Why Governments Create Inflation

Course Outline

Why Governments Create Inflation

Inflation can carry with it quite a few costs. But some governments, like Zimbabwe under President Robert Mugabe in the early 2000s, will go out of their to way to create inflation. Why?

Well, in the Zimbabwe example, the government printed the money and used it to buy goods and services. The ensuing hyperinflation acted as a tax that transferred wealth from the citizens to the government.

However, this is a fairly uncommon reason. Inflation doesn’t make for a good tax and it’s a last resort for desperate governments that are otherwise unable to raise funds.

There are other benefits to inflation that would make governments want to create it. In the short run, inflation can actually boost economic output. However, as we’ve previously covered, an increase in the money supply leads to an equal increase in prices in the long run.

If there’s a recession, governments might create inflation to spur productivity and ease the economic downturn. However, this type of inflationary boosting can be abused. Long-term boosting causes people to simply expect and prepare for it.

Reducing inflation is also costly. If the process is reversed and the growth in the money supply decreases, we get disinflation. Unemployment will likely increase in the short run and an economy can go through a recession. But in the long run, prices will adjust as well.

Inflation can be a neat trick for governments to boost productivity in an economy. But it can easily get out of hand and has even been likened to a drug. Once you start, you need more and more. And stopping is awfully painful as the economy shrinks.

This concludes our section on Inflation and the Quantity Theory of Money. Up next in Principles of Macroeconomics, we’ll be digging into Business Fluctuations.

Teacher Resources


If inflation is so costly, why do some governments create inflation? In our opening video on hyperinflation in Zimbabwe, we gave one explanation. When the government prints money and uses it to buy goods, that's like a tax -- a transfer of wealth from the people to the government. Now inflation is not an especially effective tax.


So, governments typically use inflation as a tax only when they're desperate. They can't raise funds in any other way. There are other reasons, however, why printing money can benefit governments. And in some cases, printing money can even benefit an economy. We'll be examining these in much more detail in future videos when we discuss how the government can use fiscal and monetary policy to combat a recession. In this video, we're just going to give a taste of the basic idea.


Recall the equation of exchange, MV is equal to PY. Earlier, we used this equation to explain inflation. And what we said is that since V and Y are relatively stable, the only explanation for large and sustained increases in prices is an increase in the money supply, M. We also showed empirically that in the long run, when M doubles, then P doubles, just as the theory predicts. In other words, in the long run, money is neutral.



But what about the short run? In the short run, an increase in M, especially an unexpected increase in M, that can increase real output. To understand why, let's turn to the parable of inflation. Consider a small economy consisting of a baker, a tailor, and a carpenter, who buy and sell products among themselves. Now think about what happens when a government like that in Zimbabwe starts paying its soldiers with newly printed money. At first, the baker is delighted when the soldiers walk through his door with cash for bread. To satisfy his new customers, the baker works extra hours, hires more assistants, bakes more bread, and is able to raise prices. "How wonderful," the baker thinks. With the increase in the demand for bread, I'll be able to buy more clothes and more cabinets.



Meanwhile, the tailor and the carpenter are thinking much the same thing, as the soldiers are also buying goods from them. When the baker arrives at the tailor to buy shirts, however, he finds that he's been fooled. The soldiers have bought shirts for themselves and the price of shirts has now gone up. In the same way, the tailor and the carpenter -- they discovered that the prices of the goods that they want to buy -- they've also increased. Although they earned more dollars, their real wages -- the amount of goods that the baker, the tailor, and the carpenter -- the amount of goods that they can buy with their dollars -- that has decreased. When the government next wants to buy goods, it faces higher prices and it has to print even more money to buy just as many goods as before.



Moreover, as the new money enters the economy, the baker, for example, will now race to the tailor and to the carpenter to try and spend the money before prices go up. V increases. Unfortunately, the tailor and the carpenter -- they're likely to have had the same idea. And the result is that prices increase even more quickly than the time before. Eventually, as the government continues to print money and buy goods, the baker, the tailor, and the carpenter, they'll catch on. They'll come to expect and prepare for inflation.



Instead of working extra hours, the baker, tailor, and carpenter -- they'll realize that by the time they get to spend their money, the goods that they want to buy will have already increased in price. And knowing this, the baker, the tailor, and the carpenter -- they'll no longer be so happy to see the soldiers entering their shop, waving fistfuls of dollars. And they'll no longer work extra hours baking more bread, selling more clothes, or building more cabinets. This is the parable of inflation.



We learn two things of importance from the parable. First, an increase in the money supply can boost the economy in the short run. And by the way, that can be a good thing especially if there's a recession. But this power might also be abused by governments to help swing, say, an election. Second, we also learn from the parable that when the government repeatedly tries to boost the economy by injections of money, the people come to expect the increases in prices and they come to prepare.



So, let's think about this using our equation of exchange: MV is equal to PY. In the short run, an increase in M can cause an increase in Y. But then P catches up. So, in the long run, the increase is in P only. But now notice the following: if the government wants to reduce inflation, the entire process goes into reverse. So, a decrease in the money supply -- that can cause a recession. If M decreases, for example, then in the short run, Y falls until P catches up. In the long run, a decrease in M decreases P. But the long run may come only after a short-run recession.



So, one of the biggest costs of inflation is that reducing inflation is also costly. A bit of inflation -- it seems like a good idea to boost the economy, but if you keep trying the same trick over and over again, it stops working. And then you're left with all cost and no benefit. A reduction in inflation at that point -- it slows the economy and it increases unemployment. So, inflation has been likened to a drug. The drug stimulates at first, but then you need more and more to get the same stimulus until you need the drug just to be normal.



And finally, when you stop using the drug, you get severe withdrawal pains. This is what happened in the United States in the early 1980s. Inflation was increasing in the 1970s, but by the time we got to the late 1970s, it wasn't helping any longer to reduce unemployment. So, we got so-called stagflation: inflation and unemployment together. Then in the early 1980s under Ronald Reagan, inflation fell, but at the price of a very serious recession in 1981 and 1982. So, another reason to avoid too much inflation is that reducing inflation can be very costly indeed.



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