SUMMARY

1. In analyzing high inflation, economists use the classical model of the price level, which says that changes in the money supply lead to proportional changes in the aggregate price level even in the short run.

2. Governments sometimes print money in order to finance budget deficits. When they do, they impose an inflation tax, generating tax revenue equal to the inflation rate times the money supply, on those who hold money. Revenue from the real inflation tax, the inflation rate times the real money supply, is the real value of resources captured by the government. In order to avoid paying the inflation tax, people reduce their real money holdings and force the government to increase inflation to capture the same amount of real inflation tax revenue. In some cases, this leads to a vicious circle of a shrinking real money supply and a rising rate of inflation, leading to hyperinflation and a fiscal crisis.

3. The output gap is the percentage difference between the actual level of real GDP and potential output. A positive output gap is associated with lower-than-normal unemployment; a negative output gap is associated with higher-than-normal unemployment. The relationship between the output gap and cyclical unemployment is described by Okun’s law.

4. Countries that don’t need to print money to cover government deficits can still stumble into moderate inflation, either because of political opportunism or because of wishful thinking.

5. At a given point in time, there is a downward-sloping relationship between unemployment and inflation known as the short-run Phillips curve. This curve is shifted by changes in the expected rate of inflation. The long-run Phillips curve, which shows the relationship between unemployment and inflation once expectations have had time to adjust, is vertical. It defines the nonaccelerating inflation rate of unemployment, or NAIRU, which is equal to the natural rate of unemployment. Stagflation, a combination of high unemployment and high inflation, reflects an upward shift of the short-run Phillips curve.

6. Once inflation has become embedded in expectations, getting inflation back down can be difficult because disinflation can be very costly, requiring the sacrifice of large amounts of aggregate output and imposing high levels of unemployment. However, policy makers in the United States and other wealthy countries were willing to pay that price of bringing down the high inflation of the 1970s.

7. Deflation poses several problems. It can lead to debt deflation, in which a rising real burden of outstanding debt intensifies an economic downturn. Also, interest rates are more likely to run up against the zero bound in an economy experiencing deflation. When this happens, the economy enters a liquidity trap, rendering conventional monetary policy ineffective.