Quantitive Easing As A Highway To Inflation

Quantitative Easing
as a Highway to
Hyperinflation
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Quantitative Easing as a Highway to Hyperinflation
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Quantitative Easing
as a Highway to
Hyperinflation
Imad A Moosa
Royal Melbourne Institute of Technology, Australia
World Scientific
NEW JERSEY
LONDON
8797hc_9789814504911_tp.indd 2
SINGAPORE
BEIJING
SHANGHAI
HONG KONG
TA I P E I
CHENNAI
1/2/13 9:12 AM
Published by
World Scientific Publishing Co. Pte. Ltd.
5 Toh Tuck Link, Singapore 596224
USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601
UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE
Library of Congress Cataloging-in-Publication Data

Moosa, Imad A.
Quantitative easing as a highway to hyperinflation / by Imad A Moosa (Royal Melbourne Inst of
Technology, Australia).
pages cm
Includes bibliographical references and index.
ISBN 978-9814504911
1. Quantitative easing (Monetary policy) 2. Monetary policy. 3. Inflation (Finance) I. Title.
HG230.3.M686 2014
339.5'3--dc23
2013022981
British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library.
Copyright 2014 by World Scientific Publishing Co. Pte. Ltd.

All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means,
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Printed in Singapore
August 10, 2013
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To Nisreen and Danny
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CONTENTS
List of Figures
xiii
List of Tables
xix
List of Abbreviations
xxi
Preface
xxiii
About the Author
xxvii
1.
Inflation, Deflation, Disinflation and All That

1.1
1.2
1.3
1.4
1.5
1.6
2.
What is Ination? . . . . . . . . .
Ination and Related Concepts: A
Illustration . . . . . . . . . . . . .
The Causes of Ination . . . . . .
Experience with Ination . . . . .
More Ination-Related Concepts .
Concluding Remarks . . . . . . .
. . . . . .
Graphical
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1
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The Measurement of Inflation

2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
The Ination Rate . . . . . . . . . . . . . . .

Ination, Income Growth and Money Illusion
Measuring the General Price Level . . . . . .
Core Ination . . . . . . . . . . . . . . . . .
The Consumer Price Index . . . . . . . . . .
The GDP Deator . . . . . . . . . . . . . . .
Other Price Indices . . . . . . . . . . . . . .
Concluding Remarks . . . . . . . . . . . . .
vii
1
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14
17
23
26
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48
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The Monetary Theory of Inflation
3.4
3.5
3.6
3.7
3.8
Introduction . . . . . . . . . . . . . . . . .
The Meaning of Money and Credit . . . . .
Money Creation under a Fractional
Reserve System . . . . . . . . . . . . . . .
The Quantity Theory of Money . . . . . .
Facts and Figures . . . . . . . . . . . . . .
Further Remarks on the Monetary Theory
of Ination . . . . . . . . . . . . . . . . . .
Central Bank Independence . . . . . . . . .
Concluding Remarks . . . . . . . . . . . .
49
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50
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64
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70
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Other Theories of Inflation and Some Extensions

4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
5.
3.1
3.2
3.3
4.
9in x 6in
Demand-Pull Ination . . . . . . . . . . . . . . .
Cost-Push Ination . . . . . . . . . . . . . . . .
A Combined Demand-Cost Model . . . . . . . .
Inationary Shocks, Monetary Accommodation
and Monetary Validation . . . . . . . . . . . . .
The Fiscal Theory of Ination . . . . . . . . . .
The Political Theory of Ination . . . . . . . . .
The Other Side of the Coin: Deation . . . . . .
Concluding Remarks . . . . . . . . . . . . . . .
75
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The Consequences and Costs of Inflation

5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
5.10
5.11
5.12
5.13
Introduction . . . . . . . . . . . . . . . . . .
The Positive Eects of Ination . . . . . .
Arbitrary Redistribution of Income . . . . .
Business Planning and Investment . . . . . .
Miscellaneous Business Costs . . . . . . . . .
Distortion of the Eect of Taxes . . . . . . .
The Adverse Eect of Ination on Saving . .
The Eects of Ination on Financial Markets
The Eect of Ination on Competitiveness .
Currency Depreciation . . . . . . . . . . . .
The Eect of Ination on Unemployment
and Growth . . . . . . . . . . . . . . . . . .
Ination-Triggered Social Unrest . . . . . . .
The Eect of Ination on Morality . . . . . .
91
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91
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108
109
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Contents
5.14
5.15
5.16
6.
The Optimal Ination Rate . . . . . . . . . . . . . . . . 118

Hedging the Risk of Ination . . . . . . . . . . . . . . . 119
Concluding Remarks . . . . . . . . . . . . . . . . . . . 119
The Phenomenon of Hyperinflation

6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
6.10
6.11
6.12
6.13
6.14
6.15
7.
ix
What is Hyperination? . . . . . . . . . . . . . . .
Hyperination as an Extension
of Moderate Ination . . . . . . . . . . . . . . . .
The Measurement of Hyperination . . . . . . . .
The Syndrome of Hyperination . . . . . . . . . .
The Hyperinationary Process
and Feedback Eects . . . . . . . . . . . . . . . .
Hyperination and the Death of a Fiat Currency .
The Monetary, Condence and Fiscal Models
of Hyperination . . . . . . . . . . . . . . . . . . .
The Role of Expectations . . . . . . . . . . . . . .
Other Approaches to Hyperination . . . . . . . .
The Behavior of Exchange Rates
under Hyperination . . . . . . . . . . . . . . . .
6.10.1 The basic model . . . . . . . . . . . . . .
6.10.2 The role of expectations . . . . . . . . . .
6.10.3 Currency substitution . . . . . . . . . . .
The Empirical Evidence . . . . . . . . . . . . . . .
The Consequences of Hyperination . . . . . . . .
Dealing with Hyperination: Business Issues . . .
Dealing with Hyperination: Macroeconomic
Issues . . . . . . . . . . . . . . . . . . . . . . . . .
6.14.1 Cold turkey versus gradualism . . . . . .
6.14.2 Currency boards . . . . . . . . . . . . . .
6.14.3 Dollarization . . . . . . . . . . . . . . . .
Concluding Remarks . . . . . . . . . . . . . . . .
The History of Fiat Money and Hyperinflation

7.1
7.2
121
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. . . 140
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141
142
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152
156
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158
160
160
162
163
165
Fiat Money, Monetary Debasement

and Hyperination . . . . . . . . . . . . . . . . . . . . . 165
The Early History of Fiat Money
and Hyperination . . . . . . . . . . . . . . . . . . . . . 170
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7.3
7.4
7.5
7.6
8.
9in x 6in
7.2.1 The ancient Chinese experience . . . . . .

7.2.2 The experience of ancient Rome . . . . . .
7.2.3 The Persian experience . . . . . . . . . . .
Fiat Money and Hyperination in Europe Prior
to World War I . . . . . . . . . . . . . . . . . . .
7.3.1 Fiat money in France: The story
of John Law . . . . . . . . . . . . . . . . .
7.3.2 Hyperination in France
after the revolution . . . . . . . . . . . . .
7.3.3 Hyperination and monetary debasement
in England . . . . . . . . . . . . . . . . .
Fiat Money and Monetary Debasement
in the U.S. . . . . . . . . . . . . . . . . . . . . . .
The Classical Hyperinations of the 20th Century
7.5.1 Austria . . . . . . . . . . . . . . . . . . .
7.5.2 China . . . . . . . . . . . . . . . . . . . .
7.5.3 The free city of Danzig . . . . . . . . . . .
7.5.4 Greece . . . . . . . . . . . . . . . . . . . .
7.5.5 Hungary . . . . . . . . . . . . . . . . . . .
7.5.6 Japan . . . . . . . . . . . . . . . . . . . .
7.5.7 Poland . . . . . . . . . . . . . . . . . . . .
7.5.8 Russia . . . . . . . . . . . . . . . . . . . .
7.5.9 Taiwan . . . . . . . . . . . . . . . . . . . .
7.5.10 Germany . . . . . . . . . . . . . . . . . .
Concluding Remarks . . . . . . . . . . . . . . . .
. . . 170
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. . . 176
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Hyperinflationary Episodes since the 1970s

8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
8.9
8.10
Introduction . . . . . . . . . . . .
Angola . . . . . . . . . . . . . . .
Argentina . . . . . . . . . . . . . .
Belarus . . . . . . . . . . . . . . .
Bolivia . . . . . . . . . . . . . . .
BosniaHerzegovina (Yugoslavia)
Brazil . . . . . . . . . . . . . . . .
Congo (Formerly Zaire) . . . . . .
Croatia . . . . . . . . . . . . . . .
Ecuador . . . . . . . . . . . . . .
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177
182
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201
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201
202
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219
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Contents
8.11
8.12
8.13
8.14
8.15
8.16
8.17
8.18
8.19
8.20
8.21
8.22
8.23
8.24
8.25
9.
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The Status Quo: Heading Towards Hyperinflation?

9.1
9.2
9.3
9.4
9.5
10.
Georgia . . . . . . . .
Iraq . . . . . . . . . .
Israel . . . . . . . . .
Mexico . . . . . . . .
Nicaragua . . . . . .
Peru . . . . . . . . . .
Poland . . . . . . . .
Romania . . . . . . .
Russia . . . . . . . .
Turkey . . . . . . . .
Ukraine . . . . . . . .
Zimbabwe . . . . . .
Iran . . . . . . . . . .
The Overall Picture .
Concluding Remarks
xi
The Road to Hyperination . . . . . . . . . .

Fiscal and Monetary Indicators Worldwide . .
9.2.1 Monetary indicators . . . . . . . . . .
9.2.2 The situation in general . . . . . . . .
9.2.3 Another indicator: The price of gold .
Quantitative Easing . . . . . . . . . . . . . . .
9.3.1 QE1, QE2 and QE3 . . . . . . . . . .
Hyperination in the U.S.: Why and Why Not
Concluding Remarks . . . . . . . . . . . . . .
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255
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Leading Indicators of U.S. Hyperinflation

10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8
10.9
10.10
The Fiscal Balance . . . . . . . . . . . .

The Spending Side . . . . . . . . . . . . .
The Revenue Side . . . . . . . . . . . . .
The Outlook for the U.S. Fiscal Position
Public Debt . . . . . . . . . . . . . . . .
Monetary Aggregates . . . . . . . . . . .
Lessons from Theory . . . . . . . . . . .
Lessons from History . . . . . . . . . . .
When and How It Will Happen? . . . . .
Concluding Remarks . . . . . . . . . . .
222
224
225
227
228
230
233
235
239
241
243
244
248
249
253
255
257
263
265
267
268
272
274
280
281
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281
284
290
292
293
299
302
307
309
312
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Concluding Thoughts
11.1
11.2
11.3
11.4
11.5
The Highway Network . . . . . . . . . . . .

Fire or Ice? . . . . . . . . . . . . . . . . . .
The Unthinkables . . . . . . . . . . . . . .
The Big Unthinkable: Break-Up of the U.S.
The Day of Reckoning is Inevitable . . . .
313
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313
316
320
322
324
References
327
Index
343
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LIST OF FIGURES
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
1.10
1.11
1.12
1.13
1.14
1.15
1.16
2.1
2.2
2.3
2.4
2.5
2.6
2.7
Price stability . . . . . . . . . . . . . . . . . . . . . . . .
Moderate (creeping) ination . . . . . . . . . . . . . . .
Accelerating ination . . . . . . . . . . . . . . . . . . . .
Volatile ination . . . . . . . . . . . . . . . . . . . . . .
Hyperination . . . . . . . . . . . . . . . . . . . . . . . .
Disination . . . . . . . . . . . . . . . . . . . . . . . . .
Deation . . . . . . . . . . . . . . . . . . . . . . . . . . .
Big discrete jumps in the general price level
(inationary bursts) . . . . . . . . . . . . . . . . . . . .
Reation . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stagation . . . . . . . . . . . . . . . . . . . . . . . . . .
Ination in the U.S . . . . . . . . . . . . . . . . . . . . .
Ination in Sweden . . . . . . . . . . . . . . . . . . . . .
Ination around the world . . . . . . . . . . . . . . . . .
Ination in high-ination countries . . . . . . . . . . . .
Most recent ination gures (September/October 2012)
The price level under open and suppressed inations
(simulated data) . . . . . . . . . . . . . . . . . . . . . .
Measures of the ination rate
(simulated data) . . . . . . . . . . . . . . . . . . . . . .
Nominal and real incomes at various ination rates
(simulated data) . . . . . . . . . . . . . . . . . . . . . .
The CPI, PPI and GDP deator for the U.S . . . . . . .
Ination rates calculated from the CPI
and GDP deator . . . . . . . . . . . . . . . . . . . . . .
Total and core ination rates for the U.S . . . . . . . . .
The U.S. CPI and components . . . . . . . . . . . . . .
Variants of the U.S. CPI . . . . . . . . . . . . . . . . . .
xiii
.
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5
6
7
8
9
10
11
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12
13
14
18
20
22
24
25
. . .
25
. . .
31
. . .
. . .
33
34
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35
38
41
43
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.
August 10, 2013
8:54
xiv
2.8
2.9
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
3.9
3.10
3.11
3.12
4.1
4.2
4.3
4.4
4.5
4.6
4.7
5.1
5.2
5.3
5.4
5.5
5.6
5.7
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The U.S. GDP at current and constant prices with dierent

bases periods . . . . . . . . . . . . . . . . . . . . . . . . . .
Price indices for apparel and medical care . . . . . . . . . .
The composition of M 1 and M 2 in the U.S.
(December 2011) . . . . . . . . . . . . . . . . . . . . . . . .
The composition of bank credit in the U.S.
(December 2011) . . . . . . . . . . . . . . . . . . . . . . . .
Money and credit in the U.S . . . . . . . . . . . . . . . . . .
The money supply corresponding to monetary base
(simulated data) . . . . . . . . . . . . . . . . . . . . . . . .
Monetary base, ratios and multipliers for M 1 and M 2 . . .
The eect of the velocity of circulation (simulated data) . .
Velocity of circulation in the U.S . . . . . . . . . . . . . . .
Money versus prices in the U.S. (scatter plots) . . . . . . .
Money and prices in the U.S. (time plots) . . . . . . . . . .
Money and prices in the U.S. (percentage changes) . . . . .
Ination rates and monetary growth rates adjusted
for output growth . . . . . . . . . . . . . . . . . . . . . . . .
Monetary growth and house prices . . . . . . . . . . . . . .
Actual and potential GDP with the corresponding gaps
in the U.S . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unemployment, ination and gaps in the U.S . . . . . . . .
Maintaining protability by passing costs to consumers
(simulated data) . . . . . . . . . . . . . . . . . . . . . . . .
Oil price and the U.S. GDP deator . . . . . . . . . . . . .
The U.S. wages and GDP deator . . . . . . . . . . . . . .
Wageprice spiral (simulated data) . . . . . . . . . . . . . .
Shocks without monetary accommodation and validation
(simulated data) . . . . . . . . . . . . . . . . . . . . . . . .
Real and nominal values of an invested amount of 100
(simulated data) . . . . . . . . . . . . . . . . . . . . . . . .
Real and nominal values of invested amounts at the U.S.
interest rates . . . . . . . . . . . . . . . . . . . . . . . . . .
Real and nominal interest rates (simulated data) . . . . . .
Real and nominal amounts (simulated data) . . . . . . . . .
The U.S. nominal short-term interest rates and ination . .
Real U.S. short-term and long-term interest rates . . . . . .
Nominal interest rates and ination
(cross-sectional data) . . . . . . . . . . . . . . . . . . . . . .
.
.
46
47
51
.
.
52
53
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56
57
61
61
65
66
67
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68
69
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76
77
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80
81
82
83
84
95
.
.
.
.
.
96
102
103
104
105
. 105
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List of Figures
5.8
5.9
5.10
5.11
5.12
5.13
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
6.10
7.1
7.2
7.3
7.4
7.5
7.6
7.7
8.1
8.2
GDP deator and stock prices in the U.S . . . . . . . . . . .

The eect of ination on the trade balance
(three scenarios) . . . . . . . . . . . . . . . . . . . . . . . . .
Currency depreciation under ination (simulated data) . . . .
Ination, growth and unemployment in the U.S.
(19612011) . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ination, growth and unemployment in a cross-section
of countries (averages) . . . . . . . . . . . . . . . . . . . . . .
The FAO food price index . . . . . . . . . . . . . . . . . . . .
Growth under hyperination (rank correlation) . . . . . . . .
The monthly rates corresponding to annual rates . . . . . . .
Years for prices to double at various annual
ination rates . . . . . . . . . . . . . . . . . . . . . . . . . . .
Years it takes to add a zero and currency
re-denomination . . . . . . . . . . . . . . . . . . . . . . . . .
A typical hyperinationary process . . . . . . . . . . . . . . .
Price level and currency in circulation in some 1920s
hyperinations . . . . . . . . . . . . . . . . . . . . . . . . . .
Hyperination and the death of a at currency . . . . . . . .
The eect of ination on the exchange rate
(simulated data) . . . . . . . . . . . . . . . . . . . . . . . . .
The eect of ination and expectations on the exchange rate
(simulated data) . . . . . . . . . . . . . . . . . . . . . . . . .
Erosion of receivables under ination (simulated data) . . . .
The history of money in the U.S . . . . . . . . . . . . . . . .
The purchasing power of confederate treasury notes
(1 May 18611 May 1865) . . . . . . . . . . . . . . . . . . . .
The Austrian hyperination of the 1920s
(logarithmic scale) . . . . . . . . . . . . . . . . . . . . . . . .
The Hungarian hyperination of the 1920s
The Polish hyperination of the 1920s
The Russian hyperination of the 1920s
German wholesale prices (logarithmic scale) . . . . . . . . . .
The consumer price index and money supply Angola . . .
The consumer price index and money
supply Argentina . . . . . . . . . . . . . . . . . . . . . . .
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xv
108
110
111
113
114
115
126
128
128
129
132
134
135
143
146
153
178
180
184
188
192
194
197
204
207
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xvi
8.3
8.4
8.5
8.6
8.7
8.8
8.9
8.10
8.11
8.12
8.13
8.14
8.15
8.16
8.17
8.18
8.19
8.20
8.21
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
9.9
9.10
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The consumer price index and money supply Belarus

The consumer price index and money supply Bolivia
The consumer price index and money supply Brazil .
The consumer price index and money supply Congo .
The consumer price index and money supply Croatia
The consumer price index and money supply Georgia
The consumer price index and money supply Israel .
The consumer price index and money supply Mexico
supply Nicaragua . . . . . . . . . . . . . . . . . . . .
The consumer price index and money supply Peru . .
The consumer price index and money supply Poland
supply Romania . . . . . . . . . . . . . . . . . . . . .
The consumer price index and money supply Russia .
The consumer price index and money supply Turkey
supply Ukraine . . . . . . . . . . . . . . . . . . . . .
supply Zimbabwe . . . . . . . . . . . . . . . . . . . .
The overall picture in terms of growth rates . . . . . . .
The overall picture in terms of correlations . . . . . . .
Number of days for prices to double in the worst
hyperinations . . . . . . . . . . . . . . . . . . . . . . .
Fiscal balance as a percentage of GDP . . . . . . . . . .
Actual and projected scal balances as a percentage
of GDP . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cyclically-adjusted and underlying scal balances
as a percentage of GDP . . . . . . . . . . . . . . . . . .
Gross public debt as a percentage of GDP (2012) . . . .
Actual and projected gross public debt as a percentage
of GDP . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tax revenue as a percentage of GDP . . . . . . . . . . .
Net operating balance as a percentage of spending . . .
Monetary indicators (indices) . . . . . . . . . . . . . . .
The price of gold ($/ounce) . . . . . . . . . . . . . . . .
Average annual rise in gold price in currency terms
(20032012) . . . . . . . . . . . . . . . . . . . . . . . . .
.
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.
209
211
215
218
220
223
226
229
. . . 231
. . . 234
. . . 236
. . . 238
. . . 240
. . . 242
. . . 245
. . . 247
. . . 250
. . . 251
. . . 253
. . . 258
. . . 259
. . . 260
. . . 261
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
262
263
263
264
267
. . . 268
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List of Figures
9.11
9.12
10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8
10.9
10.10
10.11
10.12
10.13
11.1
Total foreign ownership of the U.S. treasuries ($ billion) .

The U.S. scal balance and trade balance . . . . . . . . .
The U.S. government revenue, spending and scal balance
($ million) . . . . . . . . . . . . . . . . . . . . . . . . . . .
The U.S. government revenue, spending and scal balance
(% of GDP) . . . . . . . . . . . . . . . . . . . . . . . . . .
The U.S. scal balance as a percentage of spending . . . .
Interest payments with forecasts until 2017 . . . . . . . .
Military spending: An international comparison . . . . . .
The U.S. military spending since 1940 . . . . . . . . . . .
The U.S. gross public debt with forecasts until 2017 . . .
The U.S. public debt holdings ($ million) . . . . . . . . .
The composition of foreign holdings of the U.S.
treasury securities . . . . . . . . . . . . . . . . . . . . . .
The U.S. personal saving rate (%) . . . . . . . . . . . . .
The U.S. monetary aggregates ($ billion) . . . . . . . . . .
The U.S. public debt held by the Fed . . . . . . . . . . . .
Timing of hyperination in the U.S.: The credit
card approach . . . . . . . . . . . . . . . . . . . . . . . . .
The macroeconomic highway network . . . . . . . . . . .
xvii
. . 276
. . 277
. . 282
.
.
.
.
.
.
.
.
.
.
.
.
.
.
283
284
285
287
288
295
296
.
.
.
.
.
.
.
.
297
298
300
301
. . 310
. . 314
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LIST OF TABLES
1.1
1.2
1.3
3.1
3.2
6.1
6.2
7.1
8.1
9.1
10.1
10.2
Year-on-year ination rate in the U.S. (19142012) . . . .

Year-on-year ination rate in Sweden (18302011) . . . .
Year-on-year ination rates in country groups and Japan
(19702011) . . . . . . . . . . . . . . . . . . . . . . . . . .
Growth factors of P , M , Y and V (19902011) . . . . . .
Correlation of growth rates . . . . . . . . . . . . . . . . .
Average ination and growth rates in hyperinationary
countries . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The empirical evidence on hyperination . . . . . . . . . .
A history of monetary debasement . . . . . . . . . . . . .
Growth factors of prices, the money supply, output
and velocity . . . . . . . . . . . . . . . . . . . . . . . . . .
Annualized monthly growth rates
of monetary aggregates . . . . . . . . . . . . . . . . . . . .
Annualized monthly growth rates of the U.S. monetary
aggregates (%) . . . . . . . . . . . . . . . . . . . . . . . .
Factors recognized in previous studies of hyperination . .
xix
. .
. .
19
21
. .
. .
. .
23
70
71
. . 126
. . 147
. . 167
. . 252
. . 265
. . 301
. . 307
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LIST OF ABBREVIATIONS
AUD
BRIC
CAD
CBO
C-CPI-U
CDO
CDS
CHF
CNY
COLA
CPI
CPI-U
CPI-U-RS
CPI-U-X1
ECB
EFT
EUR
FAO
FIFO
GAAP
GBP
GCC
GDP
GNP
HICP
IMF
INR
ITA
Australian dollar
BrazilRussiaIndiaChina
Canadian dollar
Congressional Budget Oce
Chained consumer price index for urban consumers
Collateralized debt obligation
Credit default swap
Swiss franc
Chinese yuan
Cost-of-living adjustment
Consumer price index
Consumer price index for urban consumers
Consumer price index for urban consumers-research series
Consumer price index with a rental equivalence approach
to homeowners
European Central Bank
Exchange-traded fund
Euro
Food and Agriculture Organization
First in rst out
Generally accepted accounting principles
British pound
Gulf Co-operation Council
Gross domestic product
Gross national product
Harmonized index of consumer prices
International Monetary Fund
Indian rupee
International Tin Agreement
xxi
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xxii
JPY
LIFO
NIA
NIFO
NPV
NRL
OECD
OPEC
PIMCO
PPI
PPP
QE
RBZ
SDR
TB
TIPS
UBS
UCLA
UIP
UNCTAD
USD
VAR
VAT
WPI
9in x 6in
Japanese yen
Last in rst out
National Ination Association
Next in rst out
Net present value
National Rie Association
Organisation for Economic Co-operation and Development
Organization of Petroleum Exporting Countries
Pacic Investment Management Company
Producer price index
Purchasing power parity
Quantitative easing
Reserve Bank of Zimbabwe
Special drawing rights
Treasury bill
Ination protected securities
Union Bank of Switzerland
University of California at Los Angeles
Uncovered interest parity
United Nations Conference on Trade and Development
U.S. dollar
Vector autoregression
Value-added tax
Wholesale price index
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PREFACE
In the aftermath of the global nancial crisis, the European crisis and
the recessions associated with these crises, one tends to think that the
risk of deation is greater than the risk of ination as things stand at
the end of 2012. This is a valid argument insofar as demand-pull factors
and cost-push factors are associated with economic booms, when there
is unutilized capacity in the economy. However, hyperination tends to
be associated with economic depression hence, it cannot be ruled out
even at the current levels of unemployment and spare capacity. There are
indeed more reasons to believe that hyperination, rather than deation,
is forthcoming, particularly in the U.S. where quantitative easing has been
pursued vigorously and intensied signicantly in December 2012.
Hyperination is basically a scal phenomenon resulting from scal
recklessness and the tendency to make up for this recklessness by monetizing
the decit that is, by printing money to nance the decit. This is what
quantitative easing is all about, although some economists argue that it is
benign because it does not involve direct buying of government bonds by
the central bank from the Treasury. While most major countries have acute
scal problems and have resorted to quantitative easing, the U.S. is in a
more vulnerable position for at least two reasons. The rst is that the extent
of quantitative easing in the U.S. is far greater than in other countries, as
indicated by the available statistics on monetary aggregates. The second
is that there are indications that the U.S. dollar is gradually losing its
international status, which will force more and more money printing as
the U.S. Treasury nds it increasingly dicult to borrow from abroad. It is
actually a vicious circle whereby money printing leads to a loss of condence
in the dollar and the loss of condence leads to more printing.
In this book, it is demonstrated that theory, historical experience and
economic indicators point to the likelihood that the U.S. is sliding into
hyperination. It seems that the U.S. government and lawmakers are not
xxiii
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9in x 6in
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able or willing to sort out their scal mess for ideological reasons. The
negotiations that took place between the Obama administration and the
Republicans who control the House of Representatives, in the run-up to
the deadline for the scal cli of January 2013, were more like a circus
than a serious attempt to ll the scal gap. Agreement or no agreement
on the scal cli, the U.S. is heading towards nancial meltdown.
Since this is a topic of general interest, I started by writing the book for
the general reader by attempting to avoid technical jargon and equations.
It worked at the beginning but then I thought that it was not possible. To
understand ination and hyperination one has to have some understanding
of the quantity theory of money and the money multiplier model. The
latter is important for understanding why quantitative easing has not
been inationary so far. Furthermore, any discussion of hyperination is
inadequate unless the role of inationary expectations is taken care of.
This task proved rather dicult without the use of equations. At the end,
I decided to go for a compromise whereby I write the text in as easy language
as possible, explaining rst principles for the general reader, while putting
in some equations that can only be understood by a trained economist. In
a sense, therefore, the book is written for both the general reader, who can
ignore equations, and the trained economist who can ignore rst principles.
Following Chapter 1 which is an introduction of the concepts of
ination, deation and others Chapter 2 deals with the measurement of
ination. Chapters 3 and 4 are about the causes of ination Chapter 3
explains the monetary theory of ination whereas Chapter 4 is about other
theories of ination and some extensions. The consequences and costs of
ination are discussed in Chapter 5, before we move on to elaborate on
the concept of hyperination in Chapter 6. The history of hyperination
is the subject matter of Chapters 7 and 8, dealing respectively with the
hyperinationary episodes that took place before and after the 1970s. The
core of this book is Chapters 9 and 10, in which arguments are presented
for why hyperination will hit America. Some concluding remarks are
presented in Chapter 11 to reinforce the arguments found in Chapters 9
and 10 as well as summarizing and evaluating the arguments involved in
the ice or re debate.
Writing this book would not have been possible without the help and
encouragement I received from family, friends and colleagues. My utmost
gratitude must go to my wife and children who had to bear the opportunity
cost of writing this book. My wife, Afaf, was also the person drawing the
diagrams shown in this book, particularly the complex diagram of the
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Preface
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xxv
highway network presented in Chapter 11. I am grateful to Kelly Burns

who provided excellent research assistance, particularly the extraction and
manipulation of data.
I would also like to thank my colleagues and friends at RMIT,
particularly Tony Naughton, Larry Li, George Tawadros, Vikash Ramiah,
Bruce Cowling, Michael Schwartz, Marie-Anne Cam and Mark Stewart.
I should not forget the people I socialize with, including John Vaz, Steen
Joeris, Pashaar Halteh, Mike Dempsey, John Watson, Liam Lenten and
Brien McDonald. In preparing the manuscript, I beneted from an exchange
of ideas with members of the Table 14 Discussion Group, and for this
reason I would like to thank Bob Parsons, Greg OBrien, Greg Bailey,
Bill Breen, Rodney Adams, Paul Rule, Peter Murphy, Bob Brownlee and
Tony Paligano. My thanks also go to friends and former colleagues who
live far away but provide help via means of telecommunication, including
Kevin Dowd (to whom I owe an intellectual debt), Razzaque Bhatti, Nabeel
Al-Loughani, Bob Sedgwick, Sean Holly, Dave Chappell, Dan Hemmings
and Ian Baxter. Last, but not least, I would like to thank Ms Lum Pui Yee,
of World Scientic, who encouraged me write this book.
Naturally, I am the only one responsible for any errors and omissions
that may be found in this book. It is dedicated to my beloved children,
Nisreen and Danny.
Imad A. Moosa
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About the Author
Imad Moosa is currently a professor of Finance

at RMIT, Melbourne, Australia. He holds a BA
in economics, MA in the economics of nancial
intermediaries and a PhD in nancial economics
from the University of Sheeld (UK). He has
received formal training in model building,
exchange rate forecasting and risk management
at the Claremont Economics Institute (USA),
Wharton Econometrics (USA), and the International Center for Monetary and Banking Studies (Switzerland). Until 1991, Imad had worked
as a nancial analyst, nancial journalist and
a professional economist/investment banker. He was also an economist
at the Financial Institutions Division of the Bureau of Statistics at the
International Monetary Fund (Washington, DC). Imad has served in a
number of advisory positions, including his role as an advisor to the US
Treasury. He has published 15 books and over 180 papers in scholarly
journals.
xxvii
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Chapter 1
INFLATION, DEFLATION,
DISINFLATION AND ALL THAT
1.1. What is Inflation?
It is often said that ination is inevitable, like death and taxes. This is
probably because, as Sir Frederick Keith-Ross mentions, ination is like
sin; every government denounces it and every government practices it
(Makochekanwa, 2007). Historical stories about inationary episodes proves
that it is a phenomenon that has existed ever since money was used as a
medium of exchange. Ination is a topic that receives signicant attention
in the media, with regular features, reports and interviews. It is an issue
that is often debated by politicians in Parliament and election campaigns,
let alone economists and business executives.
The reason why ination is treated with respect is that it aects
everybody in various ways. It is an important consideration during mortgage payments and in determining the cost of essential goods and services
required for survival and those that make our lives more pleasant. We
anticipate news about whether the central bank will decide to cut or raise
interest rates, with ination typically being the prime consideration (at
least for some central banks). Most of us are fascinated by documentaries
on the great ination in Germany during the 1920s and how it relates to
the rise of Adolf Hitler. Ination has broad implications for the state of the
economy and whether or not we can keep our jobs or nd new ones. While
it is regarded as one of the four macroeconomic variables closely monitored
by policymakers (the others being growth, employment and the balance
of payments), it is often the prime indicator that triggers drastic policy
actions. Ination targeting is a more common concept than output
targeting, employment targeting or balance of payments targeting.
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Ination is dened in dierent ways, but, in general, the phenomenon is

about rising prices of goods and services (hence, the cost of living). As the
prices of goods and services rise, the value (or purchasing power) of money
falls in the sense that a monetary unit (say a dollar) buys less and less
goods and services resulting in a diminishing basket. This is why ination
is viewed as a persistent erosion of the value of the money. While it cost
60 pounds to purchase a rst class ticket on the Titanic in 1912, there is no
way these days that this amount can buy a ticket to cross the Atlantic (let
alone the Pacic) in a rst class cabin on an ocean liner (perhaps 10,000
pounds can do the job). It is for this reason that we give our children more
pocket money than what our parents gave us. People are typically nostalgic
to the good old days when things were very cheap the culprit being
ination.
Some points must be borne in mind, though. Ination does not mean
that all prices rise simultaneously some actually fall. People complain
about the rising cost of healthcare and higher education in the past 20 years
or so, but during this period the prices of electronic calculators, personal
computers and international phone calls declined drastically. In more recent
years, the prices of laptops, plasma TVs and DVD players have gone down.
Furthermore, those prices that rise do not rise at the same rate. When
we talk about rising prices, we do not mean the prices of particular goods
and services, but rather we talk about the average price of the goods and
services that we buy the so-called general price level. This is an index
that shows how the price of a (hypothetical) basket of goods and services
(called the market basket) changes over time. Another point to bear in
mind is that not all price rises are inationary. For example, prices may
rise because of the imposition of new taxes or rising tax rates. Yet another
observation is that ination refers to a sustained or long-term rise in the
general price level, not a one-o increase resulting, say, from a temporary
bad harvest or a one-o hike in the price of crude oil. Ination is, therefore,
a continuous rather than discrete process.1 Some economists, however, do
not share this view, describing one-o price hikes as inationary bursts.2
1 For
example, Bernholz (2003) denes ination as an increase of the price level

extending over a longer period, usually several years, as measured by one or several
price indices.
2 The proponents of the monetary view of ination typically advocate the proposition
that ination is a continuous process because they attribute ination totally to monetary
growth, arguing that the money supply (unlike wages and commodity prices) can increase
practically without a limit.
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Ination is a dynamic process it is about rising prices over time, not

about prices being high at a particular point in time. Prices could be high
but the ination rate could be zero; or, prices could be low but ination
could run at a high rate. Naturally, ination leads over time to a high level
of prices.
As we are going to see, some economists believe that ination is purely a
monetary problem resulting solely from monetary growth, which is nothing
but an increase in the money supply over time. While not all economists
subscribe to this view, most economists believe that (at least in the long
run) ination, whatever its cause may be, must be validated by an increase
in the money supply (otherwise it will be suppressed ination). The extreme
monetary view is that there is a proportional relation between growth in
the money supply (monetary growth) and ination. The idea is actually
intuitive. An increase in the money supply makes money less valuable in
terms of goods and services whose prices rise. Those who believe in this
process tend to dene ination as a sustained increase in the money supply
causing a sustained decline in its value. If a proportional relation between
monetary growth and the corresponding rise in the price level is discarded,
distinction may be made between monetary ination and price ination.
Those who believe that ination may be caused (at least in part) by rising
wages over time refer to the link between price ination and wage ination.
Because of the connection between money and credit, the term credit
ination also arises. The money supply increases when the central bank
issues currency and commercial banks use the currency to grant credit.
Credit creation leads to money creation because a bank loan is not given in
cash but rather it is extended by crediting the borrowers account with the
amount of the loan. This shows as an increase in the money supply, in this
case through the increase in the value of bank deposits (which constitute
the major part of the money supply in a modern economy). Thus, monetary
ination materializes out of credit ination.3 Out of this term appears
another term that of debt deation. When credit ination comes to an
end, because banks are no longer willing to lend and/or borrowers do not
wish to borrow, there will be a process of deleveraging on the repayment
of debt without new borrowing. This will have the opposite eect to that
3 While
credit appears on the assets side of the balance sheet of the granting bank, the
corresponding deposit appears on the liabilities side. This is how the balance sheet of a
bank grows under a fractional reserve banking system.
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of credit ination as the money supply shrinks, the economy would go

into deation.
1.2. Inflation and Related Concepts: A Graphical

Illustration
The ination rate determines the severity of ination, its eects on the
economy and the ease or otherwise (and cost) of stabilizing it. What matters
are two characteristics of the ination rate: how high and how volatile it is.
We will illustrate some of the patterns of ination with the help of Figs. 1.1
to 1.10, which display hypothetical (simulated) data on the price level, i.e.,
the value of money and the ination rate (calculated as the period-to-period
percentage change in the price level). The patterns actually have names.
The explanations of the patterns are as follows:
Price stability is shown in Fig. 1.1, where the ination rate is very low,
albeit not zero. The price level remains stable while the value of money
is maintained; therefore, both move within a narrow range. While there
is no agreement on the range of values assumed by the ination rate that
denes price stability, there seems to be an agreement that an ination
rate of zero is neither achievable nor desirable.
Moderate or creeping (or mild) ination is exhibited in Fig. 1.2, where
the ination rate is between zero and 3%. The price level rises steadily
while the value of money falls at the same rate. Some central banks adopt
a policy to keep the ination rate within a narrow range such as 23%
this is called ination targeting.
In Fig. 1.3, we see a case of accelerating (or galloping) ination where
the ination rises over time. The price level goes up at an increasing rate
while the value of money declines at the same rate.
In Fig. 1.4, we observe volatile ination where the ination rate is positive
but it rises and falls from one point in time to another. The general price
level rises and the value of money declines but not at steady rates.
Hyperination, the subject of this book, is shown in Fig. 1.5 as indicated
by the big numbers assumed by the price level and exhibited on the
vertical axis in the top graph. Hyperination is a case of very rapid
increase in the price level, spiraling beyond control.
In Fig. 1.6, the price level rises at a decreasing rate that is, a declining
ination rate. This is called disination, a state of aairs where the
ination rate is positive but falling.
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General Price Level

115
110
105
100
95
90
0
10
15
20
25
30
35
40
45
50
30
35
40
45
50
30
35
40
45
50
Value of Money
115
110
105
100
95
90
0
10
15
20
25
Inflation Rate
0
0
10
15
20
25
-1
-2
-3
Fig. 1.1.
Price stability.
When the price level falls over time, or when the ination rate is
negative, we have a case of deation, as shown in Fig. 1.7. Deation
is often confused with disination but they are certainly dierent. Under
disination, the ination rate is positive while the price level rises. Under
deation, the ination rate is negative while the price level falls.
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General Price Level

220
200
180
160
140
120
100
80
0
10
15
20
25
30
35
40
45
50
30
35
40
45
50
30
35
40
45
50
Value of Money
110
100
90
80
70
60
50
40
0
10
15
20
25
Inflation Rate
10
0
0
10
15
Fig. 1.2.
20
25
Moderate (creeping) ination.
In Fig. 1.8, we see two big discrete jumps in the price level correspondingly two big discrete falls in the value of money. The ination
rate is otherwise close to zero and the price level is stable. Although the
price level has almost doubled while money has lost almost half of its
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General Price Level

900
800
700
600
500
400
300
200
100
0
0
10
15
20
25
30
35
40
45
50
30
35
40
45
50
30
35
40
45
50
Value of Money
100
80
60
40
20
0
0
10
15
20
25
Inflation Rate
10
0
0
10
15
Fig. 1.3.
20
25
Accelerating ination.
value, some economists do not describe these price jumps as inationary.

We will call them inationary bursts.
Figure 1.9 represents a case of reation. This phenomenon is a consequence of a policy measure aimed at raising the general price level
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General Price Level

25000
20000
15000
10000
5000
0
0
10
15
20
25
30
35
40
45
50
30
35
40
45
50
30
35
40
45
50
Value of Money
100
80
60
40
20
0
0
10
15
20
25
Inflation Rate
25
20
15
10
0
0
10
15
20
Fig. 1.4.
25
Volatile ination.
(through expansionary policy) to counteract deationary pressures. In

December 2012, the newly elected Japanese prime minister promised
to reate the economy, having been in a deationary spiral for many
years.
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General Price Level

150000000
120000000
90000000
60000000
30000000
0
0
10
15
20
25
30
35
40
45
50
Value of Money
100
80
60
40
20
0
0
10
15
20
25
30
35
40
45
50
30
35
40
45
50
Inflation Rate
100
80
60
40
20
0
0
10
15
20
Fig. 1.5.
25
Hyperination.
In Fig. 1.10, the unemployment rate is added to illustrate the

phenomenon of stagation, which is a combination of ination, slow
economic growth and high unemployment (the last two go together).
This phenomenon became evident in the 1970s, when ination and
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10
General Price Level

350
300
250
200
150
100
0
10
15
20
25
30
35
40
45
50
30
35
40
45
50
30
35
40
45
50
Value of Money
100
80
60
40
20
0
10
15
20
25
Inflation Rate
25
20
15
10
0
0
10
15
20
Fig. 1.6.
25
Disination.
unemployment occurred simultaneously. Traditionally, it was believed

that ination could only happen when the economy was booming and
unemployment was low (in other words, when the economy was producing
at higher level than full capacity). This shows the existence of the
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11
General Price Level

100
80
60
40
20
0
10
15
20
25
30
35
40
45
50
30
35
40
45
50
Value of Money
400
350
300
250
200
150
100
0
10
15
20
25
Inflation Rate
0
-2
-4
-6
-8
0
10
15
20
Fig. 1.7.
25
30
35
40
45
50
Deation.
belief that high unemployment was associated with deation rather than
ination.
Irrespective of the patterns observed in Figs. 1.11.10, a number of
stylized facts can be put forward to describe movements of the price level
August 10, 2013
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12
General Price Level

200
180
160
140
120
100
80
0
10
15
20
25
30
35
40
45
50
30
35
40
45
50
30
35
40
45
50
Value of Money
120
100
80
60
40
0
10
15
20
25
Inflation Rate
40
30
20
10
0
0
Fig. 1.8.
10
15
20
25
Big discrete jumps in the general price level (inationary bursts).
and the corresponding ination rate. The general price level rises as long
as the ination rate is positive. If it is stable, the general price level rises
steadily; otherwise it rises at varying paces. How the ination rate behaves
has implications for the consequences of ination. It is important to realize
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General Price Level

120
110
100
90
80
70
60
0
10
15
20
25
30
35
40
45
50
30
35
40
45
50
30
35
40
45
50
Value of Money
160
150
140
130
120
110
100
90
80
0
10
15
20
25
Inflation Rate
5
4
3
2
1
0
-1
-2
-3
0
10
15
20
Fig. 1.9.
25
Reation.
that the ination rate may be high and rising, high and stable, high and
falling, low and rising, low and falling and low and stable. It may also
be negative or positive, which makes the dierence between ination and
deation.
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14
General Price Level

160
150
140
130
120
110
100
90
0
10
15
20
25
30
35
40
45
50
35
40
45
50
35
40
45
50
Unemployment Rate (Stagflation)

6
3
0
10
15
20
25
30
Unemployment Rate (Normal Conditions)

5
2
0
10
15
20
Fig. 1.10.
25
30
Stagation.
1.3. The Causes of Inflation

There is not a single, agreed-upon answer as to what causes ination
but, as Keynes (1920) put it, even the weakest government can enforce
August 10, 2013
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15
ination when it can enforce nothing else. There are, however, a number
of theories suggesting various factors that play some role in the inationary
process. Like almost everything in economics, the empirical testing of these
theories has not produced a consensus view on the causes of ination and
how the inationary process evolves. Perhaps this is a normal state of
aairs because inationary episodes dier across time and space, which
means that no single explanation is always the right explanation. Studies
of ination suggest a variety of explanatory factors such as policy mistakes
(Taylor, 1997; Sargent, 1999), rising oil and food prices (Blinder, 1982),
political factors (Nordhaus, 1975; Rogo and Sibert, 1988), scal policy
(Calvo, 1988; Friedman, 1994), the exchange rate regime (Mohanty and
Klau, 2001), and the international transmission of ination (Darby, 1983;
Turovsky et al., 1988).4 In a comprehensive empirical study, Vansteenkiste
(2009) identies as the origin of inationary episodes a combination of
policy mistakes, global shocks and structural factors, adding that too loose
monetary policy and/or a xed exchange rate regime signicantly increase
the probability that a country will enter into a prolonged period of rising
ination.
Economists generally agree that high ination rates are caused by an
excessive growth of the money supply excessive relative to the growth
rate of the economy (measured by real output). Views on what causes low to
moderate inations are more divergent: it may be attributed to uctuations
in the demand for goods and services, changes on the supply side and/or
(moderate) growth in the money supply. Ination, therefore, may come
from the supply side or the demand side of the economy. However, the
consensus view is that continuous and sustained ination arises when the
money supply grows faster than output. For some economists, ination (no
matter what causes it), must be accompanied by a rise in the money supply.
Thus, we have the monetary theory of ination, demand-pull theories,
and cost-push theories. Goldstone (1991) explains ination in the early
modern world in terms of demographic factors such as the resumption of
population growth following a halt brought about by disease, which caused
rising demand for essentials such as food, housing and energy. While Fischer
(1996) acknowledges the role of demographic factors in initiating ination,
he attributes long-term ination to the institutionalization of inationary
4 The
nding of a variety of factors causing ination means that not all economists think
that only monetary factors matter. Recognizing the role of oil and food prices means
that some economists believe that discrete price jumps are indeed inationary.
August 10, 2013
16
8:54
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psychology by indulging in practices such as trimming coins and hoarding

goods.
Historically, ination has been viewed as a monetary phenomenon as
infusions of gold and silver into an economy also led to ination. From
the second half of the 15th century to the rst half of the 17th century,
Western Europe experienced a major inationary cycle referred to as the
price revolution, as prices rose by a factor of six over 150 years. This was
largely caused by the sudden inux of gold and silver from the New World.
Some economic historians dispute the view that the inux of gold and silver
was the only reason for ination, suggesting other explanatory factors such
as cost-push factors, rising prices imposed by new monopolies, wars and
population growth (Bernholz, 2003). Demographic factors contributed to
upward pressure on prices, as population growth resumed following the
depopulation caused by the Black Death pandemic.
By the 19th century, economists identied three separate factors that
caused changes in the prices of goods: a change in the value or production
costs of the good, a change in the price of money (which was typically
caused by uctuations in the commodity price of the metallic content of
the currency), and currency depreciation resulting from increasing supply
relative to the quantity of the redeemable metal backing the currency.
Following the emergence of private paper money during the American Civil
War, the term ination started to appear as a direct reference to the
currency depreciation that occurred as the quantity of redeemable paper
money outstripped the quantity of metal available for redemption. At that
time, the term ination referred to the depreciation of the currency, not
to a rise in the price of goods.
The observation that the over-supply of paper money led to declining
value of money was noted by classical economists such as David Hume
and David Ricardo. They examined and debated what eect currency
depreciation had on the prices of goods, giving rise to the concepts
of monetary ination and price ination. Subsequently, the term
ination on its own prevailed. According to Bernholz (2003), the use
of the word inflation for an expansion of the money supply or an increase
in prices, quite in contrast to the rst occurrence of ination as historical
events, is of rather recent origin. Specically, he suggests that the term
was rst used in 1838 in the context of an ination of the currency.
From the 18th century onwards, a tendency emerged for countries to
adopt at money (paper money that is not backed by any commodity
reserve asset), which made much larger variations in the money supply
August 10, 2013
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17
possible. As a result, huge increases in the supply of paper money took

place in a number of countries, producing hyperination. As things stand
early in the second decade of the 21st century, there is talk about the reemergence of hyperination as a result of the monetary expansion pursued
by central banks in the U.S. and elsewhere through quantitative easing.
This is what this book is about.
1.4. Experience with Inflation
To demonstrate the international experience with ination we examine
ination in the U.S. going back to 1914 and in Sweden by going back to
1830. We also examine ination gures over the period 19702011 for the
world as a whole, developed countries, emerging countries and Japan.5 We
also look at high ination/hyperination episodes in four Latin American
countries in the 1980s and 1990s. A full examination of the most notorious
cases of hyperination is reserved for later chapters. The objective behind
the use of this collection of cases is to demonstrate that the ination
patterns we observed in the hypothetical data displayed in Figs. 1.11.10
do actually appear in the real world they are not just in the imagination
of economists.
We start with an examination of the general price level (measured by
the consumer price index, CPI) in the U.S. over the period 19142012,
which is depicted in Fig. 1.11. As in the graphs showing the hypothetical
numbers, Fig. 1.11 displays movement of the general price level over time
and the corresponding value of money and ination rate. As Table 1.1
shows, ination was high and volatile during the period 19141921, high
and unstable in 19671982, moderate and stable in 19831996 and low and
extremely stable in 19571966 and 19972012. The highest ination rate of
20.43% was registered in 1919 in the aftermath of World War I, while the
lowest rate was recorded soon after (in 1922) when the economy experienced
deation as the price level fell by 10.82% (an ination rate of 10.82%).
Since 1914, the U.S. economy experienced 12 years of deation.
Figure 1.12 is a time plot of the ination data in Sweden going back to
1830. As reported in Table 1.2, the country experienced severe deation
during the period 19201923 following the high and volatile ination
experienced during World War I. Two other periods of deation can be
observed: 18571901 and 19241933. Ination was low in 18301942 and
5 Japan
is an interesting case because of the deation of recent years.
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General Price Level

2500
2000
1500
1000
500
0
1914
1924
1934
1944
1954
1964
1974
1984
1994
2004
2013
1974
1984
1994
2004
2013
1974
1984
1994
2004
2013
Value of Money
100
80
60
40
20
0
1914
1924
1934
1944
1954
1964
Inflation Rate
25
20
15
10
5
0
-5
-10
-15
1914
1924
1934
1944
1954
Fig. 1.11.
1964
Ination in the U.S.
19021913. The highest average year-on-year ination rate was registered

during the period 19701982. The highest rate was 34.96% in 1915 while
the lowest was 18.45% in 1921. The country experienced year-on-year
deation 48 times and zero ination three times.
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19
Table 1.1. Year-on-year ination rate in the U.S.

(19142012).
Period
Mean
Standard
Deviation
Range
19141921
19221933
19341956
19571966
19671982
19831996
19972012
10.19
3.10
3.25
1.72
7.05
3.57
2.44
8.18
4.91
4.66
0.74
3.43
1.20
1.01
19.43
14.29
20.90
2.31
10.25
5.01
3.98
Figure 1.13 shows ination in the whole world, in developed countries,

in emerging countries and in Japan over the period 19702011. The ination
rates for country groups are calculated (by the IMF) as weighted averages of
the ination rates in individual countries where the weights are represented
by the size of the economy measured by GDP. A trend line is super-imposed
to indicate the possible direction of ination. If we are to believe in technical
analysis as applied to ination, this means that ination is expected to
rise in developed countries. While this may be plausible as a result of
quantitative easing, we do not give much credence to evidence based
on tted trend lines. Notice, however, how the location of the peak diers
between developed countries, where the highest ination rate occurred in
the 1970s and in emerging countries where ination peaked in the early
1990s.
Table 1.3 reports the mean, standard deviation and range of the yearon-year ination rates. We can see that ination has been much higher
in emerging economies where a rate of over 100% was registered in 1990.
The dierence is likely to be the tendency to monetize the decit (that
is, printing money to nance the decit) in emerging countries. Although
the average ination rate in Japan has been higher than that in developed
countries as a whole, Japan has been experiencing deation not witnessed
anywhere else in the developed world. In 1974, Japan experienced an
ination rate of over 23% that attributed to the rise in oil prices.
So far we have not shown an example of high ination or hyperination,
but here it is. In Fig. 1.14, we see the year-on-year ination rates during
the period 19831993 in Argentina, Bolivia, Brazil and Mexico. In 1989, the
ination rate in Argentina was 4,154%, but it fell subsequently. By 1992, it
was 22%. In Bolivia the ination rate hit a high of 8,175% but it declined
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General Price Level

8000
6000
4000
2000
0
1830
1850
1870
1890
1910
1930
1950
1970
1990
2010
1950
1970
1990
2010
1950
1970
1990
2010
Value of Money
100
80
60
40
20
0
1830
1850
1870
1890
1910
1930
Inflation Rate
40
30
20
10
0
-10
-20
1830
1850
1870
1890
Fig. 1.12.
1910
1930
Ination in Sweden.
very sharply in subsequent years. In 1986, the ination rate fell from that
high to only 14.6%. In Brazil, the ination rate hit a high of 1759% in
1989 but, unlike Argentina and Bolivia, the ination rate persisted at high
levels. And in Mexico, the ination rate hit a high of 159% in 1987, but that
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21
Table 1.2. Year-on-year ination rate in

Sweden (18302011).
Period
Mean
Standard
Deviation
Range
18301842
18431856
18571901
19021913
19141919
19201923
19241933
19341952
19531969
19701982
19832011
0.94
2.01
0.36
0.87
18.44
9.68
1.39
4.25
3.31
9.35
3.33
2.39
4.75
4.59
2.60
11.76
9.63
1.87
5.17
1.72
6.13
3.09
7.38
17.00
18.43
15.68
33.64
20.32
5.29
17.35
5.96
27.37
10.75
was followed by a period of disination.6 This disparity in the behavior of

ination in the four countries reects dierences in policy. These episodes
show how easy it is to put an end to hyperination, but what the picture
does not show is how easy it is to start hyperination.7 Although cases of
hyperination may seem like unusual events, this is actually not the case.
While there was no hyperination in the world between 1950 and 1983,
there were seven in the second half of the 1980s. The 1980s also witnessed
20 episodes of hyperination (dened as annual rates exceeding 100).
If it is easy to start hyperination, why is it that we are witnessing
subdued ination worldwide despite the use of quantitative easing in
the aftermath of the global nancial crisis? The latest gures (September/October 2012) for the annual CPI rates shown in Fig. 1.15 are
exceptionally low by historical standards.8 They show that Switzerland
and Japan are in deation. The highest rates shown in Fig. 1.15 are for
Venezuela, India and Turkey. China has an ination rate of 1.9%, despite
the widespread talk about mounting inationary pressures in the Chinese
economy.
6 These
gures are taken from Rogers and Wang (1993). Some of these gures may not
be consistent with the gures reported in Chapter 8 because of dierent sources and
dierent measures of the ination rate.
7 Putting an end to hyperination is not easy in the strict meaning of the word. While
appropriate policy action may be easy, the underlying costs, in terms of human economic
suering, are invariably enormous.
8 These gures were obtained from the 3 November issue of The Economist, p. 88.
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22
World
Developed Countries
16
32
28
12
24
20
8
16
12
8
4
0
1970
1980
1990
2000
2010
0
1970
1980
1990
2000
2010
2000
2010
Japan
Emerging Countries
120
28
24
100
20
80
16
60
12
40
8
4
20
0
0
-20
1970
-4
1980
1990
2000
Fig. 1.13.
2010
-8
1970
1980
1990
Ination around the world.
Low ination rates worldwide may be explained in terms of the

slowdown in economic activity following the global nancial crisis. In 2009,
immediately after the crisis, the U.S. economy was in deation. Europe
is experiencing low ination because of the ongoing credit crisis, so there
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23
Table 1.3. Year-on-year ination rates in country

groups and Japan (19702011).
Country/Group
Mean
Standard
Deviation
Range
World
Developed Countries
Emerging Countries
Japan
11.01
4.86
26.55
2.97
6.80
3.52
23.65
4.67
28.06
14.53
100.44
14.53
is no wonder that the ination rate in Greece is only 0.9%. However, a

phenomenon that has been puzzling economists and general observers is
that of low ination in the U.S. and U.K. (2% and 2.2%, respectively), two
countries that have been implementing quantitative easing robustly.9 This
is a major issue that will be discussed in Chapter 9.
1.5. More Inflation-Related Concepts
We have so far come across a number of ination-related concepts such as
deation, disination and stagation. But there are more, and we start with
the concepts of open ination and repressed or suppressed ination
(also called disguised ination).
Open ination occurs when prices are allowed to move freely. When
price controls hold prices below their market equilibrium values, suppressed
ination prevails because prices are not allowed to move according to the
forces of supply and demand. The same outcome results from subsidies. The
imposition of price controls is often observed under hyperination or high
ination, giving rise to severe shortages and the emergence of vibrant black
markets. Moral deterioration is associated with these conditions because
people cannot buy as much as they would like at the control prices and
often it is only a lucky few with inside connections who get to buy at the
control prices. Those without connections and those who want more than
what they get at the control price must pay the higher black market price.
Such suppression, nevertheless, can only be temporary. Figure 1.16 shows
how the general price level moves under open ination and suppressed
ination using two levels of control prices. The ination rate is higher
under open ination because alternatively the control prices are used to
calculate price indices and the ination rate. Since the imposition of price
9 The
Bank of England has put an end to quantitative easing in May 2012.
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Argentina
Bolivia
9000
5000
8000
4000
7000
6000
3000
5000
4000
2000
3000
2000
1000
1000
0
0
1983
1985
1987
1989
1991
1993
1983
1985
Brazil
1987
1989
1991
1993
1991
1993
Mexico
2000
180
1600
140
1200
100
800
60
400
20
1983
1983
1985
1987
1989
Fig. 1.14.
1991
1993
1985
1987
1989
-20
Ination in high-ination countries.
controls leads to shortages, we also have the concepts of shortageation

and hypershortageation.
Another concept is that of asset price ination, which is an undue
increase in the prices of real or nancial assets, such as stocks and real
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Venezuela
India
Turkey
Russia
Hungary
South Africa
Brazil
Mexico
Singapore
Spain
U.K.
Germany
U.S.
China
Canada
Japan
Switzerland
-4
Fig. 1.15.
12
16
20
Most recent ination gures (September/October 2012).
900
800
700
600
500
400
300
200
100
0
0
10
15
Open Inflation
Fig. 1.16.
20
25
Suppressed Inflation (1)
30
35
40
45
Suppressed Inflation (2)
The price level under open and suppressed inations (simulated data).
50
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estate. Central bankers have traditionally ignored asset price ination while
concentrating on goods price ination. However, a view has emerged to the
eect that it would be better to aim at stabilizing a wider general price level
ination measure that includes some asset prices, instead of stabilizing CPI
or core ination only. The reason is that by raising interest rates when stock
prices or real estate prices rise, and reducing them when these asset prices
fall, central banks might be more successful in avoiding bubbles and crashes
in asset prices. Asset price ination produces articial wealth, encouraging
consumers and rms to borrow beyond their means. In the aftermath of the
global nancial crisis, it has become an acceptable view that price stability
is insucient to maintain overall economic stability.
There is also the concept of biation (also called mixation), which
is a state of the economy where the processes of ination and deation
occur simultaneously. Under biation, the prices of commodity/earningsbased assets rise while the prices of debt-based assets fall. Biation occurs
because a greater amount of money is allocated to the purchase of essential
items, away from buying non-essential items. It can also be seen in terms
of the prices of essential items (food, energy, etc.) and luxury items such as
top-end cars and other typically debt-based assets. Unlike stagation, there
is no reference in the denition of biation to the state of the economy. The
concept has emerged as a result of the debate the world economy as a whole
is facing ination or deation (the re or ice debate).
Nouriel Roubini has coined the term stag-deation, where a recession
is associated with deationary forces (Roubini, 2008). In 2008, Roubini
predicted that the U.S. economy was heading towards stag-deation for
four main reasons: (i) a slack in goods markets, (ii) a re-coupling of the rest
of the world with the U.S. recession, (iii) a slack in labor markets, and (iv) a
sharp fall in commodity prices. He concluded that the conditions prevailing
then would reduce inationary forces and lead to deationary forces in
the global economy. The main theme of this book is that hyperination is
more likely than deation.
1.6. Concluding Remarks

This chapter is about some preliminary clarications pertaining to the
concept of ination and many related concepts. Simulated data were used
to demonstrate a variety of patterns of behavior assumed by the general
price level and the implications for ination. It was also shown that the
theoretical patterns appearing in simulated data do appear in reality.
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In the following three chapters, we examine the measurement, causes

and consequences of ination. While terms such as CPI and ination
rate are used in this chapter, the denition of these terms will be presented
in Chapter 2. This will help us to discuss the causes and consequences of
ination in Chapters 35.
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Chapter 2
THE MEASUREMENT OF INFLATION
2.1. The Inflation Rate

The ination rate is a measure of the pace of ination, the speed at which
prices rise. It is the period-to-period percentage change in the general price
level measured as a price index. If the general price level rises between
two points in time, t 1 and t, from Pt1 to Pt , the ination rate, , is
calculated as

Pt Pt1
.
(2.1)
= 100
Pt1
An important point to bear in mind here is that the ination rate, unlike
the price level, is not observable at a point in time. It is a measure of what
happens between two points in time (last year and this year, for example).
In the jargon of economics, while the price level is an instantaneous (or a
stock) variable, the ination rate is a ow variable.
If the unit of time represented by t and t 1 is a year, then Eq. (2.1) is
an expression for the annual ination rate. Data on the general price level
(measured by some index) are typically reported on a quarterly and monthly
as well as annual basis. Confusion, therefore, could arise in determining how
to measure the annual ination rate from quarterly and monthly data on
the general price level. Consider quarterly data rst, and suppose that Pt1
is the general price level observed at the end of the fourth quarter of 2011
while Pt is the general price level at the end of the rst quarter of 2012. In
this case, Eq. (2.1) can be used to calculate the ination rate for the rst
quarter of 2012. It may be tempting in this case to annualize the rate by
multiplying the expression by 4, which gives

Pt Pt1
.
(2.2)
= 4 100
Pt1
29
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After all, this is what we do when we annualize interest rates. However,

Eq. (2.2) is not a true reection of the annual ination rate in the rst
quarter of 2012. The annual (as opposed to annualized) rate is the
percentage change in the price level between the rst quarter of 2011 and
the rst quarter of 2012 in general, the percentage change in the price
level relative to its value four quarters ago. In this sense, the annual ination
rate is calculated as

Pt Pt4
= 100
,
(2.3)
Pt4
where Pt4 is the price level at the end of the rst quarter of 2011. Likewise,
we can calculate the annual ination rate in January 2012 as the percentage
change in the general price level at the end of January 2012 relative to what
it was at the end of January 2011 (12 months previously). In this case, the
annual ination rate is calculated from monthly data as

Pt Pt12
= 100
.
(2.4)
Pt12
One advantage of measuring the annual ination rate from monthly and
quarterly data relative to the value of the price index in the corresponding
period of the previous year is that it produces a less volatile ination series
that represents the ination trend, which is what matters most for policy.
Calculating the annual ination rate by annualizing the corresponding
monthly or quarterly rates produces highly volatile ination series, which
reect seasonal variation in prices if the general price level is not seasonally
adjusted.
For the purpose of cross-country comparisons, we may nd it useful
to calculate the average annual ination rate from data on the price level
over a period of many years. If Pt and Ptn represent the general price
level observed in years t and t n, the average annual ination rate over a
period of n years is

1/n
Pt
1 .
(2.5)
= 100
Ptn
In Chapter 6, which is about hyperination, more formulas will be presented
on the measurement of the ination rate and related metrics that show the
speed of extreme ination. Figure 2.1 illustrates, for a given set of simulated
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31
Annualized Inflation Rate
Price Level
3000
50
2500
40
2000
30
1500
20
1000
10
500
0
0
10
20
30
40
50
60
10
20
30
40
50
60
Average Annual Inflation Rate
Annual Inflation Rate

50
50
40
40
30
30
20
20
10
10
0
0
10
20
30
Fig. 2.1.
40
50
60
10
20
30
40
50
60
Measures of the ination rate (simulated data).
price time series, the dierence in the behavior of the ination rate measured
as the annualized rate, annual rate and average annual compound rate.
As we can see, the annualized ination rate is much more volatile than
either the annual rate or the average annual compound rate.
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2.2. Inflation, Income Growth and Money Illusion

