16: Inflation, Disinflation, and Deflation

!arrow! What You Will Learn in This Chapter

  • Why efforts to collect an inflation tax by printing money can lead to high rates of inflation and hyperinflation

  • What the Phillips curve is and how it describes the short-run trade-off between inflation and unemployment

  • Why there is no long-run trade-off between inflation and unemployment

  • Why expansionary policies are limited due to the effects of expected inflation

  • Why even moderate levels of inflation can be hard to end

  • Why deflation is a problem for economic policy and leads policy makers to prefer a low but positive inflation rate

  • Why the nominal interest rate cannot go below the zero bound and the danger a liquidity trap poses

!worldview! BRINGING A SUITCASE TO THE BANK

In 2008, the Zimbabwe dollar was so devalued by extreme inflation that this much currency was needed to pay for a single loaf of bread.

In 2008, the African nation of Zimbabwe achieved a dubious distinction: it exhibited one of the highest inflation rates ever recorded, peaking at around 500 billion percent. Although the government kept introducing ever-larger denominations of the Zimbabwe dollar—for example, in May 2008 it introduced a half-billion-dollar bill—it still took a lot of currency to pay for the necessities of life: a stack of Zimbabwean cash worth $100 U.S. dollars weighed about 40 pounds. Zimbabwean currency was worth so little that some people withdrawing funds from banks brought suitcases along in order to be able to walk away with enough cash to pay for ordinary living expenses. In the end, the Zimbabwe dollar lost all value—literally. By October 2008, the currency had more or less vanished from circulation, replaced by U.S. dollars and South African rands.

Zimbabwe’s experience was shocking, but not unprecedented. In 1994 the inflation rate in Armenia hit 27,000%. In 1991 Nicaraguan inflation exceeded 60,000%. And Zimbabwe’s experience was more or less matched by history’s most famous example of extreme inflation, which took place in Germany in 1922–1923. Toward the end of the German hyperinflation, prices were rising 16% a day, which—through compounding—meant an increase of approximately 500 billion percent over the course of five months.

People became so reluctant to hold paper money, which lost value by the hour, that eggs and lumps of coal began to circulate as currency. German firms would pay their workers several times a day so that they could spend their earnings before they lost value (lending new meaning to the term hourly wage). Legend has it that men sitting down at a bar would order two beers at a time, out of fear that the price of a beer would rise before they could order a second round!

The United States has never experienced that kind of inflation. The worst U.S. inflation in modern times took place at the end of the 1970s, when consumer prices were rising at an annual rate of 13%. Yet inflation at even that rate was profoundly troubling to the American public, and the policies the Federal Reserve pursued in order to get U.S. inflation back down to an acceptable rate led to the deepest recession since the Great Depression.

What causes inflation to rise and fall? In this chapter, we’ll look at the underlying reasons for inflation. We’ll see that the underlying causes of very high inflation, the type of inflation suffered by Zimbabwe, are quite different from the causes of more moderate inflation. We’ll also learn why disinflation, a reduction in the inflation rate, is often very difficult. Finally, we’ll discuss the special problems associated with a falling price level, or deflation.