22
INFLATION AND HYPERINFLATION
FOCUS OF THE CHAPTER



In this chapter we examine the link between money growth and inflation in normal
business cycles and in hyperinflations.
A variety of policy responses to hyperinflation are reviewed.
The necessity of stabilizing government budget deficits in hyperinflationary economies is
emphasized.
SECTION SUMMARIES
1.
Money and Inflation in Ordinary Business Cycles
The link between money growth and inflation is not as tight in the short run as it is in the long
run, in part because money growth can affect output in the short run, in part because low levels
of inflation can be a fiscal as well as a monetary phenomenon. To explain the long run theory of
inflation and money growth, we go back to the quantity theory of money:
MV  PY
where M is the money stock, V is the velocity, P is the price level and Y is the output. The above
equation, when written in growth terms is specified as
𝑚 + 𝑣 = 𝜋 + 𝑦.
In the above equation, m is the money growth rate, v is the change in velocity, π is the inflation
rate and y is the output growth rate. Since, the long run output growth rate is fairly stable (at 3
percent) and so is long run velocity, the money growth rate is reflected for one to one in inflation.
227
228 CHAPTER 22
This is consistent with the monetarist view that in the long run all inflation is due to money
growth.
Hyperinflation, therefore, is indisputably a result of excessive money growth. It is an
unfortunate reality that it is easier to create a hyperinflation than it is to stop one.
2.
Hyperinflation
Although there is no consensus on what constitutes a hyperinflation, a working definition is an
annual rate of inflation that exceeds 1,000 percent. Hyperinflationary countries all appear to
suffer from large budget deficits and high rates of money growth. Because inflation increases the
measured deficit, economists often look instead at the inflation–adjusted deficit:
total deficit - (inflation rate  national debt )
This subtracts the component of the interest payments on the debt that are attributed directly to
inflation.
The heterodox approach to stabilization combines monetary, fiscal, and exchange rate policies
with incomes policies; it constitutes a coordinated attack on inflation, and offers the possibility of
deflation without recession. But like all other policies that need to affect people’s expectations in
order to work, this heterodox approach must be credible. For countries with debt-driven
hyperinflation, this often means a strong commitment to debt reduction. Nobody’s going to
believe the government will stop printing money until the problems that made it necessary have
been dealt with.
This highlights a very important fact: that the sacrifice ratio, or the percentage decline in output
resulting from a one percentage-point reduction in the rate of inflation, can be reduced through
the implementation of credible policies. Central bank credibility can be an immensely powerful
tool.
3.
Deficits, Money Growth, and the Inflation Tax
The government can finance its deficits in two ways: it can either sell bonds, or persuade the
central bank to increase the monetary base. The Fed is said to monetize a deficit whenever it
purchases some of the bonds that the Treasury sells to finance that deficit. If it does not do this,
the fiscal expansion behind the deficit will drive up interest rates; if it does, it runs the risk of
causing inflation. Evidence is mixed on whether the Federal Reserve even partially monetizes
U.S. deficits.
Creating high-powered money serves as an alternative to taxation. The revenue collected
through money creation is referred to as seigniorage. The total amount of seigniorage that can be
collected is given by the formula
inflation tax revenue = inflation tax rate  real money base
INFLATION AND HYPERINFLATION
229
As the growth rate of money becomes large, the real money stock falls to zero; the government
cannot collect an arbitrarily large amount of tax revenue simply by printing money. The
“inflation tax” appears to be quite low in industrialized countries, where the money base is small
relative to the size of the economy. Countries with less developed financial sectors, where people
hold large amounts of currency, appear able to generate more revenue by printing money.
KEY TERMS
quantity theory of money
velocity of money
hyperinflation
inflation-adjusted deficit
heterodox approach to stabilization
credible policy
credibility bonus
inflationary inertia
sacrifice ratio
government budget constraint
monetization
seigniorage
inflation tax
GRAPH IT 22
This Graph It gives you a chance to look at the link between fiscal and monetary policy in the
U.S. Does the Fed allow money growth to rise when the budget deficit is increases? Table 22–1
provides data on the U.S. budget deficit and monetary base as a percent of GDP between 1980
and 2012. Your task is to find and plot the change in the deficit and monetary base for each year.
In Chart 22-1, plot the years 1980 to 2007. In Chart 22-2, plot the entire series from 1980 to 2012.