Another denition of ination is that it is a condition under which
nominal (or money) income rises faster than real income. Illustrating these
concepts can be made easier by switching from income to output, which
are equivalent under national income accounting as national income can
be calculated from an income and output perspective. Real output is the
physical quantity of output, while nominal or money output is the dollar
value of physical output. An increase in nominal output may result from a
rise in the physical quantity of output (real output) or a rise in the price of
output, which for the whole economy is the general price level. If we revert
back to the concept of income, then we can dene real income as nominal
income adjusted for changes in prices that is, adjusted for ination.
This is how the process works. Let Yt1 and Yt be nominal incomes
at points in time t 1 and t, respectively, while Pt1 and Pt are the
corresponding price levels. Real income is obtained by deating nominal
income by the corresponding price level. Hence, real income at t 1 and
t is Yt1 /Pt1 and Yt /Pt , respectively. Let the growth rates of nominal and
real incomes be gN and gR , respectively. Hence, we have
Yt
,
Yt1
(2.6)
Yt /Pt
Yt /Yt1
=
.
Yt1 /Pt1
Pt /Pt1
(2.7)
1 + gN =
1 + gR =
Under ination Pt > Pt1 , hence, gN > gR . Ination occurs when nominal
income grows faster than real income. In Fig. 2.2, we show simulated data
describing the time paths of nominal income and real income under ination
rates ranging between 1% and 5%. As we can see, the higher the ination
rate, the lower is the growth rate of real income. This is because from (2.7)
1 + gR =
(1 + gN )
,
(1 + )
(2.8)
where is the ination rate. By manipulating Eq. (2.8), we obtain

gN = gR +
(2.9)
because gR is approximately equal to zero under moderate ination. As

long as > 0, gN > gR , which is what is shown in Fig. 2.2.
Those who cannot distinguish between nominal and real incomes (or
nominal and real quantities in general) are said to exhibit money illusion.
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33
450
400
350
300
250
200
150
100
50
0
0
10
Nominal
Fig. 2.2.
15
Real (1%)
20
25
Real (2%)
30
Real (3%)
35
Real (4%)
40
45
50
Real (5%)
Nominal and real incomes at various ination rates (simulated data).
For example, when a person experiences a 6% rise in nominal income as a

result of a salary increase, she may be under the impression that she has
become better o as a result of the pay rise. However, if ination is also
running at 6% this person is not better o, because being better o is a
function of real income that is how much she can buy with her income.
With reference to Eq. (2.9), gN = = 6%, which gives gR = 0. With no
growth in real income, there is no improvement in the standard of living
and a person experiencing no change in real income will not be better o.
Money illusion is most likely to occur when ination is unanticipated, so
that peoples expectations of ination turn out to be far away from the
actual level. When ination is fully anticipated, the risk of money illusion
subsides.
2.3. Measuring the General Price Level
Since the ination rate is the percentage change in the general price level,
measuring ination requires the construction of an index that represents the
general price level. Hence, ination refers to a rise in a broad price index
representing the overall price level for goods and services in the economy.
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34
700
600
500
400
300
200
100
0
1968
1972
1976
1980
1984
1988
GDP Deflator
Fig. 2.3.
1992
CPI
1996
2000
2004
2008
2012
PPI
The CPI, PPI and GDP deator for the U.S.
These indices include, among others, the consumer price index (CPI), the
producer price index (PPI), and the GDP deator. There are also sectoral
or narrow price indices such as the price indices for food, medical care,
housing and energy as well as indices for special groups. Figure 2.3 shows
the three main indices for the U.S. Figure 2.4 shows the ination rates
calculated from the CPI and GDP deator for some country groups and
Japan. The indices produce dierent but highly correlated estimates of the
ination rate.
No matter which index is used to represent the general price level (and
hence to measure ination), price indices typically suer from two problems:
noise and bias. Noise refers to all transitory shocks that are assumed to add
up to zero in the long run, but exert temporary and noticeable inuence on
the general price level in the short run (particularly when price statistics
are reported at high frequencies such as monthly). Noise encompasses all
kinds of shocks that originate in the supply side of the economy, such as
seasonal phenomena and broadly dened resource shocks as well as shocks
related to exchange or tax rate changes and any other shocks inducing
shifts in relative prices. These shocks cancel out when one looks at a
longer horizon but introduce undesirable uctuations at high frequencies.
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35
Developed Countries
32
16
28
24
12
20
8
16
12
8
4
0
1970
1980
1990
CPI
2000
2010
0
1970
GDP Deflator
1980
1990
CPI
Japan
2000
2010
GDP Deflator
Emerging Countries
24
100
20
80
16
60
12
40
4
20
0
-4
1970
1980
1990
CPI
Fig. 2.4.
2000
GDP Deflator
2010
0
1970
1980
1990
CPI
2000
GDP Deflator
Ination rates calculated from the CPI and GDP deator.
2010
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Bias is either weighting bias or measurement bias. Weighting bias, which

arises as constant weights does not account for relative price shifts, may be
harmlessly neglected. Measurement bias refers to actual errors in measuring
individual prices. We will come across these problems as we go through the
construction of various price indices.
2.4. Core Inflation
Distinction is made between the overall ination rate (the percentage
change in the total price index) and core ination, which commonly refers
to a measure of ination for a subset of the components of the index. With
respect to the CPI, core ination is calculated by excluding food and energy
prices on the grounds that these items rise and fall more than other prices
(that is, they are more volatile) in the short run. For example, a bad harvest
or drought invariably leads to rising food prices, while a decision taken by
OPEC to raise the price of oil, or restrict production, as well as a cold
winter would do the same to energy prices. Movements in these prices have
much more to do with supply-side transitory shocks (often reversible) than
the fundamental state of demand in the economy. Because core ination
is less aected by the short-run supply and demand conditions in specic
markets, central banks pay particular attention to the core ination rate to
get better projections for long-term future ination trends. High volatility
of non-core items may obscure the general trend of ination, leading to
inappropriate policy actions. Williams (2012) views the introduction of the
concept of core ination as a conspiracy. This is what he writes:
This is a concept popularized by the Federal Reserve in an eort to report
and focus on the lowest possible ination rate that the government could
produce. Over periods of a year or more, the use of core ination
is nonsensical in terms of measuring consumer ination that has any
relationship to common experience.
While core ination is commonly thought of as total ination minus the

volatile components, some economists view it as the ination rate that is
compatible with a specic set of macroeconomic conditions. For example,
Eckstein (1981) denes core ination as follows:
The core rate of ination can be viewed as the rate that would occur
on the economys long-term growth path, provided the path were free
of shocks, and the state of demand were neutral in the sense that
markets were in long-run equilibrium. The core rate reects those price
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37
increases made necessary by increases in the trend costs of the inputs to

production.
Alternatively, Quah and Vahey (1995) dene it as the component of

headline ination that has no eect on output in medium and long run.
Both of these denitions imply that core ination is interpreted as an
output-neutral ination. Given this macroeconomic interpretation of core
ination, it becomes possible to estimate the core ination rate from an
econometric model typically a bivariate output-ination VAR.
The alternative to the econometric estimation of the core ination
rate is the statistical approach. The exclusion method described earlier
falls under this approach. Apart from the exclusion method, the core
ination rate may be calculated by using the trimmed means method. In
this case, the core ination rate is a weighted average in which extreme
price movements are assigned zero weights. Another statistical method is
the variance-weighted means method, which is designed to reduce noise by
substituting completely or augmenting consumption-related weights with
weights inversely proportional to volatility (thus, no item has a zero weight
as in the exclusion and trimmed means method).
Figure 2.5 shows the overall and core ination rates for the U.S. during
the period 19682011 as reported by the Department of Labor (Bureau of
Labor Statistics). While the total ination rate is more volatile than the
core ination rate, there is no evidence to indicate that core ination is
necessarily lower than total ination.
2.5. The Consumer Price Index
The CPI is the most widely used index because it is based on the
consumption of ordinary citizens, broadly available and internationally
comparable. It is a measure of the money value of a basket of consumer
goods and services typically purchased by households. The U.S. Bureau of
Labor Statistics denes the CPI as a measure of the average change over
time in the prices paid by urban consumers for a market basket of consumer
goods and services.1 The CPI is calculated as a weighted average of
periodically-calculated prices of a sample of representative consumer goods
and services. Sub-indices and sub-sub-indices are computed for dierent
1 See
http://www.bls.gov/cpi/home.htm. However, this denition is awed. The CPI is

not a measure of the change but rather the price level at a particular point in time.
The ination rate is a measure of the (percentage) change in the price level.
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38
Price Index
700
600
500
400
300
200
100
0
1968
1972
1976
1980
1984
1988
1992
Total CPI
1996
2000
2004
2008
2012
1996
2000
2004
2008
2012
Core CPI
Inflation Rate
16
14
12
10
0
1968
1972
1976
1980
1984
1988
1992
-2
Total Inflation
Fig. 2.5.
Core Inflation
Total and core ination rates for the U.S.
categories and sub-categories of goods and services. For example, housing

is a major component of the CPI, hence, there is a sub-index for housing.
Under this item, we nd electricity, water and sewerage, rates and rent.
Sub-sub-indices are calculated for these separate housing items. The weights
used to calculate the CPI reect the shares of the individual items in the
total consumer expenditure covered by the index.
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39
Two basic types of data are needed to construct the CPI: price data
and weighting data. The price data are collected from a sample of sales
outlets in a sample of locations for a sample of times. The weighting
data are estimates of the shares of the dierent types of expenditure in
the total expenditure covered by the index. These weights are typically
based upon expenditure data obtained from expenditure surveys for a
sample of households or upon estimates of the composition of consumption
expenditure in the national income and product accounts. For example, if
a typical consumer allocates 30% of their income to housing, this item will
command a weight of 0.3 in the calculation of the CPI.
The CPI can be calculated on a monthly, quarterly and annual basis.2
The index reference period, usually called the base year, is used to rescale
the whole time series to make the value for the index reference-period equal
to 100.3 Having obtained the weights and prices, the CPI is calculated as

n

Pit
wi
,
(2.10)
Pt =
Pi0
i=1
where Pt is the price index at time t, wi is the weight assigned to item i
(where an item is a group of goods and services for example, healthcare
and fuel), Pit is the price of item i at t and Pi0 is the price of item i at time
zero, which is the base period. Typically, Pt = Pi0 = 100.
To understand the meaning of the weight, imagine that the consumption basket consists of n goods and service with prices Pit for i = 1, 2, . . . , n
and xed quantities Qi0 . The CPI at time t is the ratio of the market value
of the basket at time t to the market value of the basket at time 0. Hence,
n
Pit Qi0
Pt = ni=1
.
(2.11)
P
i=1 i0 Qi0
Accordingly, the weight assigned to item i is
Pi0 Qi0
wi = n
i=1 Pi0 Qi0
(2.12)
which means that the weight assigned to i is equivalent to the fraction of

total spending allocated to this item.
We can expand Eq. (2.10) to take into account indices and sub-indices.
Assume that Pi (say housing) consists of m sub-items, Pij . The price index
2 Some
countries do not prepare the CPI on a monthly basis (for example, Australia).
it can be 10 or even 1.
3 Otherwise,
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for item i is
Pit =
m

wij
j=1

Pijt
.
Pij0
(2.13)
Hence, Eq. (2.10) can be written as

Pt =
n

i=1
wi
m

j=1

wij

Pijt
.
Pij0
(2.14)
Figure 2.6 displays the price indices for the U.S. CPI together with the
price indices of four items: food, housing, medical care, and energy. We can
readily see that the prices of food and housing have been rising at the same
rate as the overall CPI. Contrary to that, the price of medical care has been
rising at a much higher rate than the ination rate. The price of energy is
shown to be highly volatile, completely dierent from that of food. Hence,
it is not obvious why food is treated the same way as energy, in the sense
that it is excluded from the CPI for the purpose of calculating the core
ination rate on the assumption that they are both highly volatile.
The CPI is criticized for selection bias. For example, it could be that the
market basket does not contain certain common household items that did
not exist or were less common when the process was initiated (at time 0).
If the prices of these items are declining, the CPI would appear to be
articially high by failing to account for them. Some examples are laptops
and DVD players, whose prices have been declining since they were rst
introduced in the market. Bias may also arise from quality improvement.
The CPI measures the cost of purchasing a product without accounting
for the quality of the product. As a result, when consumers choose to buy
higher-quality goods, the CPI may rise despite the fact that lower-cost
products are still available. Another problem is that the CPI is typically
calculated from prices inclusive of taxes, reecting changes in tax rates that
may have nothing to do with ination may even be designed to combat
ination.
Another problem with the CPI is that, because the market basket is
xed, the index tends to overstate ination. When the price of an item rises
the quantity consumed declines, but by keeping the quantity constant, the
weight of this item is greater than it should be. When the price of an item
declines, the quantity consumed rises, which makes the weight smaller than
it should be. Thus, items with rising prices tend to have bigger weights
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41
Food
Housing
250
250
200
200
150
150
100
100
50
50
0
1968
1978
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1988
1998
CPI
2008
0
1968
1978
Food
1988
CPI
Medical Care
1998
2008
Housing
Energy
250
400
350
200
300
250
150
200
100
150
100
50
50
0
1968
1978
1988
CPI
1998
2008
Medical care
Fig. 2.6.
0
1968
1978
1988
CPI
The U.S. CPI and components.
1998
Energy
2008
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than they should have, and vice versa. This, of course, creates problems for
indexation when pay is adjusted according to the CPI.
If the CPI overstates ination, two practical problems arise. The rst
pertains to the adjustment of wages and other payments to oset the eect
of ination (indexation). The second problem is that the meaning of price
stability will be distorted. It is for this reason that price stability is not
normally taken to imply a CPI ination rate of zero, because this would
mean deation.
Other variants of the CPI are reported by the U.S. Department of
Labor (Bureau of Labor Statistics). These are price indices for commodities,
services and special groups. For the rst category, there are indices for
commodities and commodities less food and services. Special indices are
reported by excluding certain items. Under this category, we have all items
less food, all items less energy, all items less food and energy (which is
core ination) and all items less medical care. While the overall CPI is
sometimes labeled CPI-U, where the U stands for urban consumers,
other indices with symbols are CPI-U-X1, CPI-U-RS and C-CPI-U. The
CPI-U-X1 reects a rental equivalence approach to homeowners cost for
CPI-U. CPI-U-RS (consumer price index research series), which is currentmethod CPI. C-CPI-U is the chained CPI. Figure 2.7 shows time series for
these variants of the CPI apart from C-CPI-U, they are very close, which
makes one wonder why so many indices are used when they tell the same
story.
2.6. The GDP Deflator

The GDP deator (implicit price deator for GDP) is a measure of the
level of prices of all new, domestically produced, nal goods and services
in an economy hence it is a broader price index than the CPI, which
includes consumer goods and services only. Another dierence is that the
GDP deator, unlike the CPI, does not take into account the prices of
imported goods. It takes into account the total value of all nal goods and
services produced within that economy during a specied period (a year
or a quarter). Yet another dierence is that the GDP deator is not based
on a xed basket of goods and services. The basket is allowed to change
as consumption and investment patterns evolve over time. Actually, the
basket in this case is the set of all domestic goods and services, weighted
by the market value of the total consumption of each good. Therefore, new
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43
135
130
125
120
115
110
105
100
2000
2001
2002
2003
2004
CPI-U
Fig. 2.7.
2005
CPI-U-X1
2006
2007
CPI-U-RS
2008
2009
2010
2011
C-CPI-U
Variants of the U.S. CPI.
spending patterns are allowed to show up in the deator as people respond

to changing prices.
The GDP deator is calculated as the ratio of the nominal (or currentprice) GDP to the real (or constant price, chain volume) measure of GDP.
Hence,
Pt =
YN t
,
YRt
(2.15)
where YN t and YRt are respectively nominal GDP and real GDP at time t.
Like the CPI, the GDP deator is assigned the value of 100 in the base
period. Deators are calculated for certain sub-categories of GDP, such as
the personal consumption deator. In general, a deator is a factor that is
used to convert a nominal value into a real value.
Real GDP is calculated as a chained volume series, where volume
refers to a real quantity that is not calculated in terms of prices. A chained
volume series is a set of observations from successive years, converted into
real (ination-adjusted) terms by calculating the production volume for
each year in the prices of the preceding year, and then chain linking the
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data together to obtain a time series that is free from the eects of price
changes. This time series only reects production volume.
The calculation of a chained time series is as follows. Take a period of
m years, such that t = 0, . . . , m where 0 is the base period. Nominal GDP
at current prices at time t is calculated as the money value of the n goods
and services produced within a time period. Hence,
YN t =
n

Pit Qit .
(2.16)
i=1
In the subsequent period, we have

YN,t+1 =
n

Pi,t+1 Qi,t+1 .
(2.17)
i=1
Real GDP at t + 1 calculated at period t prices is

YR,t+1 =
n

Pit Qi,t+1 .
(2.18)
i=1
Thus, the growth rate of real GDP between t and t + 1 measured at the
prices prevailing at t is
n
Pit Qi,t+1
1.
(2.19)
gR,t+1 = i=1
n
i=1 Pit Qi,t
Likewise, the growth rate at t + 2 is given by
n
Pit+1 Qi,t+2
1.
gR,t+2 = i=1
n
i=1 Pit+1 Qi,t+1
(2.20)
A series of growth rates can be calculated by taking a pair of two consecutive

years to form a chain consisting of gR1 , gR2 , . . . , gRm . Real GDP can be
calculated for any period of time as
YR,t+1 = YRt (1 + gR,t+1 ).
(2.21)
By using the growth rates of real GDP we obtain a series of real GDP
as YR1 , YR2 , . . . , YRm and correspondingly a series for the GDP deator
P1 , P2 , . . . , Pm .
The calculation of real GDP does not necessarily require the use of two
consecutive years. The same results can be obtained by using the prices of
the base period and any other period. What is important in this case is
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45
that we have a series that is measured at constant prices (real GDP) and
another measured at current prices (nominal GDP). Figure 2.8 shows the
GDP of the U.S. over the period 19632011 with dierent base periods (the
year whose prices are used as the constant prices). In the data reported
in the Economic Report of the President (2012), real GDP is measured in
terms of the prices of 2005, and this is why the nominal and real GDP
graphs intersect (they are equal) in 2005. The other parts of Fig. 2.8 show
nominal and real GDP measured at the constant prices of 1963, 1980 and
2011. When the 1963 prices are used, nominal GDP is always higher than
real GDP (because of ination). When the 2011 prices are used, it is the
other way round, also because of ination. If any year in between is chosen,
real GDP is higher than nominal GDP in the years preceding that year and
lower afterwards.
2.7. Other Price Indices

The producer price index (PPI) is a measure of the prices received by
domestic producers for their output. In the U.S., the PPI was known as
the wholesale price index, or WPI, up to 1978. The importance of this
index is being undermined by the steady decline in manufactured goods
as a share of spending. The PPI rises at a slower rate than the CPI if the
prices of services (which are labor intensive), rise faster than the prices of
manufactured goods (which are capital intensive). This seems to be the
case as demonstrated by Fig. 2.9, which shows price indices for apparel (as
manufactured goods) and medical care (as services). This is why Fig. 2.3
shows that the CPI rises at a higher rate than the PPI.
The European Central Bank uses the harmonized index of consumer
prices (HICP) to measure ination in the European Union as an entity.
It is a weighted average of the price indices of member countries. The
HICP diers from the CPI, as calculated by the U.S. Bureau of Labor
Statistics, in two primary aspects. First, the HICP incorporates rural
consumers into the sample while the U.S. Bureau of Labor Statistics,
maintains a survey that is strictly based on urban population (hence, the
word urban in the denition of the CPI). In reality, however, HICP does
not fully incorporate rural consumers since rural samples are used only to
determine the weights while prices are often only collected in urban areas.
The HICP also diers from the CPI in that the former excludes owneroccupied housing. The CPI involves the calculation of rental-equivalent
costs for owner-occupied housing while such expenditure is considered as
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46
2005 Prices
1963 Prices
16000
16000
12000
12000
8000
8000
4000
4000
0
1963
1973
1983
1993
Current
2003
2013
0
1963
1973
Constant
16000
12000
12000
8000
8000
4000
4000
1983
Current
Fig. 2.8.
1993
2003
2013
Constant
1980 Prices
2011 Prices
1973
1993
Current
16000
0
1963
1983
2003
Constant
2013
0
1963
1973
1983
Current
1993
2003
2013
Constant
The U.S. GDP at current and constant prices with dierent bases periods.
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47
1600
1400
1200
1000
800
600
400
200
0
1968
1972
1976
1980
1984
1988
Apparel
Fig. 2.9.
1992
1996
2000
2004
2008
2012
Medical Care
Price indices for apparel and medical care.
investment, hence excluded from the HICP. The Bureau of Labor Statistics
breaks down CPI calculations to dierent regions of the U.S., hence the
concept of regional ination arises.
Unlike the CPI, the chain weighted price index is not based on a xed
basket of goods and services in the base year. Rather, the quantities are
allowed to change and the percentage changes in the index from one period
to another are chained together, just as in the calculation of real GDP. The
coverage of this index is wider than consumer goods as it includes capital
goods and government spending. It is not clear, therefore, how this index
diers from the GDP deator. It is also not clear if by changing the basket
we are comparing apples with apples. Williams (2012) suggests a conspiracy
theory to explain the move from straight CPI to chained CPI. He writes
the following:
The C-CPI was designed by the government as a replacement for the
CPI in calculating cost-of-living adjustment (COLA) for government
programs such as social security. With the C-CPI showing the lowest
ination of the CPI measures, the concept has been viewed positively by
Congress as a way to reduce the federal decit.
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Williams sees another conspiracy resulting from the introduction of the

CPI-U-RS. He writes:
In government reporting, the measure has been used primarily by the
Census Bureau in deating income measures in its annual poverty survey.
The use of the resulting lower historical ination rates shown in the
CPI-U-RS, versus CPI-U, has the eect of making current inationadjusted data, such as income, look relatively stronger on a historical
basis.
In fact, Williams believes that the CPI has changed from being a measure
of the cost of living needed to maintain a constant standard of living, to a
measure of a cost of living that reects a declining standard of living.
A variety of estimates for the ination rate can be obtained by using
dierent price indices, dierent components of the same index, alternative
variants of the same index and by using dierent measures of the ination
rate itself. This allows the possibility of cherry picking by those intending
to prove a point (for example, whether ination is rising or falling,
accelerating or decelerating). This may also make international comparison
more dicult. While these problems are associated with moderate ination,
the dierences are immaterial under hyperination.
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Chapter 3
THE MONETARY THEORY

OF INFLATION
3.1. Introduction
The idea behind the monetary theory of ination is simple. If more money
is created than what is required to buy goods and services, prices will rise
that is, the value of money in terms of goods and services (or the purchasing
power of money) will decline. Ination, in other words, arises when too much
money chases too few goods. In the 19th century, the relation between the
money supply and ination was articulated by Joplin (1826) as follows:
There is no opinion better established, though it is seldom consistently
maintained, than that the general scale of prices existing in every country, is determined by the amount of money which circulates in it.
In the 20th century, Milton Friedman appeared as the most outspoken advocate of the monetary theory of ination. A famous quote from Friedman
that is often repeated in the literature and the media is that ination is
always and everywhere a monetary phenomenon (Friedman, 1963).
An increase in the quantity of money is typically taken to be synonymous with the debasement of the medium of exchange. Episodes of
debasement have occurred throughout history and involved dierent forms
of money. For example, when gold was used as a currency, the government
could collect gold coins, melt them down, mix them with cheaper metals
(such as silver, copper or lead), and re-issue them at the same nominal
value. By diluting gold with other metals, the government could issue more
coins without increasing the amount of gold required to make them. The
government prots from an increase in seigniorage (which is the dierence
between the nominal value of a coin and the cost of producing it), when
the cost of producing coins is reduced in this way. As a result, the value of
49
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coins declines in terms of goods while goods prices rise, which means that
monetary ination leads to price ination.
Before proceeding with a description of the monetary theory of ination, we must dene money as it is used in a modern economy. It is no
longer the case that goods are bought only by exchanging them for gold
or silver coins this is the era of electronic money. Since there is always
confusion between money and credit, the two terms will be distinguished.
3.2. The Meaning of Money and Credit
In economics, the money supply or money stock is the total amount of
monetary assets available in an economy at a specic point in time.1 From
an individual perspective, money is the part of a persons wealth that can
be used to settle transactions. In other words, the prime function of money
is that it serves as a medium of exchange, which means that any asset that
performs this function is eectively money or a monetary asset.
While the tendency is to think of money as being the currency we
carry in our pockets (or keep under the matrices), most of the money
stock is bank deposits. The reason why bank deposits are money is that
they can be used to settle transactions (for example, by writing a cheque
on a demand deposit, alternatively known as a checkable deposit). Which
deposits are included in the money supply determine a particular monetary
aggregate. For example, the narrow money supply (M 1) consists of currency
in circulation (with the public) and checkable deposits. The broad money
supply (M 2) has as a component of less liquid deposits the idea being
that they can be made more liquid easily by transferring funds from these
deposits to a checkable deposit.
The denitions of M 1 and M 2 dier from one country to another
in some countries there are even M 3 and M 4. In the U.S., M 1 consists
of currency in circulation, demand deposits travelers cheques and other
checkable deposits. M 2 is M 1 plus saving deposits and small time deposits.
In December 2011, currency in circulation was about one trillion dollars,
comprising about 46% of M 1 and 10.4% of M 2. Figure 3.1 shows the
composition of M 1 and M 2 in the U.S. at the end of December 2011.
1 Although
the term money supply is typically used in preference to the term money
stock, the latter is actually more precise. This is because money is a stock variable,
observable at a point in time, not a ow variable accumulating over a period of time.
It is a stock variable because it is extracted from the consolidated balance sheet of the
banking system (comprising the central bank and commercial banks).
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51
Components of M1
Other Checkable Deposits
(including travelers
cheques)
19%
Currency
46%
Demand Deposits
35%
Components of M2
Currency
9%
Institutional Money Funds

15%
Demand Deposits
7%
Other Checkable
Deposits
(including travelers
cheques) 4%
Retail Money Funds

6%
Small
Denomination
Time Deposits 7%
Saving Deposits
52%
Fig. 3.1.
The composition of M 1 and M 2 in the U.S. (December 2011).
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52
US Treasury and Agency

Securities
18%
Other Loans and Leases

11%
Consumer Loans
12%
Other Securities
9%
Commercial and Industrial

Loans
14%
Real Estate Loans

36%
Fig. 3.2.
The composition of bank credit in the U.S. (December 2011).
Notice that the money supply is a liability of the banking system:

currency is a liability of the central bank while deposits represent a liability
of commercial banks and other depository institutions. Conversely, credit
is an asset of the banking system. It predominantly takes the form of loans
and leases, including commercial and industrial loans, real estate loans and
consumer loans (see Fig. 3.2). While the two items are totally dierent, they
are tightly related because a monetary expansion resulting from an increase
in deposits materializes from a credit expansion. In a closed economy, we
would expect the relation to be even tighter than in an open economy where
the increase in deposits could come from foreigners without a corresponding
increase in credit. Figure 3.3 shows money and credit in the U.S. since
1982. Notice that despite the decline in credit in 2009, both M 1 and M 2
increased. This is because the relation between money and credit is not
straightforward as the money supply is determined by factors that may
oset each other as we will see in the following section.
3.3. Money Creation under a Fractional Reserve System
Changes in the money supply, dened as currency in circulation and
deposits, occur under a fractional reserve system as follows. The central
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53
Money and Credit

10000
8000
6000
4000
2000
1982
1986
1990
1994
1998
M1
M2
2002
2006
2010
Credit
Currency and Deposits

8000
6000
4000
2000
0
1982
1986
1990
1994
Currency
Fig. 3.3.
1998
Demand Deposits
2002
2006
2010
Total Deposits
Money and credit in the U.S.
bank issues currency (notes and coins), which is called the monetary
base or high-powered money. Some of the issued currency is held by the
public, which they use to buy goods and services (settling typically small
transactions). This part of the monetary base, currency in circulation, is
a component of the money supply. The other part of the monetary base
is held by banks as reserves. Against these reserves, banks extend loans
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and create deposits in the process. Under a fractional reserve system banks
can issue loans, hence deposits, while holding a much smaller amount of
reserves than under a full reserve system. Thus, for every dollar increase
in bank reserves, resulting from an increase in the monetary base, deposits
and the money supply increase multiple times.
Let us see how this process works formally. Dene the monetary base,
B, as the sum of currency held by the public, C, and banks reserves, R.
Hence,
B = C + R.
(3.1)
The money supply is dened as the sum of currency and bank deposits,
which gives
M = C + D.
(3.2)
By dividing Eq. (3.2) by Eq. (3.1), we obtain

C +D
M
=
.
B
C+R
(3.3)
By dividing the right-hand side of Eq. (3.3) by D, we obtain

C
+1
M
= D
R
C
B
+
D D
or

M=

c+1
B,
c+r
(3.4)
(3.5)
where c is the currency to deposits ratio as determined by public preferences

and r is the banks reserve to deposits ratio, which is determined by their
preferences as well as the reserve requirements imposed on banks by the
central bank. Equation (3.5) can be simplied to
M = mB,
(3.6)
where m is the money multiplier. Under a factional reserve system r < 1,

which means that m > 1. For each dollar increase in the monetary base,
the money supply increases by a factor or multiple determined by the two
ratios, c and r. If banks decide to lend more, r will decline in the same
way as when the central bank decides to reduce r through a policy action
(expansionary monetary policy). As r declines the value of the multiplier
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55
rises, thus a greater amount of money can be created for a given increase
in the monetary base. Notice that in the extreme case, when banks decide
to stop lending and keep full reserves against deposits, r = 1 and m = 1,
which means that an increase in the monetary base will translate into an
equivalent increase in the money supply. The money supply expands when
banks decide to lend this is the connection between credit and money.
This simple relation may be the key for answering the question as to why
quantitative easing has not produced monetary ination and consequently
price ination in the aftermath of the global nancial crisis.
Figure 3.4 is based on simulated data and shows how the money
supply corresponding to a given level of the monetary base depends on the
multiplier, hence, on the reserve/deposits ratio and the currency/deposits
ratio. The monetary base is allowed to grow at rates ranging between zero
and 10% per period. The corresponding growth in the money supply is
faster for low values of the reserve/deposit ratio, because a low ratio boosts
the ability of banks to extend credit and create deposits. The same is true
of the currency/deposits ratio because if bank customers decide to keep
more cash and fewer deposits, banks will be deprived of cash that would
otherwise be reserves that can be used to create deposits. As seen in Fig. 3.4,
the money supply grows much faster when the two ratios assume the value
of 0.1 than when they assume the value of 0.5.
Figure 3.5 shows the growth of the U.S. monetary base over the period
19822011 in billions of dollars.2 Notice the big jump in the monetary base
in 2008 and 2009, which came as a response to the global nancial crisis.
Rapid growth resumed in 2011, as early optimism about recovery proved
to be unjustied. The increase in the monetary base was engineered via
quantitative easing the act of printing money to buy bonds. We also saw
a big jump in the reserve ratio in 2008, as banks stopped lending, opting
instead to build reserves. The reserve ratio corresponding to M 1 (r1) is still
standing above one, meaning that banks have more reserves than checkable
deposits. The rise in both ratios over time has led to smaller multipliers for
both M 1 and M 2.
Under a at currency system, where the currency is not backed by
gold or anything of value, there is no limit to how much currency can be
issued by the central bank. Money is created out of thin air, as they say.
Under a fractional reserve system, the only limit on how much deposits
2 The
gures are taken from the 2012 Economic Report of the President.
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56
Changing Reserves/Deposits Ratio

4000
3000
2000
1000
10
15
B
20
r=0.1
25
r=0.2
30
r=0.3
35
r=0.4
40
45
50
40
45
50
r=0.5
Changing Currency/Deposits Ratio

8000
6000
4000
2000
0
0
10
15
B
Fig. 3.4.
20
c=0.1
25
c=0.2
30
c=0.3
35
c=0.4
c=0.5
The money supply corresponding to monetary base (simulated data).
(hence, money) commercial banks can create is how much reserves they
are required or wish to hold in general, they have a signicant leeway.
Unlike a commodity standard, where the amount of currency issued is
constrained by the availability of the underlying commodity, the antiinationary device is missing under the present system of at currency
and fractional reserves.
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Monetary Base and Currency in Circulation
57
Currency and Reserve Ratios (M1)

1.5
3000
2500
1.2
2000
0.9
1500
0.6
1000
0.3
500
0
1982
0.0
1986
1990
1994
1998
Currency
2002
2006
2010
1982
1986
1990
1994
Monetary Base
1998
2002
c1
Currency and Reserve Ratios (M2)
2006
2010
2006
2010
r1
Money Multiplier
14
0.25
12
0.20
10
0.15
0.10
0.05
2
0.00
1982
1986
1990
1994
1998
c2
Fig. 3.5.
2002
r2
2006
2010
1982
1986
1990
1994
1998
m1
2002
m2
Monetary base, ratios and multipliers for M 1 and M 2.
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3.4. The Quantity Theory of Money

The money multiplier model explains how monetary ination evolves. The
quantity theory of money explains how monetary ination leads to price
ination. The relation between money and prices is explained in terms of
the quantity theory of money, and casual empiricism tells us that there
is a link. This link is most obvious under hyperination where monetary
ination mostly takes the form of massive increase in the currency issued
by the central bank.
The quantity theory of money, also called the quantity equation of
money, is based on the simple idea that the amount of money required
to settle transactions depends on the amount of transactions hence, on
the volume of output and prices (that is, nominal output). The equation is
written as follows:
MV = PY ,
(3.7)
where M is the money supply (which can be M 1, M 2 or any other monetary

aggregate), V is the velocity of circulation of money, P is the general price
level and Y is real output (real GDP) hence, PY is nominal output.
The velocity of circulation is the number of times per year each dollar is
spent or changes hands.3 Unlike other terms, the velocity of circulation has
no independent measure and can only be estimated as a residual item by
manipulating Eq. (3.7) to obtain4
V =
PY
.
M
(3.8)
The quantity equation is really an identity, which holds true by construction

rather than describing economic behavior because each term is dened by
the values of the other three. Just like V is dened by the other three
in Eq. (3.8), P can be expressed in terms of the other three variables by
3 Hence,
it represents the frequency of transactions.

statistics on M , P and Y are prepared by statistical agencies. For example, P
is calculated by sampling the prices of goods and services. However, no statistical agency
indulges in a sampling exercise to calculate and report V although it may be reported as
a residual item from Eq. (3.8). This can be problematical for those attempting to conrm
empirically that a proportional relation exists between money and prices subject to the
stability of velocity.
4 Published
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59
rewriting the equation as

V
P =
Y

M
(3.9)
which shows the connection between the price level and the money supply.
For a proportional relation between P and M to exist, the ratio V /Y
must be stable. In particular, if changes in the money supply do not aect
V , an increase in the money supply leads to an increase in nominal output,
PY. If also changes in the money supply do not aect real output (the
so-called neutrality of money), an increase in M leads to a proportional
increase in P . Those who believe in the quantity theory as providing an
explanation for ination argue that the velocity of circulation is stable and
predictable and that money is neutral with respect to real output.5
To understand the process described by the quantity theory of money
in a better way, Eq. (3.7) can be written in percentage terms (or growth
rates) as follows:
m + v = p + y,
(3.10)
where x is the percentage change or growth rate in x, which is typically

approximated by the rst log dierence. Equation (3.10) can be re-arranged
to produce
p = m + v y
(3.11)
which says that the percentage change in the general price level (the
ination rate) is equal to the percentage change in the money supply
plus the percentage change in velocity minus the percentage change in real
output (real growth rate).6 If velocity is stable, then v = 0, which means
that the ination rate is equal to the excess of monetary growth rate over the
growth rate of output. Hence, ination will only materialize if m > y.
If velocity changes, ination could arise even if there is no increase in the
money supply. Also, an increase in the money supply in excess of output
growth may not cause ination if it is oset by a drop in the velocity of
circulation.
5 The
neutrality of money can be explained alternatively as follows: the spending diusion

of new money must not raise some prices signicantly ahead of others. In the long run,
it is reasonable to assume that relative price eects are largely washed out.
6 Equation (3.11) holds exactly for continuously compounded growth rates. For yearover-year rates, it is an approximation.
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The implication of Eq. (3.11) for controlling ination is equally

straightforward. Achieving zero ination merely requires the central bank to
refrain from expanding the money supply too rapidly. More specically, for a
given velocity, the money supply must not expand at a more rapid pace than
output. The central banks of a number of countries (Australia, Canada,
the euro zone, New Zealand, Sweden and the U.K.) have, in recent years,
announced target ranges for the ination rate (often 13%) as a result
of commitment to this target, they have been rather successful in keeping
the ination rate within that range.7 This view, however, is disputed by
Kocherlakota and Phelan (1999) who argue that there is a hole in the
underlying line of reasoning. This is because how much money households
choose to hold depends on inationary expectations, which creates the
possibility of a large number of paths for the ination rate besides the
possibility that ination would run at a rate that reects the dierence
between the growth rates of money and output. Thus, they conclude, the
control of the money supply alone is not sucient.8
Figure 3.6 shows what happens to the general price level as the money
supply is allowed to grow at rates between zero and 10% when the velocity
of circulation assumes various values. The higher the velocity, the higher
will be the ination rate resulting from a given rate of monetary expansion.
It is as if high velocity reinforces the quantum of money, like the concept
of momentum in physics. Figure 3.7 shows that the velocity of circulation
of both M 1 and M 2 in the U.S. is rather stable.
The relation between the general price level and the money supply
can be seen by using an equation for the demand for money. The
predictability (or lack thereof) of the velocity of circulation is equivalent
to the predictability (or lack thereof) of the demand for money (since in
equilibrium real money demand is simply Y /V ). Consider, the following
demand for money function
Md = P Y ,
7 We
(3.12)
must bear in mind that the money supply is not totally under the control of the
central bank. If also ination, at least inationary bursts, can be caused by non-monetary
factors, it will be rather dicult for a central bank to control ination. The low ination
environment in recent years has been in large part due to the role of China as a producer
of last resort, providing cheap products for consumers worldwide. While the control of
the money supply is important, the success of central bankers in controlling ination has
been aided by China.
8 This is also an explanation for the divergence between the monetary growth rate and
the ination rate even under hyperination.
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61
250
225
200
175
150
125
100
12
16
20
v=2
Fig. 3.6.
24
v=4
28
v=6
32
v=8
36
40
44
48
v=10
The eect of the velocity of circulation (simulated data).
12
10
1972
1976
1980
1984
1988
1992
V1
Fig. 3.7.
1996
2000
2004
2008
2012
V2
Velocity of circulation in the U.S.
where Md is the nominal demand for money and is the output (Y )

elasticity of the demand for money (a measure of the responsiveness of
the demand for money to changes in real output). If the money supply is
exogenous (determined by the central bank), then in equilibrium
Md = M,
(3.13)
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where M is the money supply. Hence,

M = P Y .
(3.14)
By proper mathematical manipulation, we obtain

p = m y.
(3.15)
Equation (3.15) tells us that the ination rate is equal to the rate of
monetary expansion minus the rate of growth of the demand for money
resulting from growth in real output. Obviously if the growth rate of real
output is zero, the ination rate will be identical to the rate of monetary
expansion.9 If money is not neutral, a monetary expansion would lead to
a rise in real output and, consequently, to a rise in the demand for money.
This would produce a smaller than otherwise excess money supply and,
therefore, a smaller rise in the price level than what is implied by Eq. (3.15).
The supporting evidence for the relation between monetary growth
and ination is straightforward. Output seldom falls by more than two or
three percentage points, except for exceptional circumstances when there
is total macroeconomic mismanagement. Velocity may change over time,
typically by no more than one percentage point.10 When high-ination and
low-ination countries are compared, dierences in monetary growth are
much greater than dierences in either real output growth or velocity. As
a result, the rate of monetary expansion is the dominant factor accounting
for dierences in ination rates across countries. High-ination countries
are countries with rapid monetary growth. Remember that there is no
limit on how much the money supply can increase. Conversely, changes in
output and velocity are limited. Likewise, the dominant factor accounting
for dierent ination rates over decades in the same country (for example,
the lower U.S. ination rate in the 1990s compared with the 1970s) is
dierent monetary growth rates. High-ination decades are characterized by
rapid monetary growth. The dominance of monetary growth in accounting
for ination is particularly pronounced in hyperination. Some evidence will
be presented in Chapter 8 for a number of countries that have experienced
hyperination, showing that the growth rates of real output are much closer
9 For
the derivation of Eq. (3.15), see Moosa (1997a).

proposition is dicult to verify because there is no independent measure of
the velocity of circulation. Calculating velocity as a residual item typically produces
signicantly large changes in velocity, particularly under hyperination. This point is
further discussed in Chapter 8.
10 This
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63
than the growth rates of the money supply and prices. The output growth
factor ranges between 0.83 and 14.42, while the monetary growth factors
range between 4.05 103 and 3.54 1020. Some evidence for countries with
moderate ination will be presented later in this chapter.
This nature of the causal chain from money to ination is a subject of
contention. Some economists argue that the money supply is endogenous,
determined by the workings of the economy, not by the central bank. There
is an element of truth in this proposition, at least under normal conditions.
The money supply is determined by the central bank only to the extent that
the central bank is solely responsible for issuing currency (the raw material
used by banks to create deposits) and because it can aect the ability of
banks to grant credit and create deposits by other means such as reserve
requirements. However, the money creation process involves behavioral
factors, the preference of people for currency as opposed to deposits and
other nancial assets and the desire of banks to extend credit, given the
constraints imposed by the central bank.11 Recently, the Fed reinforced
the ability of banks to extend credit via quantitative easing, yet there
has been no corresponding increase in the money supply (corresponding
to the increase in the monetary base). These behavioral tendencies are
aected by interest rates, output and expectations, making the money
supply endogenous to some extent.
Furthermore, some economists argue that monetary ination does not
necessarily lead to price ination. A monetary expansion is supposed to
work its way to prices directly or indirectly: directly through increased
demand for goods and services, and indirectly through higher demand for
nancial assets. The latter leads to higher asset prices, lower interest rates,
more borrowing and less saving hence, more consumption (and ination).
Some economists dispute the proposition of the neutrality of money and
the stability of velocity. For example, it is arguable that an increase in the
money supply, unless trapped in the nancial system as excess reserves,
can cause a sustained increase in real production instead of ination in
the aftermath of a recession, when resources are underutilized. It is also
suggested that if the velocity of circulation changes, an increase in the
11 With reference to the multiplier model as represented by Eq. (3.5), the central bank
can aect the money supply because it has total control over B and can change r through
reserve requirements. However, the central bank has no control over c (although it can
be aected by changes in interest rates) while r is determined primarily by the behavior
of banks.
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money supply could have either no eect, an exaggerated eect, or an

unpredictable eect on the growth of nominal GDP. There is, the argument
goes, no limit to the velocity of circulation, which means that any quantity
of money can sustain any price level (see, for example, Taylor, 2004).
3.5. Facts and Figures
Let us examine the facts and gures using the U.S. data on money (M 1
and M 2) and prices (CPI and GDP deator) over the period 19722011.12
In order to eliminate the scale factor and the unit of measurement factor,
the money supply gures are transformed into indices assuming the value
of 100 in 1972. In Fig. 3.8, we see scatter plots of prices on the money
supply. In all the cases, there seems to be a good positive but nonlinear t.
This, however, may be a reection of positive time trends in both variables,
leading to spurious correlation. In Fig. 3.9, we see time plots, which again
show strong time trend but it tells us one thing: monetary ination is much
bigger than price ination there is no proportional relation between
the two. Figure 3.10 shows that monetary ination is much more volatile
than price ination, but there is some strong correlation between monetary
growth and ination, particularly for M 2. Casual empiricism, it seems, does
not support the quantity theory of money in the strict monetarist sense of a
proportional relation between changes in the money supply and the general
price level. However, there is evidence for a positive association between
the two variables.
How do we explain the gap between monetary ination and price
ination in this particular case? Between 1972 and 2011, M 1 grew by a
factor of 8.7, M 2 by a factor of 12, the GDP deator by a factor of 4.3 and
the CPI by a factor of 5.4. If the quantity theory of money was valid in the
strict sense as seen by the monetarists (that money is neutral and velocity is
stable), then the gaps should not be observed. Even if we allow for the eect
of output growth by subtracting the output growth rate from the monetary
growth rate, a substantial gap would still exists as shown in Fig. 3.11.
Economists who are supportive of the monetary view of ination
present various explanations for the gap. The rst is that the gap is accounted for by changes in the velocity of circulation. However, since there are no
independent measures of velocity, this proposition cannot be conrmed or
12 More
facts and gures can be found in Chapter 8. The U.S. gures presented in this
section are taken from the 2012 Economic Report of the President.
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CPI and M1
b1571-ch03
65
CPI and M2
600
600
400
400
200
200
0
0
200
400
600
800
1000
500
1000
1500
Deflator and M2
Deflator and M1
600
600
400
400
200
200
0
0
200
400
Fig. 3.8.
600
800
1000
500
1000
1500
Money versus prices in the U.S. (scatter plots).
otherwise. If we try to conrm it by calculating velocity as a residual item,

we will end up with mere tautology saying that the ination rate is equal
to the ination rate. Another explanation is that a signicant portion of
the U.S. money supply, particularly currency, is held abroad. According to
the estimates of Federal Reserve Bank of St Louis, approximately 50% of
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66
CPI and M1
CPI and M2
1400
1000
1200
800
1000
600
800
600
400
400
200
200
1972
1980
1988
1996
2004
M1
2012
1972
1980
1988
CPI
1996
M2
2004
2012
CPI
Deflator and M2
Deflator and M1
1000
1400
1200
800
1000
600
800
600
400
400
200
200
1972
1980
1988
1996
2004
2012
1972
1980
1988
1996
M2
M1
Deflator
Fig. 3.9.
Money and prices in the U.S. (time plots).
2004
Deflator
2012
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CPI and M1
20
15
15
10
10
-5
-5
1980
1988
1996
M1
2004
2012
1972
1980
1988
CPI
1996
2004
M2
Deflator and M1
2012
CPI
Deflator and M2
20
20
15
15
10
10
-5
1972
67
CPI and M2
20
1972
b1571-ch03
-5
1980
1988
1996
M1
Fig. 3.10.
2004
Deflator
2012
1972
1980
1988
M2
1996
2004
Deflator
Money and prices in the U.S. (percentage changes).
2012
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68
CPI and M1
CPI and M2
20
20
15
15
10
10
5
5
0
-5
-10
-5
1972
1980
1988
1996
CPI
2004
2012
1972
1980
M1-GDP
1988
1996
CPI
2004
2012
M2-GDP
Deflator and M2
Deflator and M1
20
20
15
15
10
10
5
5
0
-5
-10
-5
1972
1980
1988
Deflator
Fig. 3.11.
1996
2004
M1-GDP
2012
1972
1980
1988
Deflator
1996
2004
2012
M2-GDP
Ination rates and monetary growth rates adjusted for output growth.
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69
350
300
250
200
150
100
50
0
1990
1992
1994
1996
1998
M1
Fig. 3.12.
2000
M2
2002
2004
2006
2008
2010
2012
House Prices
Monetary growth and house prices.
all the U.S. currency in circulation is held in other countries (Anderson and
Williams, 2007). Yet another explanation is that monetary growth has been
reected mostly on house prices, and perhaps nancial prices, rather than
the prices of goods and services. Financial and housing price bubbles, which
were driven by easy money, have been common, particularly over the period
between 2002 and the advent of the global nancial crisis. Figure 3.12 shows
very strong positive correlation up to the point of the collapse of the housing
market. The problem with this explanation is that the eect on nancial
and housing prices should lead to goods price ination (the indirect channel,
according to the monetarists). Asset price ination creates a wealth eect
that boosts demand for goods and services.
Similar gures can be presented for other countries. In Table 3.1, we
present gures on the growth factors of prices (CPI), the money supply,
real GDP and the velocity of circulation in ve countries over the period
19902011. We observe that in all cases the money supply grows faster
than prices, with big gaps. In South Africa, for example, the money
supply rose by a factor of 14.46 but prices rose by a factor of 4.42. In
Australia, the growth factors of the money supply and prices are 6.75 and
1.73, respectively. Since in all cases the monetary growth rate exceeds the
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Table 3.1.
Growth factors of P , M , Y and V (19902011).
Country
Australia
Japan
South Africa
Switzerland
U.K.
1.73
1.06
4.42
1.32
1.67
6.75
1.33
14.46
2.67
4.80
1.92
1.19
1.74
1.33
1.58
0.49
0.95
0.53
0.67
0.55
ination rate, the velocity appears to have declined, but once more this is
tautology given that velocity is calculated as a residual item. It remains
true, however, that the growth factors of output are closer than the growth
factors of the money supply and prices. The gaps can be attributed to
determinants of ination other than monetary growth. While we are going
to examine other theories of ination in the following chapter, it suces here
to mention that other determinants of ination include the scal balance,
public debt, the exchange rate level and regime, wage ination, the state of
the economy, political factors, economic openness and imported ination.
Another perceived characteristic of the relation between monetary
growth and ination is that the relation is lagged, not contemporaneous
that it takes time for changes in the money supply to aect the general price
level. In the 1960s, Milton Friedman wrote about the long and variable
delays involved in a causal relation running from money to prices. The time
lags can be explained as follows. As the central bank prints money and buys
bonds, interest rates go down and as a result the velocity of circulation
declines. The decline in velocity initially osets the eect of monetary
expansion so prices may not go up much. However, a sustained increase
in the money supply will eventually produce ination. If we calculate the
correlation coecients between monetary growth and ination as shown in
Fig. 3.11, we would not nd much dierence between the contemporaneous
and lagged relations as shown in Table 3.2. In both the cases, the relation
is stronger for M 2 than for M 1.
3.6. Further Remarks on the Monetary Theory of Inflation
Belief in the monetary theory of ination has led to ination targeting,
monetary targeting and central bank independence. Some central banks
have gone as far as granting the central bank governor a bonus for keeping
ination under control. It is as if ination is caused entirely by factors that
can be controlled by the central bank.
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71
Table 3.2. Correlation of

growth rates.
Lag
CPI
Deator
No Lag
M1
0.06
M2
0.36
0.07
0.45
One-Year Lag
M1
0.09
M2
0.38
0.12
0.47
Two-Year Lag
M1
0.11
M2
0.36
0.14
0.35
In extreme cases, yes. A central bank can stop hyperination at once

by refraining from printing money and demonstrating a credible policy
commitment that kills inationary expectations. The German hyperination, for example, disappeared over night, and the same happened in the
hyperinationary episodes examined by Sargent (1982). An independent
central bank can avoid hyperination by refusing to nance the budget
decit or public debt repayments by printing money. However, it is a
dierent story under moderate ination where contributory factors other
than the money supply play a role.
Ination targeting is an economic policy whereby the central bank
announces a target ination rate then attempts to steer the actual ination
rate towards the target rate through changes in interest rates and other
policy tools. If, for example, the current ination rate is higher than the
target rate, the central bank is likely to raise interest rates. The former
governor of the Bank of England, Mervyn King, once described those
advocating ination targeting as ination nutters, arguing that central
bankers who concentrate on the ination target to the detriment of stable
growth, employment and/or exchange rates (Poole, 2006). This policy is
used in a number of countries, including New Zealand and Canada.
One of the problems with ination targeting is that the required interest
rate adjustment may hurt economic growth. Some economists prefer a
nominal income target that takes into account real income and prices. The
underlying idea is that the central bank should stabilize both output and
the general price level. For example, Quiggin (2012) argues that a system
of nominal GDP targeting would maintain or enhance the transparency
associated with a system based on stated targets, while restoring the
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72
balance missing from a monetary policy based solely on the goal of

price stability. He actually blamed the late-2000s recession on ination
targeting, arguing that in the post-crisis environment, achievement of
ination targets has no longer promoted stable economic growth and that
low ination has been a drag on growth. Frankel (2012) suggests that
ination targeting evidently passed away in September 2008, referencing
the global nancial crisis and arguing that ination targeting has been a
distraction from asset-price bubbles.
Ination targeting is associated with the Taylor rule, which stipulates
that for every 1% increase in ination, the central bank should raise the
nominal interest rate by more than one percentage point. The rule was rst
proposed by Taylor (1993) and simultaneously by Henderson and McKibbin
(1993) the objective being fostering price stability and full employment
by systematically reducing uncertainty and increasing the credibility of
future actions by the central bank.
3.7. Central Bank Independence
Since the 1990s, there has been a worldwide tendency to introduce central
bank independence with the objective of curbing ination. The underlying
proposition is that it is central banks that allow ination to happen,
typically under pressure from the government. This is certainly true of the
major episodes of hyperination. Ination bias is inherent in discretionary
monetary policy if the objective for real output is to be above the economys
potential output or if policy makers simply prefer higher output levels
(Barro and Gordon, 1983). Elected ocials may be motivated by short-run
electoral considerations or may value short-run economic expansions highly
while discounting the long-term inationary consequences of expansionary
policies. If the ability of the elected ocials to distort monetary policy
results in excessive ination, then countries whose central banks are independent of such pressure should experience lower ination rates.13 This is
how The Economist (2012a) describes this issue:
Societies give unelected technocrats power over monetary policy because
they think they will do a better job than politicians with an eye on the
next election. Some countries with memories of painful inflation (notably
13 Some
observers suggest that the U.S. administration is putting pressure on the

independent Federal Reserve to indulge in quantitative easing, justifying this action
as being necessary to bring down the unemployment rate.
August 10, 2013
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73
Germany) reached that conclusion decades ago. But in many places it is

a more recent idea.
While central bank independence may be advocated for fear of ination,

fear of deation can be a reason why independence is argued against. For
example, central bank independence was a big issue in the 2012 Japanese
general election. In his campaign, the current Prime Minister, Shinzo Abe,
attacked the Bank of Japan for acting too timidly against deation.
The Economist (2012a) also reports that some German lawmakers are
furious that the European Central Bank has promised unlimited purchases
of government bonds from the euro zones peripheral economies. The
conclusion reached by this article is that while elected politicians should be
given the responsibility of setting targets or objectives for central bankers,
politicians should keep their noses out of bankers business.
The empirical evidence shows that average ination is negatively
related to central bank independence (see for example, Cukierman, 1992;
Walsh, 2003). However, the empirical work attributing low ination to
central bank independence has been criticized along two dimensions.
First, studies of central bank independence and ination failed to control
adequately for other factors that might account for cross-country dierences
in ination rates. Countries with independent central banks may dier in
ways that are systematically related to average ination. After controlling
for other potential determinants of ination, Campillo and Miron (1997)
found little role for central bank independence. Second, treating a countrys
level of central bank independence as exogenous may be problematic.
Posen (1993) has argued strongly that both low ination and central bank
independence reect the presence of a strong constituency for low ination.
Average ination and the degree of central bank independence are jointly
determined by the strength of political constituencies opposed to ination.
In the absence of these constituencies, simply increasing a central banks
independence will not cause ination to fall.
It remains to be true, however, that since hyperination is a scal/
monetary problem caused by the monetization of the budget decit, central
bank independence is crucial for the prevention of hyperination or if it has
already occurred, putting it to an end. In reality, governments can and do
exert signicant inuence on the central bank the power to do that
can be abused by putting politics before economics. The Fed is currently
monetizing the decit because that is what the U.S. government wants.
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The view put forward by Milton Friedman that ination is always and
everywhere a monetary phenomenon has a big element of truth but
we cannot rule out other causes of ination as being irrelevant. The
characterization of ination as a monetary phenomenon may be more
valid under hyperination than under moderate ination, but even under
hyperination non-monetary factors play a role in the inationary process.
However, even if ination is caused by non-monetary factors, monetary
validation and accommodation are necessary for sustained ination. It is
all about how we dene ination, whether or not it is strictly dened as a
long-run persistent increase in the price level. If it is dened in this way, then
Freidmans characterization is valid. Meanwhile, we cannot characterize big
jumps in the general price level caused by non-monetary factors as noninationary because they do have the same inationary consequences. We
examine the non-monetary theories of ination in Chapter 4 and consider
the consequences of ination in Chapter 5.
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Chapter 4
OTHER THEORIES OF INFLATION

AND SOME EXTENSIONS
4.1. Demand-Pull Inflation
Demand-pull ination arises in a growing economy with low unemployment.
As wages rise, people tend to consume more, putting upward pressure on the
general price level. Ination occurs when production cannot cope with rising
demand, which happens particularly when the economy is operating above
capacity (that is, above what it can produce with the full employment of its
resources, which is represented by potential output). Thus, we should expect
ination to accelerate when the economy is above potential output and
for inationary pressure to subside when the economy has spare capacity
as it operates below potential output. The dierence between actual and
potential output is called inationary gap if actual output is above
potential output and deationary gap if otherwise.1 Demand pressure
emerges during an inationary gap, giving rise to inationary pressure.
Ination eases in a deationary gap, giving way to rising unemployment.
The problem is how to estimate the potential output and consequently
the inationary and deationary gaps. Typically, this is done by tting a
time trend to a series of observations on output. The gaps are then measured
as the dierence between actual and potential output (typically measured
in percentage terms). This is done in Fig. 4.1 where output is real GDP
in the U.S. over the period 19632011. Potential output is represented by
a cubic time trend in the top part of Fig. 4.1, which is superimposed on
the time plot of actual GDP; whereas the bottom part of Fig. 4.1 shows
the inationary and deationary gaps. Since 2008, the U.S. economy has
1 The
dierence between actual and potential output is also called cyclical output.
75
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76
Actual and Potential Real GDP

16000
14000
12000
10000
8000
6000
4000
2000
0
1963
1967
1971
1975
1979
1983
1987
Actual GDP
1991
1995
1999
2003
2007
2011
2003
2007
2011
Potential GDP
Inflationary and Deflationary Gaps (%)

8
6
4
2
0
1963
1967
1971
1975
1979
1983
1987
1991
1995
1999
-2
-4
-6
-8
-10
-12
Fig. 4.1.
Actual and potential GDP with the corresponding gaps in the U.S.
been in a deationary gap following the inationary gap associated with the
nancial boom that came to an end with the advent of the global nancial
crisis. There was also a big inationary gap in the rst half of the 1970s.
Figure 4.2 shows how ination and unemployment vary with cyclical
output and how they behave during inationary and deationary gaps.
Casual empiricism seems to support the proposition that ination rises in an
inationary gap where there is demand pressure and falls in a deationary
gap as demand pressure eases. This can be seen clearly in the top part of
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77
Inflation Rate and Gap (%)

15
10
0
1963
1967
1971
1975
1979
1983
1987
1991
1995
1999
2003
2007
2011
1995
1999
2003
2007
2011
-5
-10
-15
Inflation
Gap
Unemployment Rate and Gap (%)

15
10
0
1963
1967
1971
1975
1979
1983
1987
1991
-5
-10
-15
Unemployment
Fig. 4.2.
Gap
Unemployment, ination and gaps in the U.S.
Fig. 4.2. The correlation coecient between ination and cyclical output
is 0.32, which is statistically signicant. In the bottom half of Fig. 4.2, we
can observe how unemployment falls in an inationary gap, and vice versa.
The correlation coecient between cyclical output and the unemployment
rate is 0.59, which is highly signicant in a statistical sense.
Excess demand pressure may be either domestic or imported. If it is
domestic it may be either monetary or non-monetary. The reason why
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money comes in is that demand is related to money, in the sense that

demand is eective only if it is backed by the ability (of consumers) to pay
the market price that is, the purchaser has the money to pay. Hence,
any given ination rate can be maintained if it is supported by a sucient
expansion in the money supply, which takes us back to the monetary theory
of ination.2
The distinction between monetary and non-monetary excess demands
can be made with respect to government spending, which is a component
of aggregate demand and a source of demand for goods and services.
If the increase in government spending is nanced by printing money,
the resulting excess demand is monetary; if it is nanced by raising taxes
or borrowing, then it is non-monetary. Even private expenditure may be
monetary and non-monetary, depending on the policy response. If the
central bank responds by increasing the money supply (providing liquidity)
in reaction to a hike in demand, excess demand will be monetary; otherwise,
it is non-monetary.
Excess demand, hence demand ination, can be imported through
three dierent channels: trade, capital movements, and migration. Trade
eects occur whenever a change in exchange rates, taris and foreign
ination occur. For example, excess demand arises from foreign sources as a
result of domestic currency depreciation (making domestic goods cheaper in
foreign markets), reduction or removal of taris (having the same eect as
currency depreciation) and a rise in foreign ination (making foreign goods
increasingly more expensive relative to domestic goods). Capital imports
may lead to the same result if foreign capital is used to nance domestic
expenditure such as government spending and private investment (and it
is likely to have a direct eect on the money supply by allowing banks to
lend more). Excess demand may also result from foreign migrating labor.
4.2. Cost-Push Inflation
When rms are faced with rising input costs, such as commodity prices and
wages, they tend to preserve protability by passing on the increase in the
cost of production to the consumer in the form of higher prices. One source
of cost-push ination is dierent rates of technological progress. When
technological progress in one sector is rapid, productivity of this sector will
increase and so will the wages, tempting workers in other sectors to demand
2 This
is why some economists do not consider the demand-pull explanation for ination
as dierent from the monetary explanation.
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similar wage increases. However, the cost-push eect has been traditionally
blamed on trade unions demanding wage rises, hence pushing up prices.
Cohen and Linton (2010) identify unionization and the legal infrastructure
that bolstered unions bargaining positions as the distinguishing feature of
ination in the 1970s and 1980s.
Figure 4.3 shows some simulated data to demonstrate what happens as
the unit cost rises and producers respond by raising the price to match the
rise in cost. The unit cost is shown to rise at rates ranging between zero and
3% per period while producers respond by raising the price proportionately.
As the price rises, the quantity demanded declines but because demand is
assumed to be relatively inelastic, total revenue rises. As a result, prot
is not only maintained but also rises in total and per unit sold (the prot
margin). The outcome is ination as the price rises continuously. Figures 4.4
and 4.5 show how the general price level in the U.S. (represented by the
GDP deator) is related to oil prices and wages.
Like the demand-pull eect, the cost-push eect may originate from
foreign ination (through imported goods) and the exchange rate (domestic
currency depreciation). If the rise in import prices is passed on in full to
domestic consumers, the general price level rises by a percentage that is
equal to the percentage rise in import prices multiplied by the proportion of
imports to total spending. The opposite view is that, provided the monetary
and scal authorities maintain a constraint level of aggregate demand, rising
import costs do not lead to a rising general price level. In this case, a
complex series of price and wage changes balance out and keep the price
level unchanged.
Ination can get out of control because price increases lead to higher
wage demands as workers (people in general) try to maintain their real
living standards. Firms then raise prices to maintain prot, which puts
further upward pressure on wages. This process is known as a wageprice
spiral, a vicious circle whereby higher wages lead to higher prices and
higher prices lead to higher wages. Figure 4.6 shows a wageprice spiral
where big discrete changes in wages are followed by corresponding increases
in prices leading to further wage rises and so on.
4.3. A Combined Demand-Cost Model

The Nordic model of ination is a combined demand-cost model (see, for
example, Aukrust, 1975). According to this model, the economy consists
of a sheltered sector and an exposed sector. The sheltered sector comprises
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Price and Unit Cost

300
Profit Margin
25
250
20
200
15
150
100
10
50
0
10 15 20 25 30 35 40 45 50
5
Price
Unit Cost
10 15 20 25 30 35 40 45 50
Quantity
350
Total Revenue and Total Cost

45000
300
40000
250
35000
200
30000
150
100
25000
0
10 15 20 25 30 35 40 45 50
10 15 20 25 30 35 40 45 50
Total Revenue
Fig. 4.3.
Total Cost
Maintaining protability by passing costs to consumers (simulated data).
private-sector services, goods for which taris or transport costs are an

eective barrier to trade, and most of the public sector. The exposed sector
encompasses exports and home-produced goods that are close substitutes
for imports.
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Indices
3500
3000
2500
2000
1500
1000
500
0
1963
1967
1971
1975
1979
1983
1987
1991
GDP Deflator
1995
1999
2003
2007
2011
1995
1999
2003
2007
2011
Oil Price
Percentage Changes
120
100
80
60
40
20
0
1963
1967
1971
1975
1979
1983
1987
1991
-20
-40
-60
Inflation
Fig. 4.4.
Oil Price
Oil price and the U.S. GDP deator.
Firms belonging to the exposed sector of a small open economy are

governed by supply and demand in world markets they are price takers.
If the exchange rate is xed, money wages are determined by world prices
and domestic productivity. Competitive pressure causes productivity to
grow faster in the exposed sector. Sheltered sector workers obtain higher
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82
Indices
700
600
500
400
300
200
100
0
1963
1967
1971
1975
1979
1983
1987
GDP Deflator
1991
1995
1999
2003
2007
2011
1999
2003
2007
2011
Wage Index
Percentage Changes
10
9
8
7
6
5
4
3
2
1
0
1963
1967
1971
1975
1979
1983
Inflation
Fig. 4.5.
1987
1991
1995
% Change in Wages
The U.S. wages and GDP deator.
money wages that maintain their level relative to those in the exposed
sectors. Firms in the sheltered sectors pass on these increases in prices.
Prices in the exposed sector rise at the world rate while prices in the
sheltered sectors go up at a higher rate. Combining the two, prices in a small
open economy will rise faster than the world average. This model cannot
apply to the whole world hence, it cannot explain worldwide ination.
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83
200
180
160
140
120
100
80
0
10
15
20
25
Wages
Fig. 4.6.
30
35
40
45
50
Prices
Wageprice spiral (simulated data).
4.4. Inflationary Shocks, Monetary Accommodation

and Monetary Validation
Inationary shocks may be demand shocks or supply shocks, corresponding
to the demand-pull and cost-push models of ination, respectively. For
example, the huge increases in oil prices in 19731974 and 1979 represented
supply shocks. The inationary consequences of a demand and supply
shock depend on the policy response of the monetary authorities. More
specically, it depends on whether the monetary authorities validate a
demand shock and accommodate a supply shock by increasing the money
supply. Monetary validation may be necessary to counteract rising interest
rates and liquidity shortage in the case of a demand shock.
A consideration of what happens with and without monetary accommodation or validation leads to the following conclusions. First, without monetary accommodation, supply shocks cause temporary bursts of ination
accompanied by deationary gaps, which can be removed if unit production
cost falls to restore equilibrium at potential output and the initial price
level. Second, without validation, demand shocks cause temporary bursts
of ination accompanied by inationary gaps, which can be removed as
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Supply Shock
120
115
110
105
100
95
90
0
10
15
20
25
30
35
40
45
50
30
35
40
45
50
Demand Shock
120
115
110
105
100
95
90
0
Fig. 4.7.
10
15
20
25
Shocks without monetary accommodation and validation (simulated data).
wages rise, putting output at the potential level but at a higher price level.
The nal conclusion is that an ever-increasing money supply is necessary for
an ever-continuing ination. Figure 4.7 shows how the general price level
recasts to supply and demand shocks without monetary accommodation
and validation.
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4.5. The Fiscal Theory of Inflation

The scal theory of ination postulates that scal policy aects the general
price level and hence ination.3 This means that to control ination, scal
conditions must be sustainable in the sense that a balanced budget is
maintained over the course of the business cycle. In other words, while a
cyclical decit can be tolerated, something must be done about a structural
decit. This theory was developed primarily by Leeper (1991), Sims (1994)
and Woodford (1994, 1995) as an alternative to the monetary theory of
ination. While some economists see the two views as being complementary,
others see the scal theory as having loopholes or totally incorrect.
Woodford (1995) suggests that the equilibrium price level (hence the
ination rate) is the level that makes the real value of nominally denominated government liabilities equal to the present value of expected future
government budget surpluses. In nominal terms, the government must pay
o its existing debt by one of the following means: (i) renancing that
is, rolling over the debt or issuing new debt to pay debt; (ii) amortizing
that is, paying it o from surpluses in tax revenue; or (iii) defaulting on the
debt. In real terms, a government can also inate away the debt by allowing
high ination, so that the real amount it must repay will be smaller. Thus,
if the scal conditions are unsustainable in the sense that the government
is unable to pay o its debt out of tax revenue (which is what a structural
decit is all about), then it will choose the option of inating the debt
away. It follows that scal discipline, meaning a balanced budget over the
course of the economic cycle, is necessary for price stability. In other words,
unsustainable decits will trigger ination in future.
The scal theory of ination has been criticized, among others, by
Kocherlakota and Phelan (1999) and Buiter (2002). For example, Buiter
(2002) puts forward the following view of the scal theory of ination:
It is not common for an entire scholarly literature to be based on a
fallacy, that is, on faulty reasoning; misleading or unsound argument.
The fiscal theory of the price level, recently re-developed by Woodford,
Cochrane, Sims and others, is an example of a fatally flawed research
programme. The source of the fallacy is an economic misspecification.
3 This
theory is typically known as the scal theory of the price level. It follows by
denition that it is also a theory of ination.
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He further adds:
The issue is of more than academic interest. Policy conclusions could
be drawn from the fiscal theory of the price level that would be
harmful if they influenced the actual behavior of the fiscal and monetary
authorities.
In particular, Buiter is critical of the assumption or proposition that the

scal theory of ination implies that a government could exogenously x
its real spending, revenue and seigniorage plans and that the general price
level would adjust the real value of its contractual nominal debt obligations
so as to ensure government solvency. However, the scal theory of ination
is highly relevant to episodes of hyperination, which is described by some
economists as a scal phenomenon.
4.6. The Political Theory of Inflation
The political business cycle models developed by Nordhaus (1975) and
Lindbeck (1976) postulate that central banks pursue an expansionary
monetary policy in the period leading up to an election in order to boost the
governing partys chances for re-election. While this happens in practice, it
is in direct contrast with the principle of central bank independence that
governments claim to uphold.
The political theory of ination is based on one of two approaches.
Under the populist approach, conict over the distribution of economic
gains and losses forces the government to respond to public demand by
resorting to inationary nance. Nelson (1993), Haggard and Kaufman
(1992) and ODonnell et al. (1986) suggest that ination is less likely if
the government can avoid these pressures. On the other hand, those who
are following the state-capture approach attribute inationary pressures
not to demand for inationary nancing by the public but rather by the
politicians holding oce, their cronies and the elite. Hellman et al. (2000)
identify two kinds of private benets from inationary nancing: (i) credits
issued by the central bank can be directed to favored sectors, and (ii) the
resulting ination reduces real interest rates and erodes the real value of
outstanding liabilities.
In general, governments typically exhibit inationary bias, which is
more conspicuous under adverse conditions like war or revolution. In doing
so, the government prefers a concentration of the benets of its actions
in a small segment of the population so that they are perceived while the
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87
costs are spread widely so that they are not felt. This is true not only of
democratically elected governments but also of dictatorships, since dictators
tend to secure power by spending considerable resources on the military,
police and the secret service.4 They also try to safeguard their future
wellbeing against the possibility of coup detat by transferring resources
overseas. Inationary nancing may also be benecial for a dictator wishing
to alleviate the resistance of people to the regime by imposing excessively
high tax burdens. We will come back to the political theory of ination in
Chapter 6 as we use it to explain hyperination.
4.7. The Other Side of the Coin: Deflation
With reference to the quantity theory of money, deation must be associated with a shrinking money supply, declining velocity of circulation or a
growing output. In general, deation is experienced when the money supply
grows more slowly than population and output. When this happens, the
available amount of money per person falls, in eect making money more
scarcer consequently the purchasing power of money rises. Deation
occurs when the prices of goods decline as a result of improvements in
production eciency.
Deation may be caused by a combination of supply and demand
factors in the markets for goods and money specically the supply of
money going down and the supply of goods going up. Historically, deation
has often been associated with the supply of goods going up (due to higher
productivity) without an increase in the money supply, or (as with the Great
Depression and possibly Japan in the early 1990s) the demand for goods
going down combined with a monetary contraction. Demand-side factors
include an enduring decline in the real cost of goods and services resulting
in competitive price cuts, and reduction in consumption because of cash
hoarding, leading to a decrease in the velocity of circulation. Examples of
a supply-side factor are a decline in credit due to bank failures, increased
perceived risk of defaults, and a contraction of the monetary base.
A deationary spiral is a situation where falling prices force rms to
reduce production, which leads to lower wages and demand. It occurs when
falling prices lead to a vicious circle a problem that exacerbates its own
4 Hyperination
in Iraq started in 1991 when Saddam Hussien decided to quadruple the

salaries of the military and nance the project by printing money while the country
was under sanctions.
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cause (the Great Depression was regarded by some as a deationary spiral).

