Worksheet 33.1: The Inflation Tax - Garden City Public Schools

© 2015, BFW/ Worth Publishers Section 6 Krugman’s Economics for AP®, 2e Teacher’s Resource Materials

Worksheet 33.1: The Inflation Tax After reading the Deseret News’ October 2012 article “When the U.S. creates lots of money, it's just like taxation” located at http://www.deseretnews.com/article/765611836/Creating-lots-of-money-is-just-like-taxation.html?pg=all, answer the following questions. 1. What is quantitative easing? 2. Why is quantitative easing different from normal expansionary policy? 3. Why is increasing the money supply like a tax? 4. Given what you know about inflation, is quantitative easing a good idea for the economy?

Explain.


Worksheet 33.1: The Inflation Tax Answer Key

After reading the Deseret News’ October 2012 article “When the U.S. creates lots of money, it's just like taxation” located at http://www.deseretnews.com/article/765611836/Creating-lots-of-money-is-just-like-taxation.html?pg=all, answer the following questions. 1. What is quantitative easing?

This easing is an attempt to stimulate the economy by increasing the supply of available money.

2. Why is quantitative easing different from normal expansionary policy?

In normal expansionary policy, the Fed buys U.S. Treasury securities on the bond market, but with quantitative easing, the FED buys other nontraditional financial assets.

3. Why is increasing the money supply like a tax?

Increasing the money supply is like a tax since it lowers the value of money so the government pays back the debt in money that is worth less.

4. Given what you know about inflation, is quantitative easing a good idea for the economy?

Explain. Answers will vary. Students may say that inflation is not a good idea for many individuals and firms in society. Inflation robs consumers of purchasing power and raises interest rates as financial institutions added inflation expectation to the nominal interest rate.


Worksheet 33.2: Venezuela’s Biggest Enemy

After reading the Miami Herald’s February 2014 article “Andres Oppenheimer: Venezuela’s biggest enemy — hyperinflation” located at http://interamericansecuritywatch.com/andres-oppenheimer-venezuelas-biggest-enemy-hyperinflation/, answer the following questions. 1. Why is hyperinflation Venezuela’s biggest enemy? 2. What does the article suggest the government do to stop the inflationary spiral? 3. How are government policies impacting businesses? 4. How are consumers reacting to government policies?


Worksheet 33.2: Venezuela’s Biggest Enemy Answer Key

After reading the Miami Herald’s February 2014 article “Andres Oppenheimer: Venezuela’s biggest enemy — hyperinflation” located at http://interamericansecuritywatch.com/andres-oppenheimer-venezuelas-biggest-enemy-hyperinflation/, answer the following questions. 1. Why is hyperinflation Venezuela’s biggest enemy?

Inflation reached 56% last year and without intervention will continue to rise even higher. People will not be able to afford even the basic necessities and the economy will descend into chaos.

2. What does the article suggest the government do to stop the inflationary spiral?

To stop the inflationary spiral, the Venezuelan government should reduce public spending to get the deficit under control, and take other market-friendly measures aimed at rebuilding trust in the local currency.

3. How are government policies impacting businesses?

There are growing shortages of consumer goods because merchants say they are being forced to sell goods at a loss.

4. How are consumers reacting to government policies?

Venezuelans are rushing to buy U.S. dollars in order to get rid of their increasingly worthless local currency.


Exit Slip: Module 33

1. The government debt is monetized when the: A. Treasury mints new currency in order to buy Treasury bills back from foreign

governments. B. Fed conducts open-market purchases to buy Treasury bills from the public. C. Fed transfers part of its financial reserves to the Treasury, who in turn buys Treasury bills

back. D. Fed sells Treasury bills in the bond market. E. Treasury mints new currency in order to buy Treasury bills back from the Fed.

2. Government's right to print money to finance deficits is referred to as:

A. open-market sales. B. seignorage. C. fiat money implementation. D. crowding out. E. capitalization of debt.

3. When the output gap is positive, the unemployment rate is:

A. positive. B. above the natural rate. C. below the natural rate. D. negative. E. equal to the natural rate.


Exit Slip: Module 33 Answer Key

1. The government debt is monetized when the:

A. Treasury mints new currency in order to buy Treasury bills back from foreign governments.

B. Fed conducts open-market purchases to buy Treasury bills from the public. C. Fed transfers part of its financial reserves to the Treasury, who in turn buys Treasury bills

back. D. Fed sells Treasury bills in the bond market. E. Treasury mints new currency in order to buy Treasury bills back from the Fed. (B)

2. Government's right to print money to finance deficits is referred to as:

A. open-market sales. B. seignorage. C. fiat money implementation. D. crowding out. E. capitalization of debt. (B)

3. When the output gap is positive, the unemployment rate is:

A. positive. B. above the natural rate. C. below the natural rate. D. negative. E. equal to the natural rate. (C)

© 2015, BFW/Worth Publishers Section 6, Module 33 | Page 1 Krugman’s Economics for AP®, 2e Teacher’s Resource Materials

MODULE 33: TYPES OF INFLATION, DISINFLATION, AND

DEFLATION

In-Class Presentation of Module and Sample Lecture Suggested time: This module can be presented in one hour-long class session with additional time used for the in-class activity and/or Solman video.

