Research Paper on Inflation and Government Spending

1. Introduction

Inflation is generally referred to as the increase of the general price level during the specific period of time. Definition of inflation is also used to relation to some particular set of services or goods and the rise of their prices. High rates of inflation are believed to be caused by high rates of the money supply. Inflation can be measured by means of consumer price indices, cost-of-living indices, producer price indices, commodity price indices, GDP deflator, capital goods price index, as well as regional and historical inflation can be measured.

There are three major types or theories of inflation- demand-pull inflation, cost-push inflation and built-in inflation. Cost-push inflation can be also called shock supply inflation, as it occurs because of drops in aggregate supply caused by increased prices for goods or services. For example, if there is a shortage of something in the market, then its price will increase and remain high unless the situation changes. Build-in inflation can be caused by adaptive expectations.

The key inflation theory is demand-pull theory that is mainly about the money supply and says that the inflation can be caused by the rise of aggregate demand because of the private/ government expenditures increase. In other words inflation can be influenced by the money quantity in circulation increase in relation to the economy’s ability to supply them (potential output). The bright example of it is when it is the war time, the government is printing a lot of many that leads to hyperinflation, and prices can double in the short period of time. Or another case, when there is the decrease of money demand, how in was in Europe during the Black Plague.

The notion of money supply is also an essential part in determining inflation levels. Some economists claim that this notion is the part of the aggregate demand, and it is aggregate demand plays an outstanding role in determining inflation.

There is also the concept that explains the relationship between the inflation and unemployment rates, and it is called the Phillips curve. It implies that in order to decrease unemployment rates, a little raise of inflation can be very favorable. But on practice it appears to be applicable to one situation (1960s), and fail to work in another (in 1970s, when the increasing inflation was accompanied with economic stagnation or stagflation).

Inflation can be very helpful for business and level of wages. This is what the Columbia Encyclopedia says about that: “Inflation stimulates business and helps wages to rise, but the increase in wages usually fails to match the increase in prices; hence, real wages diminish. Stockholders make gains—often illusory—from increased business profits, but bondholders lose because their fixed percentage return has less buying power. Borrowers also gain from inflation, since the future value of money is reduced. Deflation, which historically has occurred in the downward movement of the business cycle, lowers prices and increases unemployment through the depression of business. Persistent deflation in Japan, beginning in the early 1990s, has resulted in a drop in consumption, record unemployment, and general economic stagnation. An unusually steep and sudden rise in prices, sometimes called hyperinflation, may result in the eventual breakdown of an entire nation’s monetary system. The most notable example is Germany (1923), where prices rose 2,500% in one month.”

Taking into consideration statistical data regarding government expenditures, unemployment, inflation, interest and GDP rates it is apparent that the highest levels of government expenditures could be observed in 1980 and 1981 (13,06 and 10,83 correspondently), then it was also high in 1985 (10,29) and later on the constant decline of government expenditures indices can be observed. The minimum level government expenditures reached in 1992-1994 (2,96, 1,59 and 2,66). In last three years, this rate is approximately not changing drastically staying at the level around 6,6 (6,61 in 2005, 6,75 in 2006 and 6,64 in 2007). As the inflation rates, were at the same highest levels in 1980 and 1981 (13,58 and 10,35 correspondently), then it was very low in 1986 (1,91) and from 1993-1998 the rate was about 2,5 in average, in 2005 the inflation rate was 3,39, the greatest for the last 15 years.

2. Money and Public Finance

In the forth chapter of “Monetary Theory and Policy” by Carl E. Walsh, inflation is called the tax, because tax, as well as inflation brings the revenue to the government. Inflation is very much connected with government budget, as any change in inflation that has the influence the revenue from the inflation tax is supposed to have budgetary implication to the government. In the chapter much attention is dedicated to the accounting and explanation of treasury budget constraint, that is expressed taking into consideration government expenditures on goods and services plus interest payments for outstanding debts and it is equaled to the tax revenue plus matters of interest bearing debt and direct receipts from central bank, and other formulas that help to understand and calculate revenue implications of the inflation. Budget constraints of the budget sector connect monetary and fiscal policies that have in important when determining the way the change in the money stock influences the equilibrium price level. But it is very important to be able to differentiate between those two policies. Fiscal policy is said to have the responsibility to ensure that the government’s budget is in balance, and monetary policy at the same time is freer to set the nominal money stock. Fiscal policy is called passive policy, and monetary- active one. Fiscal policy has an affect upon the rate of interest and therefore it has the direct influence upon the price level as well, even though the regime of monetary dominance is established. When the balanced budget increases its expenditures, the increase in real interest rate increases the nominal interest rate and the demand for money is decreased. In such case, the prices go up and the inflation occurs in order to diminish the real money supply. So, inflation and prices are influenced by the fiscal policy changes for the reason that they demand change in seigniorage and raise the future or current supply of money.