Another related idea is Irving Fishers theory that excess debt can cause
a continuing deation (Fisher, 1933). During the Great Depression overcapacity, market saturation and the SmootHawley Tari Act5 caused a
sharp contraction of international trade, severely reducing the demand for
goods, thereby idling a great deal of capacity, and setting o a string of
bank failures. The fall in demand causes a fall in prices as excess supply
emerges. This becomes a deationary spiral when prices fall below the costs
of nancing production. Unable to make enough prot no matter how low
they set prices, businesses are consequently liquidated. Banks get assets
which have fallen dramatically in value since their mortgage loan was made.
If they sell those assets, they boost excess supply, which only exacerbates
the situation.
Deation was experienced in Hong Kong in the aftermath of the
Asian nancial crisis in late 1997. In February 2009, Irelands Central
Statistics Oce announced that the country experienced deation in
January 2009, which was the rst time deation that had hit the Irish
economy since 1960. However, it is the Japanese deationary experience,
which started in the early 1990s, that has attracted most of the attention.
The Bank of Japan tried to eliminate it by reducing interest rates and
indulging in quantitative easing, but did not create a sustained increase
in broad money hence, deation persisted. Several reasons can be put
forward to explain the Japanese deation: (i) tight monetary conditions;
(ii) unfavorable demographics in the form of an aging population; (iii) falling
asset prices as a result of correction back to the price level that prevailed
before the asset bubble of the 1980s; (iv) insolvent companies with huge
bank loans; (v) insolvent banks with a large percentage of non-performing
loans; (vi) fear of insolvent banks, which caused a sharp decline in deposits;
(vii) imported deation, coming through imports from China; and (viii)
stimulus spending, which may have caused a crowing out of private
investment.
The U.S. economy has been through four signicant periods of deation. The rst and most severe was during the depression of 18181821
when the prices of agricultural commodities declined by almost 50%. That
5 The
SmootHawley Act, which was signed by President Herbert Hoover in June 1930,
allowed the U.S. government to impose taris on foreign imports. It triggered a tit-fortat reaction from other countries, destroying international trade in the process. The act
is largely blamed for the advent of the Great Depression.
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episode was caused by a credit contraction resulting from a nancial crisis

in England. The second was the depression of the late 1830s to 1843,
following the panic of 1837, when currency in circulation contracted by
about 33%. The third was after the Civil War sometimes called the
great deation. It was possibly spurred by a return to the gold standard,
retiring paper money printed during the Civil War. The period 18731896
witnessed signicant cost-cutting and productivity-enhancing technologies.
The fourth was during the period 19301933 when thousands of banks
failed and unemployment peaked at 25% during the Great Depression. The
deation of the Great Depression occurred partly because there was an
enormous monetary contraction.
Economists generally accept the view that ination is ultimately a monetary
phenomenon, but the roots of the problem can be scal and political.
For political reasons, a chronic scal decit may develop, which cannot
be sustained and eventually it is monetized, thus generating ination.
This sequence of events is more relevant to hyperination, which is the
subject matter of Chapter 6. It is for this reason that hyperination
has been described as a monetary problem, a scal problem and a
political problem. As far as moderate ination is concerned, demand-pull
factors and cost-push factors are important contributors to inationary
pressure. Yet, some economists view demand-pull ination as a monetary
phenomenon, while others believe that demand-pull ination cannot arise
without monetary validation. Likewise, some economists believe that costpush ination cannot materialize without monetary accommodation. After
all ination is about money losing its value over time in this sense it is
a monetary problem. However, ination can be triggered or aggravated by
non-monetary factors.
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Chapter 5
THE CONSEQUENCES AND COSTS

OF INFLATION
5.1. Introduction
Ination has a range of economic and social costs and adverse consequences.
Serious ination destroys the monetary system and disrupts the transactions, relationships and institutions that require such a system not only to
function but also to exist. It is the monetary system that allows people to
engage in indirect exchange, use debt and store value. This is why governments attach considerable importance to the control of ination and the
objective of price stability.
In a speech delivered to the London School of Economics on 19
November 2002, the former governor of the Bank of England, Mervyn
King, argued, it is clear that very high ination in extreme cases
hyperination can lead to a breakdown of the economy, citing a considerable body of evidence that ination and output growth are negatively
correlated in high-ination countries. However, he added, for ination
rates in single gures, the impact of ination on growth is less clear
(King, 2002). Peter Jonson, a former head of research at the Reserve Bank
of Australia quotes John Phillips, deputy governor of the Reserve Bank
of Australia, while saying, in the battle for national advantage, ination
ranks as one of the three or four great scourges and it probably ranks
behind greed and apathy, although it is closely related to both (Jonson,
1990). Jonson goes on to summarize the consequences of ination by saying
that ination forces up rates of interest, saps competitiveness, reduces
incentives to save and to invest and, ultimately, puts at risk a countrys
nancial and economic stability, concluding that eliminating ination
requires a national consensus that the costs of ination are much greater
than generally thought.
91
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Ination aects businesses, investors and consumers. The extent of

the adverse consequences of ination depends on how high it is. Excessive
ination can wreak havoc on retirement savings as it reduces the purchasing
power of the money that savers set aside for a rainy day. It also depends
on how volatile ination is, hence, distinction is made between anticipated
and unanticipated ination. If ination is anticipated, in the sense that
people can make accurate predictions of the ination rate, they can take
steps to protect themselves from its eects. For example, workers can
(perhaps through unions) negotiate with employers for higher money wages
so as to preserve real wages. Households may also be able to switch savings
into deposit accounts oering a higher nominal interest rate or into other
assets, such as real estate or stocks, which can act as a good ination hedge.
The objective in both cases is to protect the real value of wealth and cash
ows. Companies can adjust prices and lenders can adjust interest rates.
Businesses may also seek to hedge against future price movements by using
forward and futures contracts. For example, airlines buy their aviation fuel
several months in advance in the forward market, partly as a protection
against uctuations in spot oil prices. Inationary problems arise when we
experience unanticipated ination that is not adequately matched by a rise
in peoples incomes. If incomes do not rise along with the prices of goods,
the purchasing power of money will dwindle, which can in turn lead to a
slowing or stagnant economy.
Economists tend to agree on the desirability of a low, steady ination
rate. Low (as opposed to zero or negative) ination reduces the severity of
economic recessions by enabling the labor market to adjust more quickly in
a downturn, and reduces the risk that a liquidity trap prevents monetary
policy from stabilizing the economy. This is why ination is said to have a
good side despite it being a devastating economic problem. In this sense,
the objective of price stability does not mean a zero ination rate but rather
an ination rate in the range 23% or something like that. One reason for
the desire to maintain an above-zero ination rate is that the CPI tends
to overestimate ination as we saw earlier. If that is true, then a zero CPI
ination rate is eectively deation, which takes us to the second reason
that is, concern about deation and even disination.
Fischer (1981) argues that the costs of ination depend on its sources,
on whether and when the ination was anticipated, and/or the institutional
structure of the economy. There is, as Fischer argues, no short answer to
the question of the costs of ination. He further argues that since the
ination rate is not an exogenous variable to the economy, there is some
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93
logical diculty in discussing the costs of ination per se rather than the
costs and benets of alternative policy choices. For some reason, it seems
that Fischer does not think that ination is a big deal.
5.2. The Positive Eects of Ination
It may sound ironic that what is typically known as Public Enemy Number
One has positive eects. The proposition that ination has positive eects
must be qualied in terms of the following caveats: (i) ination must be
moderate, (ii) a possible positive eect for one party may be a negative
eect for another, and (iii) a positive eect is positive only in relation to
the alternative, which is deation. The following are the positive eects of
ination:
1. High ination tends to wipe out debt. Once the ination rate exceeds
the interest rate on loans and other debt instruments, ination is literally eating it away. This may be a positive eect for debtors but it is
not so for creditors. Furthermore, the positive eect is maximized by
maximizing the ination rate. A high ination rate wreaks havoc on the
economy and will more than oset any positive eect. It is because of
this presumably positive eect that lending may be curtailed during high
ination, hence adversely aecting economic activity. Afterall, a negative
eect of ination that we will consider is that it provides disincentive to
save.
2. Osetting the negative eects of deation. However, no consensus view
has emerged in choosing which one is worse: ination or deation. There
is vast literature on the costs of ination versus unemployment (see, for
example, Moosa, 1997b).
3. Moderate ination is considered positive because it results in increasing
wages and corporate protability and keeps capital owing in a presumably growing economy. As long as things are moving in relative
unison, ination will not be detrimental. This is true only if ination
is anticipated, as argued earlier.
4. Ination encourages consumption. For example, if a consumer expects
the prices of consumer durables to rise, this consumer will be encouraged
to buy some now rather than next year. Thus ination can encourage
consumption.1 Again this is true only if ination is expected. Also, for
1 This
is why some observers believe that the undeclared objective of quantitative easing
is to generate ination to revive the economy by encouraging consumption.
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94
this eect to be non-trivial the ination rate must be high, bringing

with it negative consequences. One has to remember that consumption
becomes rampant during hyperination as people rush to get rid of their
money before it loses its value. This can hardly be claimed to be a healthy
state of aairs.
Perhaps, it is worthwhile elaborating on the point that what is perceived
as a positive eect of ination is positive for some. Those who benet from
ination are: (i) borrowers of funds as the real value of repayments falls
over time, (ii) holders of real assets whose value can keep pace with the
rising price level, (iii) workers who have market power and are able to
boost their wages in line with the rising price level, and (iv) those who buy
on credit. On the other hand, there are losers: (i) lenders of money who
nd that the repayments decline in real value, (ii) individuals who have
xed interest investments such as deposits and bonds, (iii) employees in
jobs with poor bargaining positions in the labor market for example,
people in low paid jobs with little or no trade union protection may see
the real value of their pay fall. Because the government is typically the
biggest borrower, ination may seem benecial for governments, and this is
probably why governments pursue inationary policies deliberately.2 Apart
from the reduction in the real value of debt, governments benet from
ination in other ways. Rising prices make it necessary to issue more
currency; hence, the government benets from seigniorage, which is some
sort of an interest-free loan. Another benet for the government is that
ination boosts the yield of taxes at any given tax rate. Perhaps, but
this is not the whole truth. Ination typically erodes government solvency
because of increasing demand for public outlays while it is dicult to tap
new sources of revenue. It also pushes up the cost of ongoing government
operations while demand for new forms of spending emerges. And once
creditors lose their appetite to lend, the ability of the government to raise
new funds is crippled.
All of these propositions may have some element of truth, but there
is a catch here. These benets are signicant only at high ination rates,
but high ination rates inict serious damage on the economy. The claim
that ination has positive eects can be easily challenged. On the contrary,
2 Williams
(2012) suggests that if the U.S. went through a hyperination like that of
Zimbabwes, total U.S. federal debt (more than $80 trillion with unfunded liabilities)
could be paid o for much less than a current U.S. penny.
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listing and rationalizing the negative eects of ination is not such a dicult
job. This is what will be done in the remainder of this chapter.
5.3. Arbitrary Redistribution of Income
Ination causes income redistribution from one group of people to another
as the real value of money is eroded over time. Those who benet are
those who receive money sooner rather than later and pay money later
than sooner, and vice versa. In general, creditors lose, but creditors are
not only banks. Anyone entitled to a deferred payment is a creditor
thus creditors are those holding savings accounts, those investing in bonds,
those paying money into a retirement scheme and those holding insurance
policies. Blaug (1993) explains why the redistributive eects of ination are
arbitrary and haphazard in their incidence as follows:
Ination may hit the young because they are rst-time home buyers, and
may benet the old because they own appreciating real assets. But it is
equally likely that ination may hit the old because they are creditors
and may benet the young because they are debtors.
Figure 5.1 demonstrates how the real value of capital invested at a xed
interest rate is eroded by ination. The situation pertains to an individual
800
700
600
500
400
300
200
100
0
0
10
15
Zero Inflation
Fig. 5.1.
20
25
2%
4%
30
35
40
6%
8%
10%
45
50
Real and nominal values of an invested amount of 100 (simulated data).
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Amount Invested at TB Rate

900
600
300
0
1972
1977
1982
1987
1992
Nomina
1997
2002
2007
2012
2002
2007
2012
Real
Amount Invested at 10 Year Bond Yield

1800
1500
1200
900
600
300
0
1972
1977
1982
1987
1992
Nominal
Fig. 5.2.
1997
Real
Real and nominal values of invested amounts at the U.S. interest rates.
investing in a xed interest deposit paying 4%. If the ination rate is zero,
the invested capital (in real terms) grows rapidly. At an ination rate of
2%, it grows less rapidly. At an ination rate of 10%, the whole thing
disappears after a while, as the real value approaches zero (using precise
gures the invested capital loses 94% of its purchasing power despite the
accumulation of interest payments). In Fig. 5.2, we show how $100 invested
in the U.S. Treasury bonds and bills fared over the period 19722011. In
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97
both cases, the amount changed very slightly in real terms. This is why
ination is the biggest enemy of the bond market. Ination in this sense is
like the imposition of a tax; hence, the term ination tax. This is why it
has been argued that allowing ination to arise and persist is tantamount
to endorsing theft (Jonson, 1990). Ferguson (2008) points out that the
ination tax is not only applicable to bondholders but also to anyone living
on xed cash income. Therefore, it aects primarily the upper middle classes
such as senior civil servants and professionals. Only entrepreneurs are in
a position to insulate themselves by adjusting prices upwards, hoarding
foreign currencies and investing in real assets.
Figures 5.1 and 5.2 show that the issuers of bonds benet from ination
because they pay less in real value than what they borrow. Losses incurred
by lenders are the gains accruing to borrowers. In terms of Fig. 5.1,
the borrower receives 100 but what the borrower pays the lender in real
terms when ination runs at 10% is only 6. In terms of Fig. 5.2, the U.S.
government borrowed 100 in terms of Treasury bills, paying back 187 when
it should have paid back 781 under zero ination. The corresponding gures
for bonds are 152 and 1,456, respectively. This is a transfer of purchasing
power from the holders of bills and bonds to the government.
The redistributive eect of ination may be dealt with through indexation, whereby contractual obligations xed in money are adjusted to reect
the ination rate. There is the problem of choosing the price index and
whether or not the same index should be used for all purposes. The following
are examples of how indexation is applied in specic situations:
1. Pensions and other social security benets are linked to a price index
and adjusted accordingly.
2. The exemption limit for personal income tax is not stated as a xed
sum of money, but rather adjusted by the percentage change in the
price index since the base period. For example, if the exemption limit is
$10,000 while the ination rate is 5%, the real value of the exemption
rate is $9,091. To maintain the real value of the exemption limit, it
should be raised to $11,000.
3. For capital gains taxes, the purchase price is adjusted for changes in the
price index between the dates of purchase and sale. For example, if the
price of an asset that is subject to a capital gains tax rate of 20% rises
from $100 to $110, the tax payable on realized gains is $2. If the ination
rate is 5% and the sale price is adjusted for ination, the tax payable on
realized gains is $0.95.
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4. Depreciation allowances should be adjusted so that allowances for tax

purposes would be sucient to cover the replacement cost of xed assets.
Stocks should be valued at replacement cost at the time of use (the FIFO
procedure for inventory accounting).
5. The following items are adjusted for ination: interest payments and the
face values of xed-income securities, interest on deposits and loans, and
long-term contracts and wage agreements.
While indexation in itself cannot be a cure for ination, it can reduce
the cost of applying other cures such as contractionary monetary and
scal policies. Such policies may, with indexation, appear to be more
politically acceptable than otherwise. Indexation may also reduce the
risk that monetary and scal policies designed to reduce ination would
precipitate a depression. However, indexation is not without problems.
Payments of ination adjustments would involve both the government and
private sector in heavy expenses. Another argument is that it will reduce
gains to the government from ination (reducing the rise in revenue and
increasing the rise in spending), which would boost the probability that
the government has to raise taxes. It is also argued that indexation would
lead to an acceleration of ination. However, these arguments are based
on confusion between real and money payments and the assumption that
people are not prepared to accept lower initial payments in the presence
of indexation. Indexation, however, remains a treatment for the symptom
rather than the cause.
5.4. Business Planning and Investment
Ination can disrupt business planning. Budgeting becomes dicult because of the uncertainty created by rising prices and costs this may reduce
planned capital investment spending (see, for example, Cooley et al., 1975).
One of the most important business decisions that are aected by ination
is that of capital budgeting since ination may lead to inecient allocation
of capital. Failure to consider the impact of ination tends to produce
sub-optimal capital budgeting decisions for several reasons. For example,
cash-ow estimates must embody anticipated ination if the discount rate
contains an element attributable to ination. Ignoring this adjustment
would result in either an upward or a downward appraisal bias, depending
on the relative responsiveness to ination of cash inows and outows.
Even if cash expenses and revenues from an investment project were fully
responsive to ination, depreciation tax-shields would suer diminution
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99
of real value since, in conventional accounting procedures, depreciation

computations are based on historical cost.
Sub-optimal decisions may also result from overlooking the synergistic
reduction of real returns due to taxation and ination. With no ination,
a 50% tax bracket and a before-tax return of 4% produce a real aftertax return of 2%. If an ination rate of 4% is introduced, before-tax return
must be 12% to oset the combined eects of taxation and ination. Simply
adding 4% to the before-tax return to counteract 4% ination is insucient,
and would cause a 2% reduction in real return because taxes are paid on
nominal income, not real income.
Under normal conditions, a capital project is undertaken if it produces a
positive net present value or, in the case of two mutually exclusive projects,
the project that has the higher net present value (NPV) is selected. Without
taking ination into account, the cash ows expected from the project are
discounted at a discount rate that reects the risk-free rate and a risk
premium, where the risk-free rate has an ination component (the Fisher
equation).3 The sum of the discounted cash ows and the capital cost of
the project is the net present value. Under inationary conditions, the cash
ows are discounted by the expected ination rate, then real cash ows
are discounted at the real interest rate, which excludes any inationary
element. Hence without ination, we have
NPV = C0 +
n

t=1
Ct
.
(1 + i)t
(5.1)
Under inationary conditions, the net present value is calculated as

NPV = C0 +
n

t=1
Ct
.
(1 + )t (1 + i )t
(5.2)
Since the two equations give dierent results, using Eq. (5.1) may lead
to erroneous results under inationary conditions. Another implication is
that wrong capital budgeting decisions will be taken if the ination rate is
volatile or if ination is unanticipated.
Under inationary conditions, business planning becomes more dicult. Ination makes projects riskier, which means that a project with
smaller pay back period may be preferred. Inationary conditions may make
it necessary to acquire the additional funds used to nance xed assets and
3 See
Sec. 5.7, Eq. (5.7).
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working capital. Ination may make it necessary to raise the sale price of
output, with uncertain impact on demand. Ination may result in higher
input costs, which undermines protability.
5.5. Miscellaneous Business Costs
Miscellaneous business costs arise in the form of higher interest, commodity
prices and wages. In addition, there are the typical menu costs and shoeleather costs. Menu costs arise from the necessity of changing prices. While
the term menu costs stems from the cost of restaurants literally printing
new menus, economists use it to refer to the costs of changing nominal prices
in general. Menu costs may include updating computer systems, re-tagging
items and hiring consultants to develop new pricing strategies. Even when
there are few apparent costs to changing prices, customers may become
apprehensive about buying at a given price, resulting in a menu cost of lost
sales. Dawson (1992) indicates that the annual ination rate must be 20%
before menu costs amount to 0.1 of a percentage point.
Shoe-leather costs are incurred by both businesses and individuals. The
term refers to the time spent looking for the best price. More specically,
it refers to the opportunity cost of the time and energy spent to achieve
the objective of holding less cash and having to make additional trips
to the bank. It is similar to the role played by the interest rate in the
demand for money function. When ination and inationary expectations
rise, the nominal interest rate goes up. Because the interest rate is the
opportunity cost of holding money (dened in a narrow sense as a noninterest bearing asset), a higher interest rate reduces the demand for cash
balances because people prefer to keep more of their funds in interestbearing accounts. Holding less cash requires more trips to the bank, hence
shoe-leather costs. This anti-ination activity replaces productive activity,
with negative eects on the economy. Calza and Zaghini (2011) estimate
the shoe-leather cost for the U.S., suggesting that at an ination rate of
10%, the cost amounts to negligible 0.05% of total income and that at
lower ination rates, it is even negative thanks to foreigners giving up real
resources to acquire the U.S. money.
5.6. Distortion of the Eect of Taxes
Ination distorts the eect of taxes because taxes are levied on nominal
amounts. Before the U.S. income tax brackets were indexed in 1985,
ination pushed income earners with unchanged real income into brackets
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101
where they faced higher marginal income tax rates, which discouraged
people from making taxable income. However, the capital gains tax is still
levied on nominal gains. The higher the ination rate, the higher is the
eective tax rate on real capital gains, even with an unchanged nominal
capital gains tax rate. Higher ination thus discourages capital formation
by reducing the desirability of accumulating taxable assets. Another taxrelated eect of ination is that it leads to deterioration in the real scal
balance. While the eect is transmitted via several channels, an important
channel is deterioration of real tax revenue because of lags in tax collection.
5.7. The Adverse Eect of Ination on Saving
Ination leads to a rise in the general price level so that money loses its
value. When ination is high, people may lose condence in money as
the real value of savings dwindles. Savers lose out if the nominal interest
rate is lower than the ination rate (that is, if the real interest rate is
negative). This is why ination is the biggest enemy of the bond market
and why long-term bonds do not exist in high-ination countries. Since
saving is important for economic growth, ination adversely aects output,
employment and the standard of living.
Consider an individual using a saving account as a store of value.
Denote the amount saved in this account as K. When K is invested at
an annual interest rate of i for a period of one year, the nominal value of
the principal and earned interest at the end of the period is K(1 + i). The
real value of any amount is calculated by adjusting (deating) the nominal
value by the prevailing general price level. If the general price level is Pt1 at
time t1, when the amount was placed in the saving account, and Pt at the
time of maturity (the end of the year), the real values of the principal and
the principal plus earned interest are K/Pt1 and K(1 + i)/Pt , respectively.
Hence, the real return or real interest rate is given by
1+r =
K(1 + i)/Pt
.
K/Pt1
(5.3)
Since Pt = Pt1 (1 + ) where is the ination rate, it follows that

1+r =
(1 + i)
(1 + )
(5.4)
which gives the approximate formula

r = i .
(5.5)
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30
25
20
15
10
-5
-10
0
10
15
20
25
Real
Fig. 5.3.
30
35
40
45
50
Nominal
Real and nominal interest rates (simulated data).
Hence, as long as > 0, r < i and if > i, r < 0. A negative real interest
rate means that the principal and the interest earned buy less in terms of
goods and services than the principal only prior to the investment. This
can hardly be an incentive for saving.
In Fig. 5.3, we observe simulated data on real and nominal interest
rates. The nominal interest rate is initially held constant at 10% until period
35, then it is allowed to increase by a random factor until it reaches 22%
in period 50. The price level is given a base value of 100, then it is allowed
to rise at various ination rates. We can see that because the ination rate
is always positive in this exercise, the real interest rate is always below the
nominal rate and that it is negative when the ination rate is higher than
the nominal rate. Figure 5.4 shows the real and nominal values of a principal
amount of 100 invested over 25 consecutive periods at the nominal and real
interest rates. With the passage of time, the real value falls increasingly
below the nominal value, showing how ination erodes the purchasing power
of saving. Figure 5.5 shows how the U.S. short-term and long-term interest
rates move with ination, exhibiting strong positive correlation. In Fig. 5.6,
we observe the real interest rates corresponding to the nominal interest
rates: the TB rate, the Federal funds rate and the 10-year bond yield.
Negative real interest rates can be readily observed. Savers and investors
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1200
1000
800
600
400
200
0
0
10
Nominal Amount
Fig. 5.4.
15
20
Real Amount
Real and nominal amounts (simulated data).
are interested in real rather than nominal return this is why in countries
where ination is high, the nominal interest is high.
Equation (5.5) can be written as
i = r + .
(5.6)
If real interest rates are equal across countries, which is implied by real
interest parity, high ination countries should have high nominal rates.
Cross-sectional evidence based on data provided by the World Bank shows
that this is the case as in Fig. 5.7.
Equation (5.6) can be written in an ex ante form as
i = r + e ,
(5.7)
where e is the expected ination rate. This is called the Fisher equation,
which is the basis of using the nominal interest rate to predict ination.
Higher expected ination, therefore, raises the cost of capital for rms.
5.8. The Eects of Ination on Financial Markets
We have already seen how xed income securities are adversely aected
by ination. If ination runs at a constant rate, yields adjust before long,
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Short-Term Interest Rates

20
16
12
0
1972
1976
1980
1984
1988
Inflation
1992
TB Rate
1996
2000
2004
2008
2012
2004
2008
2012
Federal Funds Rate
Long-Term Interest Rates

16
12
0
1972
1976
1980
1984
1988
Inflation
Fig. 5.5.
1992
1996
2000
10-Year Bond Yield
The U.S. nominal short-term interest rates and ination.
but when ination is accelerating, the adjustment does not happen because
of the lags involved in the process. This may cause negative real rates of
return and diculties for governments to borrow.
Consider the value of an investment in a bond with a maturity of n years
after k years, such that k < n, which means the value of the investment at
a particular point in time before maturity. If the bond has annual coupon
payments, the bondholder receives k coupon payments after k years, where
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-2
-4
1972
1976
1980
1984
1988
TB Rate
Fig. 5.6.
1992
Federal Funds Rate
1996
2000
2004
2008
2012
10-Year Bond Yield
Real U.S. short-term and long-term interest rates.
14
12
Inflation Rate
10
0
0
10
12
14
Interest Rate
Fig. 5.7.
Nominal interest rates and ination (cross-sectional data).
16
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each payment is equal to the coupon rate (in per cent) multiplied by the face
value of the bond, C = cF . The total value of the bond investment consists
of (i) the accumulated value of coupon payments reinvested at the market
interest rate (i), and (ii) the market value of the bond (that is, how much
it is worth if it is to be sold at that point in time), which is equal to the
discounted value of the future cash ow (the remaining coupon payments
and the face value of the bond). An expression for the value of the bond
investment at k is the following:
V = [C(1 + i)k1 + C(1 + i)k2 + + C]

C+F
C
C
+ +
,
+
+
1 + i (1 + i)2
(1 + i)nk
(5.8)
where the term in the rst square bracket is the value of re-invested coupon
payments and the term in the second square bracket is the market value of
the bond at time k. Since C and F are xed, the value of the bond depends
on the market interest rate, i. But this is the nominal value, unadjusted for
ination.
Suppose now that ination was running at a constant rate , between
time zero and time k, and that it will be running at the expected ination
rate, e , between k + 1 and n when the bond matures and the face value
become due. The real value of the investment is

C(1 + i)k2
C(1 + i)k1
+
+ + C
V =
(1 + )k1
(1 + )k2

C+F
C
C
+
+
+
.
+
(1 + i)(1 + e ) (1 + i)2 (1 + e )2
(1 + i)nk (1 + e )nk
(5.9)
Thus, the realized real value of re-invested interest payments depends on
historical ination, while the real market value of the bond depends on
expected ination. If for some reason inationary expectations rise, the
bond market is aected adversely in the sense that bond prices fall, hence
yields rise. This is why a positive relation exists between bond yields and
ination. The reason why the bond market is extremely sensitive to ination
is that bonds are xed-income securities. The coupon interest rate is xed in
nominal terms until maturity and cannot be adjusted for ination. Ination
risk is the major type of risk associated with the bond market. Ferguson
(2008) quotes Bill Gross of PIMCO, the biggest player in the bond market,
saying that even as recently as the 1970s, as ination soared around the
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107
world, the bond market made a Nevada casino look like a pretty safe place
to invest your money. This must be a credible testimony, given that Gross
started his career as a blackjack player in Las Vegas.
The situation is dierent for the stock market because stocks are not
xed-income securities. According to the dividend discount model, the
nominal value of a stock at time 0 is determined by expected dividends.
Thus,
V =
D2
D1
Pk
+
+ +
,
1 + i (1 + i)2
(1 + i)k
(5.10)
where D is the dividend and Pk is the market price at time k, which is

determined by future dividends as follows:
Pk =
Dk+1
P
Dk+2
+ +
.
+
1+i
(1 + i)2
(1 + i)
(5.11)
In real, ination-adjusted terms, we have

V =
D1
D2
Pk
+
+ +
(1 + i)(1 + ) (1 + i)2 (1 + )2
(1 + i)k (1 + e )k
(5.12)
and
Pk =
Dk+1
P
Dk+2
+ +
. (5.13)
+
(1 + i)(1 + e ) (1 + i)(1 + e )2
(1 + i)(1 + e )
Thus, the value of a stock is also aected by ination but in this case it
is dierent because dividends are not xed. If, for example, dividends rise
faster than the ination rate, the value of a stock investment rises with
ination and inationary expectations. But, this may or may not be the
case. Here, we talk about whether or not stocks provide a satisfactory hedge
against ination.
In a high-ination economy, savers shy away from the stock market as
well as from bond and loan markets. They save less and divert their savings
into ination hedges such as houses and gold, rather than adding to the
economys stock of factories and machines. A second possible reason why
ination aects stock markets negatively is that the corporate income tax
system in many countries is not fully indexed hence, rms face higher
real tax burdens as ination rises. However, because stocks represent claims
on the real assets of the underlying rms, ination may be good for stock
investment. While the eect of ination on the stock market is ambiguous,
it has been found that stock investment produces positive real returns over
a long period of time. One reason for that is the ability of rms to pass on
price hikes to their customers.
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1600
1400
1200
1000
800
600
400
200
0
1972
1976
1980
1984
1988
1992
Deflator
Fig. 5.8.
1996
2000
2004
2008
2012
Stock Prices
GDP deator and stock prices in the U.S.
In Fig. 5.8, we see the U.S. ination rate and the S&P stock price index.
Between 1972 and 2011, the general price level rose by a factor of 4.3, while
the S&P index rose by a factor of 11.6. Over the same period, stock prices
rose at an average annual compound rate of 6.49%, compared with only
0.34% for bonds. Given that the average annual compound ination rate
was 3.78% stocks, but not bonds, have provided a good hedge over this long
period of time.
5.9. The Eect of Ination on Competitiveness

A country with a higher ination rate than its trading partners will
experience loss of competitiveness as its goods become less attractive in
foreign markets. An adverse eect will materialize on the trade balance and
employment. Consider a hypothetical situation involving three scenarios:
(1) domestic ination is 1%, foreign ination is zero and the exchange rate
does not respond; (2) domestic ination is 2%, foreign ination is zero
and the exchange rate does not respond; and (3) domestic ination is 2%,
foreign ination is zero and the exchange rate rises by 0.4% per period.
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109
Under Scenario 1, as domestic prices rise, so will the foreign price of exports
(given no change in the exchange rate). The quantity of exports declines
and the trade balance deteriorates because nothing happens on the imports
side. Under Scenario 2, the trade balance deteriorates at a much higher
rate and goes into decit very quickly. Under Scenario 3, the exchange
rate responds to ination partially, in the sense that the domestic currency
depreciates at a lower rate than ination, the trade balance deteriorates
but at a lower rate than in the absence of changes in the exchange rate.
Only when the exchange rate responds fully to ination, in the sense that
the domestic currency depreciates at a rate that is equal to the ination
rate, will competitiveness not lost. This is illustrated in Fig. 5.9, which is
based on simulated data.
5.10. Currency Depreciation
In August 2012, Warwick McKibbin, an Australian economist and a former
central bank board member, advised the Reserve Bank of Australia to
intervene and bring the Australian dollars value down by printing money
(The Economist, 2012c) The underlying idea is simple as we can see
it through purchasing power parity (PPP) and the monetary model of
exchange rates, which combines the quantity theory of money with PPP.
PPP tells us that the percentage change in the exchange rate is equal to (or
at least determined by) the ination dierential. Starting from any point in
time 0, the exchange rate at time t is the exchange rate at time 0 adjusted
for a factor that reects the ination dierential. Hence, we have

1+
S t = S0
,
(5.14)
1 +
where t is the foreign ination rate. Equation (5.14) can be approximated by
st = t t ,
(5.15)
where st is the percentage change in the exchange rate. If t > t ,

then st > 0, which implies depreciation of the currency with the
higher ination rate. Figure 5.10 shows the extent of domestic currency
depreciation over time when the foreign ination is zero while the domestic
ination rate assumes values ranging between one and three. Notice that
domestic currency depreciation itself leads to imported ination and the
creation of some sort of a spiral.
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Foreign Currency Price of Exports

30
25
20
15
10
5
0
10
15
20
25
1
30
2
35
40
45
50
35
40
45
50
Trade Balance
100
50
0
0
10
15
20
25
30
-50
-100
-150
-200
-250
-300
-350
-400
1
Fig. 5.9.
The eect of ination on the trade balance (three scenarios).
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111
1.00
0.80
0.60
0.40
0.20
0.00
0
10
15
20
25
1%
Fig. 5.10.
30
2%
35
40
45
50
3%
Currency depreciation under ination (simulated data).
5.11. The Eect of Ination on Unemployment and Growth

If ination is high and/or deeply entrenched, a long period of low
growth, even a deep economic depression, may be required to break
inationary expectations. Neither theory nor empirical analysis tells us
anything concrete about the trade-o between ination, unemployment and
growth. However, experience tells us the following: (i) monetary and scal
policies that generate ination also generate growth, particularly when
they start from a point when there is spare capacity; and (ii) restrictive
policies designed to reduce ination lead to a slowdown in growth and
rising unemployment. Very high ination rates reduce growth by diverting
energies and resources from productive work to coping with the problems
caused by ination. Another channel of causation from ination to growth
is that in addition to hampering nancial markets, the noise generated
by high ination obscures price signals with a resulting failure of the
market system to communicate information properly. This failure of the
price system distorts investment and employment decisions. Keynes (1920)
described the relation between ination and growth as follows:
As the ination proceeds and the real value of the currency uctuates
wildly from month to month, all permanent relations between debtors
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and creditors, which form the ultimate foundation of capitalism, become

so utterly disordered as to be almost meaningless; and the process of
wealth-getting degenerates into a gamble and a lottery.
Yet Bruno and Easterly (1996) suggest that like a bickering couple,
ination and growth just cannot seem to decide what their relationship
should be. They nd the following: (i) no evidence of any relation between
ination and growth at annual ination rates less than 40% (their denition
of high ination); (ii) a short- to medium-run negative relation between
high ination and growth; and (iii) no lasting damage to growth from
discrete high ination crises, as countries tend to recover back towards
their pre-crisis growth rate.
Following Bailey (1956) and estimating the area under the money
demand curve, Fischer (1981) and Lucas (1981) found that for the U.S.,
an ination rate of 10% per annum would cost 0.30.9% of national income
each year. For a cross-section of countries, Fischer (1993) found that an
increase in the ination rate of 100 percentage points would lead to a
reduction in the annual growth rate of 3.9 percentage points. Furthermore,
he found that the negative correlation between ination and growth was
stronger for low ination rates, and that the ination variance was also
negatively correlated with growth. For another cross-section of countries,
Barro (1997) estimated that an increase in the average ination rate of 10
percentage points per year leads to a reduction in the growth rate of GDP
of 0.3 to 0.4 percentage points per year.
So far, there has been no theoretical consensus on the macroeconomic
trade-os, if any, between ination and output. Moreover, it is dicult
to discriminate empirically between alternative views on the inationoutput trade-o. Figure 5.11 shows scatter diagrams for the U.S. ination,
growth and unemployment as reported in the 2012 Economic Report of the
President. There is no evidence of a systematic relation between growth
and ination, neither between unemployment and ination. These relations
may be time-varying or it could be that they are distorted by changes in
other variables. Figure 5.12 shows the same for a cross-section of countries
using averages calculated from the World Bank data. The scatter diagram
tells the same story as in the U.S.
5.12. Ination-Triggered Social Unrest
One of the most far-reaching eects of ination is the social unrest caused
by rising cost of living, particularly food prices. Food price ination was
identied as one of the primary causes behind the Arab Spring revolts.
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Unemployment versus Inflation

15
12
Inflation
0
3
10
-3
Unemployment
Growth versus Inflation
15
12
Inflation
0
-3
-2
-1
-3
Growth
Fig. 5.11.
Ination, growth and unemployment in the U.S. (19612011).
In his best-selling book, Imagining India, Nandan Nilekani writes: price

rises in India have ignited student riots, nationwide demonstrations and
government collapse (The Economist, 2012b). In September 2011, The
Wall Street Journal reported that in 2010, China was rocked by 180,000
protests, riots and other mass incidents more than four times the tally
from a decade earlier (Orlik, 2011). Chinas massive economic-stimulus
program has produced near double-digit growth, but also stoked ination,
piled up debt and fueled social unrest. A sweeping monetary stimulus
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114
Unemployment versus Inflation

10
Inflation
0
0
12
15
10
Unemployment
Growth versus Inflation
9
Inflation
0
0
Growth
Fig. 5.12.
Ination, growth and unemployment in a cross-section of countries (averages).
introduced in 2009 and 2010 with banks issuing 17.5 trillion yuan in
new loans translated into higher ination rates, reected largely in food
prices. The urban poor, who spend a large share of their income on food,
are hardest hit by rising food prices.
A similar story is that of the Southern Bread Riots, which took place
on 2 April 1863. The riots were triggered mainly by the destruction of
crops during the American Civil War. The staggering ination created by
the Confederate government was also a primary cause. The drought of 1862
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115
produced a poor harvest that did not yield enough at a time when food was
already scarce. From 1861 to 1863, the price of wheat tripled while butter
and milk prices quadrupled. Salt, which at the time was the only practical
meat preservative, was very expensive (if available at all) as a result of the
Union blockade and the capture of Avery Island by the Union. Citizens
began to protest the high price of bread, and many protesters turned to
violence as armed mobs attacked stores and warehouses and destroyed
grocery and dry goods stores. Food riots were occurring before the arrival of
the Union troops because the Confederate Army was suering the same food
shortages and was taking food stocks for its own needs. Additionally, as the
cost of war for the Confederate government exceeded tax revenue, legislation
was enacted that exacerbated the situation by deating the Confederate
currency and inating prices of goods.
In more recent years, riots have been associated with food price
ination. In Fig. 5.13, we see the FAO food price index over the period
January 1990July 2012. We can see two peaks in food prices, the rst in
June 2008 and the second in February 2011. Around the rst peak, riots
were witnessed in Somalia, India, Mauritania, Mozambique, Cameroon,
Yemen, Sudan, Cote dIvoire, Haiti, Egypt, and Tunisia. Around the second
250
230
210
190
170
150
130
110
90
70
50
1/1990
7/1991
1/1993
7/1994
1/1996
7/1997
Fig. 5.13.
1/1999
7/2000
1/2002
7/2003
1/2005
7/2006
The FAO food price index.
1/2008
7/2009
1/2011
7/2012
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peak, riots were witnessed in Libya, Egypt, Sudan, Oman, Morocco, Yemen,
Iraq, Syria, and Uganda (Lagi et al., 2011).
The National Ination Association (NIA) has warned that Egypt was
a preview of things to come in America in 2015. The rioting and looting
that took place in Egypt was primarily a result of massive food ination
and shows what all major cities in the U.S. will likely look like as a result
of the ination produced by quantitative easing. On 16 December 2009, the
NIA named Time Magazines 2009 Person of the Year, Ben Bernanke,
as the Villain of the Year, saying he created unprecedented amounts of
ination in unprecedented ways and that when it costs $20 for a gallon
of milk in a few years, Americans will have nobody to thank more than
Bernanke (Zero Hedge, 2011).
But, it is not only about food prices. Ination causes civil unrest also
because it exacerbates inequality and worsens poverty (for example, Bulir,
2001; Easterly and Fischer, 2001; Albanesi, 2007). It also leads to a malaise
in which people see society as being wrecked by exploitation, instability,
lost morale and damaged national prestige (Shiller, 1997). Furthermore,
ination promotes dissatisfaction with the government (Lewis-Beck, 1988).
It has been demonstrated that ination has contributed to revolution in
the 20th century and before (for example, Hill et al., 1977; Looney, 1982;
Goldstone, 1991).
5.13. The Eect of Ination on Morality
Swanson (1989) quotes a South American banker as saying that ination is
an immoral tax that leads to immoral values. Because ination causes an
involuntary transfer of purchasing power, it is regarded as being similar to
theft. The incentives and distortions created by ination lead to a decline in
the standards of morality in some segments of the business community and
in aspects of private behavior. For example, Fischer (1996) argues that ination is historically associated with the intensity of drug use, family disintegration and crime. Ludwig von Mises (1942) referred to this issue as follows:
The rst fact that needs to be noted in answering such questions is that
ination is detrimental to all creditors. The higher prices rise, the lower
will fall the purchasing power of the principal and interest payments due.
The dollar which was loaned out had a higher purchasing ability, could
provide more goods, than the dollar which is paid back.
Immorality also pertains to government-initiated ination. For example,

Ritenour (2010) argues that there is good reason the Christian tradition
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117
nds monetary ination incompatible with Christian morality and that

readers of the Bible will nd that it is not silent about monetary
debasement, identifying it as a form of fraud. Braun and Di Tella (2004)
show that ination variability can lead to higher corruption and lower
investment and document a positive relation between corruption and
ination variability in a sample of 75 countries. They present a simple
model where agents can inate the price that owners pay for goods that
are needed to start an investment project to demonstrate how this can lead
to higher corruption. Their panel estimates suggest that a one standard
deviation increase in ination variability from the median is associated
with an increase in corruption of 12% of a standard deviation.
In 1919, J.M. Keynes described ination as conscation of wealth
(Perkins, 2004). He wrote:
By a continuing process of ination, governments can conscate, secretly
and unobserved, an important part of the wealth of their citizens. By
this method, they not only conscate, but also conscate arbitrarily; and,
while the process impoverishes many, it actually enriches some. The sight
of this arbitrary rearrangement of riches strikes not only at security, but
at condence in the equity of the existing distribution of wealth. Those
to whom the system brings windfalls . . . become proteers, who are
the object of the hatred of the bourgeoisie, whom the inationism has
impoverished not less than of the proletariat.
Shiller (1997) highlights the dierences in perception of ination between

professional economists and the general public by presenting survey evidence. In particular, Shiller shows that the public has concerns that ination
is a conduit to deception and harms morality. He writes:
The issues of ination-generated opportunities for deception, and the
eects of ination on national cohesion and international prestige are
curious for economists, and do not appear on the FischerModigliani
list. Perhaps it is here that we should listen carefully to what the public
is telling us.4
We should expect the extent of decline in morality to vary with the ination
rate. This means that the decline in morality reaches signicant proportions
under hyperination. In his classic work on the German hyperination,
4 The
FischerModigliani list of the costs of ination can be found in Fischer and

Modigliani (1978).
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Fergusson (2010) tells numerous stories to demonstrate how hyperination

leads to a decline in morality and criminal behavior.
5.14. The Optimal Ination Rate
Central banks strive to maintain low ination, which raises the question
of how low should ination be. Although the consensus against high
ination is widespread, there is no agreement on the optimal ination rate.
Akerlof et al. (1996) advocate positive ination on the grounds that that
zero ination would lead to ineciency due to wage and price stickiness,
suggesting the view that a little bit of ination provides grease to the
economic system. The grease view of ination is shared by Vansteenkiste
(2009) who agrees that ination oils the wheels of the economy but she
adds that too much oil can ood the engine. Another argument for abovezero ination is that, since interest rates rise with ination, a positive
ination rate will produce above-zero interest rate, which preserves the
central banks option of cutting rates if the need arises for looser policy.
One of the proponents of zero ination is Poole (1999), who disputes
both of the two arguments for above-zero ination. Against the rst
argument he notes that if ination makes nominal wage rigidity easier
to live with, it is likely to perpetuate rigidity for that very reason.
Against the second argument, he suggests that low interest rates do not
make expansionary monetary policy ineective. Poole favors zero ination
because it minimizes uncertainty about future ination and the distortions
associated with unindexed taxes. On dierent grounds, Selgin (1997)
makes a case for falling prices in an economy with ongoing productivity
improvements. He notes that it is benecial to let the prices of particular
products fall as their unit costs fall. In his view, using monetary expansion
to raise other prices, so as to produce zero or positive overall ination,
does nothing to boost eciency but instead adds to the adjustment burden
placed on the price system.
Phelps (1973) is in favor of positive ination, arguing that ination is a
source of tax revenue for the government and that if ination were reduced
other taxes would have to be raised in order to replace the lost revenue. He
also argues that some ination would be desirable if the distortions associated with ination taxes were less costly than the distortions associated
with other taxes to which the government might resort.
Other factors may come in. For example, only the ination tax can be
applied to the underground economy. A second consideration applies to the
U.S. in particular because a big portion of the stock of the U.S. currency
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119
is held abroad. In this case, the U.S. ination may be desirable to collect
seigniorage from foreigners. Whether or not this proposition is ethical is a
dierent matter.
5.15. Hedging the Risk of Ination
We have already come across one ination hedge, stocks, in the sense that
investing in stocks over a long period of time generates positive real returns.
The following is a list of assets and strategies that can be used to hedge
the risk of ination:
1. Long-term investments, such as home improvement projects and capital
expenditure for a business.
2. Commodities, like oil, which will always remain in demand. An alternative to the physical commodities are commodity-based exchange traded
funds (ETFs), which oer a liquid asset that acts as an ination hedge.
3. Gold and other precious metals, which have intrinsic value that rises
with ination.
4. Real estate, whether for owner occupier or a rental property. A rental
property, for example, oers the possibility of raising rents to keep up
with ination.
5. Ination-linked nancial products such as Treasury Ination Protected
Securities (TIPS). These produces oer a nominal return as well as a
compensation for ination. In general, these are known as real return
bonds, ination-indexed bonds or linkers, which oer coupons and
par values that are adjusted for ination.
6. Dividend-paying stocks, which oer a hedge against ination because
dividends typically rise year after year. Furthermore, dividend growth
leads to capital gains resulting from rising stock prices.
7. Collectibles and works of art. These can oer signicant inationadjusted returns, but they lack liquidity.
The asset classes to be avoided under inationary environment are xedincome instruments that are not ination linked. We must bear in mind
that some of these ination hedges are subject to speculative bubbles,
particularly real estate and precious metals.
Ination has profound eects that can be classied under three headings:
(i) business-related or microeconomic eects, (ii) macroeconomic eects,
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and (iii) non-economic or social eects. Under the rst category are an
arbitrary distribution of income, the adverse eect on business planning
and investment, miscellaneous business costs (such as menu costs and shoeleather costs) and distortion of the eect of taxes. The macroeconomic
eects include the adverse consequences for saving, the eect on nancial
markets, the eect on competitiveness, currency depreciation, and the
eect of unemployment and growth. Non-economic eects, which are as
detrimental to the society as the economic and business eects, include
ination-triggered social unrest and the eect on morality.
While there are claims that ination has some positive eects because it
is better than deation or because it wipes out debt, an argument was put in
this chapter that the positive eects are not really positive. Benets from
the so-called positive eects are maximized by maximizing the ination
rate, but there is nothing more damaging for the economy than maximizing
the ination rate.
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Chapter 6
THE PHENOMENON
OF HYPERINFLATION
6.1. What is Hyperination?
Hyperination occurs when ination runs at such high (and typically, but
not necessarily, accelerating) rate to the extent that it spirals out of control.
According to Bruno (1993), hyperination is an extreme manifestation of
macroeconomic imbalances, a situation where ination now seemed to
lift o to a high life of its own, quite divorced from the real economy, like
a missile escaping the gravity of Earth. Under hyperination, the general
price level rises rapidly while (as a result) the domestic currency loses its
real value (that is, purchasing power) just as rapidly. The domestic currency
also loses its value against other currencies, which is a manifestation of
purchasing power parity (PPP). Rapid increase in the money supply leads,
via the quantity theory of money, to rapid increase in the general price
level, which translates via PPP to rapid domestic currency depreciation.
Hyperination brings about considerable currency substitution as the
domestic currency becomes incapable of performing the functions of a
measure of value and a store of value, which is what money is supposed
to do. It may still be used as a medium of exchange but even this function
may be performed by a foreign currency, sometimes by a government decree.
Because of hyperination, Ecuador abandoned its currency and adopted the
U.S. dollar as a legal tender in 2000. The same happened in Zimbabwe in
2009, as the Zimbabwean dollar was abandoned and replaced, as a legal
tender, by the U.S. dollar and South African rand.
Under normal conditions, factors other than monetary growth, such as
demand-pull and cost-push factors, may cause ination but hyperination
is invariably caused by an unchecked increase in the money supply, leading
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to unwillingness on the part of the public to hold the domestic currency for
more than the time needed to exchange it for real goods to avoid further
loss of purchasing power. It involves a vicious circle: when monetary growth
exceeds by far the growth of output, prices rise rapidly, which makes it
necessary to print more money to meet demand that in itself produces
more ination and so on. Sargent (1982) argues that it is fallacious to
suggest that when the real value of a currency declines, this currency in
a sense becomes scarce, which means that accelerating money printing is
not the prime cause of ination. During the German hyperination of the
1920s, the German central bank felt that money was tight, hence the
shortage of currency was met by adding printing presses and personnel
(printers, not economists). Hyperination also involves a game between
the public and the government. While people try to spend the money they
receive quickly, in order to avoid the ination tax, the government responds
to higher ination with even higher rates of currency production. For these
reasons, hyperination tends to be self-perpetuating.
Unlike demand-pull ination, where ination occurs when the economy
is overheating, or cost-push ination that occurs when unemployment is
low, hyperination destroys the economy to the extent that it is invariably
associated with negative growth and high unemployment. In other words,
hyperination is eectively hyperstagation. Bruno (1993) suggests that
hyperination is highly costly, typically associated with negative growth.
He shows that ination rates above 40% per year are associated with lower
economic growth and that in the two years during ination crises, countries
on average suer decline in growth while in the two years after stabilization
they experience modest growth. Hyperination is often associated with wars
(or their aftermath), as well as political or social upheaval.
While hyperination is more of a monetary phenomenon than normal
demand-pull or cost-push ination, it is also described as a political
phenomenon. For example, Mauldin (2009) suggests that while ination
is a monetary phenomenon, as Milton Friedman said, hyperination is
always and everywhere a political problem in the sense that it cannot occur
without a fundamental malfunction of a countrys political economy. For
example, it happens when there is a political will on the part of the government to run a persistent budget decit and nance it by printing money.
Arthur Burns, the Fed Chairman under Richard Nixon, once expressed the view that if the Fed or federal government ran into economic or
nancial system diculties, the federal budget decit and the U.S. dollar
simply could be ignored or sacriced. Doing that, according to Burns, would
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123
not matter because it would not cost the incumbent powers any votes
(Williams, 2012).
Dening hyperination by how high the ination rate is may be
problematical, as will be explained later. This is why it may be preferable
and less arbitrary to dene hyperination in a qualitative manner, without
putting a numerical value on the underlying ination rate. For example,
hyperination is dened as an inationary cycle without a tendency
towards equilibrium (Schutte, 2008). Makochekanwa (2007) suggests a
pragmatic denition that hyperination is ination out of control, a
condition in which prices increase rapidly as a currency loses its value.
The problem with this denition is that a currency loses its value as prices
rise whether ination is hyper or moderate. A crude, but an accurate,
denition is suggested by Williams (2012), which is that hyperination is
a circumstance where, due to extremely rapid price increases, the largest
pre-hyperination bank note ($100 bill in the United States) becomes worth
more as a functional toilet paper/tissue or wall paper than as currency.
Swanson (1989) denes hyperination as rapid, debilitating ination that
leads to a major devaluation of a countrys currency. Hyperination is
best described by a syndrome, a set of symptoms that will be presented in
a subsequent section.
6.2. Hyperination as an Extension of Moderate Ination

While some economists view hyperination as an extension of moderate
ination, others distinguish the root causes of hyperination from those of
moderate ination. For example, Durden (2012) argues that hyperination
has little to do with normal price ination and that hyperination is
not an escalation of normal ination. He distinguishes between normal
ination and hyperination on the grounds that the former is a steady and
continuous decline in the purchasing power of money, which is ultimately
attributable to an increase in the money supply while the latter is collapse
of condence in money, which results in an accelerating ight out of money
into real assets and goods, and thus an accelerating loss of the purchasing
power of money. On the other hand, others believe that hyperination
can be explained in terms of the same determinants of moderate ination
because hyperination is nothing else than ination at the very high levels
(Makochekanwa, 2007).
Lira (2010) describes as a trap the tendency to think that hyperination is an extension of moderate ination or, as he puts it, hyperination
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is simply ination on steroids ination-plus ination with balls.

