Why Governments Create Inflation

Inflation can carry with it quite a few costs. But some governments, like Zimbabwe under President Robert Mugabe in the early 2000s, will go out of their to way to create inflation. Why?

Well, in the Zimbabwe example, the government printed the money and used it to buy goods and services. The ensuing hyperinflation acted as a tax that transferred wealth from the citizens to the government.

However, this is a fairly uncommon reason. Inflation doesn’t make for a good tax and it’s a last resort for desperate governments that are otherwise unable to raise funds.

There are other benefits to inflation that would make governments want to create it. In the short run, inflation can actually boost economic output. However, as we’ve previously covered, an increase in the money supply leads to an equal increase in prices in the long run.

If there’s a recession, governments might create inflation to spur productivity and ease the economic downturn. However, this type of inflationary boosting can be abused. Long-term boosting causes people to simply expect and prepare for it.

Reducing inflation is also costly. If the process is reversed and the growth in the money supply decreases, we get disinflation. Unemployment will likely increase in the short run and an economy can go through a recession. But in the long run, prices will adjust as well.

Inflation can be a neat trick for governments to boost productivity in an economy. But it can easily get out of hand and has even been likened to a drug. Once you start, you need more and more. And stopping is awfully painful as the economy shrinks.

This concludes our section on Inflation and the Quantity Theory of Money. Up next in Principles of Macroeconomics, we’ll be digging into Business Fluctuations.

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