Increase Taxes

In some sense, these are all versions of the same thing: to finance the spending of $100 billion, the government will have to increase taxes. Those taxes may be paid now, they may be paid later (when the government repays the debt), or they 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 to the government. Commitment It is hard to imagine that a government acting in the interests of its citizens would choose to bring about hyperinflation. Why do governments apply such misguided policies? The leading explanations all fall under the heading of a “weak” central bank. A weak central bank is unable to pursue its normal goal of price stability and instead becomes a tool of other interests, such as the fiscal authorities. A government entity, such as a central bank or the treasury, suffers from acommitment problem when it is not able to make credible promises to pursue certain actions. Suppose a central bank wishes to pursue a strategy of stabilizing prices. If the economy is in a deep recession, the central bank might instead come under pressure to reduce interest rates. Reductions in interest rates require the central bank to increase the money supply and ultimately create inflation, yet if it could commit to a policy, the central bank might prefer to focus on inflation and ignore the recession. Let us see how these types of commitment problems work through some examples. Increasing Output The level of potential output in an economy is not necessarily the ideal level of output. Even when the economy is at potential, there is some unemployment and some spare capacity. The monetary authority therefore might have a target level of output that is above potential output. Suppose (for simplicity) that its target level of inflation is zero. To understand what will happen, we use our model of price adjustment: inflation rate = autonomous inflation − inflation sensitivity × output gap. Toolkit: Section 16.20 “Price Adjustment” You can review the details of price adjustment in the toolkit. To begin with, suppose that everyone in the economy believes that there will be zero inflation, so autonomous inflation is zero. Were output equal to potential output (so the output gap is zero), then actual inflation would also be zero. This situation is summarized in Figure 11.9 “The Gains to Inflation”. However, if the Fed follows a Taylor rule, it will react to the fact that output is below its target by reducing real interest rates with the aim of increasing spending and output. The price adjustment equation then tells us that there will be positive inflation.