Video Transcript: Lesson 25

Okay, let's get started on Unit Nine, Lesson One. We're going to talk about  inflation and how inflation is kind of a hidden tax. Suppose your country is at  war, right? And wars are very expensive. Not only are there soldiers to be paid  and kept supplied, but your valuable aircraft and tanks are liable to be destroyed by the enemy while you're in turn throwing costly ammunition, ammunition and  missiles at them. How do governments pay for all these expenses? One thing  that the government can do is to tax the population to pay these bills. It may not  be feasible to collect enough tax revenue in the time of a war. Many  governments instead borrow during these times of large expenses. This allows  the government to spread the tax burdens over time, and you can see in the  Bush administration when we started, when the United States started the or got  into the Iraq-Afghanistan war after the 9/11 attacks, they went into you know  borrowing a lot of money from the Chinese and started borrowing a lot of money internationally to finance these wars. So you can see that you know the United  States did the same, used the same concept to spread the tax burden on the  population over time. So far, taxation and borrowing are the only two possibilities that we have considered, but there's a third possibility: a government can simply print the money it needs. There's a government budget constraint that says  deficit equals the change in government debt plus the change in the money  supply. So, as the money supply stays the same and the government debt  increases, the deficit widens. Right. The left side of the equation is the deficit of  the government. The deficit is the difference between government outlays and  government receipts, and the right side of the equation describes how the  government finances its deficit. This equation says that the government can  finance its deficit by issuing either new government bonds or by printing new  money, so they can go into further debt or they can change the money supply  and print new money, but there is a puzzle, right? Money is just a piece of paper  with writing on it. The government can print all that it wants, yet the government  can take these pieces of paper and exchange them for goods and services of  real value. It can pay soldiers or nurses or construction workers who are building roads, who can print money, hand it over to Airbus or Boeing, and get new  planes. So, who is really paying in this case? We already know everything we  need to know to figure out the answer. When the government prints more  money, prices will eventually increase, right? So, it'll erode the value of your  dollar, causing prices to increase as there is more money printed and put into  circulation. It causes prices to rise. This comes directly from the quantity  equation. Once we remember that the real variables are independent of the  money supply in the long run. In the long run, the extra money will just result in  higher prices and no additional output. And increased prices mean that existing  money becomes less valuable. If the price level increases by 10% existing dollar bills are worth 10 percent less than they were. They will buy roughly 10 percent  less in terms of goods and services. Inflation is exactly like a tax on the money 

that people currently hold in their wallets and pocketbooks. So we say that there is an inflation tax when the government prints money to finance its deficit. So  let's examine the government budget constraint again. If we write out the deficit  in full, the equation says government purchases plus transfers minus tax  receipts equals change in government debt plus change in money supply. Right. So government purchases plus transfers minus tax receipts. So the government  purchases are expenditures, transfers are expenditures, tax receipts is how  much money they bring in. So if we are spending more money and making more purchases, the government, in terms of the government, than they do in tax.  Receipts that is going to be the deficit for the government, which equals so the  deficit then equals the change in government debt plus the change in the money supply. So if the money supply goes up, you know more money into the money,  more cash flowing into the system, right? The money supply is increasing, and a change in government debt means higher deficits. So suppose that government  purchases increase, say, due to a war, for example, by $100 billion. This  equation tells us that to finance its expense, the government could increase  taxes now by $100 billion, so they have to offset this new cost of the war, you  know, by through taxes, right? So increase taxes now by less than 100 billion  and sell some government bonds, or they could increase taxes now by less than 100 billion and print more money, so the government could fund this war, this  $100 billion need through one simply raising taxes, right, or two raise taxes and  sell government bonds to cover the 100 billion, or increase taxes, right, and print money. So they've got some ammunition in order to cover this cost. So in some  sense, there are all these are all versions of the same thing. The finances  spending of the 100 billion, the government will have to increase taxes to a  certain degree, either 100% of the 100 billion or some fraction of the 100 billion,  and then raise the cash the other ways through the supply of money increased  or the selling or purchasing of bonds. Those taxes may be paid now, but may  not. Okay, those taxes may be paid now. They may be paid later when the  government repays the debt, or may be paid through the inflation tax. The  government must decide how to best increase taxes to finance the extra  spending, and the inflation tax is one option available that the government has.