Video Transcript: Lesson 26

Okay, continuing in Unit Nine, this is Lesson Two. We're going to dive in further  to the inflation tax and look at scenarios and how the inflation tax can become  excessive. So, inflation used as one tax among many may be an efficient way of raising some of a government's revenues. The effects of the inflation tax are like  the effects of any tax. People respond by substituting away from the activity  being taxed. When the government taxes cigarettes, people smoke less. When  the government taxes income, people work less when the government taxes the money people hold. People hold less money. These changes in behavior are the distortions caused by taxation. People substitute away from holding money in  two ways. One, during moderate inflation, people allocate more of their time to  transactions. Right? They want to spend more money now, right? Because  inflation is moderately low, so prices are moderately stable and low. So spend  more money now while there's lower prices. But then, during higher inflation  periods, people may sense may cease to stop using money altogether because  they will wait for prices to come down because inflation moves up and down like  interest rates, and so if it's a period of high inflation, people are going to hold on  to their cash, wait for inflation to go down, then go back to normal spending  patterns. During high inflation, the real value of money decreases quickly. So, if  you work and get paid in cash, you had better go shopping quickly to make  purchases. During hyperinflation, people may literally spend more time trying to  get rid of their money than they do earning it in the first place, you see this in  Venezuela, right? Where you know they have had a run on their banks and their  economies turned upside down, and they've had massive hyperinflation, where  you know 50,000 units of their currency to you know buy regular household  items, you know that's the kind of stuff that goes on during hyperinflation. So, so  people are trying to spend their money quickly because inflation is going up so  fast that you know today it might be you know $1,000 for a gallon of milk, and  tomorrow it might be $5,000. So they want to buy it, you know, spend up their  cash quickly so they can at least consume what they've got. So in times of low  to moderate inflation, right, the same distortion applies, though less dramatically. People respond to inflation by carrying less less cash on average. To do so, they must spend more time standing in line in the bank and the ATMs. Okay, let's look at an example, an ice cream example. Okay, imagine that ice cream was to be  used as money, right? So now ice cream is our currency. In a very cold climate,  ice cream is just fine as a store of value. In a very hot climate, by contrast, ice  cream is a very bad store of value. You would probably want to get paid every  day, and as soon as you received your ice cream, you would run to the store  and buy goods and services before your money melted. You and everyone else  would spend much more time shopping and less time working. Melting ice  cream in this world is like inflation. There is a good reason why we do not use  ice cream as a medium of exchange because it would be such a bad store of  value. People would quickly abandon it in terms of some other way of trading 

during hyperinflation. This is exactly what we see: people substitute away from  money completely and instead resort to barter trade. So we have no store of  value. You know, the ice cream example is basically saying, "Look, my money is  melting away during this hyperinflationary period. You know, the more I sit  outside in this hot climate, the quicker it melts, and it's the same way here, right? So, you know, people then will turn away from using cash as a store of value,  and then instead turn and barter goods and services as their store of value. So  now you have things that people need, like you know utensils or whatever you  know that that somebody might need that you need this from them and they  need this from you, and then you just trade the items. That becomes your store  of value when your unit of cash or your monetary unit is under a  hyperinflationary scenario. Often, some other commodities such as cigarettes  being generally accepted as an alternative to money, but substitution away from  money is costly to the economy. Money facilitates trade. It is generally easier to  trade when everyone uses money rather than goods in an exchange. So when  people respond to high inflation by eliminating money from trades, we are  observing a distortion from the inflation tax.