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High Inflation. Hyperinflation simply means very high inflation. Inflation ultimately results from nominal money growth.
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High Inflation • Hyperinflation simply means very high inflation. • Inflation ultimately results from nominal money growth. • Countries that have suffered from hyperinflation have high nominal money growth because the budget deficit is high. Governments cannot finance its expenditures in any way other than money creation.
23-1 Budget Deficits and Money Creation • A government can finance its budget deficit either by: • Borrowing (issuing bonds), or by creating money. • Debt monetization is the process by which the government issues bonds and asks the central bank to buy them; then, the central bank pays the government with money it creates, and the government uses that money to finance the deficit.
23-1 Budget Deficits and Money Creation At the start of hyperinflations, two changes usually take place: • The start of a hyperinflation takes place when there is budget crisis, • and the government is unable to borrow from the public or from abroad. • Seignorage is the amount of real revenue the government can generate from money creation.
23-1 Budget Deficits and Money Creation • The rate of nominal money growth required to generate a given amount of seignorage is: In words, seignorage is the product of the rate of nominal money growth and real money balances.
23-2 Inflation and Real Money Balances • What determines the amount of real money balances people will hold? Real money balances depend (positively) on income and (negatively) on the nominal interest rate. A higher nominal interest rate increases the opportunity cost of holding money and leads people to reduce their real money balances.
23-2 Inflation and Real Money Balances • In times of hyperinflation, the amount of money balances people will hold depends primarily on expected inflation. • When the expected rate of inflation is very high, people will try to get rid of their money holdings as soon as possible.
23-2 Inflation and Real Money Balances • Barter is the exchange of goods for other goods rather than for money. • During hyperinflations: • Barter increases. • Wage payments are more frequent. • People rush to stores to buy goods. • People shift to foreign currencies as stores of value. The shift to dollars worldwide is an event now called dollarization—the use of dollars in another country’s transactions.
23-2 Inflation and Real Money Balances Figure 23 – 1 Inflation and Real Money Balances in Hungary, November 1922 to February 1924 At the end of the Hungarian hyperinflation, real money balances stood at roughly half their pre-hyperinflation level.
23-2 Inflation and Real Money Balances Examine the evidence from the Hungarian hyperinflation: • Panel (a) plots real money balances and the monthly inflation rate from November 1922 to February 1924. • Panel (b) presents the same information as Panel (a), but in the form of a scatter diagram.
23-3 Deficits, Seignorage, and Inflation • We have derived two relations: • The relation between seignorage, nominal money growth, and real money balances. • The relation between real money balances and expected inflation. • Combining the two equations gives
23-3 Deficits, Seignorage, and Inflation The Case of Constant Nominal Money Growth • Nominal money growth has two opposite effects on seignorage:
23-3 Deficits, Seignorage, and Inflation Figure 23 – 2 Seignorage and Nominal Money Growth The Case of Constant Nominal Money Growth Seignorage is first an increasing function, then a decreasing function of nominal money growth.
23-3 Deficits, Seignorage, and Inflation The Case of Constant Nominal Money Growth • The Laffer curve is the relation between tax revenues and the tax rate. It looks similar to Figure 23-2. • A simple analogy can be made between the Laffer curve and inflation versus money balances. Inflation can be thought of as a tax on real money balances. • The product of these two variables, is called the inflation tax.
23-3 Deficits, Seignorage, and Inflation The Case of Constant Nominal Money Growth • In all seven hyperinflations, the actual average nominal money growth far exceeded the rate of nominal money growth that maximizes seignorage.
23-3 Deficits, Seignorage, and Inflation Dynamics and Increasing Inflation • In the short run, an increase in nominal money growth may lead to little change in real money balances. • But over time, the same rate of nominal money growth yields less and less seignorage. • Therefore, the government cannot finance a deficit at a constant rate of nominal money growth. • The Tanzi-Olivera effect looks at the impact of inflation on the real value of taxes collected.
23-3 Deficits, Seignorage, and Inflation Hyperinflations and Economic Activity • In the short run, the effects of higher nominal money growth are expansionary: • But as inflation becomes very high, the adverse effects of hyperinflation dominate: • The transaction system works less and less well. • Price signals become less and less useful. • Swings in the inflation rate become larger.
23-4 How Do Hyperinflations End? • Hyperinflations do not die a natural death. Rather, they have to be stopped through a stabilization program. The Elements of a Stabilization Program Hyperinflation needs to be stopped through a stabilization program, which may include the following elements: • Fiscal reform and credible budget deficit reduction. • Taking credible steps that will demonstrate the commitment of the central bank to no longer monetize the debt. • Some economists argue that incomes policies – that is, wage and/or price guidelines or controls - should be used, in addition to fiscal and monetary measures.
23-4 How Do Hyperinflations End? The Elements of a Stabilization Program Stabilization programs that do not include income policies are called orthodox; those that do are called heterodox (because they rely on both monetary – fiscal changes and incomes policies.
23-4 How Do Hyperinflations End? Can Stabilization Programs Fail? • Can stabilization programs fail? Yes, they can fail, and they often do. • Sometimes failure comes from a botched or half-hearted effort at stabilization. • Failure can also come from the anticipation of failure.
23-4 How Do Hyperinflations End? The Costs of Stabilization • We argued that there were three reasons why inflation might not decrease as fast as nominal money growth, leading to a recession: • Wages are typically set in nominal terms for some period of time, and, as a result, many of them are already determined when the decision for disinflation is made. • Wage contracts are typically staggered, making it difficult to implement a slow-down in all wages at the same time. • The change in monetary policy may not be fully and instantaneously credible.
The Bolivian Hyperinflation of the 1980s The stabilization plan was organized around the elimination of the budget deficit. Its main features were: • Fiscal policy. • Monetary policy. • Reestablish international creditworthiness.
Figure 1 Bolivian Monthly Inflation Rate, January 1984 to April 1986 The Bolivian Hyperinflation of the 1980s
23-5 Conclusions • Although output fluctuates around its natural level in the short run, it tends to return to this natural level in the medium run. But it does not always happen this way: • Sometimes, the adjustment mechanism that is supposed to return the economy to its natural level of output breaks down. • Monetary and fiscal policy may prove unable to help. • Governments may lose control of both fiscal policy and monetary policy.
Key Terms • hyperinflations • debt monetization • seignorage • barter • dollarization • Laffer curve • inflation tax • Tanzi-Olivera effect • stabilization program • income policies • orthodox stabilization program, heterodox stabilization program