He argues that anyone falling in that trap tends to reject the scenario of
hyperination in the U.S. because in the current deationary economic
environment, hyperination is simply a long way o. He describes this line
of reasoning as ridiculous, suggesting that hyperination is not an extension or amplication of ination and that ination and hyperination are
two very distinct animals. Lira seems to attribute moderate ination to
demand-pull factors, whereas hyperination is a monetary phenomenon.
This is how he relates moderate ination to demand-pull factors:
Ination is when the economy overheats: It is when an economys
consumables (labor and commodities) are so in-demand because of
economic growth, coupled with an expansionist credit environment, that
the consumables rise in price. This forces all goods and services to rise in
price as well, so that producers can keep up with costs. It is essentially
a demand-driven phenomenon.
Hyperination, on the other hand, is the loss of faith in the currency,

a condition under which prices rise not because people want more money
for their labor or for commodities, but because people are trying to get out
of the currency.
Kiguel and Liviatan (1995) suggest that some hyperinations can be
described as extensions of moderate ination. For example, they think
that in the cases of Argentina and Brazil the scal situation did not
reach the crisis proportions of the classical hyperinations, hence these
hyperinations appear to have been the nal stage of a long process of
high and increasing rates of ination, in which a nal explosion was all
but unavoidable. Bruno and Easterly (1998) demonstrate that moderate
ination can be a stepping stone leading to high and hyperination by
pointing out that 27% of the countries experiencing 4060% ination go
through ination over 100% within three years, 78% of the countries with
100% ination experience that level within three years, and 29% experience
ination over 1000% in the same period.
Bruno (1993) distinguishes between normal ination and hyperination as follows. While both ination and hyperination are caused
by excessive creation of money by the central bank . . . the underlying
determinants of the two phenomena are radically dierent. Normal
ination, according to Bruno (1993), is brought about by the governments
choices over output stabilization, and in particular, choices to boost it
during the bust phase of the business cycles. It is about monetary policy
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125
and the striking of a balance between low ination and high output.
Hyperination, on the other hand, involves more than monetary policy
it is essentially a scal phenomenon.
Bernholz (2003) distinguishes between moderate ination and hyperination on the basis of dierences in the prevailing economic conditions.
Under hyperination, he argues, the public no longer has any illusions
about the further development of the price level. Under hyperination,
the domestic currency: (i) is no longer used as a unit of account for major
transactions, especially for those implying deferred payment; (ii) later, it
is no longer used as a store of value; and (iii) is substituted increasingly
by a stable currency even in cash transactions. This means that under
hyperination the domestic currency is no longer capable of performing the
basic functions of money. Another dierence, according to Bernholz (2003),
is that hyperinations are nearly always caused by huge budget decits and
that this need not be the case in moderate inations. Under hyperination,
trust in the government is lost. Bernholz (2003) quotes a Brazilian saying
in 1984 that if our ministers express some opinion, we just believe the
contrary. Ferguson (2008) distinguishes between ination as always and
everywhere a monetary phenomenon as articulated by Milton Friedman,
and hyperination, which is a political phenomenon, in the sense that it
cannot occur without a fundamental malfunction of a countrys political
economy.
Whether hyperination is an escalation of moderate ination or a completely dierent creature, we know from experience that hyperination is by
far more devastating for the economy than moderate ination. And while
moderate ination typically emerges in a rising economy, hyperination is
associated with economic depression. The most important distinguishing
feature of hyperination remains the loss of faith in the currency. We have
seen, for example, that under normal ination, the relation between the
ination rate and the growth rate is blurred. However, under hyperination
(high ination) the relation becomes conspicuously negative. Table 6.1
reports some average ination rates and the corresponding GDP growth
rates over periods of high ination.1 We can see from the table that
the growth rates associated with high ination is predominantly negative.
The rank correlation between growth and ination is signicantly negative
at 0.52. Figure 6.1 shows a scatter diagram based on the rankings of
1 The
calculations are based on data obtained from the World Bank.
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126
Table 6.1. Average ination and growth rates

in hyperinationary countries.
Country
Ination Rate
Turkey
Mexico
Poland
Israel
Russia
Belarus
Brazil
Nicaragua
Argentina
Ukraine
Angola
Peru
Congo
Bolivia
Georgia
Zimbabwe
60.3
88.02
151.36
165.1
244.9
718.4
823.3
851.56
863.6
876.05
961.8
1511.9
2319.96
2741.2
4945.1
36208.8
Growth Rate
0.45
0.10
1.59
4.09
5.48
1.18
1.96
2.89
1.06
9.20
1.49
1.41
4.12
2.48
19.75
7.42
18
15
Growth Rate (Rank)
12
12
15
18
Inflation Rate (Rank)
Fig. 6.1.
Growth under hyperination (rank correlation).
ination and growth rates. These stylized facts support the proposition
that hyperination is dierent from moderate ination.2
2 On
the other hand, it may be suggested that the relation between ination and growth
is nonlinear, changing from positive at low ination to negative at high ination.
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6.3. The Measurement of Hyperination

Under hyperination, the ination rate may be so high that it is measured
on a monthly or even daily basis. If the annual ination rate is such
that Pt = (1 + )Pt1 , the corresponding monthly rate is calculated as a
compound rate as follows
m = 100 [(1 + )1/12 1].
(6.1)
Another indicator of the extent of hyperination is how long it takes

the price level to double for a given value of the ination rate, which is
calculated as follows. If it takes n years for prices to double, then
(1 + )n Ptn = 2Ptn
(6.2)
which gives
n=
log 2
.
log(1 + )
(6.3)
Yet another indicator is how long it takes to add a zero to the price index
and hence to the currency. In this case,
(1 + )n Ptn = 10Ptn
(6.4)
which gives
n=
1
.
log(1 + )
(6.5)
Figures 6.26.4 show the monthly ination rates corresponding to annual

rates as well as the corresponding price doubling time and the time it takes
to add zero to the price level. This last indicator gives an idea about when
the currency is likely to be re-denominated. For example, if re-denomination
is introduced after adding three zeros, then at an annual ination rate of
100%, it takes 3.32 years to add one zero hence, re-denomination should
be expected 9.96 years after the introduction of the currency.
Hyperination is typically dened in terms of the monthly ination
rate. The classical how-high denition is that of Cagan (1956) who
dened hyperination as ination exceeding 50% a month, which implies
an annual ination rate of 12,875%. More precisely, Cagan (1956) dened
hyperination as beginning in the month the rise in price exceeds 50%
and as ending in the month before the monthly rise in prices drops below
that amount and stays below for at least a year. As much as 50% is an
arbitrary gure, it means that an ination rate of 40% per month is not
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14
12
10
Monthly
0
0
50
100
150
200
250
300
350
Annual
Fig. 6.2.
The monthly rates corresponding to annual rates.
Number of Years
0
0
50
100
150
200
250
300
350
Fig. 6.3.
Years for prices to double at various annual ination rates.
hyperination, which is bizarre. If an ination rate of 20% per year can

inict serious damage on the economy, then surely an ination rate of 40%
per month will have a signicant destructive power. It is not obvious why a
monthly ination rate of 40%, 35% or 30% cannot inict the same damage
as an ination rate of 50%. Makochekanwa (2007) suggests that Cagans
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35
Adding Zero
Currency Re-denomination
30
Number of Years
25
20
15
10
0
0
50
100
150
200
250
300
350
Fig. 6.4.
Years it takes to add a zero and currency re-denomination.
denition is not as stringent as it sounds because the denition does not

rule out a rise in price at a rate below 50% per month for the intervening
month. Bruno (1993) suggests that 2030% per month makes a (very
rough) transition point from high to hyperination. Given that much
lower ination rates than 50% per month can be extremely damaging, the
International Accounting Standards Board (2007) comes up with a more
practical and realistic denition, describing hyperination as a cumulative
ination rate over three years approaching 100% (26% per annum compounded for three years in a row. Swanson (1989) argues against the use
of the Cagan denition by referring to South American hyperination of
the 1980s, suggesting that ination rates of 20% or 25% per month were
sucient to wreak havoc. Likewise, Bernholz (2003) argues that the
borderline drawn by this denition is of a somewhat dubious quality, since
other high inations show the same qualitative characteristics as hyperinations . . . especially that hyperinations are mainly caused by budget decits
which are nanced by creating money; that an undervaluation of the domestic currency takes place; that currency substitution plays a decisive role; and
that the real stock of domestic money falls strongly below its normal level.
6.4. The Syndrome of Hyperination
An alternative to a precise quantitative denition of hyperination is to
describe a syndrome, a set of symptoms that characterize hyperinationary
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episodes. In this sense, it is more like diagnosing a disease by looking at a

set of symptoms than by saying that the patient has this or that disease
because her temperature is more than 39 or more than 39.5 Celsius.
Consider the following set of symptoms, some of which may be overlapping
or interrelated:
1. Preference for keeping wealth in non-monetary assets or in a relatively
stable foreign currency.
2. Domestic currency balances are invested immediately to maintain purchasing power.
3. Monetary amounts are measured in terms of a relatively stable foreign
currency in which prices may be quoted.
4. Sales and purchases on credit take place at prices that are adjusted
(upwards) by an amount that will compensate for the expected loss of
purchasing power during the credit period, even if the period is short.
5. The purchasing power of private and public savings is wiped out at a
rapid pace.
6. The economy is distorted in favor of extreme consumption and hoarding
of real assets.
7. The central bank prints money in larger and larger denominations as
the smaller denomination notes become worthless. Denominations of
1,000,000,000 or more are common.
8. Every now and then a currency reform is introduced by striking out
zeros such that one unit of the new currency is equal to 1,000,000,000
or so units of the old currency.
9. The scrap value of the metal in a coin exceeds its face value. Massive
amounts of coins are typically melted down and exported for hard
currency.
10. Governments often try to disguise the true ination rate by imposing
price controls, resulting in shortages, hoarding, extremely high demand
for the underlying goods, empty shelves and black markets.
11. During the time between recording a taxable transaction and collecting
the taxes, tax revenue falls in real value to a small fraction of the original
amount.
12. New issues of government securities fail to nd buyers, except at very
deep discounts or high risk premia.
13. Common under hyperination are bank runs, loans for 24 hours,
switching to foreign currencies, the use of gold or silver, and even the
use of barter.
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14. People get paid daily and strive to convert any extra local currency into
something that can preserve value such as canned food, a more stable
foreign currency and precious metals.
Swanson (1989) quotes a Brazilian businessman describing hyperination
as follows: [hyper]ination is when you go to the same restaurant each
morning, order the same breakfast, and each time have to ask how much
it costs. He also quotes a common saying: in South America, taking a
cab is cheaper than a bus because you pay for the cab at the end of the
ride because by then the money is worthless. These expressions are
more representative of hyperination than a single number. Irrespective of
whether the ination rate is 50%, 40% or 30%, any economy witnessing
all or some of these symptoms must be experiencing hyperination. These
symptoms, or some of them, have been witnessed in countries experiencing
ination rates of less than 50% per month, the conventional threshold for
hyperination.
6.5. The Hyperinationary Process and Feedback Eects
A typical hyperinationary process is represented by Fig. 6.5. The starting
point is the accumulation of scal decit and therefore debt, assuming
that the decit is initially nanced by issuing bonds. This is the basis
of the proposition that hyperination is a scal phenomenon. When debt
reaches a high level relative to GDP (which some would put at 80%)
it becomes increasingly dicult to borrow even at higher interest rates
because investors lose condence in the bonds issued by that government.
There is a feedback eect here as the loss of condence leads to further
failure of bond sales.
Given the diculty of raising funds by issuing bonds, the government
resorts to the printing press (or the computer), which could take the form
of the central bank printing (or generating) fresh money and using it to
buy the bonds issued by the government (the Treasury). The printing of
money creates ination as implied by the quantity theory of money. Ination
generates inationary expectations, which feed back into ination. This is
because when the ination rate is expected to continue to rise further,
people will adjust wages and prices to hedge themselves against future
ination. Ination will be further augmented by rising velocity of circulation
resulting from the loss of condence and hence the desire to get rid of
the currency rather quickly. There is also a feedback eect between rising
velocity and ination because rising velocity boosts ination, which in turn
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132
Deficit
Debt
Currency
Depreciation
Failure of
Bond
Sales
Loss of
Confidence
Printing
Money
Rising
Velocity
Inflation
Rising
Interest
Rates
Inflationary
Expectation
Fig. 6.5.
Shrinking
Economic
Activity
A typical hyperinationary process.
leads to higher velocity as people become more inclined to exchange their

money for goods. Furthermore, money printing will be required to pay o
existing debt particularly as the government depends increasingly on shortterm bonds.
According to the monetary model of exchange rates, an increase in
the money supply relative to other countries causes currency depreciation,
which causes further ination as import prices rise. Hyperination causes a
declining level of economic activity, which leads to further ination as too
much money chases a rapidly declining stock of goods. Economic activity
is adversely aected by rising prices because planning for the future and
raising funds become increasingly hard. There is also a demand side eect
as people who nd it dicult to pay for necessities cut back on less essential
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133
items, inicting damage on (and even causing the failure of) the rms producing these items. Also, governments usually impose price controls which
cause shortages and reduce production. Price controls can make it impossible for an entrepreneur to make prot, so the entrepreneur is better o just
shutting down his business and investing his money in gold until hyperination comes to an end. Ination aects economic activity indirectly via higher
interest rates. Then declining economic activity means lower tax revenue,
which adds up to the initial cause of the whole process: the scal decit.
While ination is mostly the outcome of money printing, other
contributory factors may exist: rising velocity, declining economic activity,
rising inationary expectations and currency depreciation. This is why
ination typically runs at a rate that is higher than the monetary growth
rate. This is also why the relation between the monetary growth rate and
the ination rate may be nonlinear it is because of nonlinearity that
ination becomes out of control. Figure 6.6 shows that relation between
monetary growth and ination in some hyperinationary episodes.
6.6. Hyperination and the Death of a Fiat Currency

There is a general pattern for the stages of hyperination, which can be
viewed as the stages of the death of a at currency. This phenomenon has
been repeated throughout history as we will nd out in Chapters 7 and 8.
Money is needed because it performs three functions: (i) it is a medium of
exchange, as it used to settle transactions that is, payment for goods and
services and the settlement of loans; (ii) it is a store of value, as savings may
be kept as money (typically as a bank account); and (iii) it is a measure of
value or a unit of account, because we value goods, services and the entire
size of the economy (gross domestic product) in terms of money. As the
economy moves through various stages of hyperination, the domestic currency loses its ability to perform these functions. At that stage, the at currency dies in the sense that it disappears and replaced by another currency.
The process is represented in Fig. 6.7. The starting point is typically
excessive government spending, pushing up the scal decit and debt to
high levels. There is no agreement on what these levels are but it has been
suggested that, as a percentage of GDP, the danger levels are a decit that
is 40% of spending and the debt is 80% of GDP. For example, Cate (2012)
views hyperination as a market response to government debt over 80%
of GNP and decit over 40% of spending when the central bank starts
printing money and buying up government debt. As a result, it becomes
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Austria (1920s)
3.E+04
Price level
3.E+04
2.E+04
2.E+04
1.E+04
5.E+03
0.E+00
0.E+00
1.E+09
2.E+09
3.E+09
4.E+09
5.E+09
6.E+09
7.E+09
8.E+09
9.E+09
3.E+06
4.E+06
4.E+06
5.E+06
Currency in Circulation
Hungary (1920s)
3.E+06
Price Level
2.E+06
2.E+06
1.E+06
5.E+05
0.E+00
0.E+00
5.E+05
1.E+06
2.E+06
2.E+06
3.E+06
Poland (1920s)
3.E+08
Price Level
3.E+08
2.E+08
2.E+08
1.E+08
5.E+07
0.E+00
0.E+00
1.E+08
2.E+08
3.E+08
4.E+08
5.E+08
6.E+08
7.E+08
Fig. 6.6.
Price level and currency in circulation in some 1920s hyperinations.
increasingly dicult to raise money by issuing bonds, particularly longterm bonds, as investors prefer short maturities (if at all). The diculty of
raising funds by issuing bonds intensies as it becomes clear that the decit
is unlikely to shrink.
At this stage, the central bank starts buying up government bonds with
fresh money coming from the printing press. If the central bank, supposedly
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Government
spending spirals
out of control
Significant
budget deficit
135
Difficulty
of raising
funds by
borrowing
Central bank
prints money to
buy bonds
Currency no
longer a medium
of exchange
General
deterioration of
economic
conditions
Capital
flight
Currency no
longer a unit of
account
More money is
printed to keep
interest rates
low
Wages and
prices indexed
to a foreign
currency
Inflation
Currency
substitution
Fig. 6.7.
Currency no
longer a store
of value
b1571-ch06
Rising
velocity
Hyperination and the death of a at currency.
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an independent body, resists demand from the government to indulge in this

activity, laws may be changed to make it mandatory for the central bank
to do so, or the government may simply re those in charge of the central
bank and replace them with more accommodating people. This is followed
by capital ight and the need to print more money to keep interest rates
at a low level. Ination picks up and so does the velocity of circulation as
people spend their money quickly before prices rise even further they
will buy even things they do not need. At this stage, people start to realize
that the domestic currency is not a good store of value.
What happens next is a wave of currency substitution as people take
money out of their bank accounts and exchange it for a foreign currency
(or gold). The government may respond by freezing bank accounts, which
would put account holders in real hardship. When wages and prices are
indexed to a foreign currency, the domestic currency is no longer the unit of
account. As ination accelerates and conditions deteriorate further, people
start to use barter or a foreign currency to settle transactions even though
the government forbids it. The black market thrives and people start to
reject local paper money in settlement of transactions. In other words, the
domestic currency is abandoned as a medium of exchange. At this stage,
the domestic currency no longer performs any of the functions of money,
therefore it dies. The death of a at currency may be the outcome of a
stabilization program designed to put an end to hyperination as an integral
component of the program is the introduction of a new currency or the use
of a foreign currency as legal tender.
Calvo and Vegh (1993) examined currency substitution in high ination
countries, arguing that the extent of currency substitution is dicult to
quantify in the absence of reliable data on the foreign currencies circulating
in an economy. They suggested that a policy of discouraging currency
substitution tends to be favored by governments that rely heavily on revenues from money creation. An extreme measure designed to prevent the use
of a foreign currency is the forced conversion into the domestic currency of
the stock of foreign currency deposits in the domestic nancial system.
6.7. The Monetary, Condence and Fiscal Models

of Hyperination
The demand for money is a central issue in models of hyperination because
the latter is the outcome of expanding money supply that is not matched by
demand and because the demand for money is a reection of the velocity of
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circulation. Hyperination is associated with both excessive money supply

growth and rising velocity the two factors are considered the root causes
of hyperination. A dramatic increase in the velocity of circulation as the
cause of hyperination is central to the crisis of condence model of
hyperination, where the risk premium that sellers demand for the paper
currency over the nominal value grows rapidly. In this model, the loss of
condence comes before monetary growth and causes it. In the monetary
model, rapid monetary growth comes rst and causes the loss of condence.
It is either that too little condence is forcing an increase in the money
supply, or too much money is destroying the condence.
In the condence model, some event (such as a military defeat or a
run on the reserve asset backing the currency) leads to the impression that
the underlying government will be insolvent. Remember that paper money
only has a value because of the condence that the money can be exchanged
for a certain quantity of goods or services in the future. If this condence
is eroded, hyperination becomes a real threat. If holders of cash start to
question the future purchasing power of the currency and switch into real
assets, asset prices start to rise and the purchasing power of money starts
to fall. Other cash holders may realize the falling purchasing power of their
money and join the mass exit from paper money into real assets. Therefore,
hyperination is ignited when this self-reinforcing cycle turns into a panic.
Because people do not want to hold a currency that is likely to lose
its purchasing power, they exchange it quickly for real goods. For the same
reason, sellers demand a higher and higher premium in the form of higher
prices. The increase in the money supply is the result of the government
attempting to buy time without coming to terms with the root cause of the
lack of condence.
In the monetary model, hyperination is a positive feedback cycle of
rapid monetary expansion where money is created to cover spiraling costs,
often from lax scal policy, or the mounting costs of warfare. When rms
detect the tendency of the government to pursue a policy of rapid monetary
growth, they mark up prices to cover the expected loss of the currencys
value hence, more money is issued to cover rising prices that would
push the currency value down even faster than before. According to this
model, the only solution is to stop abruptly the monetary expansion. Thus,
the monetary model predicts that the velocity of circulation would rise
endogenously as a result of excessive monetary expansion. Whatever the
cause, hyperination involves both the money supply and the velocity of
circulation irrespective of which one comes rst.
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If hyperination is essentially a scal phenomenon, the scal theory

of ination must be relevant. A government incurs a scal decit when
spending is greater than tax revenue. This decit has to be nanced by
borrowing, which leads to the accumulation of debt and the payment of
interest. For a scal balance, the following condition must hold:
T + B = G + iD,
(6.6)
where T is tax revenue, B is borrowing, G is government spending, i is

the interest rate on borrowed funds and D is debt. If, however, T + B <
G + iD, the dierence has to be covered by printing money. Hyperination,
therefore, results from a combination of the following factors: (i) too much
spending, (ii) too little tax revenue, (iii) big debt, and (iv) inability to
borrow. The process is initiated, for example, by a fall in tax revenue
resulting from deterioration in the terms of trade (declining price of
exports or increasing price of imports). According to Bernholz (2003),
no hyperination has occurred without a huge budget decit nanced by
money creation.
Economists express the proposition that hyperination is a scal
problem dierently. For example, Bomberger and Makinen (1983) assert
that the cause of hyperination rests in a government whose political
survival is so precarious that it cannot levy sucient explicit taxes, which
forces the government to rely on the issue of new money as the principal
source of tax revenue. Capie (1986) argues that the combination of
weak governments, civil disorder and unrest, leads to conditions which
facilitate the loss of scal discipline and to the use of ination tax as
the overwhelming source of government revenue. Loyo (1999) argues that
while hyperination is usually considered as a consequence of the monetary
nancing of serious scal imbalances, he presents a scalist alternative
in which ination explodes because of the scal eects of monetary policy.
The process is supposed to work as follows. Higher interest rates cause the
outside nancial wealth of private agents to grow faster in nominal terms,
which in scalist models calls for higher ination. If the monetary authority
responds to higher ination with suciently higher nominal interest rates,
a vicious circle is initiated.
6.8. The Role of Expectations
The role of expectations is important for the sustainability of hyperination;
hence, expectation of future ination is a determinant of hyperination.
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If, for example, rms believe that ination will continue, they will charge
increasingly higher prices for their products, thus sustaining ination.
The same happens when workers formulate wage demands when they
expect ination to persist. A question that is often brought up in studies
of hyperination is how expectations are formed typically, models
of hyperination involve one of two expectation formation mechanisms:
adaptive and rational. Under adaptive expectations, households and rms
form their expectations of ination based on recently observed ination
to be more precise, they adjust (adapt) their expectations by observing
the most recent expectational error. In simple words, prices keep on rising
because people expect them to rise and they expect them to rise because
they have seen them rise. In other words, this expectation formation
mechanism is backward looking. Under rational expectations, on the other
hand, rms and households use all the available information, including
information pertaining to current policies, to forecast future ination. The
rational expectations mechanism is forward looking, which means that
if policy makers are credibly committed to reducing ination, rational
people will understand the commitment and downgrade their inationary
expectations. This is why policy credibility is rather important for stopping
hyperination. Makochekanwa (2007) makes the interesting observation
that both adaptive (mostly used by the majority) and rational (mostly
employed by the enlightened, i.e., businessmen, learned etc.) expectations
have contributed to the hyperination in Zimbabwe.
The role of expectations in hyperination is explained by Sargent (1982)
with respect to what he calls the underlying ination rate, which is the
rate that rms and workers believe will prevail in the future. If this is the
case then this rate responds very slowly, if at all, to restrictive monetary
and scal policies. If this rate is formed by extrapolating past ination rates
into the future, ination will have momentum. However, those advocating
the rational expectations approach, including Sargent, deny the presence
of an inherent momentum in the inationary process because if rms and
workers believe that the government is committed to stopping ination,
they will revise their inationary expectations downwards. An implication
of this proposition is that ination can be stopped much more quickly
than under the momentum scenario. Thus, hyperination can be stopped
swiftly and at no huge cost if a new policy regime is implemented involving
an abrupt change in the continuing government policy, or strategy, for
setting decits now and in the future that is suciently binding as to be
widely believed. Sargent goes on to demonstrate that the experience under
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the hyperinations of Germany, Hungary, Poland and Austria are more

consistent with the rational expectations than with the momentum view.
Paul Samuelson disputed the view that the rational expectations
approach can explain hyperination. This is what he wrote in Newsweek
more than 30 years ago (Sargent, 1982):
I should report that there is a new school, the so-called rational
expectations. They are optimistic that ination can be wiped out with
little pain if only the government makes credible its determination to do
so. But neither history nor reason tempt one to bet their way.
While Sargent described the second sentence of this quote as probably

as shrewd a summary of the rational expectations view as can be made
in a single sentence, he disputed the third sentence, arguing that as for
reason, no one denies that logically coherent and well-reasoned models
underlie the claims of the rational expectationists and as for history, the
evidence summarized in this paper is surely relevant.
6.9. Other Approaches to Hyperination
Hyperination can also be explained in terms of the political economy
approach to macroeconomic policy, which emphasizes the role played by
several non-economic factors in determining or explaining ination: political
stability, policy credibility, the reputation of the government, and political
cycles. Cooper and Kempf (2001) examine the eects of political institutions
on ination, arguing that hyperination is the manifestation of a tragedy
of commons in a divided society with a weak central monetary authority.
The purely economic theories of hyperination (or just ination)
overlook the possibility that sustained government decits, as a potential
cause for ination, may be partially or fully endogenized by considering
the eects of the political process and possible lobbying activities on
government budgets, and thus, on ination. The so-called new political
economy is the study of how the political nature of decision-making aects
policy choices and, ultimately, economic outcomes. Drazen (2000) writes:
In the real world, economic policy is not chosen by the social planner
who safely inhabits economics textbooks, sheltered from agents with
conicting interests while he calculates optimal policy. Economic policy
is the result of a decision process that balances conicting interests
so that a collective choice may emerge . . . . In order to study political
economy, that is, to study the eects of politics on economic outcomes
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141
we must, therefore, begin with some political and economic building

blocks.
Therefore, the new political economy literature provides fresh perspectives

on the relations between the timing of elections, policymaker performance,
political instability, policy credibility and reputation, central bank independence and the ination process itself.
Makochekanwa (2007) explains hyperination in Zimbabwe in terms of
severe restrictions on political and civil liberties. Specically, he describes
that major determinants of hyperination in the country include intensication of political instability and macroeconomic instability following
the coming into fore of resilience opposition political party in 1999, the
controversial land reform since 1999 and the fact that the country has been
increasingly isolated from the international community. He also considers
structural factors such as weather conditions and pricing policies of the
government.
Institutional and structural factors have been used by Nielsen (2005)
to explain hyperination in the Confederacy during the American Civil
War. He points out that the experience of the Confederacy in particular
illustrates the consequence of poor nancial infrastructure and governance
and that the structure of the Southern economy also impeded eective
monetary policy. In particular, he points out that the South was heavily
dependent on agriculture with little industrial capital and few liquid assets.
The lack of liquidity made tax collection very hard in the rural South,
while the lack of economic diversication made the economy prone to
adverse shocks emanating from its few export goods such as cotton. The
combination of these structural problems, coupled with short-sighted policy
making by the Confederate Congress, meant that taxation and borrowing
ultimately failed to raise sucient funds to conduct the war. Consequently,
the Confederacy had to nance itself through excessive printing of money,
which led to hyperination.
6.10. The Behavior of Exchange Rates under Hyperination

In this section, the behavior of exchange rates under hyperination is
examined by using various versions of the exible price monetary model.
The model, which was developed by Frenkel (1976) and Bilson (1978),
assumes that PPP holds continuously, implying that it is valid in the short
run and in the long run as well.
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6.10.1. The basic model

The simplest version of the monetary model of exchange rates can be derived by assuming a stable demand for money function of the form
Md = kP Y,
(6.7)
where Md is the quantity of money demanded, P is the price level, Y is

real income and k is a positive constant. By assuming also an exogenous
money supply, equilibrium in the money market (which requires equality
between the demand for money and the exogenously-determined money
supply) yields
P =
M
,
kY
(6.8)
where M is the money supply. If PPP holds, then S = P/P , where S is the
exchange rate and P is the foreign price level.3 By substituting Eq. (6.8)
into the PPP equation, we obtain
S=
M
.
kP Y
(6.9)
The model tells us that the exchange rate will rise (the domestic currency
will depreciate) when there is an increase in the money supply, a decrease in
income and a decrease in the foreign price level. The model also tells us that
there is a proportional relation between the money supply and the exchange
rate that is, a 10% rise in the money supply, ceretis paribus, leads to a
10% rise in the exchange rate. This prediction follows from a combination of
the quantity theory of money and PPP, both of which embody the property
of proportionality. The quantity theory of money postulates that an increase
in the money supply leads to a proportional increase in the price level. PPP
then tells us that this rise in the price level leads to a proportional rise in
the exchange rate.
Figure 6.8 shows, with the help of simulated data based on Eq. (6.9)
how the exchange rate rises (the domestic currency depreciates) when the
ination rate is 3%, 5% and 20%, assuming that ination is produced
by a proportional monetary expansion. As long as domestic ination is
higher than foreign ination, the domestic currency depreciates. At an
3 In
these models, S is measured as the domestic currency price of one unit of the foreign
currency, which means that a higher S implies depreciation of the domestic currency.
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120
100
80
60
40
20
10
15
20
25
3%
Fig. 6.8.
5%
30
35
40
45
50
20%
The eect of ination on the exchange rate (simulated data).
ination rate of 20%, the domestic currency loses its international value
very quickly.4
6.10.2. The role of expectations
The role of expectations can be incorporated in the monetary model by
re-specifying the demand for money functions to be the following semi-log
equations
md,t pt = 1 yt 2 it ,
(6.10)
md,t pt = 1 yt 2 it ,
(6.11)
where 1 and 2 are positive constants and lower case letters denote the
natural logarithms of the underlying variables except for interest rates
(i and i ). For simplicity, we have imposed the assumption of symmetry
that is, equality of the income elasticities (1 ) and interest semi-elasticities
(2 ) of the demand for money. By combining the demand for money
4 In
Fig. 6.8, the exchange rate is inverted to foreign/domestic so that a declining

exchange rate signies a depreciating domestic currency.
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equations with the equilibrium conditions in the money market and PPP
(st = pt pt ), we obtain
st = (mt mt ) 1 (yt yt ) + 2 (it it ).
(6.12)
Expectation is introduced via uncovered interest parity (UIP), which is

written as
it it = set+1 .
(6.13)
By substituting Eq. (6.13) into Eq. (6.12) we obtain

st = (mt mt ) 1 (yt yt ) + 2 set+1 ,
(6.14)
where se is the expected change in the exchange rate. Equation (6.14) tells
us that a currency will appreciate or depreciate if it is expected to appreciate
or depreciate. This is because if a currency is expected to depreciate, traders
will sell it, leading to its depreciation, and vice versa.
The next step is to move from expectation of the exchange rate to
inationary expectations the two mechanisms are related via ex-ante
PPP, which is written as
e
e
set+1 = t+1
t+1
,
(6.15)
e
e
where t+1
and t+1
are the expected domestic and foreign ination rates.
By substituting Eq. (6.15) into (6.14), we obtain
e
e
t+1
).
st = (mt mt ) 1 (yt yt ) + 2 (t+1
(6.16)
Equation (6.16) tells us that the exchange rate is dependent on expected

ination rates. Thus, if it is expected that domestic ination will be
higher than foreign ination, the domestic currency should depreciate
(s rises). Furthermore, if inationary expectations are triggered mainly
by expectations concerning monetary growth then relative expected mone
e
etary growth (me me
t ) can replace (t+1 t+1 ) in Eq. (6.16).
Hence,
st = (mt mt ) 1 (yt yt ) + 2 (met+1 me
t+1 ),
(6.17)
where me (me ) is the expected change in the domestic (foreign) money

supply. Equations (6.16) and (6.17) tell us that expectations also play a
role in exchange rate determination but these expectations are induced by
monetary factors. The current level of the exchange rate is aected not only
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145
by the current levels of domestic and foreign money supplies, but also by
the money supplies expected to prevail in the future.
6.10.3. Currency substitution
Currency substitution is the tendency of individuals and businesses to alter
the composition of their money holdings between domestic and foreign
currencies. An important implication of currency substitution is that the
more highly substitutable domestic and foreign currencies are, the more
volatile exchange rates may be in response to even small changes in the
underlying economic fundamentals (such as monetary growth).
It is possible to embody the eect of currency substitution in the
monetary model. This is done by re-specifying the demand for money
functions to the following:
md,t pt = 1 yt 2 it 3 set+1 ,
(6.18)
md,t pt = 1 yt 2 it + 3 set+1 .
(6.19)
Notice that the coecient on the expected change in the exchange rate is
negative in the demand for domestic money equation (6.18) and positive
in the demand for foreign money equation (6.19). 3 is a measure of the
elasticity of demand for foreign and domestic money with respect to the
expected change in the exchange rate. It is also a measure of the elasticity
of substitution between domestic and foreign currencies. If we combine
Eqs. (6.18) and (6.19) via PPP (s = p p ), we obtain
st = (mt mt ) 1 (yt yt ) + 2 (it it ) + 23 set+1 .
(6.20)
e
e
Since it it = pet+1 pe
t+1 = mt+1 mt+1 , it follows that
e
st = (mt mt ) 1 (yt yt ) + 2 (met+1 me
t+1 ) + 23 st+1 .
(6.21)
If set+1 = met+1 me
t+1 , then
st = (mt mt ) 1 (yt yt ) + (2 + 23 )(met+1 me
t+1 ).
(6.22)
The dierence between Eqs. (6.22) and (6.17) lies in the eect of inationary
expectations resulting from expected monetary growth. Figure 6.9, which
is based on data simulated from Eq. (6.22), shows the eect ination and
inationary expectation in the presence of currency substitution. At an
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146
120
100
80
60
40
20
0
0
10
15
20
25
1%
Fig. 6.9.
30
3%
35
40
45
50
5%
The eect of ination and expectations on the exchange rate (simulated data).
ination rate of 5% and a corresponding monetary growth rate that is

expected to persist, the currency loses its value rather quickly.5
6.11. The Empirical Evidence
Table 6.2 provides a selected set of results pertaining to the testing of
models of hyperination in several countries, including the most severe
cases. The studies also include some of those involving the estimation of
models of exchange rate determination. As for the causes of hyperination,
these studies report several causes, sometimes the same causes expressed
dierently. Some of the identied causes are the following:
1.
2.
3.
4.
5.
6.
5 For
Accommodating scal policies.

Attempts to maintain stable prices via subsidies.
Reparation payments.
Diculty of collecting taxes.
Budget decit.
Monetization of the budget decit.
the purpose of simulating Eq. (6.22), it is assumed that 1 = 1, 2 = 0.5 and 3 = 0.8.
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Table 6.2.
Study
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147
The empirical evidence on hyperination.
Episode
Findings
Sargent (1982)
Germany,
Hungary,
Austria and
Poland
Restrictive monetary and scal actions in the

rst instance cause substantial reductions in
output and employment but have little, if any,
eects on the ination rate.
Makinen (1986)
Greece
The Greek hyperination was set in motion by

World War II. Scarcity of imported raw
materials led to a decline in industrial
production. The decit was covered by notes
advanced by the Bank of Greece.
Onis and
Ozmucur
(1990)
Turkey
Non-monetary, supply-side factors have

signicant eects on ination in Turkey.
Devaluations are strongly inationary. A pure
monetary interpretation of the Turkish
ination is rejected.
Rogers and
Wang (1993)
Four Latin
American
Countries
The main causes of chronically high ination

include continuous scal and monetary
expansion, productivity slowdown, and
systematic undervaluation of the domestic
currency. Successful stabilization, in essence,
results from budgetary adjustment, market
liberalization, and the adoption of a nominal
anchor, all of which ensure credibility of the
public authorities.
Michael et al.
(1994)
Germany
Reparations were a major cause of

hyperination. The German experience
reected the incapacity of organized and
powerful groups to agree on how to share the
burden of reconstruction and reparations
amongst themselves. To pay the reparations,
the country had to resort to the printing
press, thus initiating ination and
propagating hyperination.
Funke et al.
(1994)
Poland
Polish hyperination at the end of the eighties

was too excessive to be attributed to market
fundamentals only.
Siklos (1995)
Hungary
Reparation payments coupled with diculties in

collecting taxes forced the government to
print money.
Bernholz (1995)
Bolivia
Hyperination was caused by a budget decit

nanced by an increase of the monetary base.
Rising foreign debt and dwindling foreign
reserves made it dicult to raise foreign debt.
(Continued)
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148
Table 6.2.
Study
Episode
(Continued)
Findings
De Menil (1996)
Ukraine
The 1992 monetary expansion increased

pressure on prices causing the
hyperination of 1993. Subsequently,
increasing credit for the agricultural
sector caused acceleration of ination.
Following the administered price
increases, inationary expectations
intensied.
Lim and Papi

(1997)
Turkey
Monetary variables (initially money, and

more recently the exchange rate) play a
role in the inationary process.
Public-sector decits also contribute to
inationary pressures. Inertial factors are
quantitatively important.
Alper and Ucer

(1998)
Turkey
The empirical link between scal

imbalances and ination is weaker than
one might think. Ination has increased
side-by-side with a visible erosion of
monetary aggregates, with seigniorage
revenue somewhat declining. Inertia
drove ination in the short run.
Engsted (1998)
China (19461949),
Hungary
(19451946) and
Yugoslavia-Serbia
(19911993)
Money demand and price level dynamics

are analyzed using data from the three
hyperinationary episodes. The Cagan
models ability to describe money
demand during hyperination is
analyzed. The results indicate that the
Cagan model provides a valid description
of money demand during the Chinese
and Serbian hyperinations, but not
during the Hungarian hyperination.
However, in the former two cases, money
demand shocks account for a substantial
part of the variation in real balances.
Kravchuk
(1998)
Ukraine
The main factor aggravating ination was

the large quantities of cheap credit
extended to enterprises.
Wang (1999)
Georgia
Hyperination was produced by a mixture

of factors including a combination of
accommodating nancial policies and
attempts to maintain stable prices for
key commodities (bread and energy).
(Continued)
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Table 6.2.
Study
Episode
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149
(Continued)
Findings
Moosa (2000)
Germany
The currency substitution model is tested

under the German hyperination using
several expectation formation
mechanisms. The results show that
extrapolative and adaptive expectations
seem to have been predominant and that
there was a signicant degree of currency
substitution. The results also reveal that
expectation was destabilizing.
Lissovolik
(2003)
Ukraine
Two theoretical models are tested: the

mark-up model and the money market
model. The results show that the
mark-up model oers a more consistent
and well-tting overall framework for the
19962002 data. The long-term monetary
transmission mechanism operates
through the exchange rate and wages
while the money supply is a short-term
determinant of ination.
Makochekanwa
(2007)
Zimbabwe
A model is proposed and estimated,

showing that the ination rate is
determined by monetary growth, real
output, foreign exchange black market
premium, political freedom and nominal
wages.
Fudge (2010)
Argentina
Perpetual budget decits led the

government to print money rapidly,
causing currency depreciation and thus
high ination rates. By operating a
balanced budget and controlling the
money supply, chronic high ination and
hyperination can be avoided.
7.
8.
9.
10.
11.
12.
13.
14.
Rising foreign debt.

Dwindling foreign reserves.
Diculty of raising external debt.
Post-war reconstruction costs.
Scarcity of imported raw materials.
Continuous scal and monetary expansion.
Systematic undervaluation of the domestic currency.
Cheap credit extended by the government to enterprises.
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Some evidence on expectation formation under hyperination is also

available. The main results are that (i) adaptive and extrapolative
expectations are dominant under hyperination, (ii) it is not possible to
distinguish between the eects of the expected change in the exchange
rate and expected ination, and (iii) expectation is destabilizing under
hyperination.
Some economists attempted to estimate exchange rate determination
models under hyperination. For example, Petrovic and Mladenovic (2000)
proposed a modied monetary exchange rate model for the Yugoslav
hyperination of 19921994 to demonstrate that the exchange rate is
determined directly in the money market, thus implying that private agents
(due to dollarization) denominate their real money holdings in foreign
currency. Moosa (2000) tested the monetary model of exchange rates under
the German hyperination, producing results indicating that the money
supply and the expected rate of change of the exchange rate played a
dominant role in the determination of the exchange rate of the mark against
the U.S. dollar. The results also support the property of proportionality
between the exchange rate and the money supply. Furthermore, evidence
is found for the validity of the constituent components of the monetary
model, PPP and the quantity theory. Moosa (1999) tested the currency
substitution model under the German hyperination using several expectations formation mechanisms. The results reveal that extrapolative and
adaptive expectations seem to have been predominant and that there was
a signicant degree of currency substitution. The results also reveal that
expectation was destabilizing and that it was not possible to distinguish
between the eects of the expected change in the exchange rate and
expected ination.
The German hyperination has received comparatively more attention
than any other episode although it was not as severe as the Hungarian
hyperination of the 1940s. For this reason, more elaboration on studies of
the German hyperination is perhaps warranted.
Tullio (1995) classies the (partial) studies dealing with the German
hyperination into three categories. The rst category includes those studies
that examine the quantity theory of money and the determination of real
cash balances, such as Cagan (1956), Barro (1970), Frenkel (1977, 1979),
Abel et al. (1979) and Taylor (1991). The second category includes studies
that focus on exchange rate determination `
a la Frenkel (1976). The third
category encompasses studies of the theory of rational expectations whose
main contributors are Sargent and Wallace (1973) and Sargent (1977).
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151
Some studies, however, deal with more than one of these issues. For
example, Tullio (1995) presents a model that explains simultaneously the
determination of prices, the exchange rate and the money supply. While
Tullios study falls in the rst category, it also considers various expectation formation mechanisms.
The motivation for the studies belonging to the rst category is
the observation that movements in prices under hyperination are of a
magnitude so much greater than that of real variables, providing the
closest thing to a controlled experiment on the relation between money
and prices. In the words of Cagan (1956), hyperination provides a unique
opportunity to study monetary phenomena as the astronomical increases in
prices and money dwarf changes in real income and other factors. Cagan
specied a simple demand for money function in which the demand for real
money balances is a function of the expected ination rate. By utilizing the
adaptive expectations hypothesis he estimated the function using data on
Germany and three other countries that have experienced hyperination.
He found a signicantly negative coecient on the expected ination rate
for all countries.
More recent work along these lines has been primarily concerned with
the choice of econometric procedures and applying dierent expectation
formation mechanisms. Frenkel (1977) used the forward spread as a proxy
for the expected ination rate on the grounds that expected ination and
the exchange rate move together. His estimates for the coecient on the
forward spread ranged between 0.358 and 3.316. In a subsequent study,
Frenkel (1979) used three dierent proxies for expected ination, all of
which are related to the forward spread. Irrespective of the proxy used,
he found signicantly negative coecients ranging between 0.358 and
1.196.
Some economists argue that the specication of the demand for money
function that contains the expected ination rate as the only explanatory
variable is not valid if there are deviations from PPP in the short run. This
may be the case even under hyperination. Abel et al. (1979) have shown
that this was the case under the German hyperination, a result that has
been conrmed by Taylor and McMahon (1988).6 It is plausible to assume
that under hyperination, substitution occurs not only between currency
6 Abel
et al. (1979) demonstrated the presence of deviations from PPP by showing that
the ratio of price to exchange rate was not constant. Taylor and McMahon (1988) used
cointegration analysis to verify deviations from PPP.
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and foreign assets but also between currency and goods. Thus, Abel et al.
specied the demand for money to be determined by the expected exchange
rate (which is a measure of substitution between domestic and foreign
money) and the expected ination rate (which is a measure of substitution
between domestic money and goods). Their empirical results reveal that
both coecients are signicantly negative (0.59 on expected ination and
1.57 on the expected change in the exchange rate). The implication of this
nding is that substitution between money and foreign assets was stronger
than that between money and goods. This result was later conrmed by
Taylor (1991) who used cointegration analysis and rational expectations,
as he found the coecients to be 0.44 and 0.98.
6.12. The Consequences of Hyperination
Hyperination represents a traumatic experience that produces worthlessness. With reference to the German hyperination, Ferguson (2008) points
out that not only was money rendered worthless; so too were all the forms
of wealth and income xed in terms of that money. This makes one wonder
why any rational government would engage in actions that cause or sustain
hyperination. One reason for such actions is that often the alternative to
hyperination is either a depression or a military defeat. Countries that go
through this experience will in the aftermath enact policies to prevent its
recurrence. This often means making the central bank very aggressive in
accomplishing the objective of maintaining price stability, as was the case
with the German Bundesbank, or adopting a currency board.
The consequences of hyperination are severe forms of the consequences
of moderate ination all of those that were examined in Chapter 5. We
have seen, for example, that ination causes an arbitrary redistribution of
income from creditors to debtors. Therefore, a company with uncollected
receivables will be put in a disadvantage, losing more and more the longer
the receivables remain uncollected. In Fig. 6.10, we see what happens to the
value of receivables initially worth $100,000 at monthly ination rates of 1%
(moderate ination) and 20% (hyperination). The value of the receivables
declines much more rapidly under hyperination.
Hyperination is bad, actually destructive, for business planning
(and hence, economic activity) it is even bad for nancial reporting.
For example, the generally accepted accounting principles (GAAP) are
poorly adapted to describe economic reality for rms operating under
hyperinationary conditions. Traditional reporting systems produce large
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1% per month
120
100
80
60
40
20
0
0
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
14
15
16
17
18
19
20
21
22
23
24
months
20% per month

120
100
80
60
40
20
0
0
10
11
12
13
-20
months
Fig. 6.10.
Erosion of receivables under ination (simulated data).
foreign exchange gains or losses that are dicult to interpret, mismatch

revenues and expenses and overstate interest income and expenses. Under
these conditions, nancial statement users are provided with unreliable
information for the evaluation of a business. Choi and Gunn (1997)
propose a transaction-based reporting model to overcome many of these
deciencies. The model involves an examination of reported numbers in
a disaggregated fashion, showing that with little additional eort conventional accounting data can be transformed into information that can be
useful to a range of nancial statement users. Whittington et al. (1997)
show that hyperination can have a severe distortionary eect of the pattern
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of corporate nance, which is apparent from company accounts. A simple

algorithm, based upon the method of ination accounting applied in Brazil,
is developed and applied to the accounts of Turkish listed companies for
the period 19821990.
Pricing products under hyperinationary conditions is problematical,
particularly for rms marketing products globally. In order to price
products, managers must understand the behavior of customers and rms
and what behavioral changes are triggered by hyperination. Grewal and
Zinn (1996) suggested that behavior under hyperination is aected by the
interaction between the ination rate and the real interest rate. They apply
the proposed framework to describe the behavior of customers and rms
under four dierent combinations of ination and the real interest rate.
The behavior of customers in an inationary environment is inuenced by
their knowledge of prices. Because of uncertainty, customers tend to shop
and then make quick decisions because price information becomes highly
perishable as ination accelerates. The behavior of rms is often the product
of pressure to sell. Maintaining high inventory levels is a preferred strategy
when the interest rate is low but when the interest rate is high, rms have
a strong incentive to sell.
Swanson (1989) describes how business is conducted under hyperination where a rm refuses to ll a customers order who is willing to pay cash
immediately, even if inventory is available this is because the rm will
actually lose money by lling the order. That same rm faces an increase in
the prices of raw materials of 50% per month and has to pay a 40% interest
on a loan for one month. Employees got a pay raise of 15% last week and
they will ask for another raise next week. In spite of the increase in the
costs of production, the rm cannot raise its prices because the government
rejects the price increase request. In general, it is never business as usual
under hyperination as most product lines become unprotable and have
to be abandoned. Survival no longer depends on production rather it
depends on short-term activities such as speculation on currencies and
commodities.
The business environment is completely dierent under hyperination.
For example, loans are available only for short periods and at high interest
rates. Businesses cannot aord to be highly leveraged because interest rates
are unpredictable. The composition of sta changes during hyperination
as more accounting and data processing personnel are required. The
labor/management relationship becomes more adversarial because of constant demand for higher wages and the threat of redundancy. There is much
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less tolerance for over-due debt. Businesses tend to stockpile inventories

both to ensure future supplies and use them as a speculative device. As it
is often the case that protectionist measures are implemented, businesses
nd a narrower access to foreign suppliers and sales. Because money loses
its value rapidly, managerial decisions have to be taken immediately. Last,
but not least, businesses become extremely vulnerable to corruption.
We have seen that even moderate ination has an adverse eect
on saving. Under hyperination, to save was folly, was suggested by
Fergusson (2010) who asserted that the only thing to do with cash under
hyperination was to turn it into something else as quickly as possible.
Under the German hyperination, for example, farmers were in a better
position than people in any other profession because land produces real
value. At that time, farmers bought things that they needed, such as useful
machinery and furniture, as well as many useless things, at least for farmers.
According to Fergusson, who quotes an observer at that time, that was
the period in which grand and upright pianos were to be found in the most
unmusical households.
Hyperination also brings with it extreme cases of loss of law and order
and corruption. In the third week of November 1923, serious collisions took
place between rioting workers demanding wage increases and the German
police. Fergusson (2010) tells a story about Earnest Hemingway who
obtained a visa from the German consular attache in Paris with the aid
of a bribe. Crime also thrived. Metal plaques on national monuments were
removed for safe keeping. Burglaries were rife, particularly from foreigners
who commanded a higher purchasing power than the locals. Brass bell
plates were stolen from the front door of the British Embassy in Berlin.
There were even stories of shoppers who found that thieves had stolen the
baskets and suitcases in which they carried their money, leaving the money
itself behind on the ground. Fergusson articulates the moral of these stories
by suggesting that ination is the ally of political extremism, the antithesis
of order and that in post-revolutionary Russia, in Kadars Hungary, it
may have been deliberately engendered in order to destroy the social order,
for chaos is the very stu of revolution.
Many economic historians argue that the German hyperination
contributed to the rise of Hitler. This is what Zweig (1944) wrote about
the issue:
Nothing else has made the German people as embittered, as hateful,
as ripe for Hitler as the ination. For the war, as murderous as it had
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been, had at least seen hours of triumph, ringing of bells, fanfares of

victory . . . but as a consequence of the ination [the Germans] felt only
drawn into the dirt, cheated and humiliated.
Ination causes civil unrest because it exacerbates inequality and

worsens poverty. It also promotes dissatisfaction with the government. If
this can happen under moderate ination, hyperination has devastating
eects as far as social unrest is concerned. This is why Zweig (1944),
in his description of the consequences of the German hyperination,
wrote that a whole generation did not forgive the German Republic [the
government]. For the same reason, Paldam (1994) wrote that the regime/
government was seen as having allowed an arbitrary redistribution to take
place. As a consequence of hyperination, he wrote, Germany acquired
one of the worst regimes known, Austria soon lost its democracy, and
such tendency as there was for a democratic development in Poland and
Hungary ceased. Bernholz (2003) summarizes the social consequences of
hyperination in one sentence by saying that hyperinations are certainly
a traumatic experience leading to dangerous damage to the social fabric.
6.13. Dealing with Hyperination: Business Issues

Based on his study of hyperination in South America, Swanson (1989)
has developed a comprehensive list of what to do under hyperination. He
classies his recommendations as to how business rms should deal with
hyperination under four headings: (i) nancial management, (ii) marketing
strategies, (iii) manufacturing decisions, and (iv) industrial relations. Under
nancial management, he recommends the following:
1. Emphasizing and understanding the importance of the time factor when
dealing with payables and receivables, making the rapid collection of
receivables a primary goal.
2. Minimizing idle cash and emphasizing the importance of cash management.
3. Converting domestic currency balances into a stable foreign currency.
4. Avoiding credit sales.
5. Developing practices that enable the internal nancing of working
capital.
6. Considering the possibility of acting as an acceptance company to
facilitate customers purchases.
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7. Taking into account the consideration that the stock market may
become an uncertain source of capital.
8. Developing relationships with several banks to have better access to
loanable funds in tightened credit conditions.
9. Developing ability to anticipate changes in monetary and scal policies
and the consequent eects on interest rates.
10. Maintaining more than one set of books because historical costs become
meaningless for the purpose of comparison.
11. Inventory valuation should not be based on the last-in-rst-out (LIFO)
system but rather on the next-in-rst-out (NIFO) system.
12. Developing an appropriate inationary adjustment for capital replacement.
The marketing strategies suggested by Swanson include the following:
1. Executing prompt and selective price increases, which may be necessary
even on a daily basis.
2. Developing ination sensitive pricing policies.
3. Establishing a satisfactory current base price that should not only
reect the current state of the economy but also inationary expectations.
4. Preparing reaction to wage and price controls.
5. Large companies and multinationals should expect their prices to be
more closely regulated.
6. Preparing for the possibility that competitors will sidestep price
controls.
7. Preparing for the possibility of black markets.
8. Acquiring information on how competitors adjust their prices.
9. Keeping track of the actual cost of production.
10. Establishing a base period from which to judge inationary impact.
11. Monitoring the value of the currency with increasing vigilance.
12. Choosing products with the largest prot margins.
13. Moving from long-term to short-term contracts.
On the manufacturing side, Swanson recommends the following policies:
1. Emphasizing the crucial role played by the purchasing department in
the long-run survival of the rm.
2. Preparing to deal with price controls.
3. Shifting from foreign to domestic suppliers.
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4. Realizing that hyperination creates increased opportunities for corruption.

5. Modifying inventory policy to allow the accumulation of big inventories
during hyperination.
6. Anticipating the diculty of maintaining capital expenditure programs.
7. Realizing that speculation in commodities and currencies may provide a
better rate of return than capital projects.
Last, but not least, industrial relations are greatly aected by hyperination. Swanson suggests the following measures:
1. Human resources sta should be prepared for stronger unions and
continuous wage bargaining.
2. Realizing the possibility that wages may be frozen but that would not
prevent unions from putting pressure on the management to circumvent
controls.
3. Accepting the need to shorten the pay period.
4. Anticipating morale problems particularly among middle management.
5. Anticipating the eect of money illusion among employees.
6. Adjusting fringe benets to reect the underlying ination rate.
In short, running a business under hyperination is an extremely dicult
task. Even with the adoption of measures like those suggested by Swanson,
rms will invariably fail.
6.14. Dealing with Hyperination: Macroeconomic Issues
Hyperination is met with drastic remedies, such as imposing the shock
therapy of slashing government spending or changing the currency, including dollarization the use of a foreign currency (not necessarily the
U.S. dollar) as a national unit of currency. If hyperination is caused by
excessive monetary expansion, then putting an end to it must be easy: stop
issuing money. Bernholz (2003) reaches the conclusion that only monetary
constitutions binding the hands of the government can prevent or contain
ination over extended periods.7 This idea can be traded back to Jevons
(1900) and von Mises (1912).
7 Examples
of successful monetary constitutions are the gold standard, independent

central banks, and currency boards in short, arrangements that do not allow the
government to resort to the printing press at will.
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However, because hyperination is essentially a scal problem, putting

an end to money creation does not deal with the scal cause. Additional
measures must be taken, including the following: (i) stimulating growth;
(ii) improving the tax collection system; (iii) cutting back government
spending; and (iv) boosting net external ows, which may involve defaulting
on the payment of debt. In stabilization programs, designed to put an end
to hyperination, central banks are granted autonomy such that they can
refuse to nance the scal decit by printing money.
Vegh (1992) presents a unied theoretical model to interpret the main
stylized facts associated with stopping hyperination and chronic ination.
The model predicts that, in the absence of backward indexation, a credible
stabilization program puts an end to ination with no real eects. He even
presents a case as to the ability to stop hyperination suddenly with no
major costs. However, the outcome and success of any stabilization program
depends as much on the speed at which high inationary expectation is
killed. For that to happen, government commitment to put an end to ination and its credibility are essential.
A basic goal of a stabilization program is the restoration of the publics
faith in the value of money so that monetary exchange will take place once
again. The essential ingredients usually include a complete overhaul of the
scal system, designed to achieve a balanced budget. Frequently, stabilization programs also involve the additional step of restoring the convertibility of domestic money into gold or stable-value foreign currencies. This
step imposes an additional constraint on scal policy and serves to reinforce
the belief of the public that a serious attempt is being made to balance the
budget. The delegation of monetary policy, through either a currency board
or dollarization, can serve as a commitment device and thus eliminate the
ination bias created by decentralized monetary policy.
Bernholz (2003) suggest a bundle of reforms to put an end to
hyperinations, including the following: (i) limiting the amount of credit
extended to the government by the monetary authorities to cover the
budget decit; (ii) if the problem of restoring creditworthiness abroad can
be resolved, it will be possible to obtain a foreign bridging loan that can
be used to nance external and internal decits; (iii) the real stock of
money has to be restored to pre-hyperination levels; (iv) private long-term
credits that lost their value should be partially revalued at the cost of the
debtors; (v) removing exchange controls and import restrictions to restore
condence; and (vi) introducing a stable currency and an independent
central bank (or a currency board).
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In the remainder of this section, we consider three issues that pertain

to stabilization programs designed to put an end to hyperination. These
are cold turkey versus gradualism, currency boards and dollarization. The
rst issue is about whether the cure is applied in large doses or in small
frequent doses. The adoption of currency board or dollarization is intended
to prevent the government from monetizing the budget decit.8
6.14.1. Cold turkey versus gradualism
With respect to hyperination, gradualism is a policy of reducing the
growth rate of the money supply gradually over an extended period of
time, so that ination can adjust with smaller costs in terms of lost output
and unemployment. A cold turkey is a policy whereby ination is brought
under control immediately by reducing the money growth rate to a new,
low level. Many arguments have been presented for the superiority of the
cold-turkey-type approach over gradualism. Dornbusch and Fischer (1990)
stress that shock therapy is essential for gaining the necessary credibility.
Many hyperinations have been put to an end very quickly by using shock
therapy.
6.14.2. Currency boards
A currency board is a system of xed exchange rates that was common in
colonial territories during the rst half of the 20th century. It is a system
whereby the currency board is obliged to supply, on demand and without
limit, the foreign currency to which the domestic currency is pegged. The
dismantling of colonial regimes led to the virtual disappearance of currency
boards, but interest in this arrangement re-emerged in recent years as
nancial crises triggered thinking about means of stabilizing exchange
rates and bringing order to economic conditions in general. It may be an
integral component of a stabilization program designed to put an end to
hyperination because it deprives the central bank (or the government)
from the ability to print money as it wishes.
Klyuev (2001) argues that the principal dierence between a currency
board and a simple (conventional) peg is the consequent diculty of
changing the regime, which is much greater under a currency board. Because
8 In
addition to dollarization and the adoption of a currency board, Hanke (2008) suggests
a third alternative, which is free banking. Under this arrangement, commercial banks
are allowed to issue their own private notes with minimum government intervention.
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of this property, currency broads are much more stable than other regimes.
Corden (2002) argues that a proper or pure currency board operates
not only on a commitment to a rmly xed exchange rate but also as strict
regulation that eectively prohibits an independent monetary policy. Thus,
neither budget decits nor the rescue of commercial banks (the lender of
last resort function) can be nanced by resorting to the printing press.
Ho (2003) points out that currency boards are controversial for several
interrelated reasons. The rst is that they severely limit monetary policy
discretion (as well as the lender of last resort function), which boils down to
surrendering traditional central banking functions. The second issue is that
the use of institutional constraints to achieve and maintain policy credibility
is in itself a controversial notion. Finally, and this is probably a trivial issue,
currency boards are an invention of 19th century British colonialism, which
some people may nd oensive. A currency board is a blunt device, but a
blunt device is what is needed to stop hyperination. Currency boards help
to curb wasteful government spending nanced by printing money. While a
decit is allowed under a currency board, it cannot be nanced by printing
money.
The rst re-introduction of a currency board, which has proved to
be successful, was in Hong Kong in 1983. In 1991, Argentina set up a
similar arrangement whereby the peso was linked to the U.S. dollar at
a parity exchange rate (one to one). In 1992, Estonia began to operate
a currency board, followed by Lithuania in 1994. On the other hand, it
is widely believed that the Argentine nancial crisis of 20012002 has
been exacerbated by the exchange rate arrangement to the extent that the
government decided to abandon it and resort to oating the peso in January
2002. But some economists argue that the demise of Argentina would have
happened with or without a currency board (for example, Dornbusch, 2001).
According to Dornbusch, the crisis was waiting to happen because of the
legacy of high debt and earlier decits, trade unions that have consistently
thwarted reform, and obsolete industry that would not be competitive at
any exchange rate.
An interesting case study of the introduction of a currency board as
an anti-inationary device in a post-war economy is that of Iraq following
the U.S.-led invasion of the country in 2003. A U.S. Treasury team was
dispatched to Baghdad in May 2003 to study the reconstruction of the
monetary and nancial system in Iraq, including the possible adoption of a
currency board, given that Iraq experienced hyperination in aftermath of
the 1991 war and the sanctions imposed on the country in the aftermath
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of that campaign.9 Moosa (2004) concluded that a currency board is the

best available exchange rate arrangement for Iraq under the prevailing
conditions, at least in terms of costs and benets, as compromising
monetary stability is not an option for economic revival. Arguments against
a currency board for Iraq are the following10 : (i) diculties of managing
external shocks; (ii) the requirement of a strong scal policy in place;
and (iii) the possibility of serious consequences if an inappropriate level
of the xed exchange rate is selected. While there are no problems with
these arguments in a general sense, it is unacceptable to put forward
propositions that do not take into account the specics of the situation
in Iraq and its priorities as things stood in 2003. The three arguments
against a currency board can be easily discredited along the following
lines: (i) the shocks argument is mostly applicable to a developed country
with a diversied export base, not to a country that derives 95% of its
foreign exchange revenue from a commodity that is priced in U.S. dollar
terms; (ii) strong scal policy would be an outcome of a currency board,
because this arrangement prevents the monetization of the budget decit;
and (iii) the problem of choosing the appropriate level of the exchange rate
is relevant to other exchange rate regimes.
6.14.3. Dollarization
The term dollarization is generic, implying the use of the currency of
one country as the legal tender of another country. Since the U.S. dollar
is the most commonly used currency for this purpose, we use the term
dollarization and not euroization or poundization. However, some
economists and commentators take the term dollarization literally to
mean using the U.S. dollar as its legal tender (for example, Roubini, 2001).
Gulde et al. (2004) emphasize the point of using the word dollarization
in a generic sense.11
Dollarization leads to the loss of seigniorage, the revenue obtained
by issuing the national currency. This will not be the case if the anchor
9 The
present author was a member of the team in his capacity as an advisor to the U.S.
Treasury.
10 These views were put forward by some sta of the IMF in a private conversation in
June 2003.
11 As a result of the severe hyperination experienced by Zimbabwe, the central bank
decided in 2009 to adopt dollarization involving two foreign currencies: the U.S. dollar
and the South African rand. If the term dollarization is not used in a generic sense, we
can say that Zimbabwe resorted to dollarization and randization.
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country is willing to share the seigniorage gains with the dollarizing country,
but this rarely happens, if at all. De Zamaroczy and Sa (2003) describe
the Cambodian experience with dollarization by pointing out that it was
neither sought nor encouraged by the monetary authorities. It rather arose
from a combination of supply and demand factors (dollar inows from
overseas and lack of condence in the domestic currency). In addition to
the distinction between ocial (de jure) dollarization and partial (de facto)
dollarization (which is eectively a bicurrency system), Gulde et al. (2004)
distinguish between payments dollarization, nancial dollarization and real
dollarization. Payments dollarization involves the use of foreign currency for
transaction purposes, whereas real dollarization boils down to the indexing
(formally or de facto) of local prices and wages to the anchor currency.
Financial dollarization implies that residents hold foreign currency assets
and liabilities. It can be classied into domestic dollarization (involving the
use of the anchor currency in claims of residents) and external dollarization
(involving the use of the anchor currency in claims between residents and
non-residents).
A study of the theory of and empirical evidence on the causes and consequences of hyperination, while illuminating, may not be as convincing as
the actual study of hyperinationary episodes that have struck in various
parts of the world, going back to the Roman and Chinese empires to the
most recent episodes in Zimbabwe and, possibly, Iran. It is by studying
what happened in the actual episodes that we get a feel of the horror of
hyperination. This is what we will do in the following two chapters.
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Chapter 7
THE HISTORY OF FIAT MONEY

AND HYPERINFLATION
7.1. Fiat Money, Monetary Debasement and Hyperinflation
Hyperination is typically associated with at money that has no intrinsic
value. It cannot happen in systems having commodity money or paper
money backed by a commodity reserve asset such as gold and silver. This
is because hyperination requires unlimited increase in the money supply,
which cannot happen under a commodity standard because the supply of
gold and silver is limited.
In a at money system, money is said to be a mere at of the law,
where at is a Latin word meaning let it be done. Hence, at money
or at currency is money that is legal tender by a government decree,
acceptable in exchange for goods and services only because the government
says so. Sometimes this acceptance is the result of coercion as it becomes
punishable by law not to accept at money as a medium of exchange. There
are several episodes where the government outlawed the use of commodity
money to force the use of at money. The problem is that anything that
has value must be relatively scarce, and this is why commodity money
or money backed by commodities is valuable, deriving its value from the
scarcity of the commodity. Under the gold standard, for example, a central
bank cannot issue new currency without having the gold to back it. With
at money, if no limits are put on the amount of currency to be issued,
money is no longer scarce; hence, it loses its value. This is exactly what
happens under hyperination when money is abundant and people lose
faith in it. Commodity money cannot be made less scarce over a short
period of time, but at money can be. In a at monetary system, there is
no restrain on the amount of money that can be created. Hyperination
is often described as the terminal stage of any at currency this is
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because under hyperinationary conditions, money loses most of its value

in a short period of time.
Under a at money system, credit creation becomes unlimited because
the central bank can issue any amount of currency that is necessary to
nance loans to the government or to commercial banks (as the central
bank executes its function of a lender of last resort). It is typical that a
at monetary system comes into existence as a result of excessive public
debt. When the government is unable to repay all its debt in gold or
silver, it becomes tantalizing to remove physical backing rather than to
default, marking the transition from commodity money to a at money.
This actually happened in World War I as the warring countries abandoned
the gold standard to nance the war.
Table 7.1 reports major episodes of monetary debasement from ancient
Rome to Zimbabwe in 2009. Monetary debasement is the loss of the value of
a at currency as a result of hyperination, war or simply the loss of faith.
Debasement occurs also as governments seeking to earn more seigniorage
degrade the commodity content of money. In ancient Rome, monetary
debasement occurred as the silver content of coins was reduced drastically,
eventually losing its status as a medium of exchange. In ancient China,
debasement occurred as the metal content of coins was changed from copper
to iron. In 18th century France debasement occurred as the government
made it illegal to own gold (hence coercion to accept at money). In 1933,
the U.S. government removed the gold content of coins, hence debasing the
currency. Table 7.1 also shows a large number of cases where at currencies
were wiped out by hyperination.
We have to bear in mind that while a at currency is typically a
paper currency, it is not necessarily the case that a paper currency is a
at currency. If the currency is not backed by a commodity such as gold
or silver, the paper money issued by the central bank is at money it
has no intrinsic value. While it costs something like three cents to issue a
$100 bill, its nominal value is $100 worth of goods and services because
this bill is accepted as a medium of exchange. The dierence between the
nominal value and what it costs to print the bill is the seigniorage. Voltaire
(16941778) must have meant at money when he was quoted as saying
that paper money eventually returns to its intrinsic value zero.
Paper money in itself was a major invention. Compared to commodity
money, such as gold and silver coins, paper money is easier to carry
around while the metal content can be used for other purposes to
make things. A problem arises when paper money is issued without
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Table 7.1.
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A history of monetary debasement.
Time
Place
Event
00540244
Rome
The silver content of coins was reduced from 94% to

0.2%. By 0244, Roman coins were no longer accepted as
a medium of exchange.
06001455
China
The content of coins was changed from copper to iron.

This was followed by the introduction of at paper
money.
17161720
France
John Law, a Scottish banker, introduced at money in

France where it became illegal to own gold. Initially,
Law was hailed as an innovator but when the system
collapsed, he ed the country.
17951803
France
18621879
U.S.
19141923
Austria
Hyperination wiped out the value of the currency.
1914
France
The gold content of coins was removed.
1913
U.S.
Hyperination wiped out the value of the currency.

The Greenback was introduced only to lose 50% of its
value.
The Federal Reserve was established as the nations

central bank. Since then the dollar has lost 95% of its
value.
19191923
Germany
During the period the value of the German mark in terms

of the U.S. dollar declined from 12:1 to 4.2 trillion: 1.
19211924
Poland
When hyperination hit its peak the currency lost half of

its value every 19 days.
19221924
Hungary
From month to month, the currency lost 98% of its value

because of hyperination.
1930s
France
A new paper currency was introduced, losing 99% of its

value in 12 years.
1933
U.S.
The gold content of coins was removed. The dollar was

devalued by 41%. Gold certicates became
irredeemable.
19331974
U.S.
The possession of gold by U.S. citizens became illegal.
19421944
Greece
In October 1944, ination was running at 8.5 billion

percent. By 1953, a unit of the new currency was worth
50,000,000,000,000 units of the pre-1944 currency.
19441971
The World
Under the Bretton Woods system, the dollar was the only
currency pegged and convertible to the dollar.
1947
Switzerland
19481955
China
The gold content of coins was removed.

