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Summary

Inflation, Disinflation, Deflation

• 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. 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.

The Phillips Curve

• 4. 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.
• 5. 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.
• 6. 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.

Crises and Consequences

• 7. Banks engage in maturity transformation, transforming short-term liabilities into long-term assets. Shadow banks have grown greatly since 1980. Largely unregulated, they can pay savers a higher rate of return than depository banks. Like depository banks, shadow banks engage in maturity transformation, depending on short-term borrowing to operate and investing in long-term assets. Therefore, shadow banks can also be subject to bank runs.
• 8. Although banking crises are rare, they typically inflict severe damage on the economy. They have two main sources: shared mistakes, such as investing in an asset bubble, and financial contagion. Contagion is spread through bank runs or via a vicious cycle of de-leveraging. When unregulated, shadow banking is particularly vulnerable to contagion. In 2008, a financial panic hit the United States, arising from the combination of an asset bubble, a huge shadow banking sector, and a vicious cycle of deleveraging.
• 9. Severe banking crises almost invariably lead to deep and long recessions, with unemployment remaining high for several years after the crisis began. There are three main reasons why banking crises are so damaging to the economy: they result in a credit crunch, the vicious cycle of deleveraging leads to a debt overhang, and monetary policy is rendered ineffective as the economy falls into a liquidity trap. As a result, households and businesses are either unable or unwilling to spend, deepening the downturn.
• 10. Unlike during the Great Depression, governments now step in to try to limit the damage from a banking crisis by acting as the lender of last resort and by guaranteeing the banks’ liabilities. Sometimes, but not always, governments nationalize the banks and then later reprivatize them. In an extreme crisis, the central bank may directly finance commercial transactions.
• 11. Economic damage from the financial crisis of 2008 was large and prolonged. The world’s two largest economies, the United States and the European Union, suffered severe downturns. The persistence of economic difficulties after 2008 led to fierce debates about appropriate policy responses between economists and policy makers calling for more fiscal stimulus—more government spending and possibly tax cuts to promote spending and reduce unemployment—and those favoring fiscal austerity—spending cuts and possibly tax increases to reduce budget deficits.
• 12. The banking regulatory system put in place during the 1930s has eroded due to the rise of shadow banking. In the aftermath of the crisis, the U.S. Congress enacted the Dodd-Frank Act in the hope of preventing a replay of the crisis. The main elements of the law are stronger consumer protection, greater regulation of derivatives, regulation of shadow banking, and resolution authority for a variety of financial institutions. We have yet to see whether these changes will be adequate or whether they will be adopted by other countries.