Deck 12: Inflation and the Debt Bomb

Question 1

If Congress manages to agree on higher income taxes, what do you predict will be true about the size of the inflation tax, compared to a scenario in which Congress fails to agree to raise income taxes?

Answer 1

An income tax is defined as a tax that the governments impose on monetary income that entities generate within their control. By rule, individuals and businesses must case a return on income tax every year to decide whether they owe any taxes or are entitled for a tax refund. The Income tax is an important source of finances that the government uses to support its activities and to serve the general public.
Inflation tax   refers to the price for holding cash at a moment of high inflation. When the government prints more cash or reduce interest rates there is flood of cash in the market which creates inflation in long run.
The only means by which a government can reimburse an existing debt is by generating Taxes greater than government spending for long enough to pay back its obligations. Taxes can be an income tax, corporate tax, tariffs et cetera.
However, these choices entail economic tradeoffs and complex political decisions. One more option is for the government to decrease the real value of the debt through inflation. The inflation tax, or seignorage, is referred to as " hidden" tax as it does not inevitably involve an explicit decision by the politicians to lift up taxes. It occurs every time monetary policy generates inflation.
Seigniorage refers to the difference between the worth of currency and the cost to produce. If the seigniorage is positive, the government will make a financial profit and if seigniorage is negative government will make an economic loss. An increase in income taxes necessitates less of reduction in other taxes needed to repay debt.
Therefore, the governments in debt at the present is likely to repay this debt only through decline in its expenditures in future, enlarge taxes in future , or do both.

Question 2

Suppose a nation has $100 billion in currency outstanding and $1 trillion in bonds, 30 percent of which are owned by agencies of ; the government. Assume that all the bonds are payable in the country's unit of account. Calculate how much revenue the government would collect in the form of an inflation tax if the inflation rate in the country was 2 percent. How much extra revenue from the inflation tax would be collected if the inflation rate was instead 5 percent? Show your calculations.

Answer 2

Inflation tax   refers to the price for holding cash at a moment of high inflation. When the government prints more cash or reduce interest rates there is flood of cash in the market which creates inflation in long run.
The only means by which a government can reimburse an existing debt is by generating Taxes greater than government spending for long enough to pay back its obligations. Taxes can be an income tax, corporate tax, tariffs et cetera.
However, these choices entail economic tradeoffs and complex political decisions. One more option is for the government to decrease the real value of the debt through inflation. The inflation tax, is referred to as " hidden" tax as it does not inevitably involve an explicit decision by the politicians to lift up taxes. It occurs every time monetary policy generates inflation.
According to the information provided in the question:
The country has $100 billion cash outstanding and $1 trillion in bonds, out of which 30% are owned by governmental agencies.An Assumption is made that all the bonds are to be paid in country's unit of account.
Therefore, Out of the $1 trillion of existing bonds, $300 billion are held by government.So remaining $700 billion are held by the public. If the inflation rate is 2%, the worth of these existing bonds will be reduced by; This means that $14 billion revenue is collected by the government in the form of inflation tax.
If the inflation rate is 5% percent the worth of these bonds will be reduced by: This means that $35 billion revenue is collected by government in the form of inflation tax.
Therefore, when inflation is 2% government collects $14 billion while in case of 5% inflation it collects $35 billion.

Question 3

Analyze why many hyperinflations have been associated with wars or widespread civil unrest (or revolution), ( Hint: Are wars expensive?)

Answer 3

Hyperinflation is defined as the condition when a nation experiences very high and usually hastening rates of inflation, swiftly eroding the real value of the native currency, thereby causing the population to decrease their holdings of local currency. The population normally shifts to holding comparatively stable foreign currencies.
Under such situations, the general price level in the economy upsurges rapidly as the certified currency rapidly loses real value. The value of economic things remains relatively steady in terms of foreign moneys.
Wars are costly and require the governments to pay for them. At the time of wars, mostly
Unpopular ones or ones that split the nation, it is hard for the government to increase adequate revenues by traditional means.
For example, during civil conflicts, there are Likely to be a large portion of the population who do not pay income taxes.This is because they are protesting against the government. Thus, governments switch to easier and convenient techniques of making income like printing money which lead to inflation and cause hyperinflation.
Thus, it can be concluded that hyperinflations lead to wars and social unrest in the economy.

Question 4

The rule of 70 states that if something is growing at a rate of R percent per year, its value will double in 70/R years. Suppose the inflation rate becomes 5 percent per year in the United States. How long will it take for the price level to double? How long will it take for the real value of the current stock of federal debt to be cut in half? Show your calculations.

Question 5

A hyperinflation is defined as one in which the inflation rate is at least 50 percent per month. Use the rule of 70 to calculate how many days it takes for the price level to double in a nation experiencing a minimum hyperinflation.

Question 6

Average inflation rates tend to be higher in nations that have relatively weak judicial systems and property rights of the sort discussed in Chapter 1. Suggest some reasons why this pattern is observed.