The Chinese hyperination caused an astronomical loss in
currency value. By 1955, one Chinese renminbi was
worth 15,000,000,000,000,000,000 pre-1948 yuan.
(Continued)
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Table 7.1.
Time
Place
(Continued)
Event
1964
U.S.
The silver content of coins was removed.
1967
Canada
The silver content of coins was removed.
19671994
1968
1971
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Brazil
U.S.
U.S.
Because of hyperination, a new currency was adopted in

1994. Each unit of the new currency was equivalent to
2,750,000,000,000,000,000 units of the pre-ination
currency.
Silver certicate notes were no longer redeemable for
actual silver.
The dollar was no longer convertible into gold.
19751991
Argentina
19841986
Bolivia
Because of hyperination, one million pesos were

equivalent to 55 cents.
19881990
Peru
Hyperination produced a new currency that was

equivalent to 1,000,000,000 old currency units.
19881991
Nicaragua

equivalent to 50,000,000,000 old currency units.
19891994
Yugoslavia

equivalent to 1,300,000,000,000,000,000,000,000,000 old
currency units.
19911999
Angola

equivalent to 1,000,000,000 pre-1991 currency units.
19931995
Georgia
Hyperination produced a new currency (lari) that was

equivalent to one million old currency units (coupons).
19942002
Belarus
As a result of hyperination, citizens were forced to

exchange 1,000 old rublei for one new ruble.
2000
19982009
Switzerland
Zimbabwe
The overall impact of hyperination was one new peso =

1,000,000,000,0000 old pesos.
The Swiss francs 40% legal gold-reserve requirement

came to an end. The Swiss currency is no longer backed
by gold.
The domestic currency was abandoned in favor of using
the U.S. dollar (and South African rand) as legal
tender.
constraints. But there are those who argue against commodity money or
paper money backed commodities. Since the money supply is linked to
the supply of the underlying commodity, changes in the money supply
become volatile, causing swings in economic activity. In particular, a
shortage of the underlying commodity causes a shortage of money and hence
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deation this can be avoided by printing money without the constraint

of a currency back-up. Perhaps, but printing currency without limits is
always tempting, which makes the risk of hyperination real. Therefore, it
is a matter of choice between deation that may or may not occur and the
potential risk of hyperination.
Monetary debasement, however, is not a phenomenon that is associated
with paper money and metallic coins. It can even happen with stone money
as the experience of the Pacic island of Yap shows. In the late 1800s, stones
of varying sizes were used as money, the largest (and most valuable) of
which weighed several tons. The stones were brought by sea from the Island
of Palau, 210 kilometers away. Because the voyage was rather perilous,
the supply of stone money was rather limited hence, the stones had
some value. In 1874, an Irish entrepreneur, David OKeefe, decided to go
into the business of extracting more money from its source in Palau.
He then traded these stones with the Yapese for other commodities. Over
time, the increase in the money supply debased the value of old money
(stones).
According to an interesting study of the 775 at currencies that have
existed, 599 are no longer in circulation (Hewitt, 2009). The study shows
that the median life expectancy for the defunct currencies is 15 years
and that the average life expectancy of all at currencies is 27 years.
Only a small number of currencies have managed to survive until old age.
The British pound is the oldest at currency, having survived for over
300 years as it was born in 1694.1 The U.S. dollar was born in 1792 and
is still alive. Other currencies that have survived for a long time include
the Swiss franc (1825), Canadian dollar (1841), Japanese yen (1871) and
Swedish Krona (1874). However, even surviving currencies have lost some
99% of their original values (in terms of purchasing power and metallic
content). The pound originally represented one troy pound of sterling silver
(92.5% pure silver). By January 2009, it took 81.8 pounds to buy a troy
pound of sterling silver, which represents a loss of value of monumental
proportions (98.8%). The same story goes for the dollar. Under the U.S.
Mint Act of 1792, the dollar was worth 371.25 grains of silver, which means
that a troy ounce of pure silver cost $1.30. By January 2009, the price
of a troy ounce of silver was $11.22, which represents a 89.5% drop in
value. The study also found that one in ve at currencies have failed
1 This
is the pound sterling as paper money, issued by the Bank of England on its
establishment in 1694. The history of the pound, however, goes further back.
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through hyperination. In total, 156 currencies have been destroyed by

hyperination, and many of the currencies listed as being destroyed by war
also underwent hyperination.
7.2. The Early History of Fiat Money and Hyperinflation
The rst well-documented widespread use of paper money was in China
around 800 AD during the Tang dynasty (618907 AD). Paper money
spread to the city of Tabriz, Persia, in 1294 and to parts of India and
Japan between 1319 and 1331. However, its use was very short-lived in
these regions. In Persia, the merchants refused to recognize the new money,
thus bringing trade to a standstill. By 1455, after over 600 years, the Chinese
abandoned paper money due to hyperination caused by over-issuance.
7.2.1. The ancient Chinese experience
The use of paper money in China began with the ying cash that emerged
around 800 AD. The government of the day found it inconvenient to send
cash to far-away places to pay for purchases. To circumvent this problem,
the government decided to pay merchants with money certicates that came
to be known as ying cash called so because they were easy to be blown
away by the wind. These certicates were convertible into cash on demand
and they were also transferable. As a result, they were exchanged among
merchants almost like the real currency.
It was not intended for the ying cash to be a currency, and that
is why its circulation was rather limited. Proper paper money (notes) was
introduced early in the Song (9601279) dynasty, when it was utilized by
a group of merchants and nanciers in Szechuan, the same province where
printing had been invented. In 1023, private notes were withdrawn from
circulation and only ocial notes printed by the government were allowed.
The project was successful for two reasons: (i) the notes were backed by
coins that had intrinsic value; and (ii) notes and coins were interchangeable.
Moreover, the notes could be used to buy goods from government-owned
stores, which made the paper currency as good as coins. That was not a
case of at currency, as coin backing meant that the notes could not be
issued without limit.
Following the occupation of north China by Chin (11151234), the
example set by Song was adopted. In 1154, a Bureau of Paper Currency was
established in Kaifeng as the central agency in charge of all issues. Large
and small denominations of paper currency were issued the problem is
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that they were not backed by coins. The inevitable happened as ination
soared during the 12th century.
When Kublai Khan (the grandson of Genghis Khan) united China and
declared himself emperor, he decided to experiment with paper money. In
1260, paper currency of various denominations was issued. Marco Polo had
some nice things to say about Kublais experiment. He wrote:
You might say that [Kublai] has the secret of alchemy in perfection . . . the Khan causes every year to be made such a vast quantity
of this money, which costs him nothing, that it must equal in amount all
the treasure of the world . . . . This was the most brilliant period in the
history of China. Kublai Khan, after subduing and uniting the whole
country and adding Burma, Cochin China, and Tonkin to the empire,
entered upon a series of internal improvements and civil reforms, which
raised the country he had conquered to the highest rank of civilization,
power, and progress.
But then he said:

Population and trade had greatly increased, but the emissions of paper
notes were suered to largely outrun both . . . . All the benecial eects
of a currency that is allowed to expand with a growth of population and
trade were now turned into those evil eects that ow from a currency
emitted in excess of such growth. These eects were not slow to develop
themselves . . . . The best families in the empire were ruined, a new set
of men came into the control of public aairs, and the country became
the scene of internecine warfare and confusion.
Excessive printing ooded the market with depreciated paper money until
the face value of notes had no relation whatsoever to its counterpart in
silver. A phenomenon related to hyperination was observed in 1272 when
new issues were put in circulation while old issues were converted into
new ones at the ratio of ve to one. In 1309, another conversion became
necessary. In 50 years from 1260 to 1309, the value of paper money was
destroyed as the price level rose by 1000%. To make the situation worse,
the government often refused to exchange for new notes old notes that had
been worn out through a long period of circulation.
In short, the Khan made a mess (a monetary mess) of the situation,
taking his empire through two hyperinationary periods. The rst Mongol
currency depreciated rapidly after its short-lived success from 1260 to 1263,
prompting a second issue in 1264 when the new issue replaced the old issue
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at 1:5. This currency lasted until 1290 at which time it began falling in
value until about 1310. It was replaced by a third issue at the same ratio of
1:5. During the nal phase of the Mongol dynasty in around 1350, eorts
were unsuccessful in xing the monetary situation because the over-issue
of irredeemable notes destroyed their value. As Adask (2010) puts it, the
Khan got greedy for something for nothing and started printing more paper
currency than Chinas economy could justify. Marco Polo understood the
hazard of messing around with at currency 700 years ago.2
7.2.2. The experience of ancient Rome
Although the Romans did not use paper money, ancient Rome provides a
vivid example of monetary debasement. The denarius, Romes coinage of
the time, was essentially pure silver at the beginning of the rst century
AD. By 54 AD, the denarius was approximately 94% silver and by about
100 AD, the silver content of the currency was down to 85%. Successive
emperors fancied the idea of devaluing the currency in order to pay their
bills and boost their own wealth (presumably by conscating silver). By
218 AD, the denarius was down to 43% silver, and in 244 AD the reigning
emperor witnessed the decline of the silver content down to 0.05%. By the
time Rome collapsed, the silver content of the denarius was no more than
0.02%. No one accepted it as a medium of exchange or a store of value.
Some of the most notable characteristics of hyperination were witnessed by the Romans. The rst was excessive spending nanced by issuing
currency. The government started building up the army and undertaking
public works projects, attempting to cover the shortfall by raising taxes.
Higher tax rates encouraged tax evasion and discouraged economic activity,
leading to a diminishing tax base. The government reacted to that state
of aairs by monetizing the decit and debasing the coins, which took the
form of replacing the gold and silver in coins with copper and other cheaper
metals (sometimes the size and weight of coins were reduced). That meant
one thing: an explosive growth in the money supply. In 301 AD, a law was
passed to x prices, imposing the death penalty on anyone selling above
the xed prices as well as a less severe penalty for anyone paying more
than the xed prices. The result was that consumers sometimes destroyed
2 While
the last statement is attributed to Macro Polo by Jones (2012), Hewitt (2007)
attributes it to Alexander Del Mar in his book History of Monetary Systems (Del Mar,
1886). However, a search of the 400 plus pages of Del Mars book did not reveal such a
statement.
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the businesses of those who sold at higher than the xed prices and
merchants stopped selling goods, which led to penalties against hoarding.
When merchants left their trade, a law was passed stipulating that every
man had to pursue the occupation of their father (the penalty for not
doing so was, naturally, death). This was justied on the basis that
leaving the occupation of ones father was like a soldier deserting in time
of war.
Hyperination changed Rome. In the aftermath, it was much more
militarist, expansionist and eectively dictatorship. In the words of Del
Mar (1886):
For nearly two centuries, during which all that was admirable of Roman
civilization saw its origin, its growth and its maturity. When the system
fell, Rome had lost its liberties. The state was to grow yet more powerful
and dreaded, but that state and its people were no longer one.
The Roman experience shows how hyperination caused by excessive

spending nanced by monetary expansion leads to declining morals and
dictatorship. A great portion of government spending was allocated to the
military and the construction of lavish public monuments. When funds ran
out, forced labor was used.
7.2.3. The Persian experience
Events that took place more than 700 years ago show how governments can
coerce people to accept a at currency and how that creates hyperination.
In 1294 AD, the Kingdom of Persia suered a harsh winter that caused the
death of thousands of cattle and sheep (the collapse of production in todays
terminology). The scal consequence of this event was that the kings vault
was empty. The king responded by printing huge quantities of (unbacked)
paper money and issued a directive imposing the death penalty on those
who refused to accept the currency. That turned out to be a complete
disaster, with the bazaars deserted and trade at a standstill (Davis, 2002).
While the king of Persia wanted to emulate the Chinese experience, he
brought up economic collapse.
7.3. Fiat Money and Hyperinflation in Europe Prior
to World War I
It is arguable that paper money was used in Europe for the rst time in
Spain around 1438. The story goes that a Spanish military commander
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issued paper notes to pay his soldiers (Hewitt, 2009). In 1574, cardboard
coins made from the cover of prayer books were issued in the Dutch city of
Leyden. Subsequently, paper money of dierent denominations was issued
in Candia, Italy, until a shipment of coins arrived from Venice. In 1633, the
earliest known English goldsmith certicates were being used not only as
receipts for reclaiming deposits but also as evidence of the ability to pay.3
By 1660, the English goldsmiths receipts became a convenient alternative
to coins or bullion. The realization by goldsmiths that borrowers would
nd them just as convenient as depositors marked the start of the use of
banknotes in England. And in 1656, the Bank of Sweden was founded with
a charter that authorized it to accept deposits, grant loans and mortgages,
and issue bills of credit. In 1661, it became the rst chartered bank in
Europe to issue notes known as the paper daler. By the 1680s, the
use of paper money became popular in other European countries and
North America. Circulated notes on playing cards were used in the French
colony of Lower Canada. Other colonies soon developed their own paper
currency.
7.3.1. Fiat money in France: The story of John Law
The idea of at money was appealing in France when Louis XV took over
and inherited a huge debt left by the extravaganza of Louis XIV. John
Law, a Scottish adventurer and a convicted murderer, capitalized on the
circumstances and promoted the idea eventually introducing at money
in France for the rst time.
When Law ed Britain, he settled in Amsterdam where he studied
nancial institutions. In 1705, he published a treatise entitled Money and
Trade Considered in which he argued that the more money there is in
circulation, the greater is the prosperity of a country (Law, 1705).4 At
the very beginning of his book, Law explained that he wanted to remedy
the diculties the nation is undergoing from the great scarcity of money.
He demonstrated how far money aects trade and proposed measures for
preserving and increasing money because domestic trade depends upon
money and because a greater quantity employs more people than a lesser
3 The
goldsmith story is most popular in simple expositions of the origins of money in

introductory macroeconomics.
4 There is an element of truth in this statement as deation caused by a shortage of
money can be devastating for the economy. To his benet, Law wanted much more than
what was required to avoid a monetary shortage.
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quantity. He was convinced that an addition to the money adds to the

value of the country.
In 1716, Law was granted authority to create the Banque Generale
that was authorized to issue interest-bearing banknotes payable in silver
on demand. The government required regional tax payments to be in the
form of Banque Generale banknotes so there was a ready market for Laws
banknotes. Because the banknotes paid interest and were convenient, they
sold at a premium over their face value. John Law became an international
celebrity to the extent that the Pope sent an envoy to the birthday party
of Laws daughter. He was appointed Controlleur des Finances. However,
the good times did not last for long. Following failed attempts by people
to exchange their paper currency for something of real value, the currency
collapsed. John Law became the most hated man in France and was forced
to ee the country.
7.3.2. Hyperinflation in France after the revolution

In the spring of 1789, the French Assemblee authorized the issuance of
notes, called assignats, worth 400 million livres those were to be secured
by the properties that had been conscated from the Church. By the fall of
1789, the Assemblee approved the issuance of 800 million of non-interestbearing notes and set the limit on such notes at 1.2 billion livres. Further
issues were approved: 600 million livres nine months later, 300 million in
September 1791 and another 300 million in April 1791.
A typical hyperination ensued. Wages could not keep up with prices,
so a mob plundered 200 stores in Paris in 1793. Price controls were imposed while output fell, which made it necessary to introduce rationing.
The government responded with typical draconian measures: a 20-year
prison sentence for anyone selling notes and capital punishment for anyone
dierentiating in setting prices between paper livres and gold or silver
livres.
Money creation was running at a fast pace. By 1794, there were 7 billion
livres in circulation. In May 1795, this total reached 10 billion livres, and
by July 1795 it had gone up to 14 billion livres. When the total reached
40 billion livres the printing plates for assignats were destroyed in public.
A new note, called a mandat, was issued but within two years the new
money lost 97% of its value. The printing plates for mandats were also
destroyed in public. In 1797, both assignats and mandats were repudiated
and a new monetary system based upon gold was instituted.
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7.3.3. Hyperinflation and monetary debasement in England

Under Henry I, the quality of Englands silver coins fell dramatically.
Henry II reformed the English coinage system in 1158, thereby restoring
the prestige of English money that was maintained for the next three
centuries. By the end of the War of the Roses (14551485), the English
currency suered badly from clipping (reducing the amount of metal) and
counterfeiting of coins. Henry VII tried to prohibit the use of foreign
coins in 1498, triggered by the fact that although foreign coins were also
underweight, they were not so to the same extent as the English coins. This
constitutes a historical example of currency substitution, which is prevalent
under hyperination.
From 1543 to 1551, the Great Debasement took place under Henry
VIII who ordered that the silver content of each coin be dropped gradually,
so that it would cost less to issue new coins. In 1560, Elizabeth I brought
about stability by establishing the pound sterling. Debased coins were
recalled and reminted to remove the base metal component. The pound
sterling was valued as one troy pound of high purity sterling silver. In 1696,
silver coins, many of which were worn or clipped, were replaced with new
and full-weight silver coins.
It is interesting to compare what Elizabeth I did with the status quo.
This is what is written on the Bank of Englands website to explain the
meaning of I promise to pay, which appears on the pound notes5 :
The words I promise to pay the bearer on demand the sum of ve [ten/
twenty/fty] pounds date from long ago when our notes represented
deposits of gold. At that time, a member of the public could exchange
one of our banknotes for gold to the same value. For example, a 5
note could be exchanged for ve gold coins, called sovereigns. But the
value of the pound has not been linked to gold for many years, so the
meaning of the promise to pay has changed. Exchange into gold is no
longer possible and Bank of England notes can only be exchanged for
other Bank of England notes of the same face value. Public trust in
the pound is now maintained by the operation of monetary policy, the
objective of which is price stability.
The meaning of promise to pay has changed indeed, but not in the
sense portrayed by the Bank of England. It has changed because there is
nothing to pay on demand as the pound is a at currency. If public trust
5 http://www.bankofengland.co.uk/banknotes/Pages/about/faqs.aspx#2.
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177
in any at currency is dependent on peoples belief that the central bank is

committed to price stability, quantitative easing (as practiced by the Bank
of England and the Federal Reserve today) must represent a betrayal of
people.
7.4. Fiat Money and Monetary Debasement in the U.S.
The U.S. has a history of shifting from a at currency to a gold (or
commodity) standard and vice versa. Figure 7.1 shows the history of
monetary standards in the U.S. over the past 200 years or so.
In the period between independence in 1776 and the Civil War, which
broke out in 1861, successive U.S. presidents were concerned about the
unrestrained control of the money supply they agreed on the importance
of imposing constraints on the ability to issue currency. Throughout his
initial term of oce, George Washington believed that the national currency
must be backed by gold and silver he actually contributed his own silver
to initiate the minting of coins. Thomas Jeerson warned of the damage
that would be caused if the control of the money supply was assigned to
the bankers. In 1811, when he refused to renew the charter for the First
Bank of the United States (the second central bank chartered by Congress
in 1791), he stated the following6 :
I believe that banking institutions are more dangerous to our liberties
than standing armies. Already they have raised up a money aristocracy
that has set the government at deance. This issuing power should be
taken from the banks and restored to the people to whom it properly
belongs. If the American people ever allow private banks to control the
issue of currency, rst by ination, then by deation, the banks and
corporations that will grow up around them will deprive the people of all
property until their children will wake up homeless on the continent their
fathers conquered. I hope we shall crush in its birth the aristocracy of the
moneyed corporations which already dare to challenge our Government
to a trial of strength and bid deance to the laws of our country.
For Jeerson, therefore, the ability to print money was a weapon of mass
destruction that should not fall in the hands of bankers. Likewise, John
Adams said that paper money (meaning at money) is a great theft,
stealing from the society where it is used.7 The view that the government
6 http://quotes.liberty-tree.ca/quote/thomas
jeerson quote 78b4.
7 https://www.igolder.com/glossary/at-currency/.
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Fig. 7.1.
The history of money in the U.S.
steals from people by issuing at currency is still popular today, to the

extent that the U.S. is accused of using the status of the dollar as an
international reserve currency to steal from other countries that hold
dollar-denominated reserve assets.
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Prominent thinkers of 18th and 19th centuries expressed some strong

views against at money. Thomas Payne (a political activist, author, political theorist and revolutionary) said in 1786 that it should be considered
treason for anyone to even suggest that at money be allowed.8 Bancroft
(1884) put a rather strong, even emotional, view against at money. He
wrote:
Good money must have an intrinsic value. The United States of America
cannot make its shadow legal tender for debts payable in money
without ultimately bringing upon their foreign commerce and their home
industry a catastrophe, which will be the more overwhelming the longer
the day of wrath puts o its coming. Our federal constitution was
designed to end forever the emission of bills of credit as legal tender in
payment of debts, alike by the individual states and the United States;
and it will have that eect, if it is rightly interpreted and rmly enforced.
Bancroft was not exaggerating when he used the word catastrophe

because at money can destroy an economy through hyperination. The
damage caused by at money was experienced during the Revolutionary
War, which was nanced by issuing a at currency called continental. The
continental was replaced by the U.S. dollar in 1785 when the Continental
Congress adopted the latter as the national currency to replace a variety of
private banknotes.
Following the adoption of the Constitution in 1789, Congress chartered
the First Bank of the United States and authorized it to issue paper
banknotes to eliminate the confusion caused by the availability of a variety
of banknotes. The Federal Monetary System was established in 1792 with
the creation of the U.S. Mint, which produced the rst American coins in
1793. The U.S. Coinage Act of 1792 dened a dollar as a specic weight
of gold and invoked capital punishment for anyone found to be debasing
money. This is a far cry from what is happening these days as the debasing
of the national currency through quantitative easing is perceived (not by
everyone, though) as a measure taken in the national economic interest.
In 1862, the Greenback was introduced as the rst at currency in
the U.S. to nance the Civil War. The Greenback was a debt of the U.S.
government, redeemable in gold at a future unspecied date, which made
it a at currency, because otherwise it would have been redeemable on
demand. Greenbacks were circulated along with gold certicates, backed
8 https://www.igolder.com/glossary/at-currency/.
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180
120
100
80
60
40
20
0
0
Fig. 7.2.
10
15
20
25
30
35
40
45
50
The purchasing power of confederate treasury notes (1 May 18611 May 1865).
by the governments promise to pay in gold. It was during the Civil War
that the Confederate States of America experienced hyperination as a
result of the monetization of the decit. To nance the war, vast amounts
of money were issued. From October 1861 to March 1864, the commodity
price index rose at an average rate of 10% per month. When the Civil War
came to an end in April 1865, the cost of living in the South was 92 times
what it was before the war had started. Figure 7.2 shows the decline in the
purchasing power of the Confederate Treasury notes between 1 May 1861
and 1 May 1865. The increase in the money supply came as a result of
failure to raise taxes and borrow funds from farmers.
During the period 18801914, the U.S. was under the (international)
gold standard, whereby the dollar and other major currencies were pegged
to gold, in the sense that they were valued in terms of specic amounts of
gold and were redeemable in gold on demand. The system broke down with
the outbreak of World War I, as warring countries prohibited the conversion
of currency into gold and put a ban on the export of gold. The war was
nanced by printing at currency, which could not have been linked to
gold simply because there was not enough gold around. Although the U.S.
did not enter World War I until 1917, the system was unworkable as an
international standard because major European countries, most notably
Britain, had abandoned it. During the period 19151925, the U.S. was on
a oating at currency.
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181
In 1913, the U.S. took a big step away from gold towards monetary
debasement when the Federal Reserve was established as the countrys
central bank and authorized to issue paper notes that were only 40%
backed by gold while portrayed as fully convertible. In 1933, people tried
to exchange their paper money for gold, but the Fed was unable to honor
its pledge because it had issued a greater amount of the currency than
what could have been supported by gold reserves. Instead of admitting
what eectively was the bankruptcy of the central bank, the government
conscated gold from citizens, made it illegal for anyone to hold gold, and
devalued the currency to $35 per ounce of gold. This is eectively one way
of stealing from people by issuing a at currency, a proposition that is
endorsed by Jones (2012) who wrote the following:
Under the infallible leadership of President Franklin Roosevelt, it was
made illegal to own gold. On March 11, 1933, he issued an order
forbidding banks to make gold payments. On April 5, Roosevelt ordered
all citizens to surrender their gold no person could hold more
than $100 in gold coins, except for collectors coins. He also made it
unlawful to export gold for payment abroad, unless done through the
Treasury. The penalty for defying Roosevelt was 10 years in prison and
a $250,000 ne.
The gold exchange standard was established in 1926, whereby each country
pegged its currency to the British pound, which was convertible into
gold. However, that system came to an end with the advent of the Great
Depression of the 1930s as countries tried to convert their pounds into
gold. Feeling the pressure on its gold reserves, Britain decided to abolish
the convertibility of the pound into gold. Following the collapse of the
gold exchange standard, there was a period of open currency warfare when
countries tried to revive their economies by devaluing their currencies
against those of their trading partners. Until the end of World War II,
the U.S. was on a oating at currency.
In 1944, the Bretton Woods Accord was signed to set up the international nancial system for the post-war period. The Bretton Woods system
revolved around the U.S. dollar as the key reserve and intervention currency.
It was similar to the gold exchange standard, except that the dollar replaced
the pound as the supreme currency. The dollar was convertible into gold
(at $35 per ounce) while other currencies were convertible into the dollar.
As countries tried to exchange their dollars for gold in the late 1960s, they
realized that the Fed did not have an adequate stock of gold to meet its
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obligations. Instead of admitting that the central bank was bankrupt, the
U.S. government decided to close the gold window. The system collapsed
in August 1971 when Richard Nixon abolished the convertibility of the
dollar into gold, eectively creating the current system of at money. That
was another episode of stealing from people, this time from the people of
other countries.
It did not all happen in 1971 because there were early precursors
to the move towards at money. In 1963, the Federal Reserve released
new notes with no promise to pay, and in the same year the one
dollar silver certicate disappeared from circulation. Moreover, silver was
completely eliminated from all coins, except the Kennedy half-dollar, which
was reduced by Lyndon Johnson to 40%. The Coinage Act of 1965, signed
by Lyndon Johnson, abolished the original legislation signed by George
Washington 173 years earlier and enabled the U.S. Treasury to eliminate the
silver content of the currency. On 24 June 1968, President Johnson issued
a proclamation that all Federal Reserve silver certicates were merely at
legal tender that could not be redeemed in silver.
The August 1971 declaration by President Nixon that the dollar would
no longer be convertible into gold brought to an end the Bretton Woods
system and signaled the beginning of the current worldwide system of
at money, triggering the modern age of hyperination. Although an
attempt was made in 1972 to salvage the Bretton Woods system, when
the Smithsonian Agreement was signed, the inevitable happened in 1973
when oating at currencies became the order of the day. Jones (2012)
writes the following about the event:
But the ocial demise of the dollar was locked into place in 1971 when
Tricky Dick Nixon completely severed all ties between the dollar and
the gold standard. During the decade that followed, the U.S. experienced
some of the worst inations in its history, only matched by todays U.S.
monetary and scal irresponsibility.
Using history to predict the futures, Jones (2012) believes that the U.S.A.
has all the characteristics set in place that have led to the collapse of every
other at currency money in history.
7.5. The Classical Hyperinflations of the 20th Century
In this section, we examine some of the hyperinationary episodes of the
20th century, up to the 1970s. More recent episodes will be examined in
Chapter 8.
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7.5.1. Austria
At the outbreak of World War I, the Austro-Hungarian government turned
to the printing press to cover rising military spending. From the beginning
to the close of the war, the money supply expanded by 977%. A costof-living index that had stood at 100 in July 1914 had risen to 1,640 by
November 1918.
But the great Austrian ination was yet to begin. As a result of
the war, the empire broke up with the declarations of independence by
Czechoslovakia and Hungary, while the Balkan territories of Slovenia,
Croatia, and Bosnia became part of Yugoslavia. Austria was thus reduced
from the center of an empire of 625,000 square kilometers and 50 million
people to a small country of 80,000 square kilometers and 6.5 million people.
The new, smaller Republic of Austria found itself cut o from the other
regions of the former empire as the new states imposed high taris and
other trade restrictions on the new country. Within Austria, various regions
imposed internal trade barriers on other parts of the country, including
Vienna. Regional protectionism resulted from price controls on agricultural
products, so by 1921, over half the governments budget decit was assigned
to food subsidies and to the payment of wages of government employees.
The new country faced a large-scale unemployment problem stemming from
the need to reconvert the economy to peaceful activities, while reabsorbing
a large number of imperial bureaucrats who were no longer welcome in the
new states.
The government resorted to the printing press. Between 1919 and
1923, the money supply had increased by 14,250%. As a result, prices
rose dramatically. The cost-of-living index rose to 1,640 by November 1918
and to 1,183,600 by January 1923. In January 1919, one dollar could buy
16.1 crowns on the foreign exchange market but by May 1923 a dollar
traded for 70,800 crowns. Figure 7.3 shows some indicators of the Austrian
hyperination, including currency in circulation, the general price level and
the exchange rate. It shows how the three variables stabilized around the
same time.9
For that to happen, the printing presses worked night and day
to accommodate insatiable demand for currency. Ebeling (2006) quotes
Ludwig von Mises as describing the situation in front of the Society for
9 The
exchange rate is expressed as crown/dollar, which means that a rising exchange

rate implies depreciation of the crown.
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Currency in Circulation (billions of crowns)

10000
1000
100
10
1
1919M1
1920M1
1921M1
1922M1
1923M1
1924M1
1925M1
Price Index (January 1921 = 100)

100000
10000
1000
100
10
1
1919M1
1920M1
1921M1
1922M1
1923M1
1924M1
1925M1
1924M1
1925M1
Exchange Rate (crown/dollar)

100000
10000
1000
100
10
1
1919M1
Fig. 7.3.
1920M1
1921M1
1922M1
1923M1
The Austrian hyperination of the 1920s (logarithmic scale).
Social Policy in 1925 as follows:

Three years ago a colleague from the German Reich, who is in this
hall today, visited Vienna and participated in a discussion with some
Viennese economists. . . . Later, as we went home through the still of the
night, we heard in the Herrengasse [a main street in the center of Vienna]
the heavy drone of the Austro-Hungarian Banks printing presses that
were running incessantly, day and night, to produce new bank notes.
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Throughout the land, a large number of industrial enterprises were idle;

others were working part-time; only the printing presses stamping out
notes were operating at full speed.
There was also substantial currency substitution represented by the ight

form of the crown. Keynes (1924) wrote the following about the situation:
In Vienna, during the period of collapse, mushroom exchange banks
sprang up at every street corner, where you could change your krone
into Zurich francs within a few minutes of receiving them, and so avoid
the risk of loss during the time it would take you to reach your usual
bank. It became a reasonable criticism to allege that a prudent man at
a cafe ordering a bock of beer should order a second bock at the same
time, even at the expense of drinking it tepid, lest the price should rise
meanwhile.
In late 1922 and early 1923, the Austrian hyperination came to an end
with the help of a loan from the League of Nations. Like Greece today, the
granting of the loan was conditional upon the end to food subsidies and a
70,000-man cut in government employees. At the same time, the Austrian
National Bank was reorganized and the gold standard was re-established in
1925. A new currency (the Austrian shilling) was introduced at the rate of
1:10,000, and restrictions were placed on the access of the government to
the printing press. Pasvolsky (1928) wrote the following:
The moment the Council of the League decided to take up in earnest the
question of Austrian reconstruction, there was immediately a widespread
conviction that the solution of the problem was at hand. This conviction
communicated itself rst of all to that delicately adjusted mechanism,
the international exchange market. Nearly two weeks before Chancellor
Seipel ocially laid the Austrian question before the Council of the
League, on August 25, the foreign exchange rate ceased to soar and
began to decline, the internal price level following suit three weeks later.
The printing presses in Austria were still grinding out new currency; the
various ministries were still dispersing this new currency through the
country by means of continuing budgetary decits. Yet, the rate of
exchange was slowly declining. The crisis was checked.
Sargent (1982) argues that the Austrian hyperination was put to an end
very suddenly with a minor cost in terms of employment and output
that is, minor relative what the proponents of the momentum theory of
hyperination tend to believe. His explanation was in terms of rational
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expectations: people adjusted their inationary expectations downwards as

they believed in the commitment of the government to putting an end to
ination.
7.5.2. China
China saw an extended period of hyperination during the period
19391950. It was initiated after the Central Bank of China took complete
control of the money supply and began issuing at currency to nance the
budget decit. In June 1937, 3.41 yuan traded for one U.S. dollar, but
by May 1949, one U.S. dollar could be exchanged for 23,280,000 yuan for
anyone who cared to have some.
The decit resulted mainly from enormous military spending, well
beyond the capacity of the economy to bear. At the same time, an easy
credit policy was implemented, designed to encourage expansion in wartime industrial production in the parts of China that were not occupied
by Japan. The rise in government spending on the military and otherwise
was at a time when tax revenue and the supply base were shrinking as a
result of the Japanese occupation of the coastal region and some inland
territories.
Following the end of World War II, ination persisted as the root causes
were still there. The budget decit continued to rise owing to the military
spending incurred in the civil war, while the situation was aggravated by
demand pressure resulting from dishoarding and easy bank credit. On
the supply side, contributory factors included war devastation and the
dismantling of the Manchurian productive capacity by the Russians.
7.5.3. The free city of Danzig
Danzig was created on 10 January 1920 as a semi autonomous Baltic Sea
port and city state. Subsequently, the region was incorporated into Poland.
Danzig went through the worst ination in 1923 that took the highest
denomination from 1,000 mark in 1922 to 10,000,000,000 mark in 1923.
7.5.4. Greece
While Greece is dominating the economic news today, the country is
no stranger to economic disasters, having experienced one of the worst
hyperinationary episodes that started during World War II and lasted for
long after the end of the war. During the German occupation of Greece that
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lasted from 1941 to 1944, the monthly ination rate peaked at 8.55 billion
percent in 1944, which means that prices doubled every 28 hours. The end of
the war, however, did not put an end to ination. Greece was in a desperate
economic situation in the post-war period as a result of the damage inicted
on the infrastructure.
In November 1944, the Solvos stabilization plan was introduced to deal
with ination. A new drachma was introduced, while wages were frozen at
a low level to avert cost-push ination. However, political disorder (which
led to civil war after 1946 and up to 1949) and rapid changes of government
impacted business condence and inhibited production. Ination remained
a problem as the government failed to rationalize spending and reform the
tax system.
The Greek hyperination took its toll on the currency. In 1943, the
highest denomination was 25,000 drachmai. By 1944, the highest denomination was 100,000,000,000,000 drachmai. In the 1944 stabilization plan,
one new drachma was exchanged for 50,000,000,000 drachmai. In 1953, the
drachma was again replaced at an exchange rate of one new drachma = 1,000
old drachmas. The overall impact of hyperination: one (1953) drachma =
50,000,000,000,000 pre-1944 drachmai.
7.5.5. Hungary
Hungary experienced two hyperinationary episodes in the 20th Century,
each of which was associated with one of the world wars. From 1919 until
1924, the government ran a substantial budget decit, which was nanced
by borrowing from the State Note Institute, causing cancerous growth in the
liabilities of the Institute. The situation was aggravated by the increasing
volume of loans and discounts to private enterprise. The result was the
ination of the 1920s some of the indicators of that episode are displayed
in Fig. 7.4. The episode came to an end in a similar manner as what
happened in Austria (Sargent, 1982).
The 1920s hyperination was small, even tiny, if compared with the big
ination of the 1940s. In mid-1946, the ination rate was 41.9 quintillion
percent (that is 4.19 1018 %), which was the highest in modern history
and in recorded history. At this rate prices doubled every 15 hours with
the currency losing its value at an alarming speed. By July 1946, the 1931
gold pengo was worth 130 trillion paper pengos. This inationary episode
produced the largest ever denomination banknote, 100 quintillion (that is
hundred billion) pengo.
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Currency in Circulation (millions of crowns)

10000000
1000000
100000
10000
1921M7
1922M1
1922M7
1923M1
1923M7
1924M1
1924M7
1924M1
1924M7

10,000,000
1,000,000
100,000
10,000
1,000
1921M7
1922M1
1922M7
1923M1
1923M7
Exchange Rate (crown/dollar)

100000
10000
1000
100
1921M7
Fig. 7.4.
1922M7
1923M7
1924M7
The Hungarian hyperination of the 1920s (logarithmic scale).
Despite the gigantic magnitude of the Hungarian hyperination, it

came to an end in August 1946, a phenomenon that has been described
by Grossman and Horvath (2000) as an economic miracle surpassing even
the post-war German Wirschaftswunder . It has been suggested that the
Hungarian hyperination was deliberately initiated by the government for
the purpose of meeting revenue requirements. Some economists believe that
the government initiated hyperination to revive the economy, by supplying
almost interest-free loans, which sounds like an extreme expansionary
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monetary policy. This came in response to the devastation experienced

by Hungary in late 1944 and early 1945, a time span of no more than
six months. As the Germans retreated and the Soviets advanced, the
infrastructure was destroyed systematically the country lost almost half
its industrial capacity. Hungarian policymakers believed that ination was
needed to revive idle factors of production. To this end, the money supply
grew at an astronomical rate, reaching the level of 4.73 1025 currency
units in July 1946, which means an average compound monthly growth
rate of 31,319% since July 1945. This line of thinking is still followed today
by major central banks trying to revive their economies in the aftermath
of the global nancial crisis.
In August 1946, a stabilization program was introduced with three
objectives: (i) boosting the acceptability of money, (ii) reforming the scal
system, and (iii) the utilization of foreign aid and loans and rescheduling
of reparations payments. Several measures were taken to accomplish the
rst objective, including the introduction of a new currency (the forint)
to replace the pengo, the recovery of $32 million in gold (which had
been removed from the central bank by the Germans), forbidding the
central bank from lending to the government, and the imposition of 100%
reserve requirements on demand deposits (to control supply). The reform
of the scal system included measures aimed at raising taxes and slashing
government spending. By October 1946, 96% of spending was covered by tax
revenue, compared to 21% in August. As for the third objective, loans from
the U.S. were utilized while the period of reparation payments to the Soviet
Union was extended from 6 to 8 years, ending in 1952. As a result of the
stabilization program, the cost of living rose by a mere 6% between August
and December 1946. Furthermore, price stability was achieved without a
period of massive unemployment.
7.5.6. Japan
Japan experienced hyperination in the post-war period during which
consumer prices rose by 5,300%. Ination was suppressed during the war
by imposing rigid controls on prices and production. When these controls
were relaxed at the end of the war, suppressed ination turned into open
ination. The Japanese post-war ination is attributed to decit war
nancing, the general scarcity caused by increasing military needs and
military defeat. To nance the budget decit, the government increased
bond issuance paid by central bank monetization. Consequently, the growth
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rate of the monetary base rose from an average of 34% per annum in the
period 19371944 to 212% per annum by 1945. Scarcity resulted because
the war economy had reduced drastically the production of civilian goods.
This was coupled with the hoarding by merchants and farmers of goods
in anticipation of higher prices as well as bottlenecks in raw materials
and transportation, and the destruction of the countrys manufacturing
facilities. The prospect of paying reparations in goods made many large
manufacturers hesitate to reconvert their manufacturing equipment to
peace-time production.
Anti-inationary measures were taken in early 1946. Monetary measures included the freezing of savings, the introduction of a new currency
(the new yen), and the abolition of the designated bank system (large
banks that could extend almost unlimited credits to war industries while
prohibiting loans to non-war industries). Those monetary measures came
following a decision by the Bank of Japan to revise the standard discount
and loan interest rates and abolish the preferential treatment accorded to
war industries. Fiscal measures included the freezing of indemnity payments
to war industries and the imposition of a new capital levy and a tax on
property value increase (war-prots tax). Other scal measures were the
termination of payment of all military service pensions and the introduction
of a new policy of balancing the national budget. Supplementary measures
were also taken to stimulate the supply side. Apart from the removal of
price controls, priority was given to the production of food, clothing and
housing in the allocation of raw materials, equipment and labor.
The story of the Japanese post-war ination cannot be concluded
without saying something about a at currency that disappeared at the
end of the war. This was known as the military yen (or alternatively as
banana money). This currency, which was initially used to pay soldiers of
the Imperial Japanese Army and Navy, was rst issued during the RussoJapanese War of 1904, but the tradition continued during the Pacic War.
During the war, the military yen was forced upon the local population of
the occupied territories. The military yen was printed without regard for
ination, unbacked by gold and could not be exchanged for the Japanese
yen. When the Japanese occupied Hong Kong, the military yen was forcibly
exchanged for the Hong Kong dollar at the rate of one to two. Anyone
caught with Hong Kong dollar was to be tortured. After the exchange,
the Japanese military purchased supplies and strategic goods from the
neutral Portuguese port of Macau using Hong Kong dollars. On 6 September
1945, the Japanese Ministry of Finance announced that the military yen
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became void, thereby leaving overseas holders of the currency with pieces
of worthless paper.
7.5.7. Poland
Poland as a sovereign nation was born at the end of World War I,
put together by merging territories that formerly belonged to Germany,
Austro-Hungary and Russia. In the early days or years, several currencies
were circulating in Poland, including the Russian ruble, Austro-Hungarian
crowns and German marks. There were also Polish marks issued by the
Polish State Loan Bank, which had been established by the occupying force,
Germany. The end of World War I did not bring peace to Poland as the
country fought a war with Soviet Russia until 1920.
Following independence, the government ran very large decits up to
1924, nancing these decits by borrowing from the Polish State Loan
Bank. From January 1922 to December 1923, the outstanding notes of the
Polish State Loan Bank went up by a factor of 523. Over the same period,
the price index rose by a factor of 2,402 while the currency depreciated
massively against the dollar. Figure 7.5 shows some indicators of the Polish
hyperination.
The rapid ination and currency depreciation came to an end in
January 1924 as a result of a stabilization program that was implemented
without foreign loans or intervention. The two principal elements of the
stabilization program were a move towards balanced budget and the
establishment of an independent central bank that was prohibited from
lending to the government. In January 1924, the minister of nance
was granted broad powers to introduce monetary and scal reform. He
immediately initiated the establishment of the Bank of Poland to replace the
Polish State Loan Bank. It was a happy ending to a traumatic experience.
7.5.8. Russia
The hyperinationary episode in early Soviet Russia lasted between
the early days of the Bolshevik Revolution in November 1917 and the
re-establishment of the gold standard and the introduction of the gold
ruble in March 1924. In total, there were three successive currency
re-denominations when new rubles replaced old rubles in January 1922,
January 1923 and March 1924.
After three years of participation in World War I and the subsequent
revolutions and civil strife, the economy was in crisis. With the eruption of
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Currency in Circulation (millions of marks)

1000000000
100000000
10000000
1000000
100000
10000
1000
100
1919M1
1920M1
1921M1
1922M1
1923M1
1924M1
1925M1
1924M1
1925M1

1000000000
100000000
10000000
1000000
100000
10000
1919M1
1920M1
1921M1
1922M1
1923M1
Exchange Rate (mark/dollar)

10000000
1000000
100000
10000
1000
100
1919M1
Fig. 7.5.
1920M1
1921M1
1922M1
1923M1
1924M1
1925M1
The Polish hyperination of the 1920s (logarithmic scale).
the civil war in the summer of 1918, the already grim economic conditions
deteriorated further. The government of the day resorted to the printing
press to nance government spending at a time when manufacturing output
and the currency were collapsing. Manufactured consumer goods came to be
in such short supply as peasants refused to sell their products for money that
could buy nothing. Facing starvation in the cities and the death of industry
as farmers and workers returned to their villages, the government resorted
to the use of force to obtain the necessary grain required to maintain the
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193
urban economy. This action caused further decimation of agricultural

production, already seriously weakened by the loss of millions of able-bodied
peasant men to the front.
The extent of ination in Russia can be examined by looking at the
amount of paper money in circulation and the exchange rate of the ruble
against a relatively stable currency such as the pound. In the rst quarter
of 1918, one pound was worth 45 rubles. Just over two years later, a pound
was worth 10,000 rubles. In 1916, there were 3.5 billion rubles in circulation
but by 1923 that was 1,976,900 billion rubles. In that year alone, the money
supply rose by 11,268.2%. Figure 7.6 shows the currency in circulation and
the exchange rate in hyperinationary Russia.
7.5.9. Taiwan
In the late 1940s, Taiwan suered the impact of the Chinese hyperination
inicted by the civil war. At the peak of ination the highest currency
denomination was 1,000,000 dollar bearers cheque. The new Taiwan dollar
was introduced in June 1949 at an exchange rate of 1:40,000. From the
second half of 1945 until 1952, prices rose steadily, particularly from
1948 to 1949. From 1946 to 1952, the wholesale price index in Taipei City
increased by a factor of 8,342. It has been estimated that from the beginning
of 1945 to the end of 1950 the wholesale price index rose by a factor of
218,455.7 (Lee, 2011).
The cause of the Taiwanese hyperination was the usual: a large
budget decit nanced by the printing press while production was falling.
Consequently, the Taiwanese government put in place a plan to combat
ination. A completely dierent view of the cause of the Taiwanese
hyperination has been suggested by Burdekin and Whited (2001) who
viewed the Taiwanese hyperination as a purely imported ination from
Mainland China through xed exchange rates.
On 15 June 1949, the new Taiwan dollar was introduced, which severed
connection with the monetary economy of China. In addition, a policy
of high interest rates and gold reserves was adopted to maintain a scal
balance with the help of the U.S. aid. While prices largely stabilized as a
result of these measures, inationary pressure induced by the budget decit
persisted as currency in circulation continued to grow. When the Korean
War broke out in June 1950, the U.S. decided to provide Taiwan with
economic and military aid, which alleviated the decit. As a result ination
was contained.
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Currency in Circulation (billions of rubles)

10000000000
100000000
1000000
10000
100
1
1916
1917
1918
1919
1920
1921
1922
1923
1921
1922
1923
Exchange Rate (ruble/pound)

10000000000
100000000
1000000
10000
100
1
1916
Fig. 7.6.
1917
1918
1919
1920
The Russian hyperination of the 1920s (logarithmic scale).
7.5.10. Germany
The German hyperination, which reached its peak in 1923, is typically
viewed as starting in the 1920s after the end of the war. While it intensied
in the post-war period towards 1923, the problem started when Germany
entered World War I in 1914. The Germans were so convinced that they
would win the war that they decided to nance war expenditure by
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borrowing rather than raising taxes. The idea was to force the losers to
pay for the cost of the war when the war came to an end.
Instead of winning the war and forcing the losers to pay for it,
Germany lost the war and had to make heavy reparation payments. Sargent
(1982) described the reparations imposed on Germany as staggering and
suggested that they dominated Germanys public nance from 1919 until
1923 and was the most important force for hyperination. In retaliation
for the non-payment of reparations by Germany, French and Belgian troops
occupied the industrial area of the Ruhr, on the western border of Germany,
in January 1923. The Germans responded to the occupation by indulging
in passive resistance, paying striking workers by discounting treasury bills
with the Reichsbank that is, quantitative easing. As a result, 1923 was
the year of astronomical gures, of wheelbarrow ination, of nancial
phenomena that had never been observed before (Sargent, 1982).
The adverse eect that the occupation had on public nance forced
the German government to resort to the printing press. What made things
worse was that in 1923, the Reichsbank began to discount commercial bills,
eectively granting commercial loans at nominal interest rates that were
far below the ination rate. These loans were eectively transfer payments
to the recipients of the loans. A vicious circle ensued: as the value of the
mark relative to other currencies fell, the cost of imported goods went up,
which made it more expensive to run the government, hence making it
necessary to print more money, which in turn led to even higher prices and
currency depreciation. A shorter version of the vicious circle is that as prices
rose, people wanted more money to settle transactions, so more money was
printed, causing rising prices and boosting the demand for money even
further. Fergusson (2010) described this phenomenon by saying that if
prices went up, people demanded not a stable purchasing power for the
marks they had, but more marks to buy what they needed. As a result
more marks were printed, and more, and more.
Peace (on the terms dictated by the victors) was more devastating
for Germany than the war itself. As a result of the Treaty of Versailles,
Germany lost not only its colonies but also one-seventh of its pre-war
territory and one-tenth of its population. The reduction of the army to a
quarter of its size made about quarter a million men unemployed civilians.
Fiscal conditions deteriorated further by the fact that taxes were calculated
in nominal terms. The time lag between when taxes were levied and when
they were collected reduced revenue in real terms. This was augmented by
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the fact that rapid ination provided an incentive for people to delay tax
payments. The occupation of the Ruhr had a similar eect.
The Germans initially reacted to higher prices by economizing and
reducing their consumption. But when they realized that it was not just a
matter of some things becoming more expensive, but rather it was money
losing value, they reacted by spending their marks as fast as possible. This
meant that there was little constraint on prices. An emerging phenomenon
was that of currency substitution. By October 1923, the value of foreign
currencies circulating in Germany was perhaps several times the real value
of the domestic money supply (see, for example, Bresciani-Turroni, 1937).
According to Sargent (1982), this phenomenon explains why prices rose
proportionately many times more than growth in the domestic currency.
There was also signicant capital ight despite the imposition of capital
controls.
The extent of the German hyperination has been explained with
various degrees of dramatization ever since it happened. Fergusson (2010)
quoted an ocial of the British Embassy in Berlin as saying that the
number of marks to the pound equaled the number of yards to the sun. He
also quoted Germanys National Currency Commissioner as saying that at
the end of the Great War one could in theory have bought 500,000,000,000
eggs for the same price as that for which, ve years later, only a single
egg was procurable. Figure 7.7 shows the astronomical rise in German
wholesale prices during the late stages of hyperination.
It was not only the economic eects of hyperination that were
detrimental to the wellbeing of people. The social and political consequences
were also severe. Fergusson (2010) wrote the following:
Ination aggravated every evil, ruined every chance of national revival or
individual success, and eventually produced precisely the conditions in
which extremists of Right and Left could raise the mob against the State,
set class against class, race against race, family against family, husband
against wife, trade against trade, town against country . . . . It fostered
xenophobia. It promoted contempt for government and the subversion of
law and order. It corrupted even where corruption had been unknown,
and too often where it should have been impossible.
In late November 1923, the German hyperination came to an end. On

15 October 1923, a new currency, the Rentenmark, was introduced at
the rate of 1:1,000,000,000,000 (one to one trillion). The Rentenbank was
established to replace the Reichsbank. A limit was put on the total volume
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1.E+15
1.E+13
1.E+11
1.E+09
1.E+07
1.E+05
1.E+03
1.E+01
1914M1
1915M1
1916M1
Fig. 7.7.
1917M1
1918M1
1919M1
1920M1
1921M1
1922M1
1923M1
1924M1
German wholesale prices (logarithmic scale).
of Rentenmarks that could be issued (3.2 billion) and a limit was also put
on the amount of credit that could be extended to the government. The
scal balance improved dramatically as a result of a series of measures
and actions to raise taxes and reduce spending. The personnel decree of
27 October 1923 required that the number of government employees be cut
by 25% (Young, 1925). The scal situation improved also because relief
from reparation obligations was obtained through temporary suspension
and rescheduling of payments. That was the end of the notorious German
hyperination. The devastation inicted by that episode on the German
currency is summarized by Fergusson (2010) as follows:
In 1913, the German mark, the British Shilling, the French franc, and
the Italian lira were all worth about the same, and four or ve of any
were about a dollar. At the end of 1923, it would have been possible to
exchange a shilling, a franc or a lira for up to 1,000,000,000,000 marks,
although in practice by then no one was willing to take marks in return
for anything.
At least four comprehensive descriptive but technical studies have been

carried out on the German hyperination, namely those by Graham (1930),
Bresciani-Turroni (1937), Laursen and Pedersen (1964) and Holtfrerich
(1986). Graham opted for a balance of payments explanation, attributing
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the German hyperination to the reparation demands. Conversely,

Bresciani-Turroni employed the quantity theory, attributing ination to
domestic economic policy. Laursen and Pedersen used a wages-led cost push
hypothesis to explain the rise of prices in Germany between 1918 and 1923.
Holtfrerich (1986) attempted to ll out what he calls the historiographical
picture of the German hyperination portrayed by those studies, providing
a more general overview of the phenomenon as well as its causes and cures.
A conspiracy theory of the German hyperination was that the German
government initiated ination in order to avoid the costs of reparations.
This view is disputed on several grounds: (i) ination was running at high
rates before the reparations were due, (ii) reparations had to be paid either
in kind or in gold equivalent, (iii) the German authorities did not exhibit any
understanding of the connection between the money supply and ination.
The conspiracy theory, it seems, is not valid.
The main argument for at money is that there is no need to divert metals
or other commodities to the production of a medium of exchange when it
is possible to avoid that by producing at paper money. In other words,
the opportunity cost of using commodity or commodity-backed money can
be avoided by using at paper money. This is what Ben Bernanke said in
his defense of using at paper money whilst discussing the demise of the
Canadian penny in front of a Congressional panel (FOFOA, 2012b):
Transactional currency is simply a notional, purely symbolic token
medium of exchange, much more replaceable, resource-ecient and
environmentally friendly than mining stupid metals for stupid coins.
Bernankes defense of at money is the opposite to Adasks (2010) view who

describes at money as the opium of the masses. He eloquently describes
at money as the philosophers stone, the alchemists dream of turning
base metals (or paper or even electronic digits) into gold. Fiat money,
he adds, oers mankind its fondest dream: unearned wealth; something
for nothing. He goes as far as describing at money as crack cocaine,
robbery and immoral. Williams (2012) attributes the dwindling international status of the dollar to Mr Bernankes extraordinary eorts to
debase the U.S. currency.
Bernanke, therefore, chooses to ignore the many lessons of history
that it is extremely tantalizing for governments to abuse the ability to
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199
produce at money excessively and trigger hyperination. The many cases

we examined in this chapter show that this is typically the case. Those
lessons of history are summarized by Dowd et al. (2011) as follows:
States have claimed the right to manipulate money for thousands of
years. The results have been disastrous, and this is particularly so with
the repeated experiments with inconvertible or at paper currencies such
as those of medieval China, John Law and the assignats in 18th century
France, the continentals of the Revolutionary War, the greenbacks of the
Civil War and, most recently, in modern Zimbabwe. All such systems
were created by states to nance their expenditures typically to
nance wars and led to major economic disruption and ultimate
failure, and all ended either with the collapse of the currency or a
return to commodity money. Again and again, at monetary systems
have shown themselves to be unmanageable and, hence, unsustainable.
There is more to come in the following chapter as we examine major

hyperinationary episodes since the 1970s.
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Chapter 8
HYPERINFLATIONARY EPISODES
SINCE THE 1970s
8.1. Introduction
In Chapter 7, we examined hyperinations going as far back as ancient
Rome and China and ending up with the classical hyperinations of
the 20th century, which were mostly associated with war. The classical
hyperinations were experienced by countries having large scal decits
caused by the cost of war-related reconstruction and the payment of
reparations, while they underwent major domestic instability, including the
diculty of securing borders.
While some of the more recent hyperinations are associated with war,
and despite the fact that they are not homogenous, Kiguel and Liviatan
(1995) argue that they [recent hyperinations] have distinctive features
that stand in sharp contrast with the classical hyperinations. Particularly
with reference to ination in Latin American countries, they argue that the
recent hyperinations are dierent because they took place in countries
that had a relatively long history of high ination. They also argue that
in recent episodes, countries had more control over the ination process,
as well as the damaging eects of ination. By comparing the classic
hyperinations of Austria, Germany, Hungary and Poland in the 1920s
with those of Bolivia, Brazil and Peru in the 1980s and 1990s, they show
that the classical inations were longer and more extreme.1 The comparison
1 When
Kiguel and Liviatan (1995) expressed this view, the Zimbabwean hyperination
had not started yet. It is unlikely that they anticipated a modern hyperination that
would dwarf in terms of severity most of the classical hyperinations. However, they
would have been aware of the hyperination of Yugoslavia, which was as severe as any
classical hyperination.
201
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between the classical war-related hyperinations and the recent episodes,

as portrayed by Kiguel and Liviatan (1995), pertains to the debate on
whether hyperination is an extension of moderate ination or that the
two phenomena are completely dierent.
In this chapter, we examine the hyperinationary episodes experienced
since the 1970s. Although recent episodes were witnessed in the 1980s and
1990s, this chapter is about hyperination since the 1970s because severe
inations were experienced in the 1970s, a decade that is known to have
been inationary. For example, Argentina experienced three-digit ination
rates in the 1970s. Remember that we have chosen not to follow the strict
quantitative denition of hyperination of 50% per month. In this chapter,
we examine data going as far back as the 1960s (if available) to trace the
roots of recent hyperinations. The episodes are arranged alphabetically
according to the underlying country, with the exception of Iran, which is
the latest episode.
8.2. Angola
Angola is the worlds fourth largest producer of diamond by value and the
second largest producer of crude oil, after Nigeria, in sub-Saharan Africa.
Despite its natural resources, social and development indicators suggest
that Angola is one of the worst places in the world to live, not to mention
that armed conict produced casualties in excess of 1.5 million. The armed
conict started in 1961 as an anti-colonial war between the Portuguese and
three main liberation armies. When the colonial period came to an end
suddenly and inconclusively in 1975, the three liberation armies were left
to ght it out for the control of the newly independent country. The conict
subsequently became a proxy war involving major powers as the adversaries
of the Cold War backed dierent sides that supported their war eort with
natural resources. The civil war lasted for a long time spanning the period
19752002.
In 1976 and 1977, the government launched a program of nationalization that produced a large public sector including an oil company and a
diamond company, as well as agricultural and manufacturing enterprises.
Meanwhile, an extensive system of price controls was implemented, covering
almost all available products. These price controls, together with an
administratively-set system of exchange rates (which did not change
between 1977 and 1991), were designed to stem inationary pressures. The
outcome was a massive distortion in prices and a shortage of food and
products in parts of the country.
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203
Hyperination resulted from the monetization of the massive budget

decits that appeared as a result of several factors: growth in military
spending, nancial support for loss-making state enterprises, subsidies and
the low level of public revenue outside the oil sector. The decits were
nanced by printing money the inevitable result was hyperination,
which peaked in 1996. This happened despite eorts by the government
to curb ination by implementing a series of programs. In 1987, the
Programme of Economic and Financial Clean-up was launched to avoid
economic collapse. However, the reform programs were not implemented
properly or seriously. According to the South African Institute of International Aairs (2001), plans were announced, implementation was begun,
and then new plans were drawn up.
Figure 8.1 shows the time path of the CPI and money supply during the
period 19902011. Ination was in triple digits or over every year between
1992 and 2002, reaching a peak of 4,145% in 1996. The ination rate
remained above 20% until 2006 when it dropped to 13.3%. Since then it has
not fallen below 10%. Between 1990 and 2011, the CPI rose at an annual
compound rate of 190%.
The correspondence between ination and monetary growth is spectacular, providing evidence for the quantity theory of money and the monetary
theory of ination. The monetary growth rate reached a peak of 4,105% in
2006 and was in triple digits until 2002 (despite the signicant decline in
1997 and 1998). Between 1990 and 2001, the money supply rose by a factor
of 2.35 1010 , which corresponds to an annual compound rate of 211.8%.
While the nominal interest rate peaked at 125.9% in 1995, the real interest
rate was negative throughout the period.
The corresponding erosion in the value of the currency was enormous.
In early 1991, the highest currency denomination was 50,000 kwanzas. By
1994, it was 500,000 kwanzas. In the 1995 currency reform, one kwanza
reajustado was exchanged for 1,000 kwanzas. The highest denomination
in 1995 was 5,000,000 kwanzas reajustados. In the 1999 currency reform,
one new kwanza was exchanged for 1,000,000 kwanzas reajustados. The
overall impact of hyperination: one new kwanza = 1,000,000,000 pre-1991
kwanzas. It is interesting to note that what is called currency reform
involves changing the currency to a new currency with a higher par value
that is, striking out some zeros.2
2 But
then the word reform could mean anything. Zimbabwes disastrous land reform,
which triggered the worst modern hyperination, was as far away from reform as it
could have been.
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Consumer Price Index

6E+11
5E+11
4E+11
3E+11
2E+11
1E+11
0
1990
1995
2000
2005
2010
2005
2010
Money Supply
2.5E+12
2E+12
1.5E+12
1E+12
5E+11
0
1990
Fig. 8.1.
1995
2000
The consumer price index and money supply Angola.
8.3. Argentina
At the beginning of the 20th century, Argentina was the seventh richest
country in the world. Even following a series of bad economic decisions,
the country remained wealthy. On a visit to the central bank in 1946, the
new president, Juan Peron, commented that there was so much gold you
could barely walk through the corridors (Mauldin, 2009). And even though
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Argentina defaulted on its debt twice in the late 19th century, no signicant
repercussions emerged.
Trouble started in 1989, after years of massive budget decits that
were nanced with borrowing, using both external and domestic debts. The
accumulation of debt was so huge that lenders became increasingly reluctant
to provide loans as a result the government turned to the printing press
to nance the decit and pay o previous debt. Hyperination was the
inevitable outcome: no prices were displayed in grocery stores rather
someone with a microphone announced prices as they rose signicantly by
the hour (an example of the menu cost of hyperination). As in Germany
in the 1920s, people scrambled to buy anything on payday, as shelves were
becoming increasingly empty.
While hyperination is typically described as being a monetary
problem, Ferguson (2008) describes hyperination in Argentina as a
political problem in the sense that no one was interested in price stability.
In his book, The Ascent of Money, he wrote:
The economic history of Argentina in the 20th century is an object lesson
that all the resources in the world can be set at nought by nancial
mismanagement . . . . To understand Argentinas economic decline, it is
once again necessary to see that ination was a political as much as a
monetary phenomenon.
The liberalization policies of 19771980 brought increased indebtedness and

capital ight. In the 10 years before the 1985 Austral Plan, the scal decit
never fell below 5% of GDP while external debt rose by $42 billion. In
1983, a combination of events led to an upward adjustment in wages and
acceleration of ination. The Austral Plan, announced in April 1985, was
designed to curtail aggregate demand and impose direct control over wages
and prices. An agreement was signed with the International Monetary Fund
that involved a pledge to stop issuing money to nance the scal decit,
which would be nanced by borrowing from abroad. The budget decit was
reduced by rising revenues, in part due to increased real activity following
the freeze, and reduced income tax postponement. The outcome was lower
ination.
In 1989, the new president, Carlos Menem, initiated the BungeBorn
stabilization program, which involved exchange rate stabilization, price
agreements among producers, partial trade liberalization, and promised
scal adjustment. Lack of true scal adjustment led to the collapse of the
stabilization program in December 1989 and a return to hyperination.
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In late 1990, a run on the currency moved Argentina back to hyperination.

