AP Economics Mr. Bordelon

1. Inflation, Unemployment, and Stabilization Policies: Types of Inflation, Disinflation, and Deflation AP Economics Mr. Bordelon

2. 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 policy. 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.

3. 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.

4. 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.

5. 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.

6. 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 inflation. • And how far do we go? How much money should a gov’t print? This leads to another problem…

7. Hyperinflation • 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

8. Hyperinflation • 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.

9. Hyperinflation • 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 (ΔMS/M). • 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 tax! • 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 exam.

10. 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 election.

11. 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.

12. Output Gap and Unemployment 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.

13. Output Gap and Unemployment There will always be some level of unemployment (frictional and structural) even when the economy is at YP. This is the natural rate of unemployment. When actual aggregate output is equal to YP, the actual unemployment rate is equal to the natural rate of unemployment. 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.

14. 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 hyperinflation. • 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.

15. 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?