Inflation, Unemployment, and Stabilization Policies: Types of

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Transcript Inflation, Unemployment, and Stabilization Policies: Types of

Inflation, Unemployment,
and Stabilization Policies:
Types of Inflation,
Disinflation, and Deflation
AP Economics
Mr. Bordelon
Classical Model of
Money and Prices
Assume the Fed conducts
expansionary monetary policy, which
causes AD to increase, with a new
equilibrium at E2. SRAS will
decrease as nominal wages would
have to increase for the higher prices
(production slows down because it
becomes more expensive to make
things), settling at a new equilibrium
at E3. The reverse analysis can be
made using contractionary monetary
A change in MS will lead to a change
in APL, which leaves the real quantity
of money, MS/P, at the original level.
In the long run, there is no effect on
AD or real GDP.
Classical Model of Money and Prices
The classical model presumes that the adjustment from the first LRE to the
second LRE, regardless of expansionary or contractionary policy, is automatic
and instantaneous.
Low inflation (less accurate)
With a low inflation rate, it may take a while for workers and firms to react to a
monetary expansion by raising wages and prices. Some nominal wages and prices
of some goods are sticky in the short run.
As a result, under low inflation there is an upward-sloping SRAS curve, and
changes in MS can change real GDP in the short run.
High inflation (more accurate)
In a period of high inflation, short-run stickiness of nominal wages and prices
disappears. Workers and businesses, because of inflation, will raise wages and
prices in response to changes in MS.
Under high inflation there is a quicker adjustment of wages and prices of
intermediate goods than occurs in low inflation. SRAS shifts leftward more
quickly and there is a quicker return to LRE under high inflation.
The result of this rapid adjustment of all prices in the economy is that in countries
with high inflation, changes in MS are quickly end up changing the inflation rate.
Inflation Tax
A common criticism of macroeconomic policy is that the
U.S. gov’t prints money to pay for large budget deficits.
How can the U.S. gov’t do this, given that the Federal
Reserve issues money, not the U.S. Treasury?
The Treasury and the Federal Reserve work in concert.
Treasury issues debt to finance gov’t’s purchases of g/s, and
the Fed monetizes the debt by creating money and buying
the debt back from the public through open-market
purchases of T-bills.
In other words, U.S. gov’t can and does raise revenue by
printing money.
Somewhere, Shane Coll is RAGING.
Inflation Tax
The Fed creates money out of thin air and uses it to buy
government securities from private sector. Treasury pays interest
on debt owned by the Fed—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.
In other words, the Fed’s actions enabled the gov’t to pay off
billions in outstanding gov’t debt by printing money.
But there is another way to look at this…what if we look at the
right to print money is itself a source of revenue?
Seignorage. Revenue generated by gov’t’s right to print money.
Inflation Tax
“But wait!” Shane rages, after flipping a table. “Doesn’t
printing money to cover a budget deficit lead to inflation?”
Of course…but who’s going to pay the price of this inflation
because of the new printed cash is the better question.
People who currently hold money pay. Money is losing its
value. These people will pay because inflation decreases the
purchasing power of their money.
In short, the government is imposing an inflation tax,
reducing the value of the money held by the public, by
printing money to cover its budget deficit and creating
And how far do we go? How much money should a gov’t
print? This leads to another problem…
High inflation arises when the government must print a
large quantity of money, imposing a large inflation tax, to
cover a large budget deficit.
The seignorage collected by gov’t over a short period of time
equals the change in MS over that same period.
Seignorage = ΔMS
Real seignorage is more useful as information, and is the
revenue created by printing money divided by price.
Real seignorage = ΔMS/P
Finally, reducing this equation by dividing and multiplying
by the current level of MS, we end up with
Real seignorage = (ΔMS/M) x (MS/P) OR
Real seignorage = rate of growth of MS x real MS
Real seignorage = (ΔMS/M) x (MS/P)
As a matter of algebra, as high inflation continues, the
people holding money will reduce the money it holds,
so that the real MS (MS/P) gets increasingly smaller.
With this in mind, now let’s apply it to gov’t actions.
Assume that a gov’t needs to print enough money to
pay for a given quantity of g/s—in other words, it needs
to collect a given real amount of seignorage.
This will lead to an inflationary spiral.
Inflationary spiral
As people hold smaller amounts of real money due to high
inflation, gov’t responds by accelerating the rate of growth of MS
This, in turn, leads to an even higher rate of inflation.
People respond in kind to the new higher rate of inflation by
reducing their real money holdings (MS/P).
The amount of real seignorage that the gov’t must collect to pay
off the deficit does not change. The inflation rate the
government needs to impose to collect that amount increases.
You read that right. The gov’t imposes an inflation rate—inflation
Gov’t is forced to increase MS quicker, leading to higher rates of
inflation, and so on.
AP Note: Make sure you understand this process for FRQs on the
Moderate Inflation and Deflation
In the AD-AS model, there are two possible changes that
can lead to an increase in APL—decrease in SRAS or
increase in AD.
Cost-push inflation. Caused by decrease in SRAS.
Typically the result of an economy-wide increase in the price
of resources.
Demand-pull inflation. Caused by increase in AD. Caused
by economic growth coupled with either expansionary fiscal
or monetary policy.
For expansionary fiscal, politicians cut taxes even if economy
is near full employment. This shifts AD to the right and
inflation increases, but the effect is not felt until after the
Moderate Inflation and Deflation
Key point: In the short run, policies that produce a
booming economy lead to higher inflation.
Key point: In the short run, policies that reduce
inflation tend to depress the economy.
Output Gap and
The difference between actual level
of real GDP vs. YP is the output gap.
If the output gap is positive, the
economy is producing above YP and
unemployment will be low.
If the output gap is negative, the
economy is producing below YP and
unemployment will be high.
Output Gap and
There will always be some level of
unemployment (frictional and
structural) even when the economy is
at YP. This is the natural rate of
When actual aggregate output is equal
to YP, the actual unemployment rate is
equal to the natural rate of
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.
Question 1
In the following examples, would the classical model of
the price level be relevant?
There is a great deal of unemployment in the economy
and no history of inflation.
The economy has just experienced five years of
Although the economy experienced inflation in the
10% to 20% range three years ago, prices have recently
been stable and the unemployment rate has
approximated the natural rate of unemployment.
Question 2
Answer the following questions about the real inflation tax,
assuming that the price level starts at 1.
Valentina keeps $1,000 in her sock drawer for a year. Over the
year, the inflation rate is 10%. What is the real inflation tax
paid by Valentina for this year?
Valentina continues to keep the $1,000 in her drawer for a
second year. What is the real value of this $1,000 at the
beginning of the second year? Over the year, the inflation rate is
again 10%. What is the real inflation tax paid by Maria for the
second year?
For a third year, Valentina keeps the $1,000 in the drawer. What
is the real value of this $1,000 at the beginning of the third year?
Over the year, the inflation rate is again 10%. What is the real
inflation tax paid by Valentina for the third year?
After three years, what is the cumulative real inflation tax paid?
Redo these questions with an inflation rate of 25%. Why is
hyperinflation such a problem?