Budget constraint presumes that the government with the present debt must run future surpluses by means of raising revenues from seigniorage, and therefore creating the budget deficit for the future growth of money. It is necessary to understand one thing: whether the budget deficit will definitely cause inflation. The mechanism of that is the following: when the present inflation tax revenues are at the lower level, the deficit goes up and the debt volume increases. It presumes the raise in the present discounted value of the future tax revenues, as well as revenues form seigniorage. And the fiscal authority in this case has either to adjust, or monetary authority finally will be forced to set higher inflation. It was historically established that growth of money in the USA is generally related to war spending and not to deficits of peaceful times. So, deficit is the determinant of future money growth.

3. Seignorage and Inflation Rate

There is a direct dependence between the inflation rate and the seigniorage, and there can be cases when there is inflation in the country, but the government revenues are still increasing. This can be achieved upon definite conditions:

ω=i/1+i=Dc or π(max)=(1/1+r)(1/1-Dc)-1

When the inflation rate is less then the set value of π(max), the revenue of the government is increasing in the inflation rate. And when the inflation level grows bigger then the set value, then revenues from seigniorage are decreasing.

So, fiscal and monetary actions are interconnected thought the budget constraint of the government. Changes in the stock of money (growth rate, for instance) will demand involvement of such variables, as expenditures, taxes or borrowing in the budget constraint. When the fiscal policy is dominant, changes in government taxes and expenditures will require changes in inflation.

4. Inflation in the USA

In the USA, annual price raise for about 2-3 percents is not considered to be the sign of serious inflation. During the early 1970s, however, prices increased by significantly higher percentages, which made President Nixon to introduce wage-and-price controls in 1971. Stagflation can be defined as the combination of high unemployment rates and economic stagnation with inflation, which became very common in the industrialized countries during the 1970s, as well as to the United States, as I have already mentioned in the introduction. The expenditures for Vietnam War and the social programs of the Johnson administration, along with prices for oil that increased in 1974 by the Organization of Petroleum Exporting Countries (OPEC), greatly impacted U.S. inflation. By the end of the 1970s, the Federal Reserve increased interest rates attempting to decrease inflation. A recession took place in 1980s, and there was observed renewed growth, a little bit lower interest rates, and reduction in the rate of inflation.

In the early 1990s, a declining business turn formed an international recession—without substantial deflation—that substituted inflation as a main problem; the Federal Reserve decreased interest rates to stimulate economic growth. In the middle of the 1990s, there could be observed very moderate levels of inflation (about 2.5%–3.1% annually), even though interest rates at that period of time were increasing. In the late 1990s, the United States inflation was low (1.9% by 1998), despite record growth; later the tendency of its increase was observed (roughly 2%–3.5%) in subsequent years, due largely to raise in energy costs and, to a less extent, to large government deficits since 2001.

5. Conclusion

In the conclusion I would like to summarize key points of my paper. So, inflation is the increase of the general price level during the specific period of time. The opposite of inflation process is deflation. Inflation in small amounts can be even beneficial to the economic development of the country. The Bureau of Labor Statistics of the United States produces the Consumer Price Index (CPI) every year that measures changes in average price in relation to prices in an arbitrarily selected year of basis. Even though the CPI is often referred to as the most reliable evaluation of inflation, some economists are wondering whether it overstates inflationary trends. There are a lot of factors that contribute to its raise and decline, for example fiscal and monetary policies. Fiscal policy has the responsibility to ensure that the government’s budget is balanced, and monetary policy at the same time is free to set the nominal money stock. The major inflation theory is demand-pull theory that is predominantly describing the money supply and claiming that the inflation can be caused by the increase of aggregate demand because of the government expenditures increase. Government expenditures have the direct influence upon inflation and with the increase of government expenditures the inflation is subsequently increasing as well. When the balanced budget raises its expenditures, the increase in real interest rate increases the nominal interest rate and the demand for money is decreased. And subsequently, the prices go up and the inflation occurs in order to diminish the real money supply.

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