85

Money and Inflation

Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. . . . Lenin was certainly right.

There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

— John Maynard Keynes

In 1950, a shopping cart of groceries could be purchased for $25. In 2005, that same cart of groceries costs $228. Other prices—such as the average wage rate—increased even more over this 55-year period, so—in real terms—the material living standard for the average Canadian has increased. Recall from Chapter 1 that real GDP per capita has risen by more than a factor of 4 since 1950. The overall increase in prices is called inflation, and it is the subject of this chapter.

The rate of inflation—the percentage change in the overall level of prices—varies substantially over time and across countries. Indeed a one-time increase in the cost of living is not considered inflation; the term is reserved for situations in which there is an ongoing increase in prices. In Canada, prices rose an average of 2.9 percent per year in the 1960s, 7.8 percent per year in the 1970s, 5.8 percent per year in the 1980s, 1.5 percent per year in the 1990s, and 2.2 percent per year in the present century. Inflation in Canada has, by international standards, been moderate. In Russia in 1998, for instance, inflation was running about 50 percent per year. In Germany in 1923 and in Zimbabwe in 2008, prices rose an average of 500 percent per month. Such an episode of extraordinarily high inflation is called a hyperinflation.

In this chapter we examine the classical theory of the causes, effects, and social costs of inflation. The theory is “classical” in the sense that it assumes that prices are fully flexible. As we first discussed in Chapter 1, most economists believe this assumption accurately describes the behaviour of the economy in the long run. By contrast, many prices are thought to be sticky in the short run, and beginning in Chapter 9, we incorporate this fact into our analysis. Yet, for now, we ignore short-run price stickiness. As we will see, the classical theory of inflation not only provides a good description of the long run, it also provides a useful foundation for the short-run analysis we develop later.

86

The “hidden forces of economic law” that lead to inflation are not as mysterious as Keynes claims in the quotation that opens this chapter. Inflation is simply an increase in the average level of prices, and a price is the rate at which money is exchanged for a good or a service. To understand inflation, therefore, we must understand money—what it is, what affects its supply and demand, and what influence it has on the economy. Thus, Section 4-1 begins our analysis of inflation by discussing the economist’s concept of “money” and how, in most modern economies, the government plays a big part in determining the quantity of money in the hands of the public. Section 4-2 shows that the quantity of money determines the price level and that the rate of growth in the quantity of money determines the rate of inflation.

Inflation in turn has numerous effects of its own on the economy. Section 4-3 discusses the revenue that governments can raise by printing money, sometimes called the inflation tax. Section 4-4 examines how inflation affects the nominal interest rate. Section 4-5 discusses how the nominal interest rate in turn affects the quantity of money people wish to hold and, thereby, the price level.

After completing our analysis of the causes and effects of inflation, in Section 4-6 we address what is perhaps the most important question about inflation: Is it a major social problem? Does inflation really amount to “overturning the existing basis of society,” as the chapter’s opening quotation suggests?

Finally, in Section 4-7, we discuss the extreme case of hyperinflation. Hyperinflations are interesting to examine because they show clearly the causes, effects, and costs of inflation. Just as seismologists learn much by studying earthquakes, economists learn much by studying how hyperinflations begin and end.