In 1990, the Argentine government announced a stabilization plan that
included (i) comprehensive liberalization of foreign trade and capital
movements; (ii) privatization of public enterprises and the deregulation
of the economy; and (iii) reduction in the size of the public sector and
reconstruction of the tax system. When Domingo Cavallo was appointed as
the Minister of the Economy in January 1991, he wasted no time in pushing
the idea of a currency board as a means of avoiding the monetization of the
decit. In March 1991, the Convertibility Law was passed by Congress,
xing the parity at 10,000 australes to the dollar (which became one
Argentine peso per dollar in 1992).3 In April 1991, a new monetary system
was established with the creation of a currency board. With that came a
new currency, the peso, whose value would be rigidly xed against the U.S.
dollar. The plan achieved a dramatic reduction in ination.
As a result of adopting the currency board, ination fell from over
1,000% in 19891990 to 25% in 1992, and it eectively disappeared by 1996.
Growth was in excess of 8% in 19911992, having been negative for most
of the 1980s. Things, however, started to change in 1995 when Argentina
got a shock from the Mexican crisis following the collapse of the Mexican
peg in December 1994. The second major crisis followed the collapse of
the Brazilian peg in early 1999. Growth turned negative in 1999, as the
Brazilian devaluation made the Argentine economy less competitive.
Figure 8.2 shows the CPI and money supply in Argentina over a
period extending back to the 1960s. With the exception of 1969, ination
in Argentina ran in double digits throughout the 1960s. It accelerated in
the 1970s, reaching 443% in 1976. Ination accelerated again in the 1980s,
reaching a high of 3,079% in 1989. In 1992, it fell to double digits, then
it went down progressively as the economy experienced deation in the
period 19992001. In more recent years, the ination rate has been hovering
around the 10% mark. Between 1960 and 2011, the CPI rose by a factor of
3.941012, at an average annual compound rate of 77%. The corresponding
gure for the money supply was 1.91 1013 and 82%, respectively. The
nominal interest rate peaked at 1,735.1% in 1989 but the real rate was still
negative at 1,344%. When ination subsided in the period 19962001, the
real interest rate was positive.
At the beginning of 1975, the highest denomination was 1,000 pesos.
In late 1976, the highest denomination was 5,000 pesos. In early 1979,
3 For
an evaluation of Argentinas experiment with the currency board, see Moosa (2005).
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4E+14
3E+14
2E+14
1E+14
0
1960
1970
1980
1990
2000
2010
2000
2010
Money Supply
2E+15
2E+15
1E+15
8E+14
4E+14
0
1960
Fig. 8.2.
1970
1980
1990
The consumer price index and money supply Argentina.
the highest denomination was 10,000 pesos. By the end of 1981, the
highest denomination was 1,000,000 pesos. In the 1983 currency reform,
one peso argentino was exchanged for 10,000 pesos. In the 1985 currency
reform, one austral was exchanged for 1,000 pesos argentine. In the 1992
currency reform, one new peso was exchanged for 10,000 australes. The
overall impact of hyperination: one new peso = 100,000,000,000 pre-1983
pesos.
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8.4. Belarus
When the Soviet Union disintegrated in 1991, the Belaruss economy
eectively collapsed as the natural markets for the countrys exports of farm
machinery, textiles and agricultural products vanished. In 1993 the ination
rate was 1,190%, rising to a peak of 2,221% in 1994. President Alexander
Lukashenko reintroduced price controls and re-nationalized some companies
and infrastructure after coming to power in July 1994, on a platform of
market socialism. The economy was shrinking until the end of 2005, but
it returned to positive growth in 1996. Ination, however, did not subside,
going back to three digits in 1999 and 2000. The nominal interest rate
peaked at just over 100% in 1995. Between 1993 and 2011, the CPI rose
by a factor of 1.06 million, growing at an average annual compound rate
of 107%. The corresponding gures for the money supply are 378,000%
and 97%, respectively. Figure 8.3 shows the CPI and money supply in
Belarus.
As usual in countries experiencing hyperination, the currency went
through several changes. The highest denomination was 5,000 rublei. By
1999, it was 5,000,000 rublei. In the 2000 currency reform, the ruble was
replaced by the new ruble at an exchange rate of one new ruble = 2,000
old rublei. The highest denomination in 2002 was 50,000 rublei, equal to
100,000,000 pre-2000 rublei.
While things looked relatively rosy in 2010 as the ination rate subsided
to 7.7%, the money supply grew by 121% in 2011, pushing the ination rate
up to 53%. Hyperination, it seems, is on the way back. In October 2011, the
domestic currency was devalued against the dollar by some 50% resulting
in a big rise in import prices. The price of petrol was up by 24%. The
usual stories associated with hyperination began to surface as observers
predicted a return to the hyperination of the 1990s. Alexei Moiseev, chief
economist at VTB Capital, the investment-banking arm of Russias secondlargest lender, is quoted as saying that a 91-style meltdown is almost
inevitable, referring to the countrys economic slump after the collapse of
the Soviet Union (OBrien and Kudrytski, 2011). In the same article, the
following story is told:
Last night, about 50 people protested the price increase in the car park
of a Minsk hypermarket. I cant describe how I feel without using
obscenities, this is all our governments fault, said Sergey, a 32-year
old attending the protest who works for a computer importer. The
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1.E+08
1.E+08
8.E+07
6.E+07
4.E+07
2.E+07
0.E+00
1992
1997
2002
2007
2012
2007
2012
Money Supply
4.E+07
3.E+07
2.E+07
2.E+07
8.E+06
0.E+00
1992
1997
Fig. 8.3.
2002
The consumer price index and money supply Belarus.
whole world tells them, guys, you have economic problems, you should
do something, and all they did was live o getting more and more loans.
The problem with currency devaluation for a country like Belarus, which
exports little, is that it makes things worse by making imports more
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210
expensive. The typical observation of shortages under hyperination is

already there. For example, take the following story, which is reported by
OBrien and Kudrytski (2011):
At the Minsk Refrigerator Plant Co. shop in the capital today, about 20
people queued in drizzling rain to use their rubles to buy fridges. While
the shop didnt open on the day of the devaluation, most of the models
in the store already had Sold Out stickers on their doors. I came on
Saturday and it was a nightmare, the store was stormed by people who
wanted to spend their rubles because of rumors about the devaluation,
said Nikolay, a 74-year-old pensioner . . . . His entire savings of 6 million
rubles now buy one fridge compared with three before the devaluation, he
said . . . . The price of childrens diapers has gone completely insane in
Minsk, said Natalia, a 24-year-old mother who was also queuing outside
the refrigerator store. I used to buy a pack for 69,000 rubles, now they
cost 140,000, or almost half the 343,260-ruble monthly child benet
paid by the government, she said.
The story conveys the message that some symptoms of hyperination that
we considered in Chapter 6 are surfacing in the Ukraine. The dierence is
that on this occasion we observe an imported inationary burst triggered by
currency devaluation. If the imported inationary burst is accommodated
by monetary expansion, it could become genuine hyperination.
8.5. Bolivia
Bolivia is one of the Western Hemispheres poorest countries, despite an
abundance of mineral resources. The Bolivian economy has always been
dependent on mineral exports (particularly tin) but these have gradually
declined since World War II. Little of the countrys agricultural and forest
potential has been developed, to the extent that agriculture remains little
above the subsistence level, which means that the country must import
large quantities of food.
Figure 8.4 shows the CPI and money supply in Bolivia over a period
going back to the 1960s. Apart from 1968, when the economy shrank by
12%, the Bolivian economy grew at a fairly steady rate of about 5% during
the 1960s and 1970s. In the 1980s, after the second oil shock, growth turned
negative, as the economy shrank by 4% in 1982 and 1983. That period also
witnessed signicant monetary accommodation of the oil price shock, as
the monetary growth rate was in triple digits over the period 19821986.
In 1982, the ination rate was 128%, rising to 275% in 1983 and 1,281% in
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5.E+08
4.E+08
3.E+08
2.E+08
1.E+08
0.E+00
1960
1970
1980
1990
2000
2010
2000
2010
Money Supply
3.E+10
3.E+10
2.E+10
2.E+10
1.E+10
5.E+09
0.E+00
1960
1970
Fig. 8.4.
1980
1990
The consumer price index and money supply Bolivia.
1984. Attempts to implement IMF-designed austerity programs to contain

ination back-red in the face of violent protests and government eorts to
limit the hardship associated with those programs. When world tin prices
plummeted to a fraction of production costs in 1985 after the collapse of
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the International Tin Agreement (ITA), ination became uncontrollable

and the ination rate shot up to 11,749%.
The collapse of tin prices and a radical shift in external capital ows
triggered hyperination. Export earnings from tin fell from $235 million in
1980 to $75 million in 1983. That in itself led to a sudden retrenchment as
fears of default mounted, triggered by unsustainable debt in the aftermath
of the rise in world interest rates in the early 1980s and the Mexican debt
crisis of 1982. The net resource transfer from abroad shifted from 6.2% of
GDP in 1980 to 6.9% in 1983. The ratio of tax revenue fell from 9% in
1980 to 1.3% in 1985.
After 1985, a strong anti-ination consensus allowed the government
to apply strong austerity measures that brought annual ination down to
14.58% by 1987. In August 1985, a drastic anti-inationary program was
implemented including the following measures: (i) oating the domestic
currency, (ii) freezing public-sector wages, (iii) curtailment of government
spending, (iv) eliminating controls on interest rates, (v) allowing banks
to grant loans and open foreign currency accounts, (vi) initiating a
comprehensive overhaul of the tax system, (vii) eliminating price controls,
(viii) establishing a uniform 20% tari while removing tari exemptions
and eliminating trade restrictions, and (ix) modifying labor laws such as to
grant employers more freedom to hire and re. Measures were also taken
to restructure several public-sector institutions including the central bank
and the national mining corporation. The restructuring involved the closure
of branches and signicant reductions in the numbers of employees. Since
1997, the ination rate has been in single digit, with the exception of 2008.
Interest rates peaked at 108% in 1984, but in the most recent period,
a single digit was the norm. In 2010, the bank lending rate was just over
1%. The same story as in other hyperinationary countries goes for Bolivia.
Before 1984, the highest denomination was 1,000 pesos bolivianos. By 1985,
the highest denomination was 10 million pesos bolivianos. In the 1987
currency reform, the peso boliviano was replaced by the boliviano which
was pegged to the U.S. dollar.
8.6. BosniaHerzegovina (Yugoslavia)

Anyone looking at the recent ination gures of BosniaHerzegovina, the
former Yugoslavia, may not believe that between 1 October 1993 and 24
January 1995 prices rose by a factor of 51015. Under Tito, more than 80%
of Yugoslavias budget was earmarked for the military and police forces
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213
and that was nanced by printing money. The result was that ination
ran at an annual rate of 15% to 25%. The breakup of Yugoslavia led to
heavier reliance on the printing press to nance government spending, and
by December 1993, almost 95% of all government spending was nanced by
printing fresh dinars.
The government tried to combat ination by imposing price controls. As
experienced in other countries, price controls do not overcome ination
rather they create shortages. Therefore, ination continued and shortages
started to appear because price controls made the price that producers
were getting so low that they decided to stop producing. In October
1993, Belgrade was without bread for a week because the bakers stopped
making bread. Likewise, slaughter houses refused to sell meat to the state
stores, which meant that meat became unavailable. Other stores closed
down, choosing not to sell their inventories at the ocial prices. When
farmers refused to sell to the government at articially low prices, the
government used hard currency reserves to import food while maintaining
price controls. Later, the government tried to curb ination by requiring
stores to le paperwork every time they raised a price as a result many
store employees had to devote their time for lling out forms. Instead of
curbing ination, this policy actually gave it a boost because the stores
tended to raise prices by bigger amounts so that they would not have to
le forms for another price increase so soon.
The proposition that ination leads to deterioration of morality, the
collapse of the social structure and the loss of law and order is vindicated
by the horror stories told about this hyperinationary episode (Lyons,
1996). Hospitals and clinics were robbed of scarce pharmaceuticals, which
were then sold in front of the same places they were robbed. Railway
workers went on strike and closed down the railway network. The fact that
pensioners suer most from ination was also vindicated. Pensioners who
were paid at the post oce would typically line while the value of the
anticipated payment was eaten away with each minute they had to wait.
When the post oce ran out of money, they still waited in line, knowing
that they would receive much less if they went home and came back the
next day. The currency substitution phenomenon was evident to the extent
that at one stage the domestic currency was not used even as a medium
of exchange. While government employees were paid in domestic currency,
the Deutsche mark became eectively the legal tender.
Some interesting stories were told about how people delayed the
payment of telephone bills as much as possible as ination reduced the
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214
real value of payment to almost nothing. One day a postman in charge of

collecting phone bills decided to stop collecting and paid them himself the
following day. James Lyons, a journalist, tells a story about him making
20 hours of international telephone calls from Belgrade in December 1993
(Lyons, 1996). The bill for these calls, which arrived on 11 January, was
1,000 new dinars (less than one German pfennig at the exchange rate
prevailing on the day). The bill was not due until 17 January by that time
it cost him almost nothing to pay for international calls worth about $5,000.
There was also a tendency to use personal cheques to settle transactions,
particularly that it was against the law to refuse to accept cheques. The
reason for the preference for using cheques was that in the few days it took
for the cheques to clear, ination would wipe out as much as 90% of its
nominal value.
In 1992, the highest currency denomination was 1,000 dinars. By 1993,
the highest denomination was 100,000,000 dinars. In October 1993, a new
currency unit was created. One new dinar was worth one million old dinars.
In eect, the government simply removed six zeroes from the face of the
banknote.
8.7. Brazil
In the 1970s, Brazil was some sort of an economic miracle, a miracle that
came to an end with the advent of ination in the 1980s. It is the same story
all over again: the government spent beyond its means, nding that it could
not nance the decit by borrowing or raising taxes, hence resorting to the
printing press. In Brazil, one source of excessive government spending was
the indexation of prices, wages and contracts to maintain the purchasing
power of the incomes received by its citizens. Ination ran in triple digits
between 1981 and 1992. In 1994, the ination hit a high of 2,076%, while
the lending rate was at 5,175%. Between 1981 and the peak of ination,
the CPI was rising at an average annual compound rate of 490%. At the
same time, the growth rate of the money supply was 560% (see Fig. 8.5).
Leslie Evans of the Latin American Center of UCLA conducted an
interesting study of the Brazilian hyperination by interviewing a former
governor of the Central Bank of Brazil, who talked mostly about how they
managed to stop ination (Evans, 2002). This is how Evans described life
under the Brazilian hyperination:
Imagine that your rent doubled every 10 weeks. That your credit card
charged 25% a month interest. That food and clothes went up 40% a
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3.0E+13
2.5E+13
2.0E+13
1.5E+13
1.0E+13
5.0E+12
0.0E+00
1980
1990
2000
2010
2000
2010
Money Supply
6.0E+14
4.8E+14
3.6E+14
2.4E+14
1.2E+14
0.0E+00
1980
Fig. 8.5.
1990
The consumer price index and money supply Brazil.
month. That the value of your savings declined 2000% in a year! This
was Brazil for 10 years, from 1987 to 1997. During those 10 years, 40%
of GNP was eaten up by ination, and everyone got rid of cash as fast as
possible, because it lost value in your pocket. No one saved money. And
the majority of people were reduced to buying only the essentials of life,
which devastated whole industries that produced all kinds of optional
goods and services.
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9in x 6in
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According to Evans (2002), the Brazilian experience exhibited both a

wageprice spiral and inertial ination. The spiral evolved because contractors would be paid with cheques that had declined in value by 30% in
the time it took to deposit them in the bank, which prompted a doubling
of the contractor price next time. Government employees demanded preemptive wage raises to oset expected ination. The problem was that no
one would believe that prices could be stabilized, so everyone sought higher
prices or wages to hedge against expected ination.
In 1994, severe measures were taken including the following: (i) a
constitutional amendment was introduced to empower the central bank
not to nance the budget decit; (ii) the central bank made it illegal
for regional banks to buy government bonds; (iii) wages were frozen; and
(iv) a new currency (the real) was introduced as part of measures to
de-index the economy. What is interesting, however, is the story told by
Gustavo Franco, the then governor of the central bank, which amounts to
saying that desperate measures are needed to resolve a desperate situation.
Evans (2002) quotes Franco as saying that the prime reason for success
in combating ination was a unique period where none of the political
forces of the country were able to intervene in the process to promote the
special interests that the state had become committed to supporting in the
preceding decades. President Fernando Collor de Mello was impeached
in December 1992 and replaced by his vice president, Itamar Franco, who
was not interested in economics and signed anything the ministers would
bring him. Congress was also sidelined by a major scandal in December
1994, which kept them out of the discussion, and provided a window of
opportunity where the politicians did not interfere. The monetary authority
was eectively a three-member team: the central bank governor, the nance
minister, and the planning minister. In the words of Gustavo Franco, we
empowered the treasury and the central bank to subvert democracy.4 As
a result of these measures, prices dropped dramatically from July 1994
onwards. In 1995, the ination rate was 66%, down from 2,076% in 1994.
By 1997, ination had been reduced to a single digit.
The countrys experience with hyperination has resulted in a large
number of changes in the denominations and the name of the Brazilian
currency. For most of the early part of the 20th century, Brazils money was
called Reis, meaning kings. By the 1930s, the standard denomination was
4 This
story demonstrates vividly why hyperination can be characterized as being a

political problem.
August 10, 2013
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217
Mil Reis meaning a thousand kings. By 1942, the currency was devalued so
much that the Vargas government instituted a monetary reform, changing
the currency to cruzeiros (crosses) at a value of 1,000 to one. In 1967,
the cruzeiro was renamed cruzeiro novo (new cruzeiro) three zeros were
dropped from all denominations. In 1970, the cruzeiro novo was renamed,
dropping the novo, hence the currency was once again called cruzeiro.
During the 1970s, while the Brazilian economy was growing at 10% a year,
the ination rate was anywhere between 15% and 300%. By the mid 1980s,
ination was out of control, reaching a peak of 2,000%. In 1986, three zeros
were dropped and the cruzeiro became cruzado. In 1989, another three
zeroes were dropped and the cruzado became the cruzado novo. In order to
avoid confusion and not associate the new currency with previous monetary
policy, the cruzado novo was renamed cruzeiro in 1990 with no change in
value. By 1993, three more zeros were dropped from the cruzeiro, which
became known as the cruzeiro real. In 1994, the cruzeiro real was replaced
by the real (royal), worth 2.75 old cruzeiros reais. In 1994, a 1960s cruzeiro
was worth less than one trillionth of a U.S. cent, after adjusting for multiple
devaluations and note changes.
8.8. Congo (Formerly Zaire)
Ination in the Congo has always been a monetary phenomenon, resulting
from the nancing of the budget decit by printing money. It has been
caused by persistent government overspending and a lack of control of the
money supply. This is why ination has been persistently high since 1971,
but during the period 19921997 ination was exceptionally high, reaching
a peak of 4,129% in 1992 (see Fig. 8.6). This came after an attempt was
made in 1983 to introduce a stabilization program to control the growth of
the money supply and ination by gradually instituting measures designed
to restrict credit expansion. In January 1989, the government tried again
to contain the budget decit and to limit the monetary nancing of the
decit but gains from this plan were short-lived, and the ination rate rose
to 104% in 1989.
As the formal economy contracted and export earnings dwindled,
cutbacks in the U.S. economic assistance and soft loans from international
agencies triggered a major economic crisis in the early 1990s. No longer able
to nance the budget decit with foreign aid, Mobutu (the then president)
turned to the printing press, with the almost immediate result that ination
skyrocketed and the local currency lost its value. Thereafter, the formal
economy entered a period of free fall, contracting by 50% between 1989
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218

1.2E+17
9.0E+16
6.0E+16
3.0E+16
0.0E+00
1970
1980
1990
2000
2010
2000
2010
Money Supply
4.0E+16
3.0E+16
2.0E+16
1.0E+16
0.0E+00
1970
Fig. 8.6.
1980
1990
The consumer price index and money supply Congo.
and 2001 as negative economic growth was experienced every year except
1995 when the growth rate was almost zero.
Between 1970 and 2011, the CPI rose at an annual compound rate of
127%. The corresponding gure for money supply growth was 122% (see
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219
Fig. 8.6). As a result, the currency has undergone signicant changes. In

1988, the highest denomination was 5,000 zaires. By 1992, it was 5,000,000
zaires. In the 1993 currency reform, one nouveau zaire was exchanged
for 3,000,000 old zaires. The highest denomination in 1996 was 1,000,000
nouveaux zaires. In 1997, Zaire was renamed the Democratic Republic of
Congo and changed its currency to franc. One franc was exchanged for
100,000 nouveaux zaires. The overall impact of hyperination: one 1997
franc = 300 billion pre-1989 zaires.
8.9. Croatia
After Titos death in 1980 economic, political and religious diculties
started to mount and the Yugoslav federal government began to crumble.
The emergence of Slobodan Milosevic in Serbia provoked a very negative
reaction in Croatia and Slovenia as a threat to their autonomy. With
the climate of change throughout Eastern Europe during the 1980s, the
communist hegemony was challenged, and on 22 April and 7 May 1990,
the rst free multi-party elections were held in Croatia. The Croatian
constitution was passed in December 1990 categorizing Serbs as a minority
group along with other ethnic groups. On 2 May 1991, the Croatian
parliament voted to hold a referendum on independence. On 19 May 1991,
on an almost 80% turnout, 93.24% voted for independence. Armed conict
in Croatia remained intermittent and mostly on a small scale until 1995.
Monetization of scal decit was the key factor behind the initial
impulse of ination, which was maintained by backward-looking wage
indexation. Figure 8.7 shows the CPI and money supply in Croatia since
1985. Between 1987 and 1994, ination was in triple digits except in 1989
when it peaked at 1,400%. During the same period, the rate of monetary
growth averaged 334% per annum. In 1992 and 1993, the interest rate
was 658% and 379%, respectively, while growth was mostly negative. In
three years (19911993) the Croatian economy shrank by 64%, with annual
growth rates ranging between 21% and 8%.
An exchange rate-based stabilization program was implemented in
1993, involving a pre-announced time path of the exchange rate as the
nominal anchor for monetary policy, often in the form of a crawling peg.
Because the economy of Croatia was (and is) highly euroized, the exchange
rate and the ination rate are typically perceived by the public as following
the same direction. This has made it possible to import the ination rate
and reduce it to a reasonable level in relatively short period (Sonje and
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9.0E+07
6.0E+07
3.0E+07
0.0E+00
1985
1990
1995
2000
2005
2010
2000
2005
2010
Money Supply
5.0E+07
4.0E+07
3.0E+07
2.0E+07
1.0E+07
0.0E+00
1985
1990
Fig. 8.7.
1995
The consumer price index and money supply Croatia.
Skreb, 1995). By 1995, the ination rate was below 4% it has remained
in single digits since then, reaching a low of 1% in 2010.
8.10. Ecuador
Ecuador provides an interesting case study of a country that resorted to
dollarization as a result of ination and currency depreciation. Ecuador has
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221
a commodity-based economy, depending traditionally on the exports of a

few agricultural products such as cocoa, coee and bananas. The discovery
of large oil deposits in the early 1970s transformed Ecuadors economy from
an agrarian one, dependant on the exports of agricultural commodities, to
one reliant on the exports of oil. The oil wealth brought with it economic
growth and rising living standards. In 1973, oil became the prime export
earnings generator, and by the 1980s the oil sector accounted for half of total
export earnings. As oil revenues rose, government spending grew rapidly,
disproportionately to the growth of revenue. The government resorted to
external borrowing to fund the scal gap.
The oil-driven prosperity did not last long, as economic growth started
to falter. In the 1980s, the Ecuadorian economy was exposed to a series
of shocks: the international debt crisis of the early 1980s, the 1986 sharp
decline in oil prices and the March 1987 earthquake that damaged a large
stretch of the only oil pipeline. In response to these developments, particularly declining oil prices, the government adopted policies of liberalization
and diversication of the economy. However, ination ran in double digits
in the 1980s, reaching a peak of 75.6% in 1989.
In 1992, the Ecuadorian government adopted a macroeconomic stabilization plan supported by the IMF. Ination declined from 54% in 1992 to
23% in 1995. In 1997, the climate phenomenon of El Nino, destroyed much
of the infrastructure, at a time when a substantial fall in oil prices and the
nancial crisis of 19971998 had negative consequences for the economy.
The poor economic performance of the late 1990s culminated in a severe
economic and nancial crisis in 1999 when the GDP growth rate was 6.3%.
The crisis was the result of a highly expansionary monetary policy mixed
with unsustainable scal decit. In 1999, a mandatory banking holiday and
freezing of deposits meant that 60% of bank assets were administered by
the government. The ination rate was up to 52%, creating a severe case
of stagation.
In January 2000, a decision was taken to adopt the U.S. dollar as legal
tender as a drastic measure to stop hyperination. The government opted
for a model involving a complete replacement of the domestic currency with
the dollar but the central bank would retain some functions such as a lender
of last resort. The legislation was approved in May 2000 under the auspices
of the Fundamental Economic Transformation Law at this point the
central bank was instructed to use part of its foreign exchange balances to
purchase the balance of the domestic currency (the sucre). The central bank
was also instructed to issue coins in denominations smaller than one dollar
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as in a currency board against foreign exchange holdings. The ination rate

fell from a peak of 96% in 2000 to a single digit in 2003. By 2005, it was
below 2.5%.
8.11. Georgia
Georgias economy revolves around Black Sea tourism, mineral resources
(coal, copper and manganese) and some machinery production, as well
as other light industry. The economy is also dependent on agriculture as
Georgia produces citrus fruit, hazel nuts, tea and grapes. The declaration
of independence from the Soviet Union on 6 April 1991 was followed
by civil conict and political turmoil. The breakdown of law and order,
accommodative monetary and scal policies and severe economic shocks
(resulting from the collapse of the Soviet Union) led to severe hyperination,
which the International Monetary Fund (1996) describes as one of the
worst cases of hyperination on record. By early 1994, the country was at
the brink of collapse as GDP was in its third year of massive negative growth
(44.8%, 25.4% and 11.4%). In three years, the Georgian economy
shrank by two-thirds of its 1991 size.
The Georgian kupon was introduced in April 1993 initially it
circulated at par with the Russian ruble. The initial amount of kupons
in circulation was 31.7 billion. Following the July 1993 demonetization of
pre-1993 rubles in Russia, the Georgian authorities declared the kupon to
be the sole legal tender of the country in August 1993. By the end of
September, currency in circulation had exploded 153-fold to 4.85 trillion
kupons. The unocial exchange rate for the kupon peaked at ve million
to one U.S. dollar in late September 1994.
The new Georgian currency, the lari, was introduced on 25 September
1995 at an exchange rate of one million kupon to one lari it became
the sole legal tender on 2 October 1995. Hyperination started with scal
imbalances as the tax revenue to GDP ratio fell from 22% in 1991 to 8%
in 1992 and 2% in 1993. That was caused by a shrinking tax base, lags in
collection, and deterioration in tax compliance.
Monetary and credit policies after the introduction of the koupon were
highly accommodating and repeatedly subject to direct intervention of the
government and Parliament. During the period March 1993August 1994,
currency in circulation and broad money increased by a factor of 152 and
130, respectively (see Fig. 8.8). This rapid monetary growth was caused
by rapid growth in lending by the central bank to the government (Wang,
1999). In November 1993, a decree was issued instructing the central bank
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6.0E+07
5.0E+07
4.0E+07
3.0E+07
2.0E+07
1.0E+07
0.0E+00
1991
1994
1997
2000
2003
2006
2009
2012
2003
2006
2009
2012
Money Supply
5.E+07
4.E+07
3.E+07
2.E+07
1.E+07
0.E+00
1991
1994
Fig. 8.8.
1997
2000
The consumer price index and money supply Georgia.
to provide loans totalling 720 billion koupons that was 150% of the
monetary base. In February 1994, the parliament ordered a credit of 1.8
trillion to nance the budget decit and another order was issued on 30
June for further 10 trillion.
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A comprehensive stabilization program was implemented in mid-1994.

The program involved the following measures: (i) massive reduction in
central bank nancing of the budget decit, (ii) putting an end to
commercial banks access to overdraft on their accounts at the central bank,
(iii) removal of subsidies on bread, electricity and gas as well as state-owned
enterprises, and (iv) boosting tax revenue by raising tax rates and improving
the tax collection process. As a result hyperination was controlled and the
ination rate returned to single gures in 1997. With the exception of 2009,
growth has been running at a healthy pace.
One must not overlook the cost of the stabilization program in terms
of human misery. The removal of subsidies meant drastic increases in the
prices of essential goods and service. On 7 September 2004, the prices of
gas and electricity were raised by a factor of 1,000 and 600, respectively.
On 7 September 1994, the price of bread went up by a factor of 285,
from 700 to 200,000 koupons a kilo. On the same day, metro prices were
also raised. An important lesson that can be learned from the Georgian
hyperination is that exchange rate and price stability could be achieved
before the establishment of credibility (Wang, 1999).
8.12. Iraq
Following the end of the 1991 (rst) Gulf war and the imposition of
sanctions on Iraq, the Iraqi economy shrank as oil output declined. At
the same time, an expansionary scal policy was pursued to nance pay
raise, particularly for the military (the salaries of senior army ocers were
quadrupled over a short period of time). The resulting budget decit was
nanced by resorting to the printing press. As a result, hyperination
ensued and the currency depreciated rapidly. In 1996, the oil-for-food
program was initiated resulting in some stabilization of the exchange rate.
After the invasion of Iraq in March 2003, the country suered from a
prolonged period of high ination, which was brought under control in late
2008. An IMF study attributed the diculty of containing high ination to
persistent violence, commodity shortages, pervasive dollarization, a weak
monetary transmission mechanism, and lack of data (Grigorian and Kock,
2010). For these reasons, it was dicult to design and implement policies
to control ination. The study also suggests that rent-seeking behavior in
the oil sector and violence were key contributing factors to the surge in
ination and can also help explain some of the stylized facts about ination
characteristics in Iraq since 2003.
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225
The IMF study describes the pattern of ination in Iraq during the
period March 2003December 2007 in terms of some stylized facts. First,
core and headline ination moved broadly in line with each other through
2005, before the initiation of administered fuel price adjustments at the
end of 2005 and the increase in violence in the rst half of 2006. Second,
black market prices for fuel products went up further, but remained below
international levels following the introduction of the administered fuel
price adjustments at the end of 2005. Third, the ratio of black market
prices to administered prices (that is, the black market premium) declined
as administered prices were adjusted upwards. Fourth, shortages of fuel
products declined, but not eliminated, by the end of the year.
8.13. Israel
Ination accelerated in the 1970s, rising steadily from 13% in 1971 to 111%
in 1979. From 133% in 1980, it leaped to 191% in 1983 and then to 445%
in 1984. In 1985, Israel froze all prices by law. In 1985, ination fell to
185% (less than half the rate prevailing in 1984). Within a few months, the
authorities began to lift the price freeze on some items and in 1986 ination
was down to just 19%. Figure 8.9 shows the CPI and money supply since
1960.
Until 1966, Israel adopted a restrictive scal policy but the 1967 war
resulted in a large increase in government spending. As a result, the ination
rate rose rapidly to double digits in the 1970s, reaching a high of 78% in
1979. In the 1980s, the ination rate was in three digits, peaking at 373% in
1984 and remaining at above 300% in 1985. In an IMF study of the Israeli
ination, the initial rise of the ination rate to over 30% was attributed to
the slowdown in economic growth as a result of the 1973 rise in oil prices,
the October 1973 war, the failure to adjust non-military spending to reect
the slower pace of economic growth (and consequently revenue) and the
rapid growth in real wages even though private-sector productivity declined
(Fischer and Orsmond, 2000). The 1973 war was the reason why government
spending rose to 10% of GDP. The post-1977 acceleration of ination is
attributed to the weakening of the nominal anchors in the economy as a
result of the introduction of a real exchange rate rule, the introduction of
liquid foreign exchange accounts, which reduced the demand for shekeldenominated assets, as well as other policies that reduced the control
of the central bank over the monetary base. Those policies included the
liberalization of the capital account, which weakened control over domestic
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1.2E+07
1.0E+07
8.0E+06
6.0E+06
4.0E+06
2.0E+06
0.0E+00
1960
1970
1980
1990
2000
2010
2000
2010
Money Supply
1.8E+08
1.5E+08
1.2E+08
9.0E+07
6.0E+07
3.0E+07
0.0E+00
1960
1970
Fig. 8.9.
1980
1990
The consumer price index and money supply Israel.
credit, the expansion of export credit, attempts to stabilize government

bond prices on the secondary market, and maintaining a low discount rate.
In mid-1985, a stabilization program was initiated to tackle the causes
of ination. First, measures were taken to reduce the scal decit by cutting
back on spending and boosting revenue including reductions in subsidies
August 10, 2013
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227
and military spending as well as the imposition of new taxes. These

measures were supported by increased foreign aid. Second, the eectiveness
of monetary policy was enhanced by raising reserve requirements, the real
discount rate and the minimum term for dollar-indexed deposits. In 1986,
a law was passed to forbid borrowing from the central bank to nance the
budget except for bridging loans within the scal year. Third, to reduce
inationary inertia, backward-looking wage indexation was suspended and
replaced with a at increase in nominal wages. The credibility of the
stabilization program was enhanced by the U.S. nancial aid to nance
the scal decit. As a result of these measures, the ination rate fell to 48%
in 1986 and to 19.9% in 1987. By 1998, the ination rate was in single digits.
Bruno (1993) summarizes the Isreali stabilization program as having
ve components: (i) restoring internal and external balances; (ii) the use of
multiple nominal anchors to achieve rapid disination including exchange
rate peg, money and/or credit ceiling and wage freeze; (iii) moving to
new macroeconomic equilibrium including interest rate conversion rules for
nominal assets as well as de-indexation and de-dollarization of liquid assets;
(iv) structural reform to remove micro distortions such as liberalization,
deregulation and nancial sector reform; and (v) political reform.
In a study of Israeli ination, Beenstock and Ben-Gad (1989) suggest
that scal policy did not directly aect ination and that ination depended
on the rate of monetary growth and the net excess supply of money
as well as expected ination, which was triggered by expected monetary
growth. The analysis also suggests that monetary growth largely reected
the scal decit, which reached 15% of GDP by 1985. The tendency for
the authorities to accommodate inationary shocks also reinforced the
underlying inationary tendencies. The policy conclusion of the study is
that control of the scal decit is vital if ination is to be stabilized
and that the alternative of reducing monetary growth on an unannounced
basis would delay the reduction of ination and may depress the economy
unnecessarily.
8.14. Mexico
Mexico is a producer and exporter of oil. Despite the rise in oil prices in the
late 1970s, Mexico defaulted on its external debt in 1982 due to excessive
social spending and borrowing. As a result, the country suered a severe
case of capital ight and several years of hyperination as well as peso
devaluation. In 1982, the ination rate was 58%, which jumped to 101%
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in 1983 and was in triple digits until 1988. Ination subsided in the early
1990s. On 1 January 1993, the Bank of Mexico introduced a new currency,
the nuevo peso, which was equal to 1,000 old pesos. High ination was back
in 1995 and 1996 following the peso crisis of 1994. Figure 8.10 displays the
CPI and money supply in Mexico since 1960.
8.15. Nicaragua
During the period 19601977, sound macroeconomic policies produced solid
and sustained growth. A framework of economic discipline fostered a stable
environment and encouraged both domestic and foreign investments. Fiscal
discipline, monetary stability, stable exchange rates, congruent monetary
and credit policies, a modern and well-administered nancial system, and
relatively low levels of external indebtedness forged. The situation was
strengthened by favorable international conditions and buoyant markets
favoring growths in coee and cotton productions. Throughout this period,
however, non-inationary and solid economic growth proved the most
reliable instrument to reduce poverty. As a result, the economy grew at an
average annual rate of 6.4%. Per capita GDP grew at 3.1% per year, domestic ination rates were close to international levels, balance of payments
decits were moderate, and exports rose in response to growing industrial,
agricultural and livestock output levels and strong foreign demand.
By contrast, the major disruption associated with civil war in the
1980s complicated macroeconomic management and resulted in a major
misallocation of resources. An ad hoc program to transfer productive land
produced uncertainty clouded ownership and created legal chaos, leading to
disinvestment and a major decline in agricultural production. At the same
time, the foreign debt grew to unprecedented levels, reaching $8.5 billion
in 1988, almost seven times greater than the countrys GDP and the level
of the foreign debt at the end of 1978. By 1990, the foreign debt reached
$10.7 billion. This, coupled with political instability, led to a collapse in
output and the emergence of hyperination. The growth rate was negative
in every year between 1984 and 1990, as the economy shrank by over 12%
in 1988 alone. As a result per capita income fell to the 1960s level. The
ination rate peaked at 2,917% in 1988, which coincided with a monetary
growth rate of 12,513%. In the same year, the interest rate reached a peak
of 107,379%. Ination persisted in the 1990s even though the ination rate
fell from its 1988 peak to 1,794% in 1990 and 364% in 1991, while the
monetary growth rates were 7,677% and 1,519%, respectively. Economic
growth was still negative.
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9.0E+05
6.0E+05
3.0E+05
0.0E+00
1960
1970
1980
1990
2000
2010
1990
2000
2010
Money Supply
5.0E+07
4.0E+07
3.0E+07
2.0E+07
1.0E+07
0.0E+00
1960
Fig. 8.10.
1970
1980
The consumer price index and money supply Mexico.
Conditions started to improve following the introduction of corrective

policies. Backed by IMF support, a strong structural reform program
was launched that brought ination under control and renewed economic
growth. In the rst half of the 1990s, major eorts were devoted to
August 10, 2013
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the restoration of peace and the abatement of hyperination. Public

expenditure was cut by reducing the army by over three-quarters, the
privatization of 351 government-owned businesses (which accounted for
almost 30% of GDP), and the implementation of voluntary retirement
programs for public employees. Military spending fell from about 14%
of GDP in the 1980s to less than 3%. As a result of these policies,
public-sector employment was reduced from 290,000 employees (24% of
the economically active population) in 1990 to 80,000 in 2000. In 1992
1993, the government established the Oce of Territorial Rationalization
and the Oce of Indemnications to resolve pending property disputes. In
1997, the National Assembly approved a new property law that facilitated
the settlement of a backlog of property conicts, and in 2000, special courts
were created to settle property disputes.
As a result of these policies, inationary pressures abated. The ination
rate dropped to 15.7% in 1992, but it remained in double digits until
2000. Monetary growth moderated signicantly while interest rates declined
to single digit. In spite of liberalization, higher government savings,
programmed reductions in import taris, and a 50% reduction in external
debt, the fragile economy was slow to react. In 1992 and 1993, the
growth rate was 0.4% and 0.4% respectively, which was partly due
to unresolved property disputes. However, positive economic growth reemerged in 1994 thereafter the economy was growing at a healthy annual
rate (the only exception was negative growth in 2009, which was due to the
global nancial crisis).
As in every hyperinationary episode, the experience had its toll on
the currency. Before 1987, the highest denomination was 1,000 cordobas.
By 1987, it was 500,000 cordobas. In 1988, one new cordoba replaced 1,000
old cordobas. In the mid-1990, one gold cordoba replaced 5,000,000 new
cordobas. Total impact of hyperination: one gold cordoba = 5,000,000,000
pre-1987 cordobas. Since 1980, the CPI rose by a factor of 3.25 106, while
the money supply increased by a factor of 8.13 1010 , the corresponding
annual compound growth rates being 62% and 125% (see Fig. 8.11).
8.16. Peru
Peru has been a high ination country since the mid-1970s even in the
1960s, ination was in double digits in 1965 and 1968. In the period 1974
1982, ination was running in double digits with a high of 75% in 1981,
a period characterized by extremely rapid monetary growth. However, it
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4.0E+08
3.0E+08
2.0E+08
1.0E+08
0.0E+00
1980
1990
2000
2010
2000
2010
Money Supply
9.0E+12
7.2E+12
5.4E+12
3.6E+12
1.8E+12
0.0E+00
1980
Fig. 8.11.
1990
The consumer price index and money supply Nicaragua.
is generally believed that the hyperination of the 1980s was caused by

the over-expansionary domestic policies of President Alan Garcia. Some
economists believe that seigniorage may have been the root cause of
ination in Peru. That is because of economic and political instability, a
August 10, 2013
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government may generate revenue to pay for programs or to nance a large

debt (for example, Ventura, 2000).
When Garcia was elected as the Peruvian president in 1985, he
promised economic reform under a program of economic heterodoxy. In
August 1985, the government launched a stabilization program aimed at
curbing ination, which was mainly based on income policies, in the form
of price and wage controls, and a xed exchange rate. This was accompanied
by expansionary monetary and scal policies. The government succeeded
in preventing a full-blown increase in ination by keeping public-sector
prices and the ocial exchange rate articially low and by nancing the
expansion in economic activity through losses in international reserves. In
the end, however, the government ran out of reserves, and this triggered
the beginning of a long hyperination. The government needed increasing
amounts of foreign currency to nance the import requirements of the
development programs than what was available after the foreign debt was
serviced. As a result, it was announced that debt service would be limited
to 10% of export earnings.
Growth was running at 10% and 8% in 1986 and 1987, respectively
while ination was down to double digits from 163% in 1985. However,
by 1988 the economy had collapsed and high ination had turned into
hyperination. During the three years 19881990, the economy lost a
quarter of its 1987 size, while ination soared to 7,481% in 1990, and the
interest rate reached a peak of 2,440%. In August 1990, a stabilization
program, similar to that of Bolivia, was launched, but it did not achieve
the same degree of success. There was a clear commitment to balancing
the budget, and for this purpose the government created a cash committee
that would operate under a strict rule of keeping payments in line with
revenues, similar to the arrangement used in Bolivia. On the monetary
side, the program aimed at restraining monetary growth, although there
were no explicit targets except for domestic credit to the government. While
the program did not use the exchange rate as the nominal anchor (on the
contrary, it allowed it to oat freely), the exchange rate was stabilized very
quickly.
The scal adjustment was primarily aided by increasing revenues
achieved by levying emergency taxes (on trade, real estate, etc.), by elimination of tax exemptions, and by raising public-sector prices (for example,
the price of petrol was increased 20 times). In addition, the government
announced an ambitious program of structural reforms with the objective
of reversing the detrimental eects of widespread government intervention.
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233
The foreign exchange market was unied, bank deposits denominated in

dollars were authorized, and the economic team quickly started to work on
reforming labor market legislation, deregulation and trade liberalization,
tax reforms, rationalization of public-sector expenditure, and privatization
of public-sector enterprises. The program was eective in bringing down
ination, monetary growth, interest rates as well as restoring economic
growth. By 1995, the ination rate was brought down to just over 10%
and by 1999 it was down to 3.5%. In 2002, it was 0.2%. During the period
19931997, the economy grew by 40%, by almost 13% in 1994 alone.
Even if we allow for low ination periods, the CPI and money supply
have risen spectacularly. Between 1960 and 2001, the CPI rose by a factor of
2.54109, at an annual compound rate of 53%. At the same time, the money
supply increased by a factor of 1.68 1010 or an annual compound rate of
59% (see Fig. 8.12). The highest denomination in 1984 was 50,000 soles de
oro. By 1985, it was 500,000 soles de oro. In the 1985 currency reform, one
intis was exchanged for 1,000 soles de oro. In 1986, the highest denomination
was 1,000 intis, rising to 5,000,000 intis by 1990. In the 1991 currency
reform, one nuevo sol was exchanged for 1,000,000 intis. The overall impact
of hyperination: one nuevo sol = 1,000,000,000 pre-1985 soles de oro.
8.17. Poland
After three years of hyperination, the 1994 currency reform saw 10,000 old
zloty exchanged for one new zloty. Poland experienced a dramatic decline
in ination from the early transition period. From a peak ination rate
of 555% in 1990, ination dropped rapidly to reach single digit levels in
1999 (7.25%), going down further to 0.8% in 2003. In recent years, Polish
ination has sometimes even been below Euro Area levels it is currently
one of the lowest in the European Union.
Several distinct phases could be distinguished in the Polish ination
of the 1980s and 1990s. After the acceleration of ination in 19801982,
reaching 103% in 1982, it slowed after the 1982 stabilization and was further
falling until 1985 when it was 11.5%. Between 1986 and 1990, ination was
accelerating as the ination rate hit a high of 555% in 1990. According
to Kolodko (1991), the huge ination acceleration was also a result of
the introduction of a general income indexation system imposed by the
Solidarity. After the power takeover by Solidarity in August of that year,
indexation rules were somewhat modied, but the change was not good
enough to stop hyperination.
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3.0E+11
2.5E+11
2.0E+11
1.5E+11
1.0E+11
5.0E+10
0.0E+00
1960
1970
1980
1990
2000
2010
1990
2000
2010
Money Supply
2.0E+12
1.6E+12
1.2E+12
8.0E+11
4.0E+11
0.0E+00
1960
1970
Fig. 8.12.
1980
The consumer price index and money supply Peru.
The more recent Polish hyperination, according to Kolodko, was

of induced character. It was to a certain extent provoked by the
macroeconomic policy carried out in a period of fundamental political
transformation in Poland. Hyperination was provoked, on the one hand,
by political struggle and, on the other hand, by the conviction that under
August 10, 2013
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235
hyperinationary conditions it would be easier to bring down the level of

real wages and reduce the value of money balances, particularly those in
possession of households. In addition, Kolodko argues, the induced quasihyperination perceived in this way resulted from the conviction that hyperination would be easier to overcome than the shortageation syndrome in
the form in which it existed immediately before. The objectives of the
transition to a market economy was an important contributory factor,
since the accomplishment of the objective required, among other things,
liberalization of prices and a deep money devaluation as well as a rise in
credit costs up to their real levels. It was felt that the achievement of the
transition objective was not possible without the help of hyperination.
The next stage, in the words of Kolodko, was a transition from galloping
price ination, with the accompanying shortages, to quasi-hyperination.
A stabilization program was structured so as to induce processes that
would lead to the formation of a mechanism of market-clearing prices, reduction in the ination rate to the lowest possible level, and restoring equilibration in the current account. The program involved ve plans of action: (i) a
scal adjustment policy aimed at balancing the budget; (ii) price liberalization; (iii) a tough monetary policy; (iv) strict control of wage; and (v) the
introduction of internal convertibility of the domestic currency. Changes in
the rules and regulations governing foreign exchange transactions meant that
rms would be obliged to sell to the state (at the stabilized exchange rate)
foreign currencies gained from export receipts, while banks would be obliged
to sell foreign currencies to importers. A decision was taken to devalue the
Polish zloty to 9,500 for one U.S. dollar a rate that was used as a nominal
anchor supporting the whole stabilization program.
The ination rate declined progressively from a high of 555% in 1990 to
7.2% in 1999. The growth rate of the money supply declined from 164% in
1990 to 11.56% in 2000. Interest rates declined from a high of 247% in 1989
to 2.2% in 2006. And while the real interest rate was 452% in 1990, it has
been consistently positive since 1993. The inationary pattern in Poland
has led to an increase in the CPI by a factor of 4,889 between 1970 and
2011. At the same time, the money supply has increased by a factor of over
38,000 (see Fig. 8.13).
8.18. Romania
Romania is a country of considerable potential: rich agricultural lands,
diverse energy sources (coal, oil, natural gas, hydro, and nuclear), a
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5.0E+05
4.0E+05
3.0E+05
2.0E+05
1.0E+05
0.0E+00
1970
1980
1990
2000
2010
2000
2010
Money Supply
4.0E+06
3.0E+06
2.0E+06
1.0E+06
0.0E+00
1970
1980
Fig. 8.13.
1990
The consumer price index and money supply Poland.
substantial industrial base encompassing almost the full range of manufacturing activities, an educated workforce, and opportunities for expanded
development in tourism on the Black Sea and in the Carpathian Mountains.
The Romanian government indulged in heavy overseas borrowing to
build a substantial state-owned industrial base. Following the 1979 oil
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price shock and a debt rescheduling in 1981, it was decided that Romania
would no longer be under the mercy of foreign creditors. By the end of
1989, Romania had paid o a foreign debt of about $10.5 billion through
an unprecedented eort that wreaked havoc on the economy and living
standards. The government decided to slash vital imports, ration food
and fuel strictly, and export everything it could to earn hard currency
(in other words, a mercantilist trade policy was adopted). Retrenchment
of xed capital formation led to a deterioration of the infrastructure to
fall behind its historically poorer Balkan neighbors. In 1991 and 1992, the
Romanian economy shrank by 21% while ination soared to triple digits
until 1995. The growth of the money supply was running at more than
100% over this period (see Fig. 8.14). The reduction in ination from
the 19911993 annual triple-digit rates to less than 33% in 1995 was the
main achievement of the stabilization program of 19931994. However, the
expansionary macroeconomic policy pursued in 1995 led to a resurgence
of inationary pressures in the middle of 1996. After the 1996 elections,
the coalition government attempted to eliminate consumer subsidies, oat
prices, liberalize exchange rates, and put in place a tight monetary policy.
The parliament enacted laws permitting foreign entities incorporated in
Romania to purchase land. Growth did not return to positive territory
until 2000, while ination remained stubbornly high.
The main cause of the persistently high ination was the general
ineciency of the economy. The underperformance of large state-owned
rms made them unable to pay debts to suppliers and to the state budget.5
The situation changed for the better as several money-losing businesses
(especially in the metallurgy, heavy industry and oil processing sectors)
were closed or privatized in recent years. In 2002, the ination rate was down
for the following reasons: (i) abatement of cost-push inationary pressure
owing to the slower pace of nominal depreciation of the domestic currency;
(ii) sluggish consumption, which can be attributed to cautious scal policy
via spending control as well as the slowdown in household demand for
non-durables; (iii) smaller adjustment of administered prices due widely
to the capping of increase in the prices of electricity and natural gas and
to the delay in raising the price of railway transport; and (iv) imported
disination.
In 2003, the ination rate was 15.27%. This was the result of the
interplay of several factors, some of them entailing positive eects and
5 Some
150 of them accounted in 1998 for more than 90% of the losses in the economy.
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5.0E+05
4.0E+05
3.0E+05
2.0E+05
1.0E+05
0.0E+00
1990
1995
2000
2005
2010
2005
2010
Money Supply
5.0E+05
4.0E+05
3.0E+05
2.0E+05
1.0E+05
0.0E+00
1990
1995
Fig. 8.14.
2000
The consumer price index and money supply Romania.
others negative eects. Among these factors are the slowdown in the
nominal depreciation of the domestic currency, smaller adjustments of
administered prices, stable taxation, and positive developments in the prices
of imported consumer and industrial goods. Among the factors that led to
a reduction of the ination rate in 2004 were strengthening of the domestic
August 10, 2013
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239
currency, lower magnitude of administered price adjustment, and recovery

of the propensity to save due to the National Bank of Romanias prudent
monetary policy stance. In 2005, the ination rate continued to decline
for the following reasons: (i) cautious monetary policy stance, with further
restrictive monetary conditions; (ii) tight scal policy; and (iii) stronger
competition in the retail sector.
The highest denomination in 1998 was 100,000 lei. By 2000, it was
500,000 lei. In early 2005, it was 1,000,000 lei. In July 2005, the lei was
replaced by the new lei at 10,000 old lei = one new lei. In 2006, the highest
denomination is 500 lei (= 5,000,000 old lei).
8.19. Russia
Russia experienced hyperination in the aftermath of the collapse of the
Soviet Union, as the ination rate peaked at 2,520%. In 1993, the annual
ination rate was 874%, and in 1994 it was 308%. The ruble was devalued
against the dollar from about 100 in 1991 to about 30,000 in 1999. During
the period 19931998, the Russian economy shrank by about 30%, which
was a depression, given that depression has been dened as a 10% decline
in output from peak to trough. The interest rate was still over 100% in
1995. The Russian hyperination was due to a rapid increase in the money
supply: during the period 19911995, the money supply increased by a
factor of 900, or at an annual compound rate of 448% (see Fig. 8.15).
Most of the state enterprises of the Soviet Union operated at a decit in
the sense that the monetary value of their products was less than the costs
of the labor and raw materials that went into producing them. Under the
Communist system, the state covered the dierence. During the transition
to capitalism, the government of Russia stopped covering those decits. The
enterprises were then faced with a choice of cutting costs, shutting down or
nding some other way to cover the decit. The only feasible way to cover
their costs was to obtain loans from the central bank that led to monetary
expansion. This happened at a time when the economy was shrinking, hence
ination was inevitable.
While a monetary explanation of ination is plausible, a conspiracy
theory has been put forward to explain the Russian hyperination (Watkins,
2008). It has been suggested that the then head of the Russian central bank,
Viktor Gerashchenko, was a dedicated communist who wanted to sabotage
the transition to capitalism, hence he allowed the money supply to increase
via lending. The conspiracy theory states that as the price level went up,
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6.0E+06
5.0E+06
4.0E+06
3.0E+06
2.0E+06
1.0E+06
0.0E+00
1992
1997
2002
2007
2012
2007
2012
Money Supply
1.0E+07
8.0E+06
6.0E+06
4.0E+06
2.0E+06
0.0E+00
1992
1997
Fig. 8.15.
2002
The consumer price index and money supply Russia.
the state enterprises had to go to Viktor Gerashchenko and the central bank
for bigger and bigger loans so the rate of ination escalated. When he was
red his replacement, Tatyana Paramonova, was able to bring the ination
rate down. This is why Jerey Sachs described Gerashchenko in 1995 as
the worst central banker in the world (Halligan et al., 1995).
Ination rebounded in 1999 when the ination rate was at 86%, but it
declined to single digit in 2010 and 2011. Interest rates have been in single
August 10, 2013
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241
digits since 2000. Between 1991 and 2011, the money supply increased by a
factor of 94,000, which translates to an annual compound rate of 77%. The
resulting increase in CPI was by a factor of 53,000 or a compound annual
rate of 72% (see Fig. 8.15).
The Russian hyperination brought about social devastation such as
the impoverishment of pensioners and the destruction of the value of lifetime
savings. A phenomenon that emerged in capitalist Russia, which is inationrelated, was the inability of people to bury the dead. Several cases have
been reported of dead bodies left on the street because that was cheaper
than bearing the cost of having them buried. This is yet another example
of the breakdown of law and order as well as the loss of morality under
hyperination.
8.20. Turkey
Turkey has been experiencing high ination rates since the 1970s. Out of the
cases we have come across in this chapter it is the only country that recorded
double digit ination for 36 consecutive years (19712006 inclusive). The
1990s was the worst decade as the ination rate did not go below 60%,
and it was 106% in 1994. However, the highest ination rate of 110% was
recorded in 1980. In 1994, over 100% ination came as the economy shrank
by 4.7%, signifying severe stagation.
Several explanations have been put forward for the persistence of
ination in Turkey, including the following (Kibritcioglu, 2005): (i) high
public-sector budget decits, (ii) monetization of public-sector budget
decits, (iii) massive infrastructure investments of various governments,
(iv) massive military expenditure, (v) political instability which results in
inationary pressures due to populist policies that have ensued prior to
each general election, (vi) persistent inationary expectations, (vii) inationary eects of changes in exchange rates via rising prices of imported
inputs, (viii) occasional increases in world prices of major imported inputs
(particularly crude oil), (ix) increases in regulated prices of public-sector
products which are mainly used as input by the domestic private sector,
and (x) rising interest rates resulting from the crowding-out eect of publicsector borrowing in a shallow domestic capital market. Some of these
explanations are interrelated. For example, the rst ve reasons could all
come under one reason: monetization of the decit. The last ve reasons
cannot cause ination of the magnitude witnessed in Turkey, and high
interest rates are not an explanation but a consequence of high ination.
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1.6E+08
1.2E+08
8.0E+07
4.0E+07
0.0E+00
1960
1970
1980
1990
2000
2010
1990
2000
2010
Money Supply
1.0E+10
8.0E+09
6.0E+09
4.0E+09
2.0E+09
0.0E+00
1960
1970
Fig. 8.16.
1980
The consumer price index and money supply Turkey.
Between 1970 and 2011, the money supply increased by a factor of 20

million at an average annual compound rate of 51%. The CPI increased
by a factor of one million at an annual rate of 40% (see Fig. 8.16). Those
changes inicted some damage on the currency. The highest denomination
in 1995 was 1,000,000 lira. By 2000, it was 20,000,000 lira. Turkey has
August 10, 2013
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243
recently achieved single-digit ination for the rst time in decades. In the
2005 currency reform, the new Turkish lira was exchanged at the rate of
one for 1,000,000 old liras.
8.21. Ukraine
Since the independence of the Ukraine from the Soviet Union in late 1991, it
has been through several inationary episodes. In 1992, price liberalization
changed the prole of ination from suppressed to open, as prices were freed
while regulated taris were revised upwards. Initial price liberalization in
January 1992 was forced by developments in Russia, where prices were
liberalized too. Having no own currency, the Ukraine had to follow suit to
avoid (or stop) the outow of goods. Pressure on prices continued as price
liberalization was incomplete while it was not matched by the adjustment
of other policies. For example, there was always the tendency to inject
liquidity into the economy as well as lobbying pressure for subsidies and
credit to enterprises.
Typical hyperinationary symptoms started to appear in 1993, including preference for barter and foreign currency transactions. The velocity of
circulation of money that was stable in 1992 was increasing substantially
due to the fall in the demand for money. In 1993, the ination rate was
4,735% while the nominal interest rate stood at 149%. The period witnessed severe stagation or rather staghyperination (or hyperstagation).
Between 1993 and 1997, the economy shrank by 50%, losing about 23% of its
size in 1994 alone. It was, however, in 1997 when a big drop of ination was
observed, as the ination rate declined from 80% to 16%. However, ination
remained in double digits until 2002 when it was almost zero. From 2005
onwards ination was on the high side, but it was in single digits in 2010
and 2011.
The initial period of very high ination was the inevitable outcome
of lax macroeconomic policy under rather dicult external and internal
conditions. The move towards a market economy was accompanied by price
liberalization as well as scal and monetary policies that accommodated
imbalances while attempting to take care of dwindling government revenue
and maintain the real value of wages, subsidies and other items of
government spending. The budge decit averaged some 20% of GDP, with
almost full monetization of the funding gap (Lissovolik, 2003). In 1993,
1994 and 1995, the monetary growth rate was 1,809%, 567% and 116%,
respectively. As Jakubiak (2005) puts it, monetary policy in this period
August 10, 2013
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244
9in x 6in
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was used mainly as a tool to provide cheap credits to enterprises and to

nance high budget decits.
In formal studies of the Ukrainian hyperination, the ination rate is
modeled in terms of a collection of factors that reect the stylized facts
then prevailing. For example, Lissovolik (2003) tried to capture the key
sources of inationary pressure in terms of the following factors: (i) the
impact of domestic nancial disequilibria (monetization of the decit and
other sources of excessive monetary growth); (ii) the role of external
disequilibria, such as external shocks and the currency factor; (iii) the
timing of administered price increases; (iv) the output gap, which may
be a cause of the re-monetization of the economy; (v) seasonality in prices
and production; and (vi) convergence of the domestic price level towards
world prices.
Stabilization measures were implemented in October 1994. These
included the lifting of the remaining price controls and scal adjustment
whereby the budget decit as a percentage of GDP was reduced from 15%
in 1994 to 5% in 1995. The central bank was released from the responsibility
of nancing the budget decit. Ination fell subsequently despite price
liberalization, as monetary growth decelerated to around 30% in 1996 and
1997. The nominal exchange rate stabilized in late 1995. The rebound of
ination in 1999 and 2000 was due to a setback in the scal adjustment
process as the budget decit went up from 3.2% of GDP in 1996 to 5.5%
in 1997.
Between 1992 and 2011, the CPI rose by a factor of 25,746, at an
annual compound rate of 71%. The corresponding gures for the money
supply are 30,354% and 72%, respectively (see Fig. 8.17). Before 1993, the
highest denomination was 1,000 karbovantsiv. By 1995, it was 1,000,000
karbovantsiv. In 1996, the karbovantsiv was taken out of circulation, and
was replaced by the hryvnya at an exchange rate of 100,000 karbovantsivi =
one hryvnya (approximately $0.20 at the time).
8.22. Zimbabwe
Zimbabwe was the rst and so far the only country experiencing hyperination in the 21st century.6 The extent of the Zimbabwean hyperination
can be judged in terms of currency denominations as dollar notes ranging
6 That
is, if we exclude Iran which started showing signs of hyperination or high ination
towards the end of 2012.
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3.0E+06
2.0E+06
1.0E+06
0.0E+00
1992
1997
2002
2007
2012
2007
2012
Money Supply
4.0E+06
3.0E+06
2.0E+06
1.0E+06
0.0E+00
1992
1997
Fig. 8.17.
2002
The consumer price index and money supply Ukraine.
from 10 to 100 billion were printed within one year. It started shortly
after the destruction of productive capacity. Between 2002 and the height
of hyperination in 2008, the economy shrank to less than its size in
2001. At the height of hyperination in 2008, it was dicult to measure
and monitor the ination rate accurately because the government stopped
publishing ocial ination statistics. Observers became very sceptical about
August 10, 2013
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9in x 6in
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the accuracy of the gures published by the Reserve Bank of Zimbabwe

(RBZ). For example, Hanke and Kwok (2009) note that even though the
RBZ produced an ever-increasing torrent of money, and with it ever more
ination, it was unable, or unwilling, to report any meaningful economic
data during most of 2008.
The last monthly gure reported by the RBZ was for July 2008, which
put the ination rate at 2,600%, implying an annual ination rate of
231,150,888%. The next gure reported was for December 2009, putting the
monthly ination rate at 0.5%. Hanke and Kwok (2009) provide ination
gures, which they calculated on the basis of purchasing power parity, that
put the monthly ination for August, September, October and November
at 3,190%, 12,400%, 690,000,000% and 79,600,000,000%, respectively.
The corresponding annual gures are 9.69 109 , 4.71 1011 , 3.84 1018
and 8.97 1022, respectively. This is a truly spectacular hyperination.7
Figure 8.18 shows the CPI and money supply in Zimbabwe since 1964.
Zimbabwe was born on 18 April 1980 from the former British colony of
Rhodesia. The Rhodesian dollar was replaced by the Zimbabwean dollar
at an exchange rate of 1:1. In its early years, Zimbabwe experienced
strong growth. In the period 19801989, the Zimbabwean economy grew
by about two thirds in 1979, recording a growth rate of 13% in 1981, the
rst full year after independence. In the 1990s, the Zimbabwean president,
Robert Mugabe, started his project of redistributing land, which brought
a sharp drop in food production and, through the multiplier eect, in
all other sectors. All indicators of economic performance and well-being
retrenched.
Hyperination in Zimbabwe was a monetary-political problem. Apart
from the destruction of productive capacity, the government resorted to
the printing press to nance involvement in the Democratic Republic of
Congo. Excessive monetary creation was under-reported to the IMF. Other
contributory factors are those related to declining production and rising
debt. In 1980, external debt as a percentage of GDP was 11%, rising to
119% in 2008. Uncontrolled government spending accompanied the weak
economy. In 1997, the government approved spending some 3% of GDP for
bonuses to 60,000 independence war veterans. The government was under
pressure not to cover this spending by raising taxes hence, the printing
of money was the way out.
7 The
data were taken from the IMF, RBZ and from Hanke and Kwok (2009).
August 10, 2013
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7.8E+29
6.5E+29
5.2E+29
3.9E+29
2.6E+29
1.3E+29
1.0E-03
1964
1972
1980
1988
1996
2004
2012
1996
2004
2012
Money Supply
4.0E+22
3.2E+22
2.4E+22
1.6E+22
8.0E+21
0.0E+00
1964
1972
Fig. 8.18.
1980
1988
The consumer price index and money supply Zimbabwe.
As disastrous as it was, some light-hearted comments have been made

about the Zimbabwean hyperination. For example, Makochekanwa (2007)
quotes the following statement:
Zimbabweans are getting stronger. About 30 years ago, it took ve people
to carry 50 Zimbabwean dollars worth of groceries. Today, a child can
carry 500,000 dollars worth of groceries.
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248
The slogan of starving billionaires emerged as ination worsened in 2008.