I. Money and Inflation A. The Classical Model of Money and Prices B. The Inflation Tax C. The Logic of Hyperinflation II. Moderate Inflation and Disinflation A. The Output Gap and the Unemployment Rate

I. Money and Inflation Very high inflation, the type suffered by Zimbabwe, is associated with rapid increases in the money supply while the causes of moderate inflation, the type experienced in the United States, are quite different. To understand what causes inflation, we need to revisit the effect of changes in the money supply on the overall price level. A. The Classical Model of Money and Prices Note: this would be a good time to see if the students can: a) draw long-run equilibrium in the AD/AS model b) show the short-run impact of expansionary monetary policy, and c) show the long-run adjustment in the graph and explain how it happens.


As a result of a change in the nominal money supply, M, leads in the long run to a change in the aggregate price level, P, that leaves the real quantity of money, M/P, at its original level. As a result, there is no long-run effect on aggregate demand or real GDP. The classical model presumes that the adjustment from the first long-run equilibrium point to the second is automatic and instantaneous. In reality, this is a poor assumption during periods of low inflation. Why?

• 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.

• Thus some nominal wages and the 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 the money

supply can indeed change real GDP in the short run. This model more closely reflects reality in periods of high inflation. Why?

• Economists have observed that the short-run stickiness of nominal wages and prices tends to vanish.

• Workers and businesses, sensitized to inflation, are quick to raise their wages and prices in response to changes in the money supply.

• Under high inflation there is a quicker adjustment of wages and prices of intermediate goods than occurs in the case of low inflation.

• The short-run aggregate supply curve shifts leftward more quickly and there is a more rapid return to long-run equilibrium under high inflation.

• The consequence of this rapid adjustment of all prices in the economy is that in countries with persistently high inflation, changes in the money supply are quickly translated into changes in the inflation rate.

B. The Inflation Tax In the last few years, many media commentators and economists have blasted the U.S. government for “printing money” to pay for large budget deficits. How can the U.S. government 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 the government’s purchases of goods and services, and the Fed monetizes the debt by creating money and buying the debt back from the public through open - market purchases of Treasury bills. In effect, the U.S. government can and does raise revenue by printing money. The Fed creates money out of thin air and uses it to buy government securities from the private sector. The Treasury pays interest on debt owned by the Federal Reserve—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 effect, then, the Federal Reserve’s actions enabled the government to pay off billions in outstanding government debt by printing money. An alternative way to look at this is to say that the right to print money is itself a source of revenue. Economists refer to the revenue generated by the government’s right to print money as seignorage. As we have seen, printing money to cover a budget deficit leads to inflation. Who ends up paying for the goods and services the government purchases with newly printed money?


• The people who currently hold money pay. • They pay because inflation erodes the purchasing power of their money holdings. • In other words, a government imposes an inflation tax, the reduction in the value of the money

held by the public, by printing money to cover its budget deficit and creating inflation. C. The Logic of Hyperinflation How does inflation get so out of control? Note: the example used in the text about a city that decides to raise money with a fee on taxi rides is excellent. The instructor might refer to this as an example, or use the exercise at the end of this module. 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 the government over a short period—say, one month—is equal to the change in the money supply over that period.

• M represents the money supply and the symbol Δ means “monthly change in.” Then: Seignorage = ΔM • It’s more useful to look at real seignorage, the revenue created by printing money divided by the

price level, P: Real seignorage = ΔM/P • Rewrite by dividing and multiplying by the current level of the money supply, M, giving us: Real seignorage = (ΔM/M) × (M/P)

or Real seignorage = Rate of growth of the money supply × Real money supply

But in the face of high inflation the public reduces the real amount of money it holds, so that the far right-hand term M/P, gets smaller. Suppose that the government needs to print enough money to pay for a given quantity of goods and services—that is, it needs to collect a given real amount of seignorage. An inflationary spiral.

• As people hold smaller amounts of real money due to a high rate of inflation, the government has to respond by accelerating the rate of growth of the money supply, ΔM/M.

• This will lead to an even higher rate of inflation. • People will respond to this new higher rate of inflation by reducing their real money holdings,

M/P, yet again. • Although the amount of real seignorage that the government must ultimately collect to pay off its

deficit does not change, the inflation rate the government needs to impose to collect that amount rises.

• The government is forced to increase the money supply more rapidly, leading to an even higher rate of inflation, and so on.

II. Moderate Inflation and Disinflation Note: for additional practice with AD/AS, ask the students to illustrate both of these types of inflation in a correctly labeled AD/AS graph. In the AD/AS model, we can see that there are two possible changes that can lead to an increase in the aggregate price level: a decrease in aggregate supply or an increase in aggregate demand. Cost-push inflation: caused by a decrease in SRAS.


• This is most likely to be the result of an economy-wide increase in the price of resources. Demand-pull inflation: caused by an increase in AD.

• This is likely to be caused by economic growth that is coupled with either expansionary fiscal or monetary policy.

In the case of fiscal policy, politicians can sometimes boost their election possibilities by cutting taxes even if the economy is near full employment. This shifts AD to the right and creates inflation, but usually after the polls close. A. The Output Gap and Unemployment Recall that the percentage difference between the actual level of real GDP and potential output is called the output gap. If the output gap is positive, the economy is producing above potential output and unemployment should be low. If the output gap is negative, the economy is producing below potential output and unemployment should be high. There will always be some level of unemployment (frictional and structural) even when the economy is at potential output. This is called the natural rate of unemployment.

• When actual aggregate output is equal to potential output, the actual unemployment rate is equal to the natural rate of unemployment.

• When the output gap is positive (an inflationary gap), the unemployment rate is below the natural rate. When the output gap is negative (a recessionary gap), the unemployment rate is above the natural rate.

Worksheet 33.1: The Inflation Tax - Garden City Public Schools

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