Inflation: Its Causes, Effects, and Social Costs

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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 1970 the New York Times cost 15 cents, the median price of a single-family home was $23,400, and the average wage for production workers was $3.39 per hour. In 2014 the Times cost $2.50, the median price of a home was $265,700, and the average wage was $20.58 per hour. This overall increase in prices is called inflation, which is the subject of this chapter.

The rate of inflation—the percentage change in the overall level of prices—varies greatly over time and across countries. In the United States, according to the consumer price index, prices rose at an average annual rate of 2.3 percent in the 1960s, 7.1 percent in the 1970s, 5.6 percent in the 1980s, 3.0 percent in the 1990s, and 2.4 percent from 2000 to 2014. Even when the U.S. inflation problem became severe during the 1970s, however, it was nothing compared to the episodes of extraordinarily high inflation, called hyperinflation, that other countries have experienced from time to time. A classic example is Germany in 1923, when prices increased an average of 500 percent per month. In 2008, a similar hyperinflation gripped the nation of Zimbabwe.

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 flexible. As we first discussed in Chapter 1, most economists believe this assumption describes the behavior of the economy in the long run. By contrast, many prices are thought to be sticky in the short run, and beginning in Chapter 10 we incorporate this fact into our analysis. 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.

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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. In the previous chapter, we introduced the economist’s concept of “money” and discussed how, in most modern economies, a central bank set up by the government controls the quantity of money in the hands of the public. This chapter begins in Section 5-1 by showing 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 5-2 discusses the revenue that governments can raise by printing money, sometimes called the inflation tax. Section 5-3 examines how inflation affects the nominal interest rate. Section 5-4 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 5-5 we address what is perhaps the most important question about inflation: Is it a major social problem? Does inflation amount to “overturning the existing basis of society,” as the chapter’s opening quotation suggests?

Finally, in Section 5-6, we discuss the dramatic case of hyperinflation. Hyperinflations are interesting to examine because they show clearly the causes, effects, and costs of inflation. Just as seismologists learn much about plate tectonics by studying earthquakes, economists learn much about money and prices by studying how hyperinflations begin and end.