In its Annual Report, the Federal Reserve Bank of Dallas (2011) quotes the
following statement from The Economic Times:
A loaf of bread now costs what 12 new cars did a decade ago. A small
pack of locally produced coee beans costs just short of 1 billion
Zimbabwe dollars. A decade ago, that sum would have bought 60 new
cars.
The government attempted to stem rampant ination by controlling the

prices of basic goods and services in 2007 and 2008. To do that, the police
was used to force businesses and shops not to exceed ocial prices. The
result, naturally, was severe shortages, long lines and thriving black markets. The U.S. dollar and South African rand emerged as media of exchange
and barter became a common practice (for example, groceries for rent).
The Rhodesian dollar, adopted in 1970, following decimalization and
the replacement of the pound as the currency, was set at a rate of 2
Rhodesian dollars = one pound. At the time of independence in 1980, one
Zimbabwean dollar (of 100 cents) was worth $1.50. A series of banknotes
were issued ranging from 2 to 20. From 1994 to 2006, new notes were issued:
100, 500, 1000, 50,000 and 100,000. The last two were issued in the rst
half of 2006 as ination began to intensify. On 1 August 2006, the new
Zimbabwean dollar was issued at the rate of 1:1000. On 1 July 2007, a note
was introduced worth 500,000 new dollars (that is, 500,000,000 old dollars).
This was followed by the 750,000 note on 31 December 2007 and by the
new denominations of 1,000,000, 5,000,000 and 10,000,000 on 1 January
2008. On 2 April 2008, the 25,000,000 and 50,000,000 bills were introduced.
Then, came the 100 million, 250 million, 500 million, 5 billion, 25 billion,
50 billion and 100 billion notes between May and July 2008. On 1 August
2008, 10 zeros were slashed from the new (second) dollar and a third dollar
(worth 10 billion second dollars) was introduced.
8.23. Iran
Hyperinationary signs appeared in Iran in the second half of 2012 triggered
by international sanctions. The following signs were observed:
1. Iranians started dumping the rial and holding the dollar instead.
2. On 1 and 2 October 2012, the currency lost more than 25% of its value
against the dollar, bringing the decline since the beginning of the year
to over 80%.
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249
3. Despite subsidies, prices of staples such as bread, milk and rice, at least
doubled since the beginning of the year.
4. Shops started closing.
5. Protests erupted in the capital, Tehran.
6. A large number of currency traders have been arrested.
Estimates produced by a hyperination expert, Steve Hanke, show that
ination was running at a monthly rate of almost 70% in October 2012
(Khalaf, 2012). Although the gure may be exaggerated, the signs of
hyperination are unmistakable.
8.24. The Overall Picture
The overall picture presented by our examination of various recent hyperinationary episodes is summarized in Table 8.1 and Figs. 8.19, 8.20 and
8.21. Table 8.1, which is similar to Table 3.1, reports the growth factors
of the variables entering the quantity theory of money: prices, money
supply, output (GDP) and velocity.8 We can readily see the big increases
in both prices and the money supply, much bigger than the corresponding
gures appearing in Table 3.1. Changes in output are very small, which
means that the contribution of output growth to the ination rate under
hyperinationary conditions is minimal. Again, we cannot take changes
in velocity to explain the divergence between the growth rates of money
and prices because velocity is calculated as a residual item. What explains
the divergence is other contributory factors to ination, most notably
inationary expectations, which play an important role in sustaining
hyperination.9 For example, Weidenmier (2010) considers the role of
expectations in the hyperinationary episode of the Confederate States of
America during the American Civil War. He argues that the Confederate
citizens were forward looking, incorporating all available information in
8 The
growth factor is measured as the value of the underlying variable in 2011 relative
to its value in the base period.
9 For example, the calculated increase in velocity in the case of Zimbabwe is ridiculously
and unrealistically high. It is totally implausible that instead of conducting, say,
one million transactions a day under normal conditions, 4.65 1023 transactions are
conducted under hyperination. This enormous gure was obtained because velocity
was calculated as a residual item from the quantity equation, eectively ignoring the
role played by factors that account for the divergence between the growth rate of the
money supply and the ination rate. This also shows that the quantity theory of money
on its own cannot explain ination, not even hyperination.
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Inflation versus Monetary Growth

1200
1000
Inflation Rate (%)
800
600
400
200
0
100
200
300
400
500
600
700
800
-200
Monetary Growth Rate (%)

GDP Growth versus Inflation
15
GDP Growth Rate (%)
10
5
0
200
400
600
800
1000
1200
-5
-10
-15
-20
Inflation Rate (%)

Interest Rate versus Inflation
1600
1400
Interest Rate (%)
1200
1000
800
600
400
200
0
-200
50
100
150
200
250
300
Inflation Rate (%)
Fig. 8.19.
The overall picture in terms of growth rates.
350
400
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9in x 6in

Inflation and Monetary Growth
1.2
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
Inflation and GDP Growth
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
-1.2
Inflation and Interest Rate

1.2
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
Fig. 8.20.
The overall picture in terms of correlations.
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251
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252
Table 8.1.
Growth factors of prices, the money supply, output and velocity.
Country
Base Period
Angola
Argentina
Belarus
Bolivia
Brazil
Congo
Croatia
Georgia
Israel
Mexico
Nicaragua
Peru
Poland
Romania
Russia
Turkey
Ukraine
Zimbabwe
1990
1960
1992
1960
1981
1969
1985
1991
1960
1960
1979
1960
1970
1990
1991
1960
1992
1964
5.11 109
3.94 1012
1.06 106
4.90 106
2.98 1011
1.02 1015
8.48 105
5.17 105
1.16 105
8.02 103
3.25 106
2.54 109
4.89 103
4.52 103
5.30 104
1.52 106
2.57 104
6.17 1027
2.35 1010
1.91 1013
3.78 105
2.63 108
5.75 1012
3.74 1014
4.15 105
4.69 105
1.58 106
4.11 105
8.13 1010
1.68 1010
3.82 104
4.05 103
9.43 104
9.12 107
3.04 104
3.54 1020
3.20
4.42
2.15
4.32
2.21
1.10
1.11
0.97
14.42
7.62
1.78
6.05
2.22
1.28
1.38
9.48
0.83
2.66
0.72
0.90
6.10
0.15
0.12
3.01
2.27
1.07
0.98
0.15
0.01
0.91
0.28
1.43
0.78
0.16
0.71
4.65 1017
forming their expectations of future ination. War news was the main
determinant of inationary expectations such that an expectation of a
Confederate defeat implied higher government spending and money supply
growth in the future, which led them to bid up prices immediately.
In Fig. 8.19, we observe scatter plots of the relations between ination,
on the one hand, and, on the other hand, monetary growth, output growth
and interest rates. These plots are based on period averages covering the full
sample period as well as parts of the sub-sample periods when ination was
either very high or moderate. We can see a conspicuous positive relation
between ination and monetary growth and a negative relation between
ination and output growth. A positive relation between ination and
interest rate can also be observed. These relations are much stronger under
hyperination than under moderate ination. With respect to the inationoutput relation, the dierence between what we see here and what we saw
in Chapter 5 conrms the proposition that hyperination is much more
damaging for the economy than moderate ination. In Fig. 8.20, we observe
the sorted correlation coecients between ination and the other three
variables, which conrms the perception derived from Fig. 8.19.
Last, but not least, we compare some of the worst hyperinations in
history, including those that were considered in Chapter 7. Figure 8.21,
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Brazil
Angola
Chile
Austria
Belarus
Bolivia
Argentina
Georgia
Congo
Nicaragua
Poland
Ukraine
Peru
Taiwan
Danzig
China
Greece
Germany
Zimbabwe
Hungary
0
10
15
20
25
30
35
40
Days
Fig. 8.21.
Number of days for prices to double in the worst hyperinations.
which is based on the information provided by Hanke and Krus (2012),

shows how many days it took prices to double at the height of ination. In
the worst of these cases (Hungary), it took prices 15 hours (0.63) days to
double. In the least bad case of Brazil, prices doubled every 33.5 days. It
is horrifying to live under conditions where ones savings lose half of their
values every 15 hours or even every 35 days.
In this chapter, we examined the most serious hyperinationary episodes
since the 1970s, so that we may derive lessons for the current situation. By
far, the worst episode was that of Zimbabwe. John Williams describes the
situation in Zimbabwe at the end of hyperination as follows (Gold Report,
2010):
After devaluation upon devaluation, they successively lopped the zeros
o the bills. If you took a $2 bill that they rst issued back in the 80s
and then tried to come up with the equivalent of a $2 bill in the last
form of the currency, it would be very dicult to do because it was so
worthless. If you put a pile of those together to equal the original $2
bill, it would actually stretch from the earth to the Andromeda Galaxy.
Were talking light years. There are not enough trees on earth to print
them.
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Williams uses the Zimbabwean episode to project what could happen in a

hyperinationary U.S. He argues that the Zimbabwean economy functioned
because of a back-up system, which was a black market in the U.S. dollars.
Since it does not have such a back-up system, the U.S. will be in a worse
shape under hyperination.
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Chapter 9
THE STATUS QUO: HEADING

TOWARDS HYPERINFLATION?
9.1. The Road to Hyperinflation
When the scal decit and public debt become unsustainable, the
government faces a tough choice. If there is no scope for boosting revenue
by raising taxes or borrowing, the choice is between austerity (reducing
spending) and printing money. Austerity is a vote-loser as it is deationary,
recessionary and painful (look at what is happening in Spain and Greece
these days). That leaves the printing press as the only way out. Consider
Spain, for example. In October 2012, Spains credit rating was put down
to the vicinity of junk bonds as the rating was brought down from BBB+
to BBB, which means that the next station would be a full-edged junk
status. The change in credit rating has undermined the ability of Spain to
borrow, at least at reasonable interest rates, as investors demand higher risk
premia on Spanish government bonds. Spain is not in a position to boost
revenue by raising taxes, given the state of the economy and popular revolt
against austerity. And because Spain is in a currency union (the European
Monetary Union), it cannot resort to the printing press, which is under the
control of the European Central Bank (ECB). That leaves austerity as the
only way out. However, monetary implications for the European Union as
a whole may arise if the ECB purchases Spanish bonds by printing more
euros.
The tough choice between austerity and the printing press is a choice
between pain today and pain tomorrow. Resorting to the printing press, as
we have seen, has been the easy choice that always brought about economic
catastrophe. It is here once again under the name quantitative easing
(QE), a policy whereby the worlds big four central banks (the U.S. Federal
Reserve, European Central Bank, Bank of England and Bank of Japan)
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have since 2008 produced trillions of dollars worth of fresh money. This
production of money has taken one of two forms: directly through bond
buying, as in the U.S. and U.K., or in a more oblique form of cheap longterm lending by the ECB to commercial banks. The U.S. is already in the
third round of QE, having gone through QE1 and QE2. Governments in
these countries have opted to resort to the printing press as they watch the
unpleasant conditions caused by austerity in Greece and Spain. Conspiracy
theorists believe that the Federal Reserve is indulging in QE for the sole
purpose of saving banks at the expense of the whole economy (in other
words, saving Wall Street at the expense of Main Street). For example,
Williams (2012) believes that the Federal Reserve and the U.S. Treasury
moved early in the current solvency crisis to prevent a collapse of the
banking system, at any cost.1 He further believes that attempting to
push the big problems further into the future continues to be the working
strategy for both the Fed, under Chairman Ben Bernanke, and the current
Administration and Congress.
While the Federal Reserve has opted to go for yet another round of
QE, the Bank of England voted on 10 May 2012 not to provide further cash
injection (that is, to put an end to QE) as concerns over ination outweighed
the risk of a prolonged recession. Putting an end to quantitative easing
in the U.K. may make life more dicult for the Conservative-led ruling
coalition, which was battered in local elections in May 2012, because loose
monetary policy can be used to soften the pain of the austerity measures
aimed at reducing the countrys huge public borrowing. But after buying
325 billion pounds worth of government debt with freshly-baked money,
50 billion pounds of which has been purchased during FebruaryApril
2012, the Bank of England has judged that its policy stance is adequately
supportive. The minutes of the Monetary Policy Committees April 2012
meeting show that ination worries had become more dominant, forcing a
policy U-turn. This does not seem to be happening in the U.S., perhaps
because conspiracy theorists are right about the intentions of the Fed or
because of the belief that quantitative easing is benign, particularly when
the economy is weak.
1 Williams
(2012) points out that the Federal Reserve is not a government entity, but
rather a private corporation owned by private banking interests. Hence, irrespective of
federal government mandates that the Fed pursues policies to maintain stable economic
growth and to contain ination, the Feds primary mission has been to protect the
banking system, to keep the system solvent and protable.
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257
As things stand towards the end of 2012, neither the budget decits
of many large countries nor the speed of the current global monetary
policy expansion are sustainable. If government nances do not improve
and the global monetary expansion is not brought under control in time,
hyperination could set in. The rst of the two ifs is a big if indeed, as it is
much more dicult to correct scal imbalances than to avoid the printing
press, particularly in the short run. It is not clear how much scal and
monetary policies can expand before a loss of condence in paper money
sets in. As far as inationary trends are concerned, the situation is more
alarming in the U.S. than in any other major country. Still many observers
believe that the risk of deation is more serious than the risk of ination.
Strong arguments against this view will be presented.
9.2. Fiscal and Monetary Indicators Worldwide

Currently, hyperination is a concern for some major countries because
hyperinationary symptoms are emerging: large scal decits have forced
austerity and deleveraging, which central banks have responded to with
large-scale monetary easing. According to a report authored by UBSs
Caesar Lack, the risk of hyperination is greatest in the U.S. and the U.K.
(Nisen, 2012).
The more the scal situation deteriorates and the more central banks
debase their currencies by printing more, the higher is the risk of a loss
of condence in the future purchasing power of money. It follows that
the leading indicators of hyperination pertain to the scal situation and
monetary policy stance. However, current budget decits and the central
bank balance sheets may not be sucient to indicate the sustainability
of the scal or monetary policy stance and thus the risk of hyperination.
The scal situation can worsen without aecting the current scal decit
for example, when governments assume contingent liabilities of the banking
system or when the economic outlook deteriorates unexpectedly. Similarly,
the stance of monetary policy can change without any consequences for the
size of the central bank balance sheet. This happens, for example, when
central banks alter collateral requirements or interest rates, in particular,
the interest rate paid on reserves deposited with the central bank. We know
from historical experience that conditions can worsen quickly, igniting
hyperination when no one is prepared for it. A signicant deterioration of
the scal situation or a sizeable monetary expansion in large-decit countries boosts the probability of the advent of hyperination.
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258
2009 (Actual)
Norway
Switzerland
Sweden
Finland
Germany
Australia
Canada
Italy
France
OECD
Portugal
U.K.
Spain
U.S.
Ireland
Greece
-20
-15
-10
-5
10
15
2013 (Projected)
Norway
Sweden
Switzerland
Italy
Australia
Germany
Finland
Spain
Portugal
France
Canada
OECD
Greece
U.K.
Ireland
U.S.
-10
-5
Fig. 9.1.
10
15
Fiscal balance as a percentage of GDP.
Let us examine the scal and monetary indicators, starting with the
scal balance as a percentage of GDP. Figure 9.1 shows the scal balance to
GDP ratio for a number of OECD countries in 2009 and what is projected
by the OECD for 2013. Out of the 15 countries listed, only two (Norway
and Switzerland) had budget surpluses in 2009 when huge decits arose as
a result of the global nancial crisis. Not surprisingly, Greece and Ireland
had the worst indicators as the scal decits in these two countries were
15.8% and 14.2% of GDP, respectively. The U.S. was just less bad than
Ireland at 11.6%. However, it is projected that by 2013, the U.S. will be
in the worst position with a decit to GDP ratio of 8.3%. Greece, Spain,
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0
2006
2007
2008
2009
2010
2011
2012
2013
-5
-10
-15
-20
-25
-30
-35
Ireland
Fig. 9.2.
Italy
Portugal
Spain
U.S.
Actual and projected scal balances as a percentage of GDP.
Ireland and Italy are expected to be in a better shape as judged by this

indicator. It is interesting that the bottom three countries (the U.S., the
U.K. and Ireland) are those that went too far in allowing banks to do
whatever they wanted then rescued them with taxpayers money.
In Fig. 9.2, we observe the scal balance to GDP ratio for the U.S.,
Spain, Portugal, Italy and Ireland between 2006 and what is projected by
the OECD for 2013. We can see the big anticipated improvement in the
case of Ireland, but the U.S. will end up at the bottom of the league.
The dierence is that other countries have gone for pain today (austerity)
while the U.S., it seems, is going for pain tomorrow (hyperination). It
must be mentioned here that, apart from the U.S., all other countries
shown in Fig. 9.2 have taken drastic measures to put their scal aairs
in order (thus choosing pain today). For example, Spain has announced
a series of measures to reduce the decit as a percentage of GDP by 1.1
percentage points. These measures include spending cuts and temporary
tax hikes on income, capital and high-value homes. In Italy, a package
was approved in December 2011 to bring the budget back into balance
on a cyclically-adjusted basis. The measures include the re-introduction of
real estate taxes on primary residences as well as other measures to slash
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Cyclically-Adjusted Fiscal Balances

Italy
Germany
Euro zone
Spain
Portugal
Greece
Ireland
Total OECD
U.K.
U.S.
-8
-7
-6
-5
-4
-3
-2
-1
Underlying Fiscal Balances

Italy
Germany
Euro zone
Spain
Greece
Portugal
Ireland
Total OECD
U.K.
U.S.
-8
Fig. 9.3.
-7
-6
-5
-4
-3
-2
-1
Cyclically-adjusted and underlying scal balances as a percentage of GDP.
pension spending, In Portugal, new adjustment measures were incorporated

in the 2012 budget including spending cuts and broadening of the VAT tax
base. In Fig. 9.3, we observe that the U.S. and the U.K. are in the worst
scal positions measured by the ratio of cyclically-adjusted scal balance
and the underlying scal balance as a percentage of GDP.2 But, while the
British government is trying to do something about the decit (without
2 The
ratio of cyclically-adjusted balance as a percentage of GDP is the ratio of the

balance to potential GDP. The underlying scal balance is the scal balance adjusted
for cyclical and one-o events.
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Japan
Greece
Italy
Portugal
U.S.
France
U.K.
Canada
Germany
Egypt
Brazil
Pakistan
Switzerland
Finland
Belarus
Mexico
Argentina
Turkey
New Zealand
Sweden
Australia
Bulgaria
Cameroon
Kazakhstan
Azerbaijan
50
Fig. 9.4.
100
150
200
250
300
Gross public debt as a percentage of GDP (2012).
cutting spending on the so-called nuclear deterrence, of course), American

politicians have been engaging in a circus-like negotiations to avert the
scal cli.3
In Fig. 9.4, we see gross public debt as a percentage of GDP.4 Japan
has absolutely the highest public debt to GDP ratio of 238%, followed
by three European countries that are currently in trouble, then the U.S.
If we look at Fig. 9.5, we see the projected public debt to GDP ratios
until 2016 as envisaged by the OECD. We can see that over the period
20112016, the U.S. will witness deterioration of the debt/GDP ratio,
3 The
British government is doing the right thing by taking austerity measures, but the
pain that is being inicted on the population can be reduced by curtailing spending on
the military. Apart from the nuclear deterrence, billions of pounds have been spent on
the production of drones that so far y but do not come back.
4 A comparison of public debt across countries can be problematical. To start with, there
is a dierence between public debt and government debt. Public debt is that part
of government debt held by the public (private individual and institutional investors).
Total government debt is the sum of public debt and intergovernmental debt, such as
the debt held by Medicare and social security. Distinction is also made between gross
debt and net debt: gross debt is total liabilities outstanding while net debt is gross debt
minus government-owned nancial assets. Then, there is the issue of how the public
sector is dened, whether it covers the federal government only or includes state and
local governments.
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262
200
180
160
140
120
100
80
60
40
20
0
2 011
2012
20 13
Greece
Fig. 9.5.
2014
Italy
Turkey
20 15
U.K.
2 016
U.S.
Actual and projected gross public debt as a percentage of GDP.
unlike some countries that are typically characterized by the lack of scal
discipline. Again it is because, unlike the U.S., these countries are trying
to do something about the scal mess. A stark dierence between the U.S.
and everyone else is that the U.S. has absolutely the lowest tax revenue
to GDP ratio, apart from tax-free countries (such as Kuwait and Qatar)
and countries where the tax collection system is rudimentary. In Fig. 9.6,
the U.S. is seen to have lower tax revenue to GDP ratio than Zimbabwe,
Greece, Ireland and any other country. It is not that the U.S. tax collection
system is more rudimentary than that of Zimbabwe it is because the
prevailing ideology in the U.S. dictates that a high tax revenue/GDP ratio
is indicative of a large government, which is perceived to be bad for the
economy. In Fig. 9.7, the U.S. is second only (and just) to Ireland, which
has the worst net operating scal balance as a percentage of government
spending.5
5A
measure of the scal decit as a percentage of GDP is a criterion used by Bernholz

(2003) to predict the timing of hyperination. An operating decit indicates that the
government must borrow or sell assets to nance its spending. By denition, the net
operating balance excludes interest payments.
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Zimbabwe
Denmark
Sweden
Belgium
France
Norway
Finland
Italy
Germany
Netherlands
Cyprus
U.K.
Argentina
Luxembourg
Czech Republic
New Zealand
Canada
Ireland
Greece
Japan
U.S.
10
Fig. 9.6.
20
30
40
50
60
Tax revenue as a percentage of GDP.
Germany
Australia
Italy
Portugal
France
Canada
Japan
U.K.
Spain
Greece
U.S.
Ireland
-30
-25
Fig. 9.7.
-20
-15
-10
-5
Net operating balance as a percentage of spending.
9.2.1. Monetary indicators

Figure 9.8 shows the monetary base and money supply, both measured
as indices, during the period December 2006December 2011. The U.S. is
the odd one out because of the seriousness of quantitative easing. First,
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U.S.
Eurozone
350
150
300
140
250
130
200
120
150
110
100
100
50
2006M 12 2007M 12 2008M 12 2009M 12 2010M 12 2011M 12
Monetary Base
90
2006M 12 2007M 12 2008M 12 2009M 12 2010M 12 2011M 12
Money Supply
Monetary Base
U.K.
Money Supply
Canada
160
140
130
140
120
120
110
100
100
90
80
2006M 12 2007M 12 2008M 12 2009M 12 2010M 12 2011M 12
2006M 12 2007M 12 2008M 12 2009M 12 2010M 12 2011M 12
Monetary Base
Money Supply
Fig. 9.8.
Monetary Base
Money Supply
Monetary indicators (indices).
we observe two big jumps in the monetary base, most likely caused by
the initiation of QE1 and QE2 (the period does not cover QE3).6 Second,
while the money supply and monetary base grew in tandem earlier in the
period, the initiation of quantitative easing led to an explosive growth in
the monetary base while the money supply kept on growing at a moderate
pace. The only explanation for this divergence in growth rates is that the
6 See
next section for some details on QE1, QE2 and QE3.
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265
increase in the monetary base was not translated into growth in the money
supply because banks have been reluctant to extend loans, choosing instead
to accumulate reserves. This tendency has prevented a credit expansion and
consequently a monetary expansion.
In the U.K., the eect of quantitative easing does not show as in the
U.S. case, most likely because the increase in the monetary base happened
more gradually (or it could be that most of the activity took place in the
rst half of 2012 before a decision was taken to put an end to quantitative
easing). Over the whole period, the money supply moved in tandem with
the monetary base, unlike the situation in the U.S. In the Eurozone, the
monetary base grew faster than the money supply while the Canadian
money supply grew faster than the monetary base. These are reections
of dierences in the portfolio behavior of banks (and perhaps the public)
as described by the money multiplier model.
In Table 9.1, the annualized monthly growth rates of the money supply
and monetary base are reported for the period December 2006August 2008
and September 2008December 2011. We can see in the case of the U.S. the
acceleration of monetary base growth after September 2008, which grew at
a much higher rate than that of the money supply. The vast dierence in
the growth rates of the monetary base in the U.S. and elsewhere show the
extent of indulgence in quantitative easing in the U.S. compared to other
countries.
9.2.2. The situation in general
According to many observers, the situation is alarming in general. Bonner
(2009) argues that the worlds governments will need $1 trillion per month
in nancing, and wonders who has that kind of money? He points
out that neither the U.S. government, nor the Chinese government
not even Warren Buett has this kind of money. In particular, he
Table 9.1.
Annualized monthly growth rates of monetary aggregates.

2006:122008:8
Canada
U.S.
U.K
Eurozone
2008:92011:12
Monetary Base
Money Supply
Monetary Base
2.51
1.63
5.31
9.18
6.95
0.57
9.72
7.38
5.41
33.65
5.50
6.34
Money Supply
10.32
13.48
2.87
6.07
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highlights the problem of paying interest on growing debt. The low interest
environment has been maintained by monetary easing but this cannot last
forever.
Evans-Pritchard (2010) uses the evidence produced by Peter Bernholz
in his Monetary Regimes and Inflation to explain why the situation in
the U.S. and Japan is worrying. According to this evidence, prices start
to spiral into the stratosphere once the decits as a share of government
expenditure rises above a third and stays there for several years. Hence,
Japans decits are already within the hyperination red ag zone
identied by Bernholz who shows that the range for the ve hyperinations
is surprisingly wide, ranging between 33% and 91%. Evans-Pritchard (2010)
explains that Japan has been in that range almost continuously for the
last eight years, while the U.S. joined the party in 2009. The massive
Japanese indebtedness has been so far nanced by the Japanese themselves.
This is how Bonner (2009) puts it
The Japanese saved 20% of their household incomes in 1980. But the
Japanese are aging. When they retire, people cease saving and begin
drawing on savings to cover living expenses. At the current pace, the
household savings rate should fall to zero in 5 years. Then, who will buy
Japans bonds? Who will cover Japans decits? The same people who
are supposed to cover Americas decits?
Evans-Pritchard (2012) argues that Japan is dangerously close to blowing

up on its sovereign debts, with consequences that will be felt across the
world. The only reason why this has not yet blown up is that investors
(mostly Japanese) have not yet had the leap in imagination required to
understand their predicament, and act on it. However, Fernando (2010)
argues that hyperination in Japan will have severe repercussions for the
U.S. or as he puts it Japanese hyperination could turn the dollar into
toilet paper. We will come back to this point later.
While the scal outlook is not that good for most OECD countries, it
is particularly gloomy for the U.S. Williams (2012) believes that the euro is
used as a foil against the dollar and that the United States remains the
elephant in the bathtub of sovereign solvency problems. We have already
seen that, unlike the U.S., the European countries facing scal distress have
taken painful measures to make things better. Other countries, which are in
less serious trouble, have likewise taken corrective measures. For example,
Germany has passed a balanced budget constitutional amendment, the
U.K. has launched a four-year plan to deal with the decit and France
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has raised the pension age. The U.S., on the other hand, has no taste
for austerity measures, which is justied by saying that the economy is
not in a good shape for taxes to be raised. It is, however, ideology rather
than macroeconomic conditions that motivate the U.S. distaste for austerity
measures.
9.2.3. Another indicator: The price of gold
Perhaps a good indicator of the forthcoming hyperination is the skyrocketing price of gold. Due to its long standing as the foremost, non-inatable,
liquid alternative currency, gold is the rst destination for wealth eeing
from paper money into real assets. Gold can be considered a hyperination
hedge, and its price can be considered an indicator for the probability
of hyperination. A sudden rise in the price of gold would be a warning
sign that the risk of hyperination is increasing, in particular, if it went
along with a worsening of the scal situation in the decit countries
and an easing of monetary policy. Figure 9.9 shows the price of gold
in the U.S. dollar per ounce over the period since 1970 with a superimposed trend. It shows the exponential rise in the price in recent years.
In Fig. 9.10, we show the average annual percentage rise in the price
2000
1600
1200
800
400
0
1970
1976
1982
1988
1994
2000
-400
Fig. 9.9.
The price of gold ($/ounce).
2006
2012
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25
20
15
10
0
AUD
Fig. 9.10.
CAD
CHF
JPY
CNY
EUR
USD
GBP
INR
Average annual rise in gold price in currency terms (20032012).
of gold in terms of several currencies since 2003. The annual increase

in the price of gold ranges between 11.3% against the Australian dollar
(AUD) and 19.2% against the Indian rupee (INR). The recent acceleration
of the golds price must, at least in part, reect mounting inationary
expectations.
9.3. Quantitative Easing
Quantitative easing has become common in the aftermath of the global
nancial crisis and the great recession. The practice involves the creation
of money and injecting the newly created money into the domestic economy,
typically by buying securities from banks and other nancial institutions.7
The underlying idea is that the new money will ow (in the form of loans)
from banks to other areas of the economy where they are needed, boosting
spending, production and investment. Specically, long-term bonds are
bought with newly printed money, pushing up prices and reducing yields,
thus providing a boost to growth when short-term interest rates are
7 It
may also take the form of giving direct loans to banks nanced by newly created
money.
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269
close to zero. This is how the Bank of England describes quantitative

easing8 :
This policy of asset purchases is often known as Quantitative Easing.
It does not involve printing more banknotes. Furthermore, the asset
purchase programme is not about giving money to banks. Rather, the
policy is designed to circumvent the banking system. The Bank of
England electronically creates new money and uses it to purchase gilts
from private investors such as pension funds and insurance companies.
These investors typically do not want to hold on to this money, because
it yields a low return. So they tend to use it to purchase other assets,
such as corporate bonds and shares. That lowers longer-term borrowing
costs and encourages the issuance of new equities and bonds.
This description of quantitative easing has two aws, deliberately inserted

to evade the truth: (i) quantitative easing does not involve printing
banknotes, and (ii) it is not about giving money to banks. The reason
why the Bank of England stresses the point that quantitative easing does
not involve printing banknotes is to give the impression that the policy
has no inationary consequences this is not the truth, the whole truth
and nothing but the truth. There is no dierence, as far as the inationary
consequences are concerned, between creating money by printing physical
notes and by doing it electronically in both cases, the subsequent increase
in purchasing power is bound to have inationary consequences. As to
claiming that quantitative easing is not about giving money to banks,
Randazzo (2012) makes the following comment:
Quantitative easing a fancy term for the Federal Reserve buying
securities from predened nancial institutions, such as their investments
in federal debt or mortgages is fundamentally a regressive redistribution program that has been boosting wealth for those already engaged
in the nancial sector or those who already own homes, but passing
little along to the rest of the economy. It is a primary driver of income
inequality formed by crony capitalism. And it is hurting prospects for
economic growth down the road by promoting malinvestments in the
economy.
Even worse, quantitative easing is portrayed as an action that is dictated

by a depressed economy. Williams (2012) argues that quantitative easing
8 See
http://www.bankofengland.co.uk/monetarypolicy/Pages/qe/default.aspx.
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was an eort to provide the banking system with adequate liquidity, but
the related actions were sold to the public and the media as an eort to
boost economic activity.
There is yet another aw in the description of quantitative easing as
put forward by the Bank of England. If investors perceive QE to have
inationary consequences, the last thing they want to buy is bonds
they would rather rush to buy gold. Then it does not make any sense that
pension funds and insurance companies sell gilts (government securities)
and use the proceeds to buy new bonds when interest rates are so low that
the possibility of future capital gains is almost non-existent. The argument
that low interest rates on their own encourage investment seems to ignore
the more logical argument that you can take the horse to the water but
you cannot force it to drink. Is not this the era of cash is king?
Central banks that indulge in quantitative easing stress the distinction
between creating money to buy nancial assets and to buy goods and
services the latter representing a monetization of the decit. The
underlying idea is that buying bonds from banks is dierent from buying
bonds directly from the government only the latter constitutes a
monetization of the decit. Ben Bernanke, for example, remarked once
that the government would not print money and distribute it willy nilly
but would rather focus its eorts in certain areas (for example, buying
federal agency debt securities and mortgage-backed securities) (Wolf, 2008).
According to Robert McTeer, former president of the Federal Reserve
Bank of Dallas, there is nothing wrong with printing money during a
recession, and quantitative easing is dierent from traditional monetary
policy only in its magnitude and pre-announcement of amount and timing
(McTeer, 2010). However, Richard Fisher, president of the Federal Reserve
Bank of Dallas, warned of the risk of being perceived as embarking on the
slippery slope of debt monetization, suggesting that once a central bank is
perceived as targeting government debt yields at a time of persistent budget
decits, concern about debt monetization quickly arises (Fisher, 2010).
He reached the conclusion that the Fed is monetizing the government debt.
This is how he puts it:
The math of this new exercise is readily transparent: The Federal Reserve
will buy $110 billion a month in Treasuries, an amount that, annualized,
represents the projected decit of the federal government for next year.
For the next eight months, the nations central bank will be monetizing
the federal debt.
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The use of the printing press or the computer to create money makes no
dierence for the consequent eect on the money supply on ination. This
is how Jericho (2012) puts it:
Quantitative easing is the rather weasel-word phrase given to when the
central bank buys a stack of bonds, which has the eect of increasing
the money supply in the economy essentially printing more money
(but doing it electronically).
It seems that central bankers nd it dicult to sell the idea that quantitative easing is benign. Bill Gross, who manages a $237 billion fund, thinks
that quantitative easing is like a Ponzi scheme, arguing that he will not
buy Treasuries until the Fed stops doing it (The Economist, 2011a). Adam
Fergusson, the author of an inuential book on the German hyperination,
thinks that there is no dierence between quantitative easing and what the
German central bank did in the 1920s. This is what he thinks of quantitative
easing (Fergusson, 2010):
Money may no longer be physically printed and distributed in the
voluminous quantities of 1923. However, quantitative easing that
modern euphemism for surreptitious decit nancing in an electronic
era can no less become an assault on monetary discipline. Whatever the
reason for a countrys decit necessity or proigacy, unwillingness
to tax or blindness to expenditure it is beguiling to suppose that if
the day of reckoning is postponed economic theory will come in time to
prevent higher unemployment or deeper recession.
He also writes:
It is alarming that some respected bankers and economists today, in the
U.S. as in Britain, are still able to command the printing press (in so
many words!) as a fail-safe, a last resort. A countrys budget can indeed
be balanced in that way, but at the cost, to whatever degree, of its
citizens savings and pensions, their condence and trust, their morals
and their morale.
While the Bank of England and Federal Reserve try hard to give the impression that QE is a legitimate means of reviving the economy, it is not an
easy job to convince the public that QE has no inationary consequences.
Whether money is produced by a printing press or a computer makes no
dierence. Ringer (2009) describes quantitative easing as a dumb and
idiotic venture, considering the venture as signaling a hyperinationary
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strike. There is, however, an element of truth in the claim that quantitative
easing is intended to revive the economy, except that no one central banker
would tell you how it is intended to do that. One way to encourage
consumption is to boost inationary expectations so perhaps the main
objective of quantitative easing is that, to boost inationary expectations.
Bernanke is also quoted as saying that quantitative easing is an
inappropriate description of what should be called securities purchases.
This is how von Greyerz (2010) responds to Bernankes remark:
Who is he kidding? What the Fed is buying has nothing to do with
securities. There is no security whatsoever in the rubbish the Fed is
purchasing. They are buying worthless pieces of paper with worthless
pieces of paper. This is the Ponzi scheme of all Ponzi schemes.
Some observers go as far as accusing Bernanke of pursuing policies that

are identical to those adopted by Rudolf Havenstein, the governor of
the Reichsbank during the German hyperination. Turk (2009) thinks so,
suggesting that Mr Bernanke is creating more currency by creating more
debt, which is the singular underlying cause of hyperination.
9.3.1. QE1, QE2 and QE3
On 13 September 2012, the Federal Reserve announced that it would launch
round 3 of quantitative easing known as QE3. In an 11-to-1 vote,
a decision was taken to launch a new $40 billion a month, open-ended,
bond purchasing program of agency mortgage-backed securities and also
to continue extremely low interest rates policy until at least mid-2015.
Jensen (2012) describes QE3 as eectively a stimulus program which allows
the Federal Reserve to relieve $40 billion dollars per month of commercial
housing market debt risk with no maximum amount or time limit. Egan
(2012) believes that the Feds decision (to initiate QE3) will hurt the
U.S. economy and, by extension, credit quality. The only member of
the Federal Open Market Committee to vote against QE3, the Richmond
Federal Reserve Bank President Jerey Lacker (2012), said:
The impetus . . . is to aid the housing market. Thats an area thats fallen
short in this recovery. In most other U.S. post-war recoveries, weve seen
a pretty sharp snap back in housing. Of course, the reason it hasnt
come back in this recovery is that this recession was essentially caused
by us building too many houses prior to the recession. We still have a
huge overhang of houses that havent been sold that are vacant. And,
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its going to take us a while before we want the houses we have, much
less need to build more.
Before QE3, the Fed initiated QE1 and QE2. QE1 was launched in late
November 2008 in response to the global nancial crisis, with the objective
of buying mortgage-backed securities and Treasury bills in order to boost
the economy. By June 2010, the Fed had bought about $2.1 trillion worth
of assets. QE2 started in August 2010 with the objective of buying up
Treasury bonds.
According to Jericho (2012), the big dierence this time is that QE3,
unlike the rst two, is open ended in the sense that the rst two times were
short injections of monetary policy stimulus, but this time the Federal
Reserve announced it would buy around $85 billion worth of bonds and
mortgage backed securities per month, but that it will keep doing it until
there is substantial improvement in the labor market.9 This, according
to Jericho is a big change and signals that the Federal Reserve has
shifted from targeting ination towards targeting nominal GDP growth.
So, Jericho emphasizes the inationary consequences of QE3 because it
doesnt actually cost the U.S. government anything to buy the bonds i.e.,
it doesnt go into debt by $85 billion a month but what it does do is reduce
the value of the U.S. currency, and when that happens, ination rises.
The Fed repeatedly says that it can reverse quantitative easing
whenever it wishes by selling the bonds it has acquired. This sounds like an
alcoholic declaring with a high degree of condence that he or she can quit
booze any time. Just like quitting booze is not easy for an alcoholic, stopping
quantitative easing is not easy for the Fed, particularly if stopping
involves selling the accumulated bonds. The Fed has accumulated trillions
of dollars worth of Treasuries it will be a task of monumental proportions
to nd buyers under the present and anticipated circumstances. The
Economist (2011a) makes it clear that it is easy to start quantitative easing
but dicult to get out of it. If the Fed cannot sell the Treasury bonds it
has acquired from banks, then that will be eectively a monetization of the
decit.
A term that is related to quantitative easing is that of Operation
Twist. In September 2011, the Federal Reserve announced the operation,
9 This
announcement was made on 12 December 2012. The extension of operations and

relating QE to the labor market has been dubbed QE4. We will come back to this
point later.
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a stimulus move reviving a policy from the 1960s. The policy involved
selling $400 billion in short-term Treasuries in exchange for the same
amount of longer-term bonds, starting in October and ending in June 2012.
The operation was designed to bring down yields on long-term bonds,
while keeping short-term rates little changed. The objective was to push
down interest rates on everything from mortgages to business loans, giving
consumers and rms an additional incentive to borrow and spend money.
The operation has been criticized on the grounds that interest rates were
already low.
9.4. Hyperinflation in the U.S.: Why and Why Not
A strong case for the proposition that the U.S. is unlikely to experience
hyperination, despite the current developments, has been put forward by
OBrien (2012) who argues that fears of hyperination in the United States
are almost certainly unfounded because the countries that have suered
the pain of a worthless currency share very little with the United States.
Hyperination, OBrien argues, is typically associated with war, revolution
or terribly bad economic policy (such as the land reform in Zimbabwe),
which are not symptoms of the U.S. However, OBrien also suggests that
the economic collapse begets a collapse in tax revenues, which makes
the government look like a terrible credit risk. This government will be
cut o from international lenders, the government is left with a gaping
hole in its budget, and no way to ll it. He adds:
It gets worse. These governments usually have piles of foreign debt
to pay o, too. Whether its from reparations or excessive borrowing
doesnt matter so much. What matters is that big chunks of what cash
the government does have is earmarked for foreign creditors. Thats
politically toxic in a society going through a collapse. For politically weak
governments, the temptation to substitute an ination tax for actual
taxes is enormous.
According to OBrien, however, the U.S. is in a dierent position because

the U.S.: (i) does not have any problems selling sovereign debt, (ii) is not
actually printing money, and (iii) is a highly productive economy. On the
rst point, OBrien argues that unlike Hungary in the 1940s, investors
are scrambling to buy Treasuries even though interest rates are very low.
On the second point, he argues that quantitative easing is not really printing
money, but rather swapping one asset (cash) for another (bonds). Thus,
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whatever money the Fed prints is stuck in the banks. That money,
according to OBrien, isnt inationary as long as the banks dont lend
it out. If banks decided to lend the money out, the Fed can respond by
raising the interest on excess reserves or require the banks to set aside more
money.10 On the third point, he argues that its very dicult to have
hyperination when you still have a functioning economy. Even though
the U.S. economy is not in a terribly good shape, it has not experienced
huge economic shocks that devastate an economy so much that lenders
think printing money is the only solution to growth.
It is not dicult to respond to OBriens arguments because they are
awed. The U.S. may not have a problem selling sovereign debt for the
time being for several reasons, the two important being the situation in
Europe and the Basel accords that encourage the holding of sovereign
debt by nancial institutions. At one time, Greece had no problem selling
sovereign debt but things have changed dramatically, as we all know. It is
not about the situation now it is about the fact that the U.S. has already
begun the journey along the Hazard Highway towards hyperination
as we are going to demonstrate later. Furthermore, the gures on the
foreign ownership of the U.S. debt tell us a dierent story from the one
portrayed by OBrien. For example, the biggest foreign holder of Treasury
securities, China, reduced its holdings by 9% between September 2011
and September 2012. Figure 9.11 shows that total foreign ownership of
Treasuries is leveling o. The gures do not indicate any scrambling
to buy Treasuries as OBrien claims (on the contrary they show lost
appetite). Given also the stock of Treasuries accumulated by the Fed as
a result of QE, there is probably a glut of Treasuries. It will become
increasingly dicult to sell the U.S. government debt, particularly to the
largest collector, China.
The second argument that the U.S. is not printing money takes us
back to a point that we discussed earlier and reached the conclusion that
quantitative easing involves the creation of new money and that using the
printing press is not dierent from using the computer to create fresh money
in so far as the eect on the money supply and ination is concerned.
The argument that what happens under QE is a mere swap of cash for
bonds is valid but where does the cash come from? It comes from the
computer. Monetary expansion has not yet caused ination because banks
10 Setting
aside more money presumably means raising reserve requirements.
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5500
5400
5300
5200
5100
5000
Jan-12
Feb-12
Fig. 9.11.
Mar-12
Apr-12
May-12
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
Total foreign ownership of the U.S. treasuries ($ billion).
are not lending their excess reserves. Given that the reserve/deposit ratio
is at a historical high, it is unlikely that banks will keep on accumulating
reserves because they may as well go out of business. The proposition that
the Fed can respond to an increase in lending by raising interest rates
does not make sense because such an action will be counterproductive from
the Feds perspective. Quantitative easing and Operation Twist have been
implemented for the very reason of keeping interest rates low. Given that
banks reserve ratio is extremely high, there is no scope for the Fed to raise
reserve requirements.
Then, there is the claim that buying bonds by creating money is
dierent from buying goods and services. It is not the only dierence
is the time lag. If the U.S. government does not buy goods and services
directly, the inationary eects will be delayed. It takes time for the eect
to run from monetary base expansion to rising bank reserves to expanding
credit to the private sector and consequently monetary expansion and
ination. But, then who says that the U.S. government is not buying
goods and services directly? A plausible explanation for why the U.S.
government uses money printing to ll the budget gap can be found in
the size of the budget decit relative to that of the trade decit. The
argument goes as follows: the federal budget decit is more than twice the
trade decit hence, the foreign sector is supporting less than half while
Fed printing supports the rest. And because there are signs that foreign
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400
200
-200
-400
-600
-800
-1000
-1200
-1400
-1600
1980
1982
1984
1986
1988
1990
1992
1994
1996
Fiscal Balance
Fig. 9.12.
1998
2000
2002
2004
2006
2008
2010
2012
Trade Balance
The U.S. scal balance and trade balance.
support is waning, money printing will become increasingly important as

a nancing device. A proposition has been put forward that it is a myth
that QE is a result of the Feds concern for the economic outlook or even
about keeping interest rates down because QE began at the same time
as the federal budget decit overtook and surpassed the trade decit
(FOFOA, 2012a). It is further suggested that the amount of QE matches
close enough . . . the dierence between the budget decit and the trade
decit. The claim that quantitative easing coincided with the overtaking
of the trade decit by the budget decit is conrmed by Fig. 9.12, which
shows that 2008 was the last full year in which the budget decit was
lower than the trade decit. In 2012, the budget decit was just over
one trillion dollars whereas the trade decit was just over half a trillion
dollars.
OBrien (2012) seems to confuse the cause and the eect when
he argues that it is very dicult to have hyperination when you
still have a functioning economy. It is hyperination that transforms
a functioning economy into a devastated one. It could happen in a
functioning economy if the budget decit is nanced by creating money.
Israel certainly had a functioning economy in the 1980s but it experienced
hyperination. Furthermore, hyperination is not necessarily associated
with war and revolution Mexico, Brazil and Argentina had it without war
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or revolution. Ferguson (2008) argues that war is not a necessary condition

for hyperination. He writes:
If hyperination were exclusively associated with the costs of losing
world wars, it would be relatively easy to understand. Yet, there is a
puzzle. In more recent times, a number of countries have been driven
to default on their debts either directly by suspending interest
payments, or indirectly by debasing the currency in which the debts
are denominated as a result of far less serious disasters.
But, if anything, the U.S. is currently at war and spending excessively on

the military. Jones (2012) argues on the following lines:
We are currently at war, and the nancing of this war is extremely
inationary. In fact, if you look back at our history, since 1914, the U.S.
has engaged in 16 military conicts. We have been involved in some
form of violent international accord in 44 of the past 93 years. The
overwhelming majority of military conicts result in monetary ination.
Furthermore, Jones argues, the U.S. has a debt similar to that of Weimar
Germany and that although the reasons for the debt are completely
dierent, it appears that this Mount Everest of IOUs is going to be
impossible to pay back. Williams (2012) suggests that there is no viable
or politically-practical way of balancing this nancial Armageddon.
While OBrien rules out the possibility of hyperination in the U.S. by
using awed arguments, his description of the circumstances under which
hyperination occurs is perfectly applicable to the U.S. He refers to: (i) a
collapse in tax revenue, (ii) the government looking like a terrible credit
risk, (iii) a gaping hole in the budget, (iv) piles of foreign debt, and (v) a
big chunk of the available cash is earmarked for foreign creditors. These
are either current symptoms of the U.S. economy or it is heading that
way. Tax revenue is rather low it is unlikely to improve given that the
Republicans, who currently call the shots, still talk about tax cuts. We will
nd out later why it is that the U.S. government with the passage of time
look like a terrible credit. There is already a gaping hole in the budget,
which is unlikely to improve any time soon. There is also signicant foreign
debt, which is why a big portion of interest payments go to foreign creditors.
There are good reasons to expect that the U.S. will experience hyperination, which is essentially a political-scal-monetary problem, sooner
or later because of failure to deal with the scal decit. An annual budget
decit in excess of one trillion dollars requires the federal government to sell
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279
bonds for the amount of the decit plus any bonds coming due. Investors
are mostly buying short-term bonds, so the Fed will buy any bonds not
bought by anybody else. The federal government will make sure that will
happen even if that requires changing the laws governing the Fed or the
people running it. Right now, Bernanke seems to be compliant. Government
spending is out of control and the Fed will keep creating money as fast as
the government needs.
Hyperination sceptics may say that the U.S. is currently going through
what Japan has been experiencing in the last two decades after all, it
was the Japanese who invented quantitative easing more than 20 years
ago. Japan is not experiencing hyperination but rather deation. While
there is an element of truth in this claim, there is a big dierence: Japanese
sovereign debt is more stable than that of the U.S. because it is held mostly
by Japanese citizens, which makes Japan less vulnerable than the U.S. to
the changing sentiment of foreign creditors. Hence, Japan is less likely to
monetize its decit than the U.S.
Lira (2010) draws up a very interesting scenario on how hyperination
will hit the U.S. The chain of eects goes as follows:
1. A slight but sudden rise in the price of a necessary commodity, such
as oil.
2. Portfolio managers reduce their Treasury holdings and go into the
underlying commodity to make prot.
3. In an eort to counteract the sell-o and maintain low yields, the Fed
will buy Treasuries. This encourages portfolio managers to dump even
more Treasuries. When the Fed begins buying Treasuries on a massive
scale, portfolio managers reach the conclusion that it is time to dump
the lot.
4. A run on commodities ensues, at which time people get their rst taste
of hyperination. They start buying things like heating oil, food and
petrol while they are still aordable.
5. When panic-buying of basic commodities starts, the prices of nancial
assets collapse as people rush to get cash to buy commodities.
Lira believes that neither the Fed nor the federal government can do
anything about the situation. The Fed cannot prevent a run on Treasuries
except by buying them, thus fueling ination. The government may resort
to price controls, which will create rampant black markets. Rationing
may be introduced, which requires the government seizing control of
major supermarkets and petrol stations. While this may prevent riots,
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the underlying problem of hyperination will remain. Likewise Williams

(2012) believes that government actions could include supportive dollar
intervention, restrictions on international capital ows, wage and price
controls, etc., and that eects of any such moves in delaying the onset of
full hyperination would be limited and short-lived.
It may be dicult for some to envisage this scenario for the U.S. because
the U.S. is not a banana republic. However, Louisiana looked like any part
of any banana republic in the aftermath of Hurricane Katrina no one
had thought that was possible. As Williams (2012) puts it, there is no
obvious course of action or external force at this point of the process that
meaningfully would put o the nearing day of reckoning.
Some respected economists believe that the current expansionary monetary
policies will only postpone the inevitable. This is how Dowd et al. (2011)
put it:
Instead of addressing these problems by the painful liquidations and
cutbacks that are needed, current policies are driven by an ever more
desperate attempt to postpone the day of reckoning. Consequently,
interest rates are pushed ever lower and central banks embark on further
monetary expansion and debt monetization. However, such policies serve
only to worsen these problems, and unless reversed, will destroy the
currency and much of the economy with it. In short, the United States
and its main European counterparts are heading for hyperinationary
depressions.
Hyperination is by no means unavoidable it is typically a matter of

choice. Taylor (2006), who believes that hyperination is a feat achieved
through hard and steady work, explains this proposition by demonstrating how Czechoslovakia/Czech Republic avoided hyperination following
World War I, World War II and the collapse of Communism that happened by choice. The U.S. had this choice at one time but it is doubtful if the
choice is available now, given the deterioration in the scal position. In
Chapter 10, we demonstrate the extent of the scal deterioration to
reinforce the argument that the U.S. is heading towards hyperination.
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Chapter 10
LEADING INDICATORS OF U.S.

HYPERINFLATION
10.1. The Fiscal Balance

Figure 10.1 displays the U.S. government revenue, spending and the
dierence between them, which is the scal balance (decit or surplus)
over the period 19502012. Figure 10.2 displays the same as a percentage
of GDP. Since 1970, decits were recorded every year except for the years
19982001 when surpluses were recorded as a result of rapid economic
growth, which boosted tax revenue, and deliberate spending cutting actions
by the Clinton administration. The blow up of the decit since then has
been due to slow growth or recession, expansion of military spending and
the bailout of failed nancial institutions in the aftermath of the global
nancial crisis. Improvements (relative to the previous year) in 2010 and
2012 resulted from lower spending compared with the massive spending of
2009. It is also due to cyclical factors as the economy emerged from the
2009 recession.
It is likely, however, that the decit will keep on expanding. The
Congressional Budget Oce warns that unless policymakers restrain the
growth of spending, increase revenues signicantly as a share of GDP, or
adopt some combination of those two approaches, growing budget decits
will cause debt to rise to unsupportable levels (CBO, 2010). The problem
with the U.S. decit is that it is not just a passing phenomenon rather it
is a structural long-term problem created by addiction to excessive spending and the belief that tax cuts pay for themselves. The Peter Peterson
Foundation (2010) describes the situation as follows:
Even after the economy recovers, the special federal interventions are
complete, the wars are over, and unemployment levels are down, decits
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282
Revenue and Spending ($million)

4,000,000
3,000,000
2,000,000
1,000,000
1950
1960
1970
1980
Revenue
1990
2000
2010
Spending
Fiscal Balance ($million)

300,000
-300,000
-600,000
-900,000
-1,200,000
-1,500,000
1950
Fig. 10.1.
1960
1970
1980
1990
2000
2010
The U.S. government revenue, spending and scal balance ($ million).
and debt are expected to grow at a rapid rate. As a result, the U.S. will
nd itself in an unsustainable scal position in the years to come.
In Fig. 10.3, we observe the scal balance as a percentage of total spending,

which is the measure used by Bernholz (2003) to indicate the risk of
hyperination. This indicator touched the 40% mark (or even higher,
depending on how the scal balance is measured) in 2009. While the ratio
improved subsequently for cyclical reasons, it is likely to deteriorate unless
drastic action is taken on both the revenue and spending sides of the budget.
Although the preceding gures look alarming, some observers believe
that they do not reect the true situation rst because they are cash-based
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283
Revenue and Spending (% of GDP)

28
24
20
16
12
1950
1960
1970
1980
Revenue
1990
2000
2010
Spending
Fiscal Balance (% of GDP)

3
-3
-6
-9
-12
1950
Fig. 10.2.
1960
1970
1980
1990
2000
2010
The U.S. government revenue, spending and scal balance (% of GDP).
and because they do not include annual changes in the net present value
of the unfunded liabilities for social security and Medicare. If the budget
decit is calculated on a GAAP basis and include changes in unfunded
liabilities, the decit can be as big as $5 trillion. This is what Williams said
about the situation (Gold Report, 2010):
If the government wanted to balance its decit on a GAAP basis for
a year, and it seized all personal income and corporate prots, taxing
everything 100%, it would still be in decit. It cant raise taxes enough to
contain this. On the other side, if it cuts all government spending except
for Social Security and Medicare, it still would be in decit. With no
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20
10
-10
-20
-30
-40
-50
1950
1960
Fig. 10.3.
1970
1980
1990
2000
2010
The U.S. scal balance as a percentage of spending.
political will to contain the spending, eventually the government meets

its obligations by reviving the currency printing press.
We will now review the spending and the revenue sides in turn. We start
with the spending side.
10.2. The Spending Side

The U.S. government spending is classied into discretionary and mandatory. Discretionary spending, which has to be funded through annual appropriation legislation, includes military spending, interest payments on public
debt, and everything else (including education, transport, agriculture, housing, space and science, natural resources and the payment of salaries to keep
the government functioning). Mandatory spending does not require annual
Congressional approval because the U.S. government is legally committed
under current law to payments for programs such as Medicare (the federal
health program for the elderly), Medicaid (the federal-state health program
for the poor) and social security (pensions). Mandatory spending is about
60% of total spending, about one third of that is used to cover social security
payments. Discretionary spending is just over 40% of total spending. Just
over a half is claimed by the military, 15% is required to cover interest
payments and everything else takes 34%.
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Interest expenses are projected to grow dramatically as debt grows and

interest rates rise from the very low current levels to more typical historical
levels. The CBO (2010) predicts that nearly half of the debt increases over
the period 20092017 will be due to interest payments. Figure 10.4 shows
the interest payments since 1970, in both dollar terms and as a percentage
of spending. The CBO forecasts up to 2017 are also displayed. Given that
interest rates are currently at historical lows that cannot be maintained
$ million
600,000
500,000
400,000
300,000
200,000
100,000
0
1970
1980
1990
2000
2010
2020
% of Spending
18
15
12
0
1970
1980
Fig. 10.4.
1990
2000
2010
Interest payments with forecasts until 2017.
2020
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indenitely, it comes as no surprise that interest payments will rise as

depicted in Fig. 10.4.
According to the Peter Peterson Foundation (2010), a big threat comes
from interest payments, which are projected to be the largest single line
item in the federal budget larger than defense, Medicare or Social
Security. It is estimated that by 2040, assuming that the U.S. does not
have to pay a risk premium, federal interest costs will account for 14% of
the entire U.S. economy.1 If interest rates rise just two percentage points,
interest costs alone could represent about 20% of the economy by 2040.
The estimates show that by 2024, historical revenue levels will not cover
interest payments, social security, Medicare and Medicaid.
Throughout history, hyperination has been associated with excessive
military spending. The outlook for military spending by the U.S. government is that it is unlikely to decline substantially even though Mitt Romney
lost the 2012 presidential election, having promised to keep America
strong. The U.S. is by far the biggest spender on the military as shown in
Fig. 10.5. The latest gures show that the U.S. spends 4.7% of its GDP on
the military, compared with 2% only for China. It is not obvious, therefore,
why the U.S. complains about Chinese military spending.2 In terms of the
dollar value, the U.S. is responsible for over 40% of total world spending
on the military. Figure 10.6 shows the U.S. military spending since 1940 in
dollar amounts, as a percentage of total spending and as a percentage of
GDP. At its peak in 1945, it was 89% of total spending and 37% of GDP.
These levels have not been seen since although there was a big surge in the
1950s caused by the Korean War. In 2012, military spending amounted to
$716 billion, comprising 18.8% of total spending and 4.6% of GDP.
1 As
condence in the dollar diminishes, the U.S. government will have to pay a premium
on its borrowing. This is what is happening to Spain, which is on the verge of becoming
a junk bond issuer. The U.S. has already experienced downgrading with respect to credit
risk the more that happens, the higher will be the risk premium required to attract
funds.
2 The U.S. complained bitterly about the Chinese second-hand and only aircraft carrier,
despite the fact that the U.S. has 12 of them. Liu (2005a) argues that it is pathetic
that the U.S. Secretary of Defense Donald H. Rumsfeld tries to persuade the world that
Chinas military budget, which is less than one tenth of that of the U.S., is a threat
to Asia, even when he is forced to acknowledge that Chinese military modernization is
mostly focused on defending its coastal territories, not on force projection for distant
conicts, as is the U.S. military doctrine. There is nothing in Chinas modern history to
indicate its willingness to bomb another country back to the Stone Age as a pre-emptive
strike this cannot be said about the U.S.
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$ billion
U.S.
China
Russia
U.K.
France
Japan
Saudi Arabia
Germany
Brazil
Italy
South Korea
Australia
Canada
Turkey
0
100
200
300
400
500
600
700
800
% of GDP
U.S.
Russia
South Korea
U.K.
Saudi Arabia
Turkey
France
China
Australia
Italy
Brazil
Canada
Germany
Japan
0
0.5
1.5
2.5
3.5
4.5
% of World
U.S.
China
Russia
France
U.K.
Japan
Germany
Saudi Arabia
Italy
Brazil
South Korea
Australia
Canada
Turkey
0
Fig. 10.5.
10
15
20
25
30
35
Military spending: An international comparison.
40
45
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288
$ million
800,000
600,000
400,000
200,000
0
1940
1950
1960
1970
1980
1990
2000
2010
1990
2000
2010
1990
2000
2010
% of Spending
100
80
60
40
20
0
1940
1950
1960
1970
1980
% of GDP
40
30
20
10
0
1940
1950
1960
Fig. 10.6.
1970
1980
The U.S. military spending since 1940.
A large number of observers believe that the massive increase in

military spending is unjustiable. Hartung (2007) criticized the military
spending spree of George Bush II, arguing that it comes at a time when
Americas main enemy is not a rival superpower like the Soviet Union, but a
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289
network of terrorist groups armed primarily with explosives, shoulder-red

missiles, and AK-47s. Hossein-Zadeh (2007) describes the George Bush II
administrations escalation of war and military spending as a boon for
Pentagon contractors, arguing that these proteers of war and militarism
have also played a critical role in creating the necessary conditions for war
proteering that is, instigating the escalation of the recent wars of
choice and the concomitant boom of military spending. Specically, he
describes giant arms manufacturers such as Lockheed Martin, Boeing and
Northrop Grumman as the main beneciaries of the Pentagons spending
bonanza. Reporting on some of the eects of this policy, Shane and
Nixon (2007) suggested that without a public debate or formal policy
decision, contractors have become a virtual fourth branch of government.
They attributed the explosive increase in spending on contractors to a
philosophy that encourages outsourcing of almost everything government
does. The inuence of these groups is unlikely to wane down soon, neither
is there any indication that the U.S. is about to be a nation of peace in the
near future.
The military-industrial complex is so powerful in the U.S. that it
can oppose successfully any tendency towards peace and reduced military
spending. The term military-industrial complex is used to refer to the
entire network of military contractors, the Pentagon, the Congress and the
executive branch. At any time, there is an enemy that justies huge military
spending. The U.S. did not demobilize after World War II until 1977
when Jimmy Carter took steps to break away from Americas militarized
past. However, Ronald Reagan brought back the inuence of the militaryindustrial complex. George Bush II must win the gold medal in this
competition. Just after he took over, the military budget reached a new
record in 2002. Del Rosario-Malonzo (2002) wrote the following:
In arming the U.S., the so-called Globocop corporations derive the
most benet because they are lavished with billions to come up with
lethal weapons, surveillance equipment, tanks, submarines, ships and
airplanes designed for a seemingly never ending war.
For a situation like this to perpetuate, there must be one or preferably more
than one enemy hence, the axis of evil, rogue states, countries that do
not respect their civilians, and so on and so forth. Let us hope that it will
not get as far as the enemy being countries that have football (soccer) as
the national sport as opposed to baseball.
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Liu (2005a) makes a very interesting comment whereby he relates

the military budget to the trade decit. By referring to the 2004 gures,
when the trade decit and the budget decit were about 6% and 4% of
GDP respectively, he argues that the trading partners of the U.S. are
paying for one and a half times of the cost of a military that can someday
be used against any one of them for any number of reasons, including
trade disputes. This follows from the ability of the U.S. to print dollars and
use them to buy goods and services under the umbrella of dollar hegemony.
Without a reduction in military spending, it is unlikely that the scal
balance will improve. Elements of a comprehensive solution may include,
according to the Peter Peterson Foundation (2010), a reduction of military
spending to pre-war levels, implementation of Department of Defense
reforms, reviewing weapons systems, making procurement programs more
ecient, making military compensation and benets more aordable, and
reviewing and eliminating other ineective programs. Hence, the underlying
belief of the authors of the report is that excessive military spending is
indeed a big problem that must be solved to get the budget decit under
control.
Last, but not least, mandatory spending and obligations under Medicare, Medicaid and social security represent a big problem, simply because
these programs are not funded. In a June 2010 opinion piece in the
Wall Street Journal, the former chairman of the Federal Reserve, Alan
Greenspan, noted that only politically toxic cuts or rationing of medical
care, a marked rise in the eligible age for health and retirement benets,
or signicant ination, can close the decit (Greenspan, 2010). He warned
that if signicant reforms are not undertaken, benets under entitlement
programs will exceed government income by over $40 trillion over the next
75 years.
10.3. The Revenue Side

Although tax revenue in the U.S. is rather low by international standards, the Republicans and right-wing economists and commentators still
advocate tax cuts. Controversy is currently rampant about the eect of
tax cuts (or alternatively not raising taxes), particularly the proposition
that tax cuts pay for themselves. These economists and politicians
argue that the decit is a spending problem, not a revenue problem.
For example, Republican Congressman and Speaker of the House, John
Boehner, believes that Washington has a spending problem, not a revenue
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problem (Boehner, 2011). Naturally, commentators on Foxtel agree

enthusiastically.
Since the late 1970s, some supply-side economists have contended that
tax reductions stimulate economic growth to such a degree that tax revenue
would rise rather than fall. However, there is little empirical evidence to
support this hypothesis. In a study of the Joint Committee on Taxation
(2005) that examined the economic eects of reducing marginal tax rates,
it is suggested that growth eects eventually become negative . . . because
accumulating federal government debt crowds out private investment.
The study concludes that lowering marginal tax rates is likely to harm the
economy over the long run if the tax reductions are decit nanced.
A variety of tax cuts were enacted under President George Bush II
between 2001 and 2003 (commonly referred to as the Bush tax cuts)
through the Economic Growth and Tax Relief Reconciliation Act of 2001,
and the Jobs and Growth Tax Relief Reconciliation Act of 2003.
Kogan (2003) evaluated the claims that the Bush tax cuts of 2001 would
boost growth and found little support for claims made by Administration
ocials and other proponents of these tax cuts that either the 2001 tax cut
or the new growth package would generate substantial improvements in
long-term economic growth, that these tax cuts would have only a small
eect on the economy over the long term, and that the eect is as likely
to be negative as positive.
Kogan (2003) argues that the proposition that tax cuts can pay for
themselves like most claims of a free lunch is too good to be true and
that it does not withstand scrutiny. He goes so far as to argue that the
Presidents [George Bush II] own Council of Economic Advisers does not
believe the tax cuts will come closer to paying for themselves. He compares
between what happened in the 1980s (a period of tax cuts) and the 1990s
(a period of tax hikes) and concludes that income tax revenue grew 13 times
faster in the 1990s than in the 1980s.
Krugman (2007) argues that supply side doctrine, which claimed
without evidence that tax cuts would pay for themselves, never got
any traction in the world of professional economic research, even among
conservatives. Roubini (2010) suggests that the Republican Party is
trapped in a belief in voodoo economics, the economic equivalent of
creationism. Buett (2003b) commented on the proposed reduction in
taxes on dividends by arguing that when you listen to tax-cut rhetoric,
remember that giving one class of taxpayer a break requires now or
down the line that an equivalent burden be imposed on other parties.
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In other words, he said, if I get a break, someone else pays, which

means that government cant deliver a free lunch to the country as a
whole. Fukuyama (2008) argues against the idea that tax cuts pay for
themselves, pointing out that the traditional view was correct: if you cut
taxes without cutting spending, you end up with a damaging decit. The
problem, according to The Economist (2011b), is that the vast majority
of Republicans, driven by the wilder-eyed members of their party and the
cacophony of conservative media, are clinging to the position that not a
single cent of the decit reduction must come from a higher tax take.
10.4. The Outlook for the U.S. Fiscal Position
Following the re-election of President Obama in November 2012, negotiations resumed between the administration and the Republicans in Congress to reach a deal to reduce the long-term scal decit and avoid the
scal cli of automatic tax increases and spending cuts. The circus-like
negotiations ended up with an agreement past the deadline of midnight on
31 December 2012. This agreement as well as the deals that were struck
in 2012 and the deals that will follow do not match in seriousness the dire
scal situation.
The rhetoric is rather strong: while the Republican Speaker of the
House, John Boehmer, declared on 8 November 2012 that raising tax rates
is unacceptable, the following day President Obama declared that he was
not going to ask students and seniors and middle-class families to pay down
the entire decit (The Economist, 2012d). To be fair, it is not only the
Republicans who are obstructing attempts to implement serious measures
to ll the huge scal gap. The following is the conclusion reached by The
Economist (2013) in the aftermath of the inadequate deal of January 2013:
Democrats pretend that no changes are necessary to Medicare (health
care for the elderly) or Social Security (pensions). Republican solutions
always involve unspecied spending cuts, and they regard any tax rise as
socialism. Each side prefers to denounce the other, reinforcing the very
polarization that is preventing progress.
The Economist (2012f) quotes Eugene Steuerle, who served in Reagans

Treasury Department and is now a scholar at the Urban Institute, as saying
the following:
The current problem is far greater than previous ones because the structure of taxes and spending is so badly distorted that there is no way to
x it without widespread pain. This, in turn, feeds the divisions between
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the parties, since the necessary solution would require tax increases or
spending cuts on a scale that one party, or both, will nd repugnant.
Samuelson (2009) argues that the president does not want to confront
Americans with choices between lower spending and higher taxes. This is
similar to the sentiment expressed in an editorial in the 5 January 2013
issue of The Economist. The editorial says that neither Mr Obama nor
the republican leaders have been brave enough to tell Americans what it
will really take to x the scal mess (The Economist, 2013).
The decit problem cannot be solved with only spending cuts or higher
taxes. Some six years back, Kotliko (2006) argued that the U.S. must
eventually choose between bankruptcy, raising taxes, or cutting payouts.
In general, he pointed out that countries can go broke, the United States
is going broke, that remaining open to foreign investment can help stave o
bankruptcy, but that radical reform of U.S. scal institutions is essential to
secure the nations economic future.
For Kotliko (2006), the proper way to consider a countrys solvency
is to examine the life-time scal burdens facing current and future generations. If these burdens exceed the resources of these generations or are
close to doing so, he argues, the countrys policy will be unsustainable
and can constitute or lead to national bankruptcy. A measure of the
scal burden is the scal gap (also called scal exposure) the present
value of the dierence between future government spending and revenue.
The calculations of Gokhale and Smetters (2005) show that the U.S. scal
gap is $65.9 trillion, which is more than 4.5 times the level of GDP
meaning that even if all discretionary spending were cut, it would not
be adequate to solve the problem. Kotliko concludes with the sombre
note that our country has only a small window to address our problems
before the nancial markets will do it for us. Likewise, Walker (2008)
argues that the status quo is not an option, pointing out that balancing
the budget in 2040 could require actions as large as cutting total federal
spending by 60% or raising federal taxes to two times todays level. Penner
(2010) argues that the budget decit is on a ruinous path and getting o
the path involves far more signicant policy changes than the American
people are used to. The situation is indeed alarming.
10.5. Public Debt
The U.S. public debt is a measure of the obligations of the U.S. government
as represented by the Treasury. It consists of two components: (i) the
outstanding Treasury securities held by institutions and individuals outside
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the U.S. government, and (ii) intergovernmental holdings representing

the obligations of the federal government for specied programs such as
social security and Medicare.3 In March 2003, at the start of the invasion
of Iraq, the debt was at $6.5 trillion. Between 2005 and 2008, it increased
at an average rate of $2.27 billion per day, only to grow faster in the
aftermath of the global nancial crisis because of the bailout of failing
nancial institutions. By the end of 2012, gross U.S. public debt stood at
$16.35 trillion.4
The nancing of World War II and the social programs introduced
by the Roosevelt and Truman administrations in the 1930s and 1940s led
to an increase in public debt by a factor of 16, from $16 billion in 1930
to $257 billion in 1950. Subsequently, the growth of public debt closely
matched the ination rate as it tripled in size from $257 billion in 1950
to $909 billion in 1980. The spending spree of President Ronald Reagan
(mostly on military programs but also on the bailout of Continental Illinois
under the notorious pretext of too big to fail) followed by that of another
Republican President, George Bush I, caused public debt to quadruple
during the period 1980 to 1992.
A combination of unnecessary tax cuts and excessive military spending
by the administration of George Bush II took public debt from $5.8 trillion
in 2001 to about $10 trillion in 2008. Under the Obama administration,
public debt grew bigger because of the generous schemes to bailout nancial
institutions and the great recession that followed the global nancial crisis.
The CBO (2012) expresses the following view about public debt:
The sharp rise in debt stems partly from lower tax revenues and higher
federal spending caused by the severe economic downturn and from
policies enacted during the past few years. However, the growing debt
also reects an imbalance between spending and revenues that predated
the recession.
Figure 10.7 shows the growth of gross public debt since 1950 with forecasts
for the period until 2017. In terms of absolute amounts, public debt is
expected to rise through 2017 to be in excess of $21 billion. In terms of
3 For
this purpose, the Fed is not considered part of the government (technically, it is
not anyway). It is classied under institutions outside the U.S. government.
4 Strictly speaking, there is a dierence between public debt and government debt,
as the former does not include intergovernmental holdings of securities. However, the
two concepts are used interchangeably here.
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$ billion
25000
20000
15000
10000
5000
0
1950
1960
1970
1980
1990
2000
2010
2020
2000
2010
2020
2000
2010
2020
% of GDP
120
100
80
60
40
20
0
1950
1960
1970
1980
1990
Per Capita ($)

80000
60000
40000
20000
0
1950
1960
Fig. 10.7.
1970
1980
1990
The U.S. gross public debt with forecasts until 2017.
debt as a percentage of GDP, it is expected to moderate slightly if and

only if growth resumes but it will remain above the 100% level. Stockman
(2010) argues that the U.S. public debt if honestly reckoned to include
municipal bonds and the $7 trillion of new decits baked into the cake
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296
through 2015 will soon reach $18 trillion, which is a Greece-scale

