Inflation Tax and Money Growth
1.1. Sometimes the government has to print money to meet its spending requirements. Printing money creates inflationary pressure on the economy. The term “inflation tax” implies the revenue from printing money that causes inflation and imposes a tax on the people who have money. If inflation rises in the economy, the inflation tax on the holders of the money rises (Hu, & Zhang, 2019).
The wealth saved in a bank is not subject to a change in value due to inflation because while fixing the interest rate the expected inflation rate was also considered. The interest rate can be of two types: nominal (i) and real(r). The Fisher equation shows: i=r+πe.
If the actual inflation rate is greater than the expected rate of inflation (πe) then the savings accounts are hurt because of the rising inflation rate (Sun, & Phillips, 2004).
1.2. No, if velocity is constant and inflation is zero the money growth rate is not necessarily equal to zero.
From the quantity theory of money, it can be seen that:
M*V=P*Y
Where M is money supply, V is the velocity of money, P is the aggregate price level and Y is output (Mankiw, 2011). A total derivative is done on both sides after taking the logarithm:
log M+ log V= log P+log Y
Or, (ΔM/M)+(ΔV/V)=(ΔP/P)+(ΔY/Y)
Suppose, V is constant thus (ΔV/V)=0, and inflation is zero hence, (ΔP/P)=0
Or, (ΔM/M)=(ΔY/Y)
From the above equation it can be said that if velocity is constant and inflation is zero, the rate of money growth is equal to the output growth rate.
2.1. In 1973, the price of oil rose because of a drastic fall in the supply of the same (Baumeister, & Kilian 2016). As the oil price rises, the cost of production rises in the economy. The aggregate supply curve shifts in the leftward direction (AS to AS’). The price rises (from P to P’) and output falls (to Y from potential output Y*). This is called stagflation which is the result of oil price rise in the short run. In the short run, the economy moves from point A to point B.
Fig: AS-AD model and negative oil price shock
Source: Author’s computation
In the long run, if the government does not intervene, then the economy readjusts itself. The rise in the price level means people have to spend more money for buying goods and services and less money available for savings. Thus, the savings is less and the interest rate is high. High-interest rates and low production activities mean lower investment and lower employment rates. The rise in unemployment creates downward pressure on wages. As wages fall, the cost of production starts falling. The aggregate supply curve starts to shift in the rightward direction until the initial long-run equilibrium (A) is reached (Mankiw, 2011).
Fig: AS-AD model and positive oil price shock
Source: Author’s computation
In 1986, the price of oil rose due to the rise in oil supply (Lorusso, & Pieroni, 2018). If the oil price falls, the cost of production falls. In the short run, the aggregate supply shifts in the rightward direction (to AS’). The price level falls (to P’) and the output rises (to Y) in the economy. In the long run, rising output implies rising demand for factors of production such as labor and other raw materials that creates upward pressure on the price of raw materials in the long run. Hence, in the long run, the aggregate supply curve again starts shifting in the leftward direction (AS’ towards AS) until the initial long-run equilibrium (A) is achieved (Mankiw, 2011).
References
Baumeister, C., & Kilian, L. (2016). Forty years of oil price fluctuations: Why the price of oil may still surprise vs. Journal of Economic Perspectives, 30(1), 139-60.https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.30.1.139
Hu, T. W. , & Zhang, C. (2019). Responding to the Inflation Tax. Macroeconomic Dynamics, 23(6), 2378-2408.
https://doi.org/10.1017/S1365100517000736
Lorusso, M., & Pieroni, L. (2018). Causes and consequences of oil price shocks on the UK economy. Economic Modelling, 72, 223-236.https://eprints.ncl.ac.uk/file_store/production/264327/874E5E65-F97B-47B6-B122-A808154F2FD4.pdf
Mankiw, N. G. (2011). Principles of Macroeconomics, 6th ed. Mason, OH: South-Western Cengage Learning.
Sun, Y., & Phillips, P. C. (2004). Understanding the Fisher equation. Journal of Applied Econometrics, 19(7), 869-886.
https://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.414.5770&rep=rep1&type=pdf
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