Page 622 - The Principle of Economics

638 PART TEN
MONEY AND PRICES IN THE LONG RUN
inflation tax
the revenue the government raises by creating money
as inflation that exceeds 50 percent per month. This means that the price level in- creases more than 100-fold over the course of a year.
The data on hyperinflation show a clear link between the quantity of money and the price level. Figure 28-4 graphs data from four classic hyperinflations that occurred during the 1920s in Austria, Hungary, Germany, and Poland. Each graph shows the quantity of money in the economy and an index of the price level. The slope of the money line represents the rate at which the quantity of money was growing, and the slope of the price line represents the inflation rate. The steeper the lines, the higher the rates of money growth or inflation.
Notice that in each graph the quantity of money and the price level are al- most parallel. In each instance, growth in the quantity of money is moderate at first, and so is inflation. But over time, the quantity of money in the economy starts growing faster and faster. At about the same time, inflation also takes off. Then when the quantity of money stabilizes, the price level stabilizes as well. These episodes illustrate well one of the Ten Principles of Economics: Prices rise when the government prints too much money.
THE INFLATION TAX
If inflation is so easy to explain, why do countries experience hyperinflation? That is, why do the central banks of these countries choose to print so much money that its value is certain to fall rapidly over time?
The answer is that the governments of these countries are using money cre- ation as a way to pay for their spending. When the government wants to build roads, pay salaries to police officers, or give transfer payments to the poor or el- derly, it first has to raise the necessary funds. Normally, the government does this by levying taxes, such as income and sales taxes, and by borrowing from the pub- lic by selling government bonds. Yet the government can also pay for spending by simply printing the money it needs.
When the government raises revenue by printing money, it is said to levy an inflation tax. The inflation tax is not exactly like other taxes, however, because no one receives a bill from the government for this tax. Instead, the inflation tax is more subtle. When the government prints money, the price level rises, and the dol- lars in your wallet are less valuable. Thus, the inflation tax is like a tax on everyone who holds money.
The importance of the inflation tax varies from country to country and over time. In the United States in recent years, the inflation tax has been a trivial source of revenue: It has accounted for less than 3 percent of government revenue. Dur- ing the 1770s, however, the Continental Congress of the fledgling United States re- lied heavily on the inflation tax to pay for military spending. Because the new government had a limited ability to raise funds through regular taxes or borrow- ing, printing dollars was the easiest way to pay the American soldiers. As the quantity theory predicts, the result was a high rate of inflation: Prices measured in terms of the continental dollar rose more than 100-fold over a few years.
Almost all hyperinflations follow the same pattern as the hyperinflation dur- ing the American Revolution. The government has high spending, inadequate tax revenue, and limited ability to borrow. As a result, it turns to the printing press to pay for its spending. The massive increases in the quantity of money lead to