Does Inflation a Good or a Bad Thing?

What is inflation? Inflation is simply an increase in the average level of prices, and a price is the rate at which money is exchanged for a good or a service. To understand inflation, therefore, we must understand money—what it is, what affects its supply and demand, and what influence it has on the economy.

When we say that a person has a lot of money, we usually mean that he or she is wealthy. By contrast, economists use the term “money” in a more specialized way. To an economist, money does not refer to all wealth but only to one type of it: money is the stock of assets that can be readily used to make transactions.

The Functions of Money

Money has three purposes: it is a store of value, a unit of account, and a medium of exchange.

As a store of value, money is a way to transfer purchasing power from the present to the future.

As a unit of account, money provides the terms in which prices are quot-

ed and debts are recorded.

As a medium of exchange, money is what we use to buy goods and services.

          The quantity of money available in an economy is called the money supply. In a system of commodity money, the money supply is simply the quantity of that commodity. In an economy that uses fiat money, such as most economies today, the government controls the supply of money: legal restrictions give the government a monopoly on the printing of money. Just as the level of taxation

and the level of government purchases are policy instruments of the government, so is the quantity of money. The government’s control over the money supply is called monetary policy.

Seigniorage: The Revenue from Printing Money

all governments spend money. Some of this spending is to buy goods and services (such as roads and police), and some is to provide transfer payments (for the poor and elderly, for example). A government can finance its spending in three ways. First, it can raise revenue through taxes, such as personal and corporate income taxes. Second, it can borrow from the public by selling government bonds. Third, it can print money. The revenue raised by the printing of money is called seigniorage.

When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.

The amount of revenue raised by printing money varies from country to country. In countries experiencing hyperinflation, seigniorage is often the government’s chief source of revenue—indeed, the need to print money to finance expenditure is a primary cause of hyperinflation.

Hyperinflation

Hyperinflation occurs when a country experiences very high and usually accelerating rates of inflation, rapidly eroding the real value of the local currency, and causing the population to minimize their holdings of local money. The population normally switches to holding relatively stable foreign currencies. Under such conditions, the general price level within an economy increases rapidly as the official currency quickly loses real value.

The Costs of Hyperinflation

The shoeleather costs associated with reduced money holding, for instance, are serious under hyperinflation. Business executives devote much time and energy to cash management when cash loses its value quickly. By diverting this time and energy from more socially valuable activities, such as production and investment decisions, hyperinflation makes the economy run less efficiently.

Menu costs also become larger under hyperinflation. Firms have to change prices so often that normal business practices, such as printing and distributing catalogs with fixed prices, become impossible. In one restaurant during the German hyperinflation of the 1920s, a waiter would stand up on a table every 30 minutes to call out the new prices.

The Causes of Hyperinflation

          hyperinflation is caused by excessive growth in the supply of money. When the central bank prints money, the price level rises. When it prints money rapidly enough, the result is hyperinflation. To stop the hyperinflation, the central bank must reduce the rate of money growth.

Conclusion: The Classical Dichotomy

The real wage is the quantity of output a worker earns for each hour of work, and the real interest rate is the quantity of output a person earns in the future by lending one unit of output today. All variables measured in physical units, such as quantities and relative prices, are called real variables.

nominal variables—variables expressed interms of money. The economy has many nominal variables, such as the price level, the inflation rate, and the dollar wage a person earns.

At first it may seem surprising that we were able to explain real variables without introducing nominal variables or the existence of money. In Chapter 3 we studied the level and allocation of the economy’s output without mentioning the price level or the rate of inflation. Our theory of the labor market explained the real wage without explaining the nominal wage. Economists call this theoretical separation of real and nominal variables the classical dichotomy. It is the hallmark of classical macroeconomic theory. The classical dichotomy is an important insight because it simplifies economic theory. In particular, it allows us to examine real variables, as we have done, while ignoring nominal variables. The classical dichotomy arises because, in classical economic theory, changes in the money supply do not influence real variables. This irrelevance of money for real variables is called monetary neutrality.

Book : MACROECONOMICS by N. Gregory Mankiw