Inflation as an Endogenous Variable

In the preceding section, we were introduced to p, the rate of inflation. What determines the rate of inflation?

For high inflation rates (above, say, 10 percent per year), most economists would focus on monetary growth as the determinant of inflation. In order for high inflation to persist, the monetary authorities must accomodate inflation by printing more money. Otherwise, interest rates rise, the economy slumps, and inflation dies away. In 1980, when inflation in the United States was approaching double-digit rates, Federal Reserve Chairman Paul Volcker began to raise interest rates and slow the rate of money growth, helping to bring the rate of inflation down to much lower levels seen today (between 1 and 3 percent in recent years).

At low rates of inflation, the best predictor of inflation seems to be "output gap," which is the gap between output at full employment (potential output) and actual output. When the "output gap" is close to zero or negative, meaning that aggregate demand matches capacity, there tends to be upward pressure on inflation. When the gap is large, meaning that aggregate demand falls short of capacity, there tends to be downward pressure on inflation.


For very high rates of inflation, of 100 percent per year or more, the "output gap" does not seem to be a good predictor of inflation. Very high rates of inflation are associated with very high rates of money growth. However, another factor that is associated with very high rates of inflation is a government budget deficit that cannot be financed by borrowing.

What happens when a government cannot finance its deficit by borrowing is that it must print money to pay for goods and services. Printing money is a subtle form of taxation, sometimes called the "inflation tax," because financing a government deficit in this way almost always leads to excessive money creation and inflation. In fact, there have been many episodes of hyper-inflation in this century--most famously in Germany in the late 1920's. During a hyper-inflation, the government prints a lot of money, causing prices to rise, which forces it to print even more money to cover its spending, which leads to more inflation, etc. Hyper-inflations create crazy situations in which prices can rise by more than 100 percent in a single day!

The only cure for hyper-inflation is to cut back government spending to align with taxes. When governments are weak, this is not possible. Often, the goverment must fall and be replaced by a new, stronger government before hyper-inflation can be stopped.