120% of gross domestic product, and fairly screams out for austerity and
sacrice. Public debt per capita has risen from $1,700 in 1950 to over
$52,000 in 2012, and it is expected to rise to over 65,000 in 2017. Going
further into the future, the Peter Peterson Foundation (2010) believes that
if current policies are left unchanged, debt held by the public is projected
to spike even further, reaching over 300% of GDP in 2040.
For some observers, what is even more alarming is that an increasing
portion of the U.S. public debt is held by foreigners. Figure 10.8 shows
the breakdown of ownership of public debt among the federal government,
Federal Reserve and others the last and biggest chunck includes foreign
creditors. As of September 2012, foreigners held $5.46 trillion worth of
Treasury securities. Figure 10.9 shows that about 42% the holdings by
foreigners (just over $3 trillion) belong to China and Japan. Other countries
with signicant holdings are OPEC countries, Brazil, Caribbean countries,
Taiwan, Switzerland and Russia. Friedman (2008) argues that increasing
dependence on foreign sources of funding will render the U.S. less able to
act independently. He quotes the old saying, he who has the gold makes
the rules and suggests that we [the U.S.] no longer have as much gold, and
16,000,000
14,000,000
12,000,000
10,000,000
8,000,000
6,000,000
4,000,000
2,000,000
0
1940
1950
1960
1970
Federal Government
Fig. 10.8.
1980
Federal Reserve
1990
Other
The U.S. public debt holdings ($ million).
2000
2010
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China
21.2%
Others
33.9%
Russia
3.0%
Japan
20.7%
Switzerland
3.6%
Taiwan
3.7%
OPEC Countries
4.9%
Carribean Countries
4.4%
Fig. 10.9.
Brazil
4.6%
The composition of foreign holdings of the U.S. treasury securities.
until we get some, we will have to pay more heed to the rules of those who
lend us theirs. Buett (2003a) argues that foreign ownership of public debt
is no less than the transfer of the countrys net worth to foreigners. Unlike
domestic debt holders, foreign lenders are concerned about the exchange
rate factor, which makes the U.S. more vulnerable to the sentiment of
foreign providers of credit. One reason why the U.S. is over-dependent on
foreign credit is the low saving rate in the U.S. economy. Figure 10.10
shows the downward trend in the U.S. personal saving rate at one time
it reached a low of 0.9 in October 2001.5
Excessive public debt has been recognized as a factor that is clearly
related to hyperination it plays a critical role in the condence and
monetary models of hyperination. For example, a high level of debt
5 For
an analysis of the reasons for the low saving rate in the U.S., see Moosa (2012).
Several explanations for the decline in saving have been put forward including nancial
innovation, the trends in the way companies compensate shareholders, asset price
bubbles, and extreme inequality.
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16
14
12
10
Jan-59 Jan-63 Jan-67 Jan-71 Jan-75 Jan-79 Jan-83 Jan-87 Jan-91
Fig. 10.10.
Jan-95 Jan-99 Jan-03 Jan-07 Jan-11
The U.S. personal saving rate (%).
triggers demand by borrowers for a higher risk premium, thus it becomes

more expensive for the U.S. to borrow. It may also trigger a downgrading of
the credit rating of the country, thus increasing funding costs. Furthermore,
excessive debt forces the government to borrow more on a short-term basis,
as opposed to long-term basis, to nance payments for maturing securities.
And, a growing level of debt boosts the probability of a sudden scal crisis
during which investors lose condence in the ability of the government to
manage its budget, thus it becomes dicult to borrow at aordable rates.
For the U.S. in particular, a high level of public debt would undermine the
role of the dollar as a reserve currency, which would deprive the U.S. of
a privilege that it has been enjoying since the end of World War II. This
privilege enables the U.S. to earn the seigniorage resulting from issuing the
dollar as the most internationally accepted currency.
Krugman (2010) claims that the U.S. government debt level is not a big
deal because the U.S. was at similar levels after World War II and things
worked out ok. However, after the war most of the budget was military
and easily cut, because the war was over. So, the decit went away. This
time is much worse than back then because there is no way to make the
kinds of huge government cuts made back then. On this occasion, the U.S.
has a huge debt and also an out-of-control decit that keeps making the
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299
debt larger. Back then the budget went into surplus and the debt did not
get larger, so the situation was under control. This time it is dierent.
Irrespective of the existence or otherwise of a debt threshold, the U.S.
debt situation is alarming. Some observers argue that the situation is not
serious because the debt-to-GDP ratio is lower than that of Japan and other
developed countries, nominal long-term interest rates are low, the dollar is
the worlds reserve currency and because China, Japan and other countries
still like the U.S. Treasuries. Kotliko (2006) responds to these remarks
by saying that ocial debt does not reect scal fundamentals, implying
that they are weak, because federal discretionary spending and medical
expenditures are exploding. He also argues:
The United States has a history of defaulting on its ocial debt via ination . . . the government has cut taxes well below the bone . . . countries
holding U.S. bonds can sell them in a nanosecond . . . the nancial
markets have a long history of mispricing securities, nancial implosion
is just round the corner.
A direct response to these remarks is that, as we have seen and will see later
(i) Japans debt is more stable because it is owed primarily to citizens, not
foreigners; (ii) nominal interest rates will rise `
a la Greece and Spain; (iii) the
dollar will gradually lose its international status; and (iv) China, Japan and
other countries are no longer in love with the U.S. Treasuries.
In 2006, David Walker, the then head of the Government Accountability
Oce (an arm of Congress that audits and evaluates the performance of the
U.S. government), warned that if the United States government conducts
its business as usual over the next few decades, a national debt that is
already $8.5 trillion could reach $46 trillion or more, adjusted for ination.
He added that a hole that big could paralyze the U.S. economy . . . just
the interest payments on debt that big would be as much as all the taxes
the government collects today (CBS News, 2006).
10.6. Monetary Aggregates
Figure 10.11 shows four U.S. monetary aggregates over the period December
2006October 2012: the adjusted monetary base of the Federal Reserve
Bank of St Louis, commercial banks reserves with the Fed, M 1 and M 2,
all in billions of dollars.6 The charts show the extent of quantitative easing
6 Data
were obtained from FRED, the Federal Reserve Bank of St Louis data base.
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Adjusted Base
Reserves with the Fed
3000
1800
2500
1500
2000
1200
1500
900
1000
600
500
300
0
2006M 12
b1571-ch10
2008M 12
2010M 12
2012M 12
0
2006M 12
2008M 12
2010M 12
2012M 12
M2
M1
12000
2700
2400
2100
9000
1800
1500
6000
1200
900
3000
600
300
0
2006M 12
2008M 12
2010M 12
Fig. 10.11.
2012M 12
0
2006M 12
2008M 12
2010M 12
2012M 12
The U.S. monetary aggregates ($ billion).
and the fact that expansion of the monetary base has not been reected on
M 1 and M 2 because banks accumulated reserves.
Table 10.1 reports the annualized monthly growth rates of the four
items over two periods: December 2006August 2008 and September 2008
October 2012 that is, pre-post quantitative easing. The monetary
aggregates M 1 and M 2 grew at a slower pace than the monetary base.
It is interesting to note that towards the end of the sample period, just
after the implementation of QE3, reserves and the monetary base declined
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Table 10.1. Annualized monthly growth rates of the U.S.

monetary aggregates (%).
2006:122008:8
2008:92012:10
2.6
19.6
2.2
6.2
33.4
155.2
15.7
8.0
Adjusted monetary base

Reserves
M1
M2
2,000,000
1,600,000
1,200,000
800,000
400,000
0
1990
1992
1994
1996
Fig. 10.12.
1998
2000
2002
2004
2006
2008
2010
2012
The U.S. public debt held by the Fed.
while the money supply rose. This shows indeed that banks cannot keep
on accumulating reserves indenitely, because they might as well go out of
business. This also shows that quantitative easing can lead to monetary
expansion with inationary consequences, unlike what OBrien (2012)
argues.
It is interesting to see what happened to the public debt owned by
the Fed since 2008 when QE1 was initiated, which is shown in Fig. 10.12.
It actually exploded, rising from $491 billion in 2008 to $1.7 trillion in
2011. This has two implications. The rst is that it will be rather dicult
to reverse quantitative easing by o-loading this enormous stock of public
debt. The second is that if this is not a monetization of the decit, then
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what it is? The fact that the Fed bought the debt from nancial institutions,
not directly from the Treasury, makes no dierence whatsoever.
10.7. Lessons from Theory
We studied theories of hyperination in Chapter 6 and examined historical
episodes of hyperination in Chapters 7 and 8 with the objective of
identifying the conditions under which hyperination occurs and the path
that countries take to get there. In this section, we try to nd out if anything
in these theories and historical episodes is applicable to the current state
of the U.S. economy thus putting forward a case for why the U.S. is not
immune to hyperination.
In the crisis of condence model of hyperination, the loss of condence
comes before monetary growth and causes it. In the monetary model, rapid
monetary growth comes rst and causes the loss of condence. So, it is
either that too little condence forcing an increase in the money supply, or
too much money destroying condence. The status quo is that condence
in the dollar is dwindling for reasons other than quantitative easing, but
QE is causing the process to accelerate. Loss of condence in the dollar
comes partly from the collective desire to kill the exuberant privilege that
the U.S. has enjoyed since the end of World War II. The U.S. ability to
take wealth from dollar reserves all around the world was like the golden
goose. But now that they have pushed too far, the golden goose is going
to die.
The term exorbitant privilege refers to the benet accruing to
the U.S. from the use of its own currency as the international reserve
currency a privilege that enables the U.S. to pay for imports by printing
money. The term was coined in the 1960s by Valery Giscard dEstaing,
then the French Finance Minister, although it is frequently (and wrongly)
attributed to Charles de Gaulle, who held similar views. Back in the 1960s,
Robert Trin explained why using a national currency as the international
reserve currency would fail the proposition became to be known as
the Trin Dilemma (Trin, 1960). The idea is simple: for the dollar
to serve as an international medium of exchange, the U.S. must provide
adequate quantities and run a current account decit. But that causes a
loss of condence in the dollar hence, the dilemma. In other words, more
and more dollars are created until at some point people lose condence in it.
The issuing country, the U.S., gets goods and services by printing money,
which means that it makes sense to print more and more with oblivion
towards the eventuality of loss of condence. The Trin Dilemma is the
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basis for Chinas opposition to the use of the dollar, which is a national
currency, as the international currency (Zhou, 2009).
Opposition to the exuberant privilege has never been as intense as it is
now, aided by quantitative easing. Countries around the world are realizing
the validity of Joness (2012) argument that it is fundamentally unfair
for the U.S. to get real wealth from billions of poor people around the
world in exchange for giving them pieces of paper, and then to devalue
those pieces of paper by printing more all the time. He adds that as
other countries realize they are being ripped o because they are using and
holding dollars they will reduce their exposure to dollars and that when
central banks do this they call it diversifying reserves, which will cause a
crash in the value of the dollar. Thanks to QE, the printing of dollars has
accelerated to such a rate that the rest of the world is now worried they are
losing value too fast by holding the U.S. dollars. If other countries hold $6
trillion dollars while the U.S. ination rate is 10%, the U.S. has eectively
stolen $600 billion from the people of other countries. This is about the
level of the U.S. military budget. So a case can be made that the U.S.
ination tax on the rest of the world pays for the U.S. military, which can
then dominate the world.
Those who deny the possibility of hyperination in the U.S. also believe
that there is no viable alternative for the dollar as a reserve currency and
that the dollar will not lose its international status. However, it would be
a mistake to assume that since the Roman dinar, the Spanish reale, and
the British pound each took many years to lose reserve currency status
that the demise of the dollar will be slow. When those currencies ruled
the roost, there was no instant worldwide information ow now there
is, and news travels fast. The collapse of the dollar will probably set a
new speed record for the loss of the reserve currency status. The Chinese
have already started reducing their holdings of Treasuries, now that Chinas
trade surplus is declining. As a matter of fact, a deputy governor of Chinas
central bank declared once that China no longer hoovers up dollar reserves
(The Economist, 2012e). Note too that the Japanese will also have to run
down their holdings of the U.S. Treasuries because they have a debt problem
of their own. With time, the Japanese will be more worried about their own
problem than about solving Americas debt problem (in other words, they
will stop buying Treasuries).7
7 Dylan
Grice of Societe Generale is quoted as saying the following: as Japans retiree age
and run down their wealth, Japans policymakers will be forced to sell assets including
U.S. Treasuries (see Fernando, 2010).
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Individual countries have been demanding an end to the international

role of the dollar. Following a well-established French tradition, the French
president, Francois Hollande, is in favor of the end of the U.S. dollar as
the worlds reserve currency, suggesting that it should be replaced by a
basket of currencies (Infowars.com, 2012; Escobar, 2012). China has been
demanding an end to dollar supremacy for years. In 2009, China called for
the creation of a new currency to replace the dollar as the worlds standard,
proposing a sweeping overhaul of global nance that reects developing
countries growing unhappiness with the U.S. role in the world economy
(Batson, 2009).8 In the 2009 G20 summit in London, Russia put forward a
set of proposals including discussions on a global reserve currency (China
View, 2009a).
Even the IMF has been consistently calling for the end of the dollar as
the worlds reserve currency, and for its replacement by the Special Drawing
Rights (SDR). In February 2011, the IMF issued a report on a possible
replacement for the dollar as the worlds reserve currency, suggesting
that SDR could help stabilize the global nancial system (CNN Money,
2011). According to the report, the goal is to have a reserve asset for
central banks that better reects the global economy since the dollar is
vulnerable to swings in the domestic economy and changes in the U.S.
policy. The UN has the same view. In a 2009 report, the UN Conference
on Trade and Development (UNCTAD) said that the system of currencies
and capital rules which binds the world economy is not working properly,
and was largely responsible for the nancial and economic crises. The
report added that the present system, under which the dollar acts as the
worlds reserve currency, should be subject to a wholesale reconsideration
(Conway, 2009).
Well-respected economists have been calling for the replacement of the
dollar as the international reserve currency. In March 2009, Nobel Prizewinning economist Joseph Stiglitz called for a new global reserve system to
replace the U.S. dollar as the world reserve currency (China View, 2009b).
He told a press conference in the UN headquarters that there is a growing
consensus that there are problems with the dollar reserve system, and
that one of the problems (with single currency reserves) is that because
of the huge level of volatility, countries are accumulating large amounts of
reserves. Stiglitz described the dollar reserve system as relatively volatile,
8 The
proposal was made by central bank governor, Zhou Xiaochuan, in an essay that
attracted international attention.
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305
deationary, unstable and (had) inequity associated with it, arguing that
the system was contributing to the weakness of the global economy. He
went as far as saying that developing countries have been lending the United
States trillions of dollars at almost zero interest rates when they themselves
desperately need that money. Hence, he argued, its a net transfer, in a
sense, to the United States of foreign aid. This is a reverse Robin Hood
redistribution of wealth.
Liu (2002) refers to the dominance of the dollar as dollar hegemony,
which he describes as follows:
World trade is now a game in which the U.S. produces dollars and
the rest of the world produces things that dollars can buy. The
worlds interlinked economies no longer trade to capture a comparative
advantage; they compete in exports to capture needed dollars to service
dollar-denominated foreign debts and to accumulate dollar reserves to
sustain the exchange value of their domestic currencies. To prevent
speculative and manipulative attacks on their currencies, the worlds
central banks must acquire and hold dollar reserves in corresponding
amounts to their currencies in circulation. The higher the market
pressure to devalue a particular currency, the more dollar reserves its
central bank must hold. This creates a built-in support for a strong
dollar that in turn forces the worlds central banks to acquire and hold
more dollar reserves, making it stronger. This phenomenon is known
as dollar hegemony, which is created by the geopolitically constructed
peculiarity that critical commodities, most notably oil, are denominated
in dollars. Everyone accepts dollars because dollars can buy oil.
Incidentally, Liu (2005a) believes that the dollar is a at currency not

backed by gold, not backed by the U.S. productivity, not backed by the
U.S. export prowess, but by the U.S. military power.
There are three dimensions to the loss of condence in the dollar: (i) the
international reserve status, (ii) a currency to which other currencies under
xed exchange rates are pegged to, and (iii) the currency of invoicing and
the medium of exchange in the international trade of commodities. We have
already addressed the rst dimension, arguing that condence in the dollar
as the international reserve currency is dwindling. How this is related to
the possibility of hyperination is intuitively simple. As countries refrain
from accumulating dollar-denominated reserve assets (such as Treasuries),
the U.S. will nd it increasingly dicult to raise funds by borrowing,
not to mention that it will be also dicult to reverse quantitative easing
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by o-loading the securities already acquired. The printing press (or the
computer) will be the last resort.
On the second point, countries that peg their currencies to the dollar
tend to experience imported ination as the dollar depreciates against other
currencies again, thanks to quantitative easing. Take, for example, the
case of Kuwait. In January 2003, Kuwait decided to go for an exchange
rate regime shift by abandoning the policy of pegging the Kuwaiti dinar
to a basket with unknown components that had been in place since 1975.
The declared reason for this policy shift was to unify exchange rate regimes
across member countries of the Gulf Co-operation Council (GCC), which
comprises Kuwait, as well as Saudi Arabia, Qatar, the United Arab Emirates, Bahrain and Oman. But things changed subsequently. The weakness
of the dollar made the Kuwaiti currency rather weak against the euro, yen
and pound, which are the currencies of the other major trading partners. As
a result, the National Assembly put pressure on the government to abandon
the dollar peg and return to a basket peg, so that the domestic currency may
strengthen against these currencies. This materialized in May 2007. Most
of the ination experienced in the other GCC countries has been brought
about by the weakening of the dollar. These countries may show some
wisdom and abandon the single peg to the dollar. Remember that under
a system of single currency peg the intervention currency is the currency
to which the domestic currency is pegged. By abandoning the dollar peg,
these countries will not need to accumulate dollar-denominated assets.
The third dimension is that the dollar may lose its status as the
currency of invoicing and settlement in international trade, particularly
commodities (most notably, oil). It is strange that some observers claim
that it would take the oil-exporting Gulf states many years to replace the
dollar as the currency oil is priced in. For example, Iran has declared that
it has proted from switching to non-dollar oil sales. Other countries can
see this and switch quickly too. OPEC is reportedly looking to price oil in
something other than U.S. dollar (Gold Report, 2010). GCC countries have
been for some time now thinking about a common currency. Given the small
volume of intra-regional trade and investment, a common currency will
not be benecial unless these countries use it as the currency of invoicing
and settlement in oil trade. Liu (2002) believes that everyone accepts
dollars because dollars can buy oil, but he argues that China is in a
position to kick start a new international nance architecture that will
serve international trade better, which can be done by requiring payment
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307
for Chinese exports in yuan, thus making it an alternative reserve currency

(Liu, 2004).
10.8. Lessons from History
Now we move on to a consideration of the factors associated with hyperination as identied from real-life inationary experience. These factors
are reported in Table 10.2, albeit with some repetition. The following
observations can be made:
1. The point about not possible to get something for nothing can be
used to mean two dierent things in a modern U.S. context. In the
original context, it meant that you cannot create wealth (something)
Table 10.2.
Factors recognized in previous studies of hyperination.

Factor
Applicable to U.S.
Historical Episodes
1.
2.
3.
4.
5.
Not possible to get something for nothing.

Excessive spending nanced by issuing currency.
Building up armies.
Tendency to monetize the decit if not covered by taxes.
Collapse of production.
Yes
Yes
Yes
Yes
?
20th Century-1970s (Classical Hyperinflations)

1. Rising military spending nanced by printing money.
2. Big government.
3. Enormous military spending well beyond the
capacity of the economy.
4. War destruction resulting from occupation.
5. Desire to revive the economy.
6. Civil war.
Yes
?
Yes
No
Yes
No/?
Recent Hyperinflations (since the 1970s)

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Monetization of the decit.

Military spending.
Financial support for loss-making state enterprises.
Subsidies.
Budget decit.
A political set-up where no one is interested
in price stability.
The collapse of the price of main exports.
External borrowing to fund the scal gap.
Populist policies.
Political problems.
Yes
Yes
?
?
Yes
?
No
Yes
Yes
Yes
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2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
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by printing money (nothing) or by debasing the currency. This is true

when it is applied to quantitative easing. However, the U.S. has been
getting something for nothing in terms of dollar hegemony.
Military spending is denitely a factor, as we have seen.
Covering the decit by monetizing it is also applicable.
There is a question mark on the collapse of production because
there is no collapse of production as such. However, the demise of
manufacturing industry is some sort of a collapse the collapse of
manufacturing production.
There is also a question mark over big government because there is
no reason why a big government is necessarily inationary. If, in the
modern U.S. context, the government is big only because of a big
military budget, then yes that is inationary. The unfunded liabilities
under Medicare/Medicaid and social security can be inationary. In
the years to come, the U.S. government will be facing a tough choice of
defaulting on these obligations or nancing them by printing money.
While there is no civil war in contemporary U.S., civil strife could erupt
because of extreme inequality, racial tension and attitude towards the
federal government. There is some talk about the possibility of a break
up of the U.S. `
a la the Soviet Union and Yugoslavia.
There is a Yes on desire to revive the economy because this is the
declared objective of quantitative easing.
There are question marks on nancial support for loss-making state
enterprises and subsidies because that is what salvaging nancial
institutions under the notorious pretext of too big to fail is all about.
Yes, Citibank is not a state enterprise but it has so much power on the
government that Citi and its bosses may consider the government to
be their enterprise. One must not forget that the Federal Reserve is a
private shareholding company owned by banks.
External borrowing to fund the scal gap is a denite Yes.
Populist policies take several forms such as the funding of populist
projects under the scal stimulus scheme and feet-dragging over the real
problem of unfunded Medicare/Medicaid and social security liabilities.
A political set-up where no one is interested in price stability may be
an exaggeration when applied to contemporary U.S. However, failure
to reach an agreement between the Republicans and Democrats on
serious measures to reduce the scal gap can be interpreted in this
manner. This is what The Economist (2013) calls inability to get
beyond patching up.
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309
12. Political problems as related to hyperination are exemplied by

inability of the administration and Congress to reach a compromise
on tax reform.
In the 1980s, when ination was raging in South America, a team of
American economists, led by Gerald Swanson, visited Bolivia, Brazil and
Argentina four times in a two-year period to investigate hyperination
and draw conclusions for American business that is, they wanted to
learn some lessons from the South American experience. Swanson (1989)
describes the ndings of his mission as quite frightening. The following
are some of the ndings:
1. The principal source of ination is decit spending.
2. The U.S. is well along the road to high ination because of several
factors that the U.S. has in common with South American pre-hyperinationary economies: (i) large scal decits, (ii) deterioration of the
external position (balance of payments), (iii) calls for protectionism, and
(iv) eroded condence in the national currency.
3. Ination can accelerate without warning into hyperination in a period
as short as a few days.
4. Successful South American individuals and businesses survived by
investing in dollars. Should ination take o in the U.S., there is no
alternative currency to turn to. Actually the same is true of the case of
Zimbabwe where the economy functioned because of a big dollar black
market.
5. The best way to ght hyperination is to prevent it from starting because
once it begins, it feeds on itself and becomes extremely dicult to stop.
None of the lessons provided by history has altered the scal irresponsibility
of the U.S. government. While it is easy to dismiss the relevance of
South American inationary experiences, to do so is to underestimate the
economies in question and the devastating impact of severe ination.
10.9. When and How It Will Happen?
In timing the possibility of hyperination in the U.S., McSpadden (2012)
uses an interesting analogy. It is like the government can pay for things
in two ways: money earned from wages (taxes) and using a credit card
(borrowing by issuing Treasury securities). This situation can keep going,
getting further and further into debt, until the wages no longer bring in
enough to make the minimum payments on the credit card. At that point,
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310
the government will get another credit card (monetization of debt) to pay
for the old credit card (existing securities).
In 2012, gross public debt was $16.4 trillion and tax revenue was $2.5
trillion. Dividing tax revenue by debt, we get a rate of 15.6%. This means
that the current level of wages can support an average interest rate of
15.8% on the credit card. In 2012, the U.S. government paid $565 billion
in interest, which works out to about somewhere around a 3.5% interest
rate. The idea here is that hyperination will set in when interest payments
as a percentage of debt is over 15%. If the latter also changes (and it would),
hyperination will set in when the interest/debt ratio is equal to the tax
revenue/debt ratio. Assuming that tax revenue increases at the same rate
as it did between 2002 and 2012 (2.8%), debt will grow at 6% and interest
payments at 10%. Under this scenario, hyperination will arise in 2034 as
shown in Fig. 10.13.
Another criterion for timing is that developed by Bernholz (2003)
based on the historical experience with hyperination. Having examined
29 cases of hyperination, he reached the conclusion that hyperination
follows after the debt gets over 80% of GDP and the scal decit gets
over 40% of spending for a few years. While the debt/GDP ratio is higher
than 80%, the decit/spending ratio is down from the 40% level it reached
in 2009, but it is still over 30%. In any case, hyperination has been
18
16
14
12
10
0
2012
2017
2022
2027
Tax/Debt Ratio
Fig. 10.13.
2032
2037
Interest/Debt Ratio
Timing of hyperination in the U.S.: The credit card approach.
2042
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311
experienced in many countries when the decit/spending ratio was less

than 40%.
We have argued that hyperination cannot be given a precise denition
in terms of a threshold ination rate. Likewise, we cannot judge when
hyperination will start by using one or two ratios. The question is whether
or not the conditions are right for the emergence of hyperination and
they are. Some leading indicators are the following: (i) record debt and
decits; (ii) some oil producers have stopped accepting dollars and rumors
of others changing; (iii) some countries may stop pegging their currencies
to the dollar; (iv) the Fed holding interest rates at almost 0% and printing
money at record speeds; (v) foreign investors are less interested in buying
the U.S. debt; and (vi) trillions of dollars in central banks, retirement funds,
etc. around the world that they might want to unload.
Several triggering factors can cause a run on the dollar and the loss of
condence, leading to hyperination. The following are the possibilities:
1. A serious rush to gold triggered by the euro crisis may lead to a loss of
faith in any at currency, including the dollar.
2. Big holders of Treasury bonds o-loading their stocks and buying real
estate or commodities.
3. Intensication of quantitative easing, which is already happening.
4. Failure of a U.S. bond sale.
5. Oil countries are taking a collective decision to stop using the dollar to
settle oil transactions.
6. BRIC countries deciding not to use the dollar as the currency of invoicing in international trade.
7. One or more countries that currently peg their currencies to the dollar
could decouple from the dollar.
8. An audit of the Fed might uncover something disturbing. For example,
instead of holding 8,000 tons of gold, the Fed may have much less
because of the amounts that have been lent to companies that cannot
pay back.
9. China might switch to buying international commodities in yuan
instead of dollars.
10. A currency crisis in a country with dollar reserves could make people
worry that country would start selling dollars.
11. It might be disclosed that some substantial pressure was put on banks
or some foreign country to buy the U.S. bonds.
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12. Several prominent economists who had been calling for deation might
switch to saying the danger now is ination.
The scal position of the U.S. in terms of decit and debt is simply
unsustainable, providing optimal conditions for triggering hyperination.
This is what Dowd et al. (2011) say about the U.S. scal position:
The ocial U.S. debt, high as it is, is merely the tip of a much bigger
iceberg: we must also consider the unfunded obligations of the U.S.
government those future obligations it has entered into but not
provided for. Shortly before the crisis, Lawrence Kotliko estimated
these to be a little under $100 trillion, and his most recent estimates
put these at $211 trillion more than doubling over ve years. To put
this latter gure into perspective, it is 15 times the ocial debt, 14 times
the U.S. GDP and a debt of $580,000 for every man, woman and child
in the country and rising fast.
They believe that Uncle Sams Ponzi scheme will stop but it will stop
too late. The U.S. is broke because a debt of well over half a million
dollars per capita and rising fast cannot realistically be repaid. Still there
is a prevailing state of denial as politicians are preoccupied with the tip of
the iceberg. The whole iceberg is as big, in relative terms, as the one that
sank the Titanic.
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Chapter 11
CONCLUDING THOUGHTS
11.1. The Highway Network

The ideas suggested in this book can be summarized in a picture presented
in Fig. 11.1. We can see ve countries in dierent places on the highway
network, having started on the Hazard Highway. By driving on the Hazard
Highway, these countries were exposed to all or some of the hazards leading
to adverse macroeconomic consequences the hazards include: persistent
budget decit, excessive public debt, inadequate saving, inadequate tax
revenue, excessive military spending, and unfunded liabilities. For sure, the
U.S. has been exposed to all of these hazards: a budget decit in excess
of $1 trillion, a public debt to GDP ratio of more than 100%, a meager
saving rate that at one time fell below 1%, a tax revenue to GDP ratio that
is higher only than those found in tax-free countries, military spending in
the vicinity of half the military spending of the whole world, and trillions
of dollars of unfunded liabilities of Medicare, Medicaid and social security.
These are denitely indicators that are associated with hyperination
this is what theory and experience tell us, as we saw in Chapters 6, 7 and 8.
Having come to the end of the Hazard Highway, two of the ve countries
i.e., the UK and the U.S. turned left on the Quantitative Easing Highway.
After a while on the Quantitative Easing Highway, the U.K. decided to do
a U-turn, moving towards the Austerity Highway, which is where Spain,
Ireland and Greece are stationed. By entering the Austerity Highway, these
three countries entered a recessionary period thereby deciding to endure
pain in the present times for prosperous times in the future. It is expected
that eventually, they would pass through recovery and then turn either
left or right on the South Stability Highway. The U.K., which is not yet
in recession but is heading that way, made the U-turn when the Bank
of England decided to quit quantitative easing, feeling that the risk of
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314
Stabilization
Hyperinflation
Depression
Recovery
North Stability Highway
US
Excessive
Public
Debt
Excessive
Military
Spending
Inadequate
Saving
Hazard Highway
Budget
Deficit
Unfunded
Liabilities
Inadequate
Tax
Revenue
UK
Recession
Spain
Ireland
Austerity Highway
Greece
Recovery
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Quantitative Easing Highway
August 10, 2013
South Stability Highway
Fig. 11.1.
The macroeconomic highway network.
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Concluding Thoughts
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315
hyperination was becoming greater than the risk of recession. Eventually,

the U.K. too will follow Spain, Ireland and Greece through recession and
recovery, then turning right or left on the South Stability Highway.1
As for the U.S., a decision by the Federal Reserve to launch QE3 in
September 2012 meant that the country would go north on the Quantitative
Easing Highway. This highway leads to hyperination and hyperinationary
depression. A painful stabilization program will be required to go through
the recovery phase. Eventually, the U.S. will turn right or left on the North
Stability Highway as the country recovers from hyperination. By following
this route, the U.S. has opted for pain tomorrow, and this is why the U.S.
currently looks in a better shape than most European countries.2 The U.S.
is showing all of the symptoms indicating that it is heading that way. While
a U-turn towards the Austerity Highway may make it possible to avoid
hyperination, the U.S. has spent such a long time on the Hazard Highway
that hyperination may come from the loss of condence in the dollar. And,
despite reaching a compromise to avoid the scal cli in January 2013,
this compromise does not constitute a genuine 180-degree U-turn (and there
will be more scal clis to come). The Economist (2013) describes the deal
as lousy, arguing that the saddest thing about this weeks deal is how
unaware Messrs Obama and Boehner seem to be of the wider damage their
petty partisanship is doing to their country. Failure on the scal front
will be exacerbated by a monetary decision taken in December 2012 to
intensify quantitative easing (dubbed QE4), which means that the U.S.
will be on the Quantitative Easing Highway for a long time to come. Both
the monetary and condence models of hyperination are applicable to the
current state of aairs in the U.S. economy.
A number of observers have written about hyperination hitting
America sooner or later. It is not easy to predict when this might happen,
and this is why we do not want to make such a prediction. All we can say
is that the U.S. is forging ahead towards the gates of hyperination, because
1 In
the fourth quarter of 2012, British GDP shrank by 0.3%. Spain, on the other hand,
was in negative territory in all of the four quarters of 2013. Ireland started to post positive
growth in the third quarter. In terms of industrial production, the British economy went
down by 2.5% in November 2012, while the Spanish economy posted a massive negative
growth of 7.3%. The positioning of countries on Austerity Highway in Fig. 11.1 may not
reflect the growth figures precisely.
2 The U.S. has not posted a negative quarterly GDP growth rate since 2010. In terms of
industrial production, the U.S. economy was up by 2.2% in December 2012. The disparity
in growth figures indicates, among other things, the U.S. has opted for pain tomorrow
while European countries are experiencing pain today.
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the leading indicators tell us that this is the case. The fact that ination is
still subdued does not mean that quantitative easing is benign it is not.
Ination is still subdued because the expansion in the monetary base has
not been translated into a corresponding expansion in the money supply as
banks have been accumulating reserves rather than giving out loans. But
this is already changing, and it should because banks cannot accumulate
reserves indenitely they may as well go out of business. Again, it must
be emphasized that even a U-turn on the Quantitative Easing Highway
(which is unlikely) may not save the day because the loss of condence in
the dollar would come even if the Fed decided to quit quantitative easing.
The signs are conspicuous as we saw in Chapter 10.
11.2. Fire or Ice?

A debate is currently raging about whether the U.S. economy is heading
towards deation (ice) or hyperination (re).3 This book makes a contribution to this debate by presenting a strong case for re and by casting
doubt on the validity of arguments for ice and against re. We have not yet
considered the arguments for ice.
In the aftermath of the global nancial crisis and the recession that
followed, the Federal Reserve started to pump liquidity in the system via
quantitative easing. While it is only natural to think that a monetary
expansion caused by quantitative easing will eventually lead to ination,
some economists believe that quantitative easing will actually lead to
deation. Others, guided by the Japanese experience, believe that it will be
deation with and without quantitative easing. Some economists think that
both outcomes are possible, depending on the current and future actions of
policy makers. Duncan (2012), for example, concludes that the price level
could either collapse (ice) or surge higher (re), depending on whether
governments cease quantitative easing or, by attempting to prevent deation, maintain quantitative easing, thus generating hyperination. Likewise,
Bourque (2012) argues that whether we have ination or deation depends
on just how much governments are willing to do to prevent deation. As
things stood at the end of 2012, it was expected that quantitative easing
would be maintained for a long time to come hence re is more likely.
3 In
a more dramatic language, ice and fire are respectively called ice storm and fire
storm.
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317
Arguments for ice are based on the proposition that the U.S. economy
is already pushing towards a debt deationary depression as a result
of an extended credit bubble. The bursting of the bubble will reduce
the velocity of circulation of money, thereby causing downward pressure
on prices. High unemployment, coupled with large and growing amounts
of government debt, is said to indicate that deation and a subsequent
depression will occur. Since the Fed cannot continue to inate the money
supply via quantitative easing, the argument goes, austerity measures will
become unavoidable. The problem with this argument is that in the age of
computer-generated at money, there is no limit on the ability of the Fed
to inate the money supply. Abandoning quantitative easing can be caused
by the realization that the risk of ination is high, which is why the Bank
of England abandoned the policy in May 2012, and/or the realization that
QE is ineective. It does not seem that Bernanke believes in either, thus
he will continue driving on the Quantitative Easing Highway.
A proposition has been put forward suggesting that ice will be the
very outcome of quantitative easing that QE will cause ice. The
underlying idea is that by reducing returns on government bonds, QE will
curtail the consumption of those who are receiving interest income such
as annuities. For example, Stiglitz (2012) argues that quantitative easing
will punish consumers who invested in government bonds and diminish
their consumption. It is reduced consumption and the hoarding of cash by
these sectors of the economy that will produce deation, a situation that is
exacerbated by an ageing population. This argument is not convincing in
the sense that low interest rates should encourage consumption rather than
the other way round. The reason why this is not happening is the classic
you can take the horse to the water but you cannot force it to drink.
With or without quantitative easing, the propensity to consume is low.4
Several economists put forward the argument that as soon as large
amounts of government debt make quantitative easing no longer viable,
deation and economic downturn will follow. Chapman (2010) argues that
the continued creation of government debt and monetization of the decit
by the Fed means that a deationary collapse, one way or another, is
inevitable. Duncan (2012) argues that current economic conditions are
4 The
proposition that low interest rates, resulting from QE or otherwise, would depress
consumption sounds counterintuitive. For the whole economy, low interest rates should
have a positive impact or at worst no impact on consumption. Furthermore, interest
income is small compared to the income derived from wages and salaries.
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similar to those that resulted in the Great Depression caused by large

at-money-denominated credit. These conditions threaten a New Great
Depression should government intervention cease. He goes on to say
that as soon as the government withdraws stimulus or the governments
capacity to provide any more stimulus is exhausted . . . the deationary
death spiral will resume. Two points are noteworthy here. The rst is
the big dierence between the Great Depression and the current situation
(monetary contraction versus expansion). The second is that there is no
limit on the provision of money via quantitative easing money can be
created at the click of a mouse. Then, it sounds strange that Chapman talks
about the monetization of the decit yet he expects deation.
One justication for the ice view is that quantitative easing has been
ineective in stimulating the economy. The meaning of this is that the
realization of the ineectiveness of QE will force its abandonment, leading
to deation. This view, however, does not reect the current state of aairs.
The initiation of QE3 in September 2012 indicates the belief that quantitative easing can and does work. On 12 December 2012, Bernanke announced
that he would intensify quantitative easing until the unemployment rate
falls below 6.5%, a move that was dubbed QE4 (Fontevecchia, 2012).
Given how sluggish the unemployment rate is, quantitative easing will be
maintained for a very long time.
We have already cast a big shadow of doubt on the validity of the
arguments against re, the rst of which is that quantitative easing has
not led to a monetary expansion and the related arguments that QE is
not about money printing and that it makes a dierence if newly created
money is used to purchase bonds from nancial institutions or from the
government, which we dealt with in Chapter 9. It is true that the money
supply is not reecting the growth in the monetary base, but this situation
is unsustainable because the current reserves to deposits ratio is greater
than one. The situation is already changing, which is shown in the gures
provided by the Federal Reserve Bank of St Louis. In October 2012, reserves
of commercial banks with the Fed declined by almost 4%, a massive monthly
gure. In the same month, the narrow money supply rose by over 3%.
The other arguments against re are that quantitative easing is not
going to lead to ination because of the currently underutilized productive
capacity and high levels of unemployment. Stiglitz (2012) argues that
QE3 will not cause serious ination because of economys underutilized
productive capacity. Levine-Weinberg (2012) similarly argues that quantitative easing will not cause hyper or even severe ination because
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319
of the current unemployment and underemployment in the U.S. Harvey

(2011) points out that there is no reason why quantitative easing will
not lead to a rise in production and employment as opposed to prices,
as long as excess money balances are invested in productive activities
to meet the new demand. This reasoning is awed because it does not
distinguish between moderate ination and hyperination. Reference to
spare capacity and unemployment implies that these economists are talking
about moderate demand-pull ination. What we are talking about here is
hyperination, which is not an extension of moderate ination, as pointed
out in Chapter 6. While moderate ination can be attributed to demandpull factors, hyperination is a scal-monetary problem that could arise
irrespective of the cyclical state of the economy.
Yet another argument against re is that hyperination is typically
associated with war and revolution, which are not symptoms of the U.S.
(OBrien, 2012). More specically, the argument is that the U.S. is in a
dierent position because it does not have any problems selling sovereign
debt, and because it has a highly productive and functioning economy. This
argument is awed because there are indications that major holders of the
U.S. Treasuries (most notably, China) have already lost their appetite as
we saw in Chapter 10. Given also the stock of Treasuries accumulated by
the Fed as a result of QE, there is probably a glut of Treasuries, making
it increasingly dicult to sell the U.S. government debt. The argument
also confuses the cause and eect. It is hyperination that transforms a
functioning economy into a devastated one.
There are a large number of economists who support the arguments
for re put forward in this book. According to Bourque (2012), the U.S.
is engaging in excessive amounts of quantitative easing and is threatening hyperination. In an open Letter to Ben Bernanke, several leading
economists warned that the planned asset purchases by the Fed risk
currency debasement and ination and will not achieve its objective of
promoting full employment (Asness et al., 2010). Wade and Bilson (2012)
suggest that there are legitimate concerns over the impact of the huge
expansion in the monetary base and greater velocity.
There are good reasons to expect that the U.S. will experience
hyperination sooner or later because it has gone so far down the path
towards hyperination. An annual budget decit in excess of one trillion
dollars requires the federal government to sell bonds for the amount of
the decit plus any bonds coming due. Investors are mostly buying shortterm bonds, so the Fed will buy any bonds not bought by anybody else.
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The federal government will make sure that will happen even if that requires
changing the laws governing the Fed or the people running it. Government
spending is out of control and the Fed will keep creating money as fast
as the government needs. The re view is supported by theory, history,
intuition, and actual macroeconomic indicators.
Dowd et al. (2011) portray a picture of how hyperination will hit the
U.S., arguing that if the Fed persists along its declared path, the prognosis
is accelerating ination leading ultimately to hyperination and economic
meltdown. They predict that the Fed will be forced to monetize the whole
of the federal debt, which requires a rapid expansion of the monetary base.
For them, hyperination in the U.S. is inevitable, particularly that the Fed
has denitely persisted along its declared path and will continue to do so.
11.3. The Unthinkables

For some people, hyperination in the U.S. is unthinkable. For others, it is
also unthinkable that the dollar would lose its status as the international
reserve currency. But then, it was unthinkable that the U.S. would be
replaced by China as the largest economy and largest manufacturing
power in the world. Let us consider, in turn, these once unthinkables and
demonstrate why they have become not only thinkables but also realities.
In Chapter 10, a case was made for why the dollar is likely to lose its
international status. Ben Bernanke himself admitted in a speech in Tokyo
in October 2012 that emerging economies can insulate themselves from
his decisions by simply decoupling their currencies from the dollar, which
came in response to complaints from policy makers in emerging markets
that Fed easing destabilizes their economies, contributing to higher ination
and asset price (The Economist, 2012e). In a speech on the same day, a
deputy governor of Chinas central bank pointed out that China no longer
accumulates dollar-denominated reserves. Subramanian and Kessler (2012)
demonstrate that, for a sample comprising emerging market economies, the
yuan has increasingly become a reference currency as measured by a high
degree of co-movement with other currencies. They believe that a yuan bloc
has emerged because it is eclipsing the role of the dollar. For example, they
show that seven out of 10 South East Asian currencies co-move more closely
with the yuan than with the dollar. They envisage that a more global yuan
bloc could emerge by the mid-2030s. This was unthinkable few years back.
The rise of the Chinese currency follows the rise of China. The U.S.
has been the worlds leading economic power since 1871: It has contributed
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321
some 30% on average to world GDP since 1960 and made up 22% of the
pie in 2011 (at market exchange rates). While China contributes just 10%,
it has seen its share of world GDP rise rapidly, from just 1.8% in 1991.
An analysis of 21 dierent indicators chosen by The Economist (2011c)
reveals that China has already overtaken the U.S. on over half of them and
will be top on virtually all of them within a decade. On a few indicators,
such as steel consumption and ownership of mobile phones, the milestone
was reached as long as a decade ago. Since then, several more indicators
have been surpassed. In 2011, China exported about 30% more than the
U.S. and spent some 40% more on xed capital investment. China is the
worlds biggest manufacturer, and partly as a result it burns around 10%
more energy and emits almost 40% more greenhouse gases than the U.S.
(although its emissions per person are only one-third as big). The Chinese
buy more new cars each year than anybody else. China is also challenging
the U.S. in innovations: In 2011, more patents were granted to residents in
China than in America.
In a study published in Greater Pacic (2012), the following two
conclusions are reached on the economic and political decline of the U.S.:
(i) based on an economic model, the U.S. power would begin to decline
around 2030 and its decline would be complete by the end of the century;
and (ii) based on a political model and taking into account 9/11, the war
in Iraq and the global nancial crisis, American decline may have begun in
2001 and would be complete between 2055 and 2065.
Consider now the once-unthinkable of the demise of manufacturing
industry in the U.S, which free-marketeers consider to be natural,
a phase of economic evolution. Liu (2005b) quotes Alan Greenspan as
saying, in a testimony to Congress, that thinking jobs are better than
doing jobs and that the U.S. will keep higher-paying jobs in nancial
services, management, design, development, sales and distribution and let
the emerging economies have the low-paying assembly line jobs in factories
owned by the U.S. companies. Liu (2005c) attributes the erosion of the U.S.
manufacturing base to neo-liberal global trade in the last two decades,
motivated by dollar hegemony: print dollars and buy the stu rather than
toiling to make it.
Friedman (2002) disagrees with the proposition that it is natural for services to replace manufacturing industry by arguing along the following lines:
Such beliefs were plausible in 19941998, when business-service employment was booming. As millions of jobs in technically demanding work
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programming computers, setting up communications systems, for

example were created, business services oset slower growth or job
losses in manufacturing. But when manufacturing went into a tailspin in
the later 1990s, the business-service growth that powered the healthiest
phases of the decades boom slowed too. Rather than supplant manufacturing, business-service enterprises depended on healthy factories, which,
after all, were among their biggest clients.
Friedman is justiably sarcastic when he points out that it is hard to

imagine how service-sector expansion can play a role in wealth creation
if growth in, say, manicurists exceeds that of engineers. Krugman (2011)
asserts that manufacturing, once Americas greatest strength, seemed to
be in terminal decline.
The U.S. economy has changed (by choice) from a super manufacturing
power to one dominated by the nancial sector. While the Chinese have
been making consumer goods and machine tools, the Americans have been
making nancial products that have no social value whatsoever and can be
destructive as demonstrated by the global nancial crisis. While the Chinese
have been promoting the products of scientic innovation and engineering,
the Americans have been promoting the products of the so-called nancial
engineering: options on futures, futures on options, options on futures on
options on swaps, CDOs, CDSs, and so on. Was it thinkable in the 1950s
that Detroit would lose its status as the motor industry capital of the world?
11.4. The Big Unthinkable: Break-Up of the U.S.
A federal system or a political union, in general, survives as long as major
economic diculties do not arise but once they do, member states start
complaining about cross-subsidization. As economic diculties intensify in
Spain, the Catalans are thinking about independence from Spain for the
usual reason that we give more than we take. The big unthinkable now
is the break-up of the U.S., which many do not consider to be a remote
possibility. Just 10 years before the break-up of the Soviet Union, it was
hardly imaginable that something like that could happen, but it did.
Koenig (2008) argues that the United States of America is really
50 sovereign states in a union and that union can dissolve just like the Soviet
Union did, suggesting that the likelihood of some kind of breakup of the
union is about an eight on a scale of one to ten and that the likelihood
that the U.S. will fragment into many new nation states . . . is about 5050.
Those who think that the U.S. is likely to break-up attribute it to the
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323
increasing power of the federal government. This is what a blogger wrote

in 20085:
The government is predicting that systems will break down. But instead
of doing anything to actually fix the underlying problems which are
leading to the break down (like making sure that politicians follow the
Constitution and making sure that Americas manufacturing base is
rebuilt, so that we can make something real, and our workers can make
decent wages on a sustainable basis), the government is just planning on
implementing police state measures to quell protests.
The break-up of the U.S. will come as nancial and demographic trends
provoke a political and social crisis in the U.S. When the going gets
tough, wealthier states will withhold funds from the federal government
and eectively secede from the union. It has been reported that more
than 675,000 digital signatures appeared on 69 separate secession petitions
covering all 50 states, according to a Daily Caller analysis of requests
lodged with the White Houses We the People online petition system.6
Baldwin (2010) argues that the break-up of the U.S. is inevitable and that:
People all over America are discussing freedoms future. In short, they
are worried. In fact, many are actually talking about State secession.
In coee shops and cafes, and around dining room tables, millions of
people are speaking favorably of states breaking away from the union.
Not since the turn of the 20th century have this many people thought
(and spoken) this favorably about the prospect of a state (or group of
states) exiting the union.
History may provide indicators as to what the future will hold. Financial
crises preceded both the American secession from the British and the
Southern secession from the union. The current economic crisis has some
chance of being followed by secession of some states. A potential triggering
factor lies at the heart of the issue under investigation in this book
the ability of the Federal Reserve to impose ination tax on people. The
Fed is essentially a private company that is run by people who are not
elected by voters hence, what we have is a situation of taxation without
5 http://georgewashington2.blogspot.com.au/2008/12/will-financial-breakdown-cause-
break-up.html.
6 http://iestreetlife.aforumfree.com/t3914-is-the-usa-breaking-up-petitions-seeking-
approval-to-secede-now-come-from-all-50-states.
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representation, which was one of the reasons for the American Revolution.
As a result, states-rights movements and secession movements are growing
across the country.
If and when the time comes when the paper money used by the
federal government to pay for unemployment, welfare, food stamps, social
security and Medicare is so devalued that it is no longer adequate to take
care of people, states may decide that they will be better o eliminating
payments to the federal government and taking care of their own people.
If rich states were to exit, the remaining states would have a higher debt
burden per capita, which will force the Fed to impose even higher ination
taxes.
Some would argue that there have not been any successful secession
movements in America since the secession from the British however, this
is not exactly correct. West Virginia seceded from Virginia, Nevada seceded
from the Utah Territory, and both Texas and California seceded from Mexico. Let us also not forget how the civil war started economic dierences
about taris between the industrial north and agricultural south, leading
to a secession of southern states. The unthinkable could happen again.
11.5. The Day of Reckoning is Inevitable

For most people, it is unthinkable that the U.S. will experience hyperination. But history tells us that many great nations and empires experienced
hyperination, and even the U.S. has gone through the experience twice
already, rst during the revolution and then in the South during the civil
war. The great Roman Empire experienced hyperination, and with that
came its demise.
There are those who think that the U.S. is experiencing the same
circumstances that led to the fall of the Roman Empire. Historians attribute
the collapse of the Roman Empire, which once seemed invincible, to three
factors: (i) overstretched and overcondent military, (ii) moral deterioration, and (iii) scal proigacy. These factors are symptomatic of contemporary America. The U.S. military is overstretched, ghting unnecessary wars
here and there, some of which have nothing to do with the war on terror
and a lot to do with the war of terror. The fact that the U.S. military is
overcondent is symbolized by Donald Rumsfelds belief, in his heyday, that
the invasion of Iraq would be a walk in the park and by George W. Bushs
infamous statement of mission accomplished, not to mention the U.S.s
catastrophic adventure in Vietnam. Moral deterioration is exemplied by
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325
the transfer of money from the average taxpayer to wealthy bankers under
the pretext of too big to fail, Donald Trumps call for free oil from Iraq
and the control of the mineral resources of Afghanistan to compensate
America for the liberation of these two countries, the authorization of
torture and kidnapping by George Bush II, the glorication of war, the
justication of proteering by all necessary means, the rationalization as
natural of extreme income and wealth inequality, contempt towards the
rest of the world (symbolized by the do-as-I-say attitude), and the attitude
of blaming others for own problems (China is the reason why we have a
trade decit and why we no longer have manufacturing industry). A sign of
moral deterioration is very much related to ination that is the ability
to print money and exchange it for real goods produced by poor foreigners.
There is no need to talk once more about scal proigacy any more
but a remark made by Williams (2012) is on the spot particularly that
it pertains to hyperination. He said: the U.S. government already had
condemned the U.S. dollar to a hyperinationary grave by taking on debt
and obligations that never could be covered through raising taxes and/or
by severely slashing government spending that had become politically
untouchable. With the creation of massive amounts of new at dollars,
he adds, comes the eventual full destruction of the value of the U.S. dollar
and related dollar-denominated paper assets.
Those who think that the U.S. is economically invincible and immune
from hyperination must be living in a state of denial. In 1989, Gerald
Swanson warned that if the U.S. fails to reign in its debt . . . American
businesses might nd themselves facing South Americas inationary
nightmare and suggesting that the United States has destroyed its
economic exibility, and the longer we wait to confront our problems, the
more impossible they will be to overcome (Swanson, 1989). The U.S.
has avoided ination only because other countries have been willing to
nance American excesses. Whatever the reason for this aberration, the
trend cannot continue.
For some politicians, it is business as usual, refusing even to
acknowledge that there is a scal problem that requires a drastic action
on both the spending and revenue sides. It is still nono for taxes on the
rich because these are the people who create economic growth. It is like
the NRL denying that there is a link between the ease of getting hold of re
arms and the rate of violent murders. Like the case with the scal mess,
gun control is a non-starter and the best way to avoid a Newtown-type
massacre is to put armed police in schools. Why? Because the constitution
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says that citizens have the right to bear arms, just like the free market
ideology says that everything will correct itself through market forces.
Those who think that way, whether they are in Congress or the NRL,
seem to forget that desperate situations need drastic actions: they should
accept a constitutional change to allow gun control and do what it takes to
correct the scal decit. While it is not too late to go for gun control, they
have left it a bit late to correct the scal imbalance. By the way, the two
are connected. Going for a full gun control requires a program of buy-backs
of the 300 million or so guns of all sorts held by American households.
This will require additional funding, which has to be nanced somehow (by
printing money, for example).
The situation is grim, indeed, and the day of reckoning is inevitable.
The situation following the scal cli agreement is described on the cover
of the 5 January 2013 issue of The Economist as follows: a broken system,
a lousy deal and no end in sight. Even more representative of the current
state of aairs is the following: America used to have Steve jobs, Johnny
Cash and Bob Hope now America has no jobs, no cash and no hope.
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b1571-index
INDEX
accelerating ination, 4
adaptive expectations, 139, 149151
adjusted monetary base, 299
administered prices, 225, 238
aggregate demand, 78
American Civil War, 16, 114
American Revolution, 324
annual poverty survey, 48
anticipated ination, 92, 98
Arab Spring, 112
Asian nancial crisis, 88
asset price ination, 24, 26, 69
asset-price bubbles, 72
austerity, 255257, 259, 261, 296, 317
Austral Plan, 205
Austrian National Bank, 185
Bureau of Labor Statistics, 37, 42, 45,

47
Bush tax cuts, 291
capital budgeting, 98, 99
capital controls, 196
capital ight, 196, 227
capital formation, 101
capital gains tax, 97, 101
casual empiricism, 64, 76
central bank independence, 70, 72,
86, 141
Central Bank of Brazil, 214
Central Bank of China, 186
chain weighted price index, 47
chained CPI, 42, 47
chained volume series, 43
chronic ination, 159
civil unrest, 156
classical hyperinations, 201
Coinage Act of 1965, 182
Cold War, 202
commodity money, 165, 166
commodity prices, 78
commodity standard, 56, 165
commodity-based exchange traded
funds, 119
comparative advantage, 305
competitiveness, 108
Confederate Congress, 141
Confederate States of America, 180
Confederate Treasury notes, 180
conspiracy theory, 239
consumer price index, 17, 34, 37
balance of payments targeting, 1

banana money, 190
Bank of England, 176, 255, 256,
269271, 313, 317
Bank of Japan, 73, 88, 190, 255
Bank of Mexico, 228
Bank of Poland, 191
Bank of Sweden, 174
barter, 136
base year, 39
Black Death pandemic, 16
black market premium, 225
black markets, 23, 130, 136, 225, 248,
279, 309
Bolshevik Revolution, 191
Bretton Woods system, 181, 182
broad money supply, 50
343
August 10, 2013
344
8:54
9in x 6in
b1571-index
Continental Congress, 179

Convertibility Law, 206
core ination, 26, 36
corruption, 117, 155, 158
cost of living, 2, 48
cost-of-living adjustment, 47
cost-push ination, 78, 122, 187
cost-push theories, 15
crawling peg, 219
credit bubble, 317
credit expansion, 52
credit ination, 3, 4
creditworthiness, 159
creeping ination, 4
currency board, 152, 158160, 206
currency substitution, 121, 129, 136,
145, 176, 185, 196, 213
currency substitution model, 149,
150
currency to deposits ratio, 54
cyclical decit, 85
cyclical output, 76, 77
debt deation, 3
debt-based assets, 26
deation, 5, 13, 23, 73, 87, 92, 93,
168, 257, 279, 316
deationary depression, 317
deationary gap, 75, 76
deationary spiral, 8, 87, 88
deleveraging, 3, 257
demand for money, 62
demand shocks, 83
demand-pull ination, 75, 122, 319
demand-pull theories, 15
discount rate, 98, 227
discretionary spending, 284, 293,
299
disguised ination, 23
dishoarding, 186
disination, 4, 5, 23, 92, 227, 237
dollar hegemony, 290, 305, 308, 321
dollar-indexed deposits, 227
dollarization, 150, 159, 160, 162,
220
easy money, 69
Economic Growth and Tax Relief
Reconciliation Act, 291
Economic Report of the President,
45, 112
economic stability, 26
elasticity of substitution, 145
electronic money, 50
employment targeting, 1
entitlement programs, 290
European Central Bank, 45, 73, 255
European Monetary Union, 255
European Union, 45
Eurozone, 265
excess demand, 78
exchange rate regime, 15
expectation formation mechanisms,
151
expected ination, 106
extrapolative expectations, 149, 150
exuberant privilege, 302, 303
FAO food price index, 115
Federal Open Market Committee,
272
Federal Reserve, 255, 256, 269, 271,
273, 296, 308, 315, 316
Federal Reserve Bank of St Louis, 65
at currency, 133
at currency system, 55
at money, 16, 165
FIFO, 98
nancial engineering, 322
re or ice debate, 26
First Bank of the United States, 177
scal cli, 261, 292, 315, 326
scal exposure, 293
scal gap, 293
scal models of hyperination, 136
scal policy, 85
scal theory of ination, 85
Fisher equation, 103
ow variable, 29
food price ination, 112
foreign ination, 79
forward market, 92
August 10, 2013
8:54
9in x 6in
Index
forward spread, 151

fractional reserve system, 52, 54, 55
free banking, 160
full employment, 72
full reserve system, 54
Fundamental Economic
Transformation Law, 221
GAAP, 283
galloping ination, 4
GDP deator, 34, 42
general price level, 2, 17, 26, 29, 33,
5860, 70, 79, 101, 121
generally accepted accounting
principles, 152
global nancial crisis, 21, 22, 26, 55,
69, 72, 76, 189, 230, 258, 268, 273,
281, 294, 316, 321, 322
gold exchange standard, 181
gold standard, 89, 158, 165, 166, 180,
185, 191
goods price ination, 26
Government Accountability Oce,
299
government debt, 261, 294
Great Debasement, 176
great deation, 89
Great Depression, 8789, 181, 318
great recession, 268, 294
Greenback, 179
gross debt, 261
Gulf Co-operation Council, 306
Gulf war, 224
harmonized index of consumer prices,
45
headline ination, 225
high-powered money, 53
hoarding, 130
housing market, 69
hyperinationary depression, 315
hypershortageation, 24
hyperstagation, 122, 243
imported ination, 70
income policies, 232
b1571-index
345
income redistribution, 95
indexation, 42, 97, 98, 159, 214, 219,
227, 233
industrial relations, 158
inertial ination, 216
ination accounting, 154
ination bias, 72
ination rate, 29
ination targeting, 1, 4, 7072
ination tax, 97, 118, 138, 274, 303,
323
ination variability, 117
ination-indexed bonds, 119
inationary bias, 86
inationary bursts, 2, 7, 60
inationary expectations, 60, 71, 100,
106, 111, 131, 133, 139, 144, 145,
249, 252, 268, 272
inationary nance, 86
inationary gap, 7577
inationary inertia, 227
inationary pressure, 75
inationary process, 15
inationary shocks, 83
International Accounting Standards
Board, 129
international debt crisis, 221
international reserves, 232
International Tin Agreement, 212
international transmission of
ination, 15
Jobs and Growth Tax Relief
Reconciliation Act, 291
Korean War, 193, 286
League of Nations, 185
lender of last resort, 161, 166
linkers, 119
liquidity trap, 92
macroeconomic mismanagement, 62
macroeconomic policy, 243
mandatory spending, 284, 290
mark-up model, 149
market basket, 2, 40
August 10, 2013
346
8:54
9in x 6in
b1571-index
market socialism, 208

measurement bias, 36
Medicaid, 284, 286, 290, 308,
313
Medicare, 284, 286, 290, 294, 308,
313
medium of exchange, 50
menu costs, 100
Mexican crisis, 206
mild ination, 4
military yen, 190
moderate ination, 71, 123, 124, 152,
156, 319
monetary accommodation, 83
monetary aggregate, 50
monetary assets, 50
monetary base, 53, 54, 63, 87, 190,
265, 316
monetary debasement, 165
monetary easing, 266
monetary expansion, 52, 60, 62
monetary ination, 3, 16, 50, 55, 58,
63, 64
monetary model of exchange rates,
109, 132, 142, 150
monetary policy, 72
monetary targeting, 70
monetary theory of ination, 15
monetary validation, 83
money illusion, 32, 33, 158
money income, 32
money market model, 149
money multiplier, 54, 58, 265
mortgage-backed securities, 270, 272,
273
multiplier, 55
narrow money supply, 50
National Bank of Romania, 239
national income accounting, 32
National Ination Association,
116
net debt, 261
net operating scal balance, 262
net present value, 99
neutrality of money, 59, 63
new political economy, 140

nominal anchor, 232, 235
nominal GDP, 43, 45
nominal income, 71
Nordic model of ination, 79
Oce of Territorial Rationalization
and the Oce of Indemnications,
230
oil prices, 79
oil-for-food program, 224
open ination, 23, 189
Operation Twist, 273, 276
opportunity cost, 100
optimal ination rate, 118
output gap, 244
output targeting, 1
Pacic War, 190
pay back period, 99
personal consumption deator, 43
peso crisis, 228
policy mistakes, 15
Polish State Loan Bank, 191
political business cycle models, 86
political cycles, 140
political economy approach to
macroeconomic policy, 140
political theory of ination, 86
potential output, 72, 75
price controls, 130, 133, 190, 208, 213,
279
price ination, 3, 16, 50, 55, 58, 63,
64
price revolution, 16
price signals, 111
price stability, 4, 26, 42, 72, 85, 91,
92, 152, 176, 177, 189, 224
producer price index, 34
prot margin, 79
Programme of Economic and
Financial Clean-up, 203
proportionality, 142
protectionism, 183, 309
public debt, 70, 71, 261, 294,
310
August 10, 2013
8:54
9in x 6in
Index
Public Enemy Number One, 93

purchasing power parity, 109, 121,
246
QE1, 264, 301
QE2, 264
QE3, 264, 300, 315, 318
QE4, 315, 318
quantitative easing, 17, 19, 21, 23, 55,
63, 88, 116, 177, 265, 268, 274, 279,
299, 313
quantity equation of money, 58
quantity theory of money, 58, 64, 87,
109, 121, 131, 142, 150, 203,
249
quasi-hyperination, 235
rational expectations, 139, 150,
152
rationing, 279
real GDP, 43, 45, 58
real income, 32, 71
real interest parity, 103
real output, 32, 58, 59, 62
real return bonds, 119
reation, 7
regional ination, 47
Reichsbank, 195, 272
Rentenbank, 196
Rentenmark, 196
reparation payments, 146
replacement cost, 98
repressed ination, 23
Reserve Bank of Australia, 91, 109
Reserve Bank of Zimbabwe, 246
reserve requirements, 63
reserve to deposits ratio, 54
resource shocks, 34
Revolutionary War, 179
risk of defaults, 87
Russo-Japanese War, 190
seigniorage, 49, 86, 94, 119, 148, 162,
163, 166, 231, 298
selection bias, 40
shock therapy, 158, 160
b1571-index
347
shoe-leather costs, 100

shortageation, 24, 235
Smithsonian Agreement, 182
SmootHawley Tari Act, 88
social security, 284, 286, 290, 294,
308, 313
Solvos stabilization plan, 187
Southern Bread Riots, 114
Special Drawing Rights, 304
speculation, 158
speculative bubbles, 119
spurious correlation, 64
stag-deation, 26
stagation, 9, 23, 26, 221, 241,
243
staghyperination, 243
State Note Institute, 187
state-capture approach, 86
structural decit, 85
sub-indices, 39
subsidies, 146
supply shocks, 83
supply side doctrine, 291
supply-side transitory shocks, 36
suppressed ination, 3, 23, 189
symmetry, 143
taris, 78
Taylor rule, 72
technological progress, 78
terms of trade, 138
trade balance, 108, 109
trade unions, 79
Treasury Ination Protected
Securities, 119
Treaty of Versailles, 195
Trin Dilemma, 302
trimmed means method, 37
U.S. Coinage Act of 1792, 179
UN Conference on Trade and
Development, 304
unanticipated ination, 92
uncovered interest parity, 144
underground economy, 118
underlying ination rate, 139
August 10, 2013
348
8:54
9in x 6in
variance-weighted means method, 37

velocity of circulation, 5860, 63, 64,
70, 87, 131, 136, 137, 243, 317
voodoo economics, 291
wage ination, 3, 70
wage rigidity, 118
wage-price spiral, 79, 216
wealth eect, 69
weighting bias, 36
wheelbarrow ination, 195
wholesale price index, 45
working capital, 100
World War I, 180, 183, 191, 194
World War II, 181, 186, 298, 302
worldwide ination, 82
b1571-index

Quantitive Easing As A Highway To Inflation

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Quantitative Easing as a Highway to Hyperinflation

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August 10, 2013

Quantitative Easing as a Highway to Hyperinflation

About the Author

Inflation, Deflation, Disinflation and All That

The Measurement of Inflation

The Ination Rate . . . . . . . . . . . . . . .

August 10, 2013

The Monetary Theory of Inflation

Other Theories of Inflation and Some Extensions

Quantitative Easing as a Highway to Hyperinflation

Quantitative Easing as a Highway to Hyperinflation

The Consequences and Costs of Inflation

August 10, 2013

Quantitative Easing as a Highway to Hyperinflation

The Optimal Ination Rate . . . . . . . . . . . . . . . . 118

The Phenomenon of Hyperinflation

The History of Fiat Money and Hyperinflation

Fiat Money, Monetary Debasement

August 10, 2013

Quantitative Easing as a Highway to Hyperinflation

Quantitative Easing as a Highway to Hyperinflation

7.2.1 The ancient Chinese experience . . . . . .

Hyperinflationary Episodes since the 1970s

August 10, 2013

Quantitative Easing as a Highway to Hyperinflation

The Status Quo: Heading Towards Hyperinflation?

The Road to Hyperination . . . . . . . . . .

Leading Indicators of U.S. Hyperinflation

The Fiscal Balance . . . . . . . . . . . .

August 10, 2013

Quantitative Easing as a Highway to Hyperinflation

Quantitative Easing as a Highway to Hyperinflation

The Highway Network . . . . . . . . . . . .

August 10, 2013

Quantitative Easing as a Highway to Hyperinflation

August 10, 2013

Quantitative Easing as a Highway to Hyperinflation

Quantitative Easing as a Highway to Hyperinflation

The U.S. GDP at current and constant prices with dierent

August 10, 2013

Quantitative Easing as a Highway to Hyperinflation

GDP deator and stock prices in the U.S . . . . . . . . . . .

August 10, 2013

Quantitative Easing as a Highway to Hyperinflation

Quantitative Easing as a Highway to Hyperinflation

The consumer price index and money supply Belarus

August 10, 2013

Quantitative Easing as a Highway to Hyperinflation