THE INFLATION TAX
If inflation is so easy to explain, why do countries experience hyperinflation? That is, why do the central banks of these countries choose to print so much money that its value is certain to fall rapidly over time?
The answer is that the governments of these countries are using money creation as a way to pay for their spending. When the government wants to build roads, pay salaries to police officers, or give transfer payments to the poor or elderly, it first has to raise the necessary funds. Normally, the government does this by levying taxes, such as income and sales taxes, and by borrowing from the public by selling government bonds. Yet the government can also pay for spending simply by printing the money it needs.
When the government raises revenue by printing money, it is said to levy an inflation tax. The inflation tax is not exactly like other taxes, however, because no one receives a bill from the government for this tax.Instead, the inflation tax is subtler. When the government prints money, the price level rises, and the dollars in your wallet are less valuable. Thus, the inflation tax is like a tax on everyone who holds money.
The importance of the inflation tax varies from country to country and over time. In the United States in recent years, the inflation tax has been a trivial source of revenue: It has accounted for less than 3 percent of government revenue. During the 1770s, however, the Continental Congress of the fledgling United States relied heavily on the inflation tax to pay for military spending. Because the new government had a limited ability to raise funds through regular taxes or borrowing, printing dollars was the easiest way to pay the American soldiers. As the quantity theory predicts, the result was a high rate of inflation: Prices measured in terms of the continental dollar rose more than 100-fold over a few years.
Almost all hyperinflation follow the same pattern as the hyperinflation during the American Revolution. The government has high spending, inadequate tax revenue, and limited ability to borrow. As a result, it turns to the printing press to pay for its spending. The massive increases in the quantity of money lead to massive inflation. The inflation ends when the government institutes fiscal reforms-such as cuts in government spending-that eliminate the need for the inflation tax.