Explain why a large increase in the money supply causes a larger short-run increase in real GDP in an economy that previously had low inflation than in an economy that previously had high inflation. What does this say about situations in which the classical model of the price level applies?
The inflation rate is more likely to quickly reflect changes in the money supply when the economy has had an extended period of high inflation. That’s because an extended period of high inflation sensitizes workers and firms to raise nominal wages and prices of intermediate goods when the aggregate price level rises. As a result, there will be little or no increase in real output in the short run after an increase in the money supply, and the increase in the money supply will simply be reflected in a proportional increase in prices. In an economy in which people are not sensitized to high inflation because of low inflation in the past, an increase in the money supply will lead to an increase in real output in the short run. This illustrates the fact that the classical model of the price level best applies to economies with persistently high inflation, not those with little or no history of high inflation even though they may currently have high inflation.
Question
Suppose that all wages and prices in an economy are indexed to inflation, meaning that they increase at the same rate as the price level. Can there still be an inflation tax?
Yes, there can still be an inflation tax because the tax is levied on people who hold money. As long as people hold money, regardless of whether prices are indexed or not, the government is able to use seignorage to capture real resources from the public.