# Economics: Theory Through Applications, v. 1.0 (2 Volume Set)

by Russell Cooper and A. Andrew John

## 26.3 The Causes of Inflation

### Learning Objectives

After you have read this section, you should be able to answer the following questions:

1. What is the inflation tax?
2. How is inflation caused by the central bank’s commitment problem?
3. What happens if there are multiple regions (states or countries) independently choosing how much money to print?

We have argued so far that inflation is caused by excessive money growth, which in turn leads to increases in the velocity of money. But we have also documented that rapid inflations are damaging to the functioning of an economy. There is therefore a deeper question to be asked: why on earth do monetary authorities pursue policies that lead to such disastrous outcomes?

## The Inflation Tax

Suppose your country is at war. Wars are expensive. Not only are there soldiers to be paid and kept supplied, but your valuable aircraft and tanks are liable to be destroyed by the enemy while you are in turn throwing costly ammunition and missiles at them. How do governments pay for all these expenses? One thing that the government can do is to tax the population to pay these bills. It may not be feasible to collect enough tax revenue in the time of a war, however. Many governments instead borrow during times of large expenses. This allows the government to spread the tax burdens over time.

So far, taxation and borrowing are the only two possibilities that we have considered. But there is a third possibility: a government can simply print the money it needs. There is a government budget constraint that saysThe government budget constraint is discussed in Chapter 29 "Balancing the Budget".

deficit = change in government debt + change in money supply.

The left side of this equation is the deficit of the government. The deficit is the difference between government outlays and government receipts. The right side of this equation describes how the government finances its deficit. This equation says that the government can finance its deficit by issuing either new government bonds or new money.

You can review the details of the government budget constraint in the toolkit.

There is a puzzle here. Money is just a piece of paper with writing on it. The government can print it at will. Yet the government can take these pieces of paper and exchange them for goods and services of real value. It can pay soldiers, or nurses, or construction workers who are building roads. It can print money, hand it over to Airbus or Boeing, and get a new airplane. So who is really paying in this case?

We already know everything we need to know to figure out the answer. When the government prints more money, prices will eventually increase. This comes directly from the quantity equation once we remember that real variables are independent of the money supply in the long run. In the long run, the extra money will just result in higher prices and no additional output. And increased prices mean that existing money becomes less valuable. If the price level increases by 10 percent, existing dollar bills are worth 10 percent less than they were; they will buy (roughly) 10 percent less in terms of goods and services. Inflation is exactly like a tax on the money that people currently hold in their wallets and pocketbooks. Indeed, we say that there is an inflation taxA tax occurring when the government prints money to finance its deficit. when the government prints money to finance its deficit.

Examine the government budget constraint again. If we write out the deficit in full, the equation says

government purchases + transfers − tax receipts = change in government debt+ change in money supply.

Suppose that government purchases increase, say due to a war, by $100 billion. This equation tells us that, to finance this expense, the government could • increase taxes now by$100 billion,
• increase taxes now by less than $100 billion and sell some government debt, • increase taxes now by less than$100 billion and print some money.