Table 22-1
Year
Budget
Deficit (%
of GDP)
Monetary
Base (% of
GDP)
1980
1.71
4.91
1981
1.57
4.65
1982
4.23
4.75
1983
4.85
4.79
1984
3.75
4.63
1985
3.71
4.64
1986
3.90
4.77
1987
2.90
4.90
1988
2.38
4.89
1989
2.08
4.78
1990
2.94
4.84
1991
3.74
5.13
Change in
Budget
Deficit
Change in
Monetary
Base
-0.14
-0.26
230 CHAPTER 22
1992
4.79
5.26
1993
4.22
5.55
1994
2.99
5.72
1995
2.66
5.79
1996
1.60
5.63
1997
0.29
5.57
1998
-0.92
5.63
1999
-1.50
5.81
2000
-2.28
5.81
2001
-0.24
5.93
2002
2.88
6.23
2003
3.73
6.32
2004
3.27
6.25
2005
2.04
6.12
2006
1.14
6.00
2007
1.66
5.85
2008
4.80
6.86
2009
9.61
12.67
2010
9.64
13.84
2011
8.88
16.67
2012
16.83
3.50
0.40
3.00
Change in budget deficit
2.00
0.20
1.50
0.10
1.00
0.50
0.00
0.00
-0.50 1980
-1.00
1985
1990
1995
2000
2005
-0.10
-0.20
-1.50
-2.00
Chart 22-1
-0.30
Change in monetary base
0.30
2.50
6.00
7.00
5.00
6.00
4.00
5.00
3.00
4.00
2.00
3.00
1.00
2.00
0.00
1.00
1980
1985
1990
1995
2000
2005
231
Change in monetary base
Change in budget deficit
INFLATION AND HYPERINFLATION
2010
-1.00
0.00
-2.00
-1.00
Chart 22-2
REVIEW OF TECHNIQUE 22
Dynamic Expectations
When expectations are based on current or lagged variables, they change over time to reflect the
impact of new information. This Review of Technique works through a simple model with
dynamic expectations.
Suppose that permanent income is given by the formula:
YP  Y e
where Ye is the average amount of money you expect to earn each year for the rest of your life.
Suppose also that your expectations regarding this stream of income are given by the formula
Ye 
1
2
Y  Y1 
and that consumption, investment, and government spending are as follows:
C  21 YP  21 Y e 
I  1000
G0
1
4
Y  Y1 
232 CHAPTER 22
Table 22–2 traces out, for a few periods, this process of expectational adjustment and shows the
effect that it has on consumption. We use the national income accounting relationship
Y = C + I + G, or, more precisely,
Y
1
2
Y  Y1   100
to track the way that income changes over time.
Do you see how changes in people’s expectations of future income affect their consumption
patterns?
Table 22–2
Period
Y
Y-1
Ye
C
I
G
0
1,400.00
1,000.00
1,200.00
600.00
1000.00
0
1
1,600.00
1,400.00
1,500.00
750.00
1000.00
0
2
1,750.00
1,600.00
1,675.00
837.50
1000.00
0
3
1,837.50
1,750.00
1,793.75
896.88
1000.00
0
(Note: The function that we have used to represent these expectations is not a realistic one. If we were building a more
careful model, we would want people’s expectations to be formed rationallyto take into account all available
information about the economy.)
INFLATION AND HYPERINFLATION
233
FILL-IN QUESTIONS
1.
Hyperinflations have historically tended to occur in the aftermath of ______________.
2.
Wage and price controls are referred to as _______________________.
3.
The revenue collected through money creation is called ___________________.
4.
The creation of high-powered money in order to generate revenues is referred to as an
______________________.
5.
The Fed is said to _____________________ a deficit when it buys some or all of the bonds that the
treasury sells to finance that deficit.
6.
A ___________________ approach to stabilization consists of the simultaneous use of monetary,
fiscal, exchange rate, and incomes policies.
7.
The government can finance its budget deficits in two ways: it can either _______________ or
______________________________.
8.
Countries with hyperinflation often have large, persistent ___________________.
TRUE-FALSE QUESTIONS
T F
1.
long run.
The link between money and inflation is stronger in the short run than in the
T
F
2.
Wage and price controls are an effective way to halt inflation.
T
F
3.
A heterodox approach to stabilization offers the possibility of deflation without
recession.
T
F
4.
Policy credibility has no effect on sacrifice ratio.
T
F
5.
In the long-run, there is no trade-off between inflation and output.
MULTIPLE–CHOICE QUESTIONS
1.
Which of the following annual rates of inflation would be called a hyperinflation?
a. 10%
b. 100%
c. 1000%
d. (b) and (c)
234 CHAPTER 22
2. There is a stronger link between the rate of money growth and the nominal rate of inflation in
the
a. long run
b. short run
3.
Hyperinflations are usually ended through
a. currency reform
b. reduced budget deficits
4.
c. tight monetary policy
d. all of the above
Monetarists claim that inflation is mostly caused by
a.
b.
c.
d.
5.
c. steady-state
d. no difference
changes in velocity
changes in the monetary base
changes in GDP
all of the above
During the Great Recession, money growth and inflation were
a.
b.
c.
d.
positively correlated
negatively correlated
unrelated
very low
CONCEPTUAL PROBLEMS
1. Explain why each of the following situations might lead to hyperinflation. Can you think of
any historical examples in which they’ve done exactly this?
a) A government cannot meet its debt obligations (does not have sufficient revenues to repay
the interest on its debt).
b) A country is assessed war reparations that force its government to run huge budget
deficits.
c)
A government lacks either the power or the necessary infrastructure to collect taxes.
2. How can the creation of high-powered money be a source of government revenue?
INFLATION AND HYPERINFLATION
235
TECHNICAL PROBLEMS
1. How much inflation tax revenue would be generated in a country with a real money base of
$1,000 and an inflation rate of 1000%?
2. How much inflation tax revenue would be generated in a country with a real money base of
$500 and an inflation rate of 1000%?
3. What happens to the real money base, over time, when the growth rate of money becomes
large? Given this, do you think that seigniorage is a good way to generate revenue?