12 Inflation and the Quantity Theory of Money

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CHAPTER OUTLINE

Defining and Measuring Inflation

The Quantity Theory of Money

The Costs of Inflation

Takeaway

Appendix: Get Real! An Excellent Adventure

Robert Mugabe had a problem. The dictatorial president of Zimbabwe needed money. Unfortunately, Mugabe’s policy of seizing commercial farms had driven productive farmers and entrepreneurs out of the country, frightened off foreign investors, and pushed Zimbabwe, once called the breadbasket of Africa, to the verge of mass starvation. Zimbabwe had almost nothing left to tax, but Mugabe still needed money to bribe his enemies and reward his supporters, especially the still loyal Zimbabwean army. Mugabe thus turned to the last refuge of needy governments, the printing press.

Governments and counterfeiters alone can pay their bills by printing money. Beginning in 2001, when inflation was already running at 50% per year, Mugabe pushed the printing presses to breakneck speed. Whenever a bill came due or soldiers needed paying, it was no problem—just print more money. In May 2006, for example, the government announced plans to print 60 trillion Zimbabwean dollars to finance a 300% increase in pay for soldiers. Ironically, the payment was delayed because Zimbabwe didn’t have enough U.S. dollars to buy ink and paper.1

When the ink and paper arrived, the government flooded the economy with more money. The economy, however, could not produce more goods. When more money chases the same goods, the consequences are easy to see: inflation. In Zimbabwe, the inflation rate quickly increased from 50% a year to 50% a month to more than 50% a day! The Zimbabwean economy was disintegrating.

In this chapter, we explain how inflation is defined and measured, the causes of inflation, the costs and benefits of inflation, and why governments sometimes resort to inflation.

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