and services.– It’s like a giant auction where everybody bidding on items

keeps getting more and more money to bid with

Paying Bills by Printing Bills

• If a government gets into the habit of rapidly printing new money to pay its bills, inflation can soon reach or even surpass 20 or 30 percent per month, a situation referred to as hyperinflation.

• Economists hate hyperinflation because it greatly disrupts daily life and ruins the investment climate.

Paying Bills by Printing Bills

• Hyperinflation does the following:– Causes people to waste huge amounts of time

trying to avoid the effects of rising prices.• Spend paycheck before prices change.

– Destroys the incentive to save• Why save money when it won’t be worth anything

tomorrow?

– Harms business• People aren’t investing.

Feeling Printing Press Pressures

• Even if the government isn’t trying to use inflation to increase tax revenues, a certain political constituency will always pressure it to circulate more money.

• You may even be a member of this group – they’re called borrowers.– To understand the politics of inflation, understand

that one of the functions of money is to act as a standard of deferred payment.

– What does that mean?

Feeling Printing Press Pressures

• Imagine that you borrow $1,000 to invest on your farm, promising to pay the bank back $1,200 next year.

• For the past several years, prices in the economy have been stable, and, in particular, the pigs that you raise have sold for $100 each

• Essentially, your loan lets you borrow the equivalent of 10 pigs with the promise to pay back 12 pigs next year.

Feeling Printing Press Pressures

• But you’ve got an idea.– You lobby your congressman to lobby the

government to print more money.– All that new money causes inflation, after which

the price of pigs rise to $200 each.– Now you have to sell only six pigs to pay back the

$1,200 loan, leaving you with more pigs.

Feeling Printing Press Pressures

• If the aforementioned scenario takes place, the bank is going to do everything in its power to fight the inflation.– If the inflation happens, the bank becomes the

loser.– The loan was for $1,000 or the equivalent of 10

pigs.– However, the bank is only going to get 6 pigs paid

back to it.– The bank loses 40% of the loan’s value.

Stimulating the Economy with Inflation

• A legitimate reason for governments to print more money has the very respectable name of monetary policy.

• Monetary policy refers to the decisions a government makes about increasing or decreasing the money supply in order to stimulate or slow down the economy.

Stimulating the Economy with Inflation

• The basic idea of monetary policy is that if the economy is in a recession, the government may print up some new money and spend it.– All the goods and services it buys with the new money

stimulate the economy immediately.– In addition, all those businesses that received money

from the government can now go out and spend that money themselves.

– This can go on and on so long as no one starts to save the money that they got until it actually lifts an economy out of a recession.

Stimulating the Economy with Inflation

• The sad upshot is that an increase in the money supply stimulates the economy only when it’s a surprise (remember, increasing the money supply increases prices).

• If the government can print the money and start spending it before people can raise prices, you get an increase in the amount of goods and services sold.– Eventually, of course, people figure it out and raise

prices, but until they do, the monetary stimulus works.

Tallying up the Effects of Inflation

• In the United States, prices rise only a small amount each year.

• However, even moderate inflation causes problems by cutting into the practical benefits of using money instead of barter.

• You can get a better sense of this fact by looking at the four functions that economists generally ascribe to money and the ways in which inflation screws up each of them.

Tallying up the Effects of Inflation

• They are:– Money is a store of value– Money is a unit of account– Money is a standard of deferred payment– Money is a medium of exchange

Why Recessions Happen

Why Recessions Happen

• Macroeconomics' biggest ask is to try to prevent – or at least shorten – recessions, those periods of time during which the economy’s output of goods and services declines.

• Economists, politicians, and most other people who work for a living despise recessions because of the toll they exact in human suffering.– That’s because when output falls, firms need fewer workers.

They typical result is massive layoffs, which cause significant increases in unemployment.

– In countries such as the United States, millions of workers lose their jobs, as well as their ability to support themselves and their families.

Why Recessions Happen

• Typically, recessions begin with what economists like to call shocks – unexpected bad events such as terrorist attacks, natural disasters, the introduction of bad government policies, or sudden spikes in the cost of important natural resources such as oil.

The Business Cycle

• Economies go through alternating periods during which the total output of goods and services expands and then contracts.

• The alternating pattern of economic expansion and contraction, illustrated on the next slide, is often called the business cycle because businesses are so greatly affected by the changes in output.

The Business Cycle

The Business Cycle

• The solid line on the previous graph represents how the economy’s total output of goods and services varies over time.

• It alternates between troughs and peaks, which helps you identify periods of recession and recovery.

The Business Cycle

• Recessions, or contractions, are the periods of time during which output falls – that is, after a peak and before the next through.

• Recoveries, or expansions, are the periods of time during which output increases – that is, after a trough and before the next peak.

The Business Cycle

• The dotted line represents the long-run, average growth trend for an economy’s total output of goods and services.

• This particular chart shows sustained economic growth.– In other words, on average, total output tends to

rise year after year.

The Business Cycle

• Looking at the graph, you can see that macroeconomic policy has two very natural goals:– Make the long-run average growth line as steep as

possible.• The steeper it is, the faster (on average) total output and

living standards rise.

– Reduce the size of business cycle fluctuations around the long-run average growth line.• Smaller distances between peaks and troughs translate into

fewer people suffering through bouts of unemployment when output falls.