CHAPTER 23

CHAPTER23

High Inflation

Prepared by:
Fernando Quijano and Yvonn Quijano

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Olivier

Chapter 23: High Inflation

High Inflation

Hyperinflation simply means very high inflation.

Inflation ultimately results from nominal money
growth.
Countries that have suffered from hyperinflation
have high nominal money growth because the
budget deficit is high. Governments cannot
finance its expenditures in any way other than
money creation.

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High Inflation

Chapter 23: High Inflation

Table 231

Seven Hyperinflations of the 1920s and 1940s

Beginning

End

PT/P0

Average Monthly
Inflation Rate
(%)

Austria

Oct. 1921

Aug. 1922

70

47

31

Germany

Aug. 1922

Nov. 1923

1.0 x 1010

322

314

Greece

Nov. 1943

Nov. 1944

4.7 x 106

365

220

Hungary 1

Mar. 1923

Feb. 1924

44

46

33

Hungary 2

Aug. 1945

Jul. 1946

3.8 x 1027

19,800

12,200

Poland

Jan. 1923

Jan. 1924

699

82

72

Russia

Dec. 1921

Jan. 1924

1.2 x 105

57

49

Country

Average Monthly Money

Growth
(%)

PT/P0: Price level in the last month of hyperinflation divided by the price level in the first month.

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High Inflation

Table 23-2 High Inflation in Latin America, 1976-2000

Chapter 23: High Inflation

Average Monthly Inflation Rate, (%)

1976-1980

1981-1985

1986-1990

1991-1995

Argentina

9.3

12.7

20.0

2.3

0.0

Brazil

3.4

7.9

20.7

19.0

0.6

Nicaragua

1.4

3.6

35.6

8.5

0.8

Peru

3.4

6.0

23.7

4.8

0.8

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Chapter 23: High Inflation

23-1

Budget Deficits
and Money Creation

A government can finance its budget deficit either

by:
Borrowing (issuing bonds), or by creating
money.
Debt monetization is the process by which
the government issues bonds and asks the
central bank to buy them; then, the central
bank pays the government with money it
creates, and the government uses that money
to finance the deficit.

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Chapter 23: High Inflation

Budget Deficits
and Money Creation
The start of a hyperinflation takes place when
there is budget crisis,
and the government is unable to borrow from
the public or from abroad.
Seignorage is the amount of real revenue the
government can generate from money creation.

M
s e ig n o r a g e
P

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Budget Deficits
and Money Creation

Chapter 23: High Inflation

The rate of nominal money growth required to

generate a given amount of seignorage is:

M
M

P
P

M
M

M
M

M
s e ig n o r a g e
M

M
P
M
P

In words, seignorage is the product of the rate of

nominal money growth and real money balances.

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23-2

Inflation and
Real Money Balances

Chapter 23: High Inflation

What determines the amount of real money

balances people will hold?

M
Y L (i)
P
( )
Real money balances depend (positively) on
income and (negatively) on the nominal interest
rate.
A higher nominal interest rate increases the
opportunity cost of holding money and leads
people to reduce their real money balances.

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Chapter 23: High Inflation

Inflation and
Real Money Balances
In times of hyperinflation, the amount of
money balances people will hold depends
primarily on expected inflation.

M
Y L (i)
P

i r

M
Y L (r e )
P

M
Y L (r e )
( )
P

When the expected rate of inflation is very

high, people will try to get rid of their money
holdings as soon as possible.

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Chapter 23: High Inflation

Inflation and
Real Money Balances
Barter is the exchange of goods for other goods
rather than for money.
During hyperinflations:
Barter increases.
Wage payments are more frequent.
People rush to stores to buy goods.
People shift to foreign currencies as stores of
value. The shift to dollars worldwide is an event
now called dollarizationthe use of dollars in
another countrys transactions.

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Inflation and
Real Money Balances

Chapter 23: High Inflation

Figure 23 - 1
Inflation and Real Money
Balances in Hungary,
November 1922 to
February 1924.

At the end of the

Hungarian hyperinflation,
real money balances
stood at roughly half their
prehyperinflation level.

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Chapter 23: High Inflation

Inflation and
Real Money Balances
Panel (a) plots real money balances
and the monthly inflation rate from
November 1922 to February 1924.
Panel (b) presents the same
information as Panel (a), but in the form
of a scatter diagram.

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Chapter 23: High Inflation

23-3

Deficits, Seignorage,
and Inflation

We have derived two relations:

The relation between seignorage, nominal
money growth, and real money balances
M M

M P
The relation between real money balances and
expected inflation

M
Y L (r e )
P
( )

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Deficits, Seignorage,
and Inflation

Chapter 23: High Inflation

Combining the two equations gives:

M M

s e ig n o r a g e
M P

M
Y L ( r e )

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Chapter 23: High Inflation

The Case of Constant Nominal

Money Growth

M
M

s e ig n o r a g e
Y L (r

M
M
Nominal money growth has two opposite effects
on seignorage:

S e ig n o r a g e
M

M
M
e
e
S e ig n o r a g e

L (r )
M
P

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The Case of Constant Nominal

Money Growth
Figure 23 - 2

Chapter 23: High Inflation

Seignorage and Nominal

Money Growth

Seignorage is first an
increasing function, then
a decreasing function of
nominal money growth.

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Chapter 23: High Inflation

The Case of Constant Nominal

Money Growth
The Laffer curve is the relation between tax
revenues and the tax rate. It looks similar to
figure 23-2.
A simple analogy can be made between the
Laffer curve and inflation versus money
balances. Inflation can be thought of as a tax on
real money balances.

M
In fla tio n ta x

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M M


S e ig n o r a g e
M P
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The Case of Constant Nominal

Money Growth
Table 22-3 Nominal Money Growth and Seignorage

Chapter 23: High Inflation

Country

Rate of Money Growth

Maximizing Seignorage
(% per month)

Implied
Seignorage
(% of output)

Actual Rate of
Money Growth
(% per month)

Austria

12

13

31

Germany

20

14

314

Greece

28

11

220

Hungary 1

12

19

33

Hungary 2

32

12,200

Poland

54

4.6

72

Russia

39

0.5

49

In all seven hyperinflations, the actual average

nominal money growth far exceeded the rate of
nominal money growth that maximizes seignorage.

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Chapter 23: High Inflation

Dynamics and Increasing Inflation

In the short run, an increase in nominal

money growth may lead to little change in real
money balances.
But over time, the same rate of nominal
money growth yields less and less
seignorage.
Therefore, the government cannot finance a
deficit at a constant rate of nominal money
growth.
The Tanzi-Olivera effect looks at the impact of
inflation on the real value of taxes collected.

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Hyperinflations and Economic

Activity

Chapter 23: High Inflation

In the short run, the effects of higher nominal

money growth are expansionary:

gm i
But as inflation becomes very high, the adverse
effects of hyperinflation dominate:
The transaction system works less and
less well.
Price signals become less and less useful.
Swings in the inflation rate become larger.

gm e

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Chapter 23: High Inflation

23-4

How Do
Hyperinflations End?
Hyperinflation do not die a natural death.
Rather, they have to be stopped through a
stabilization program. What follows are
the elements of a stabilization program.

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Chapter 23: High Inflation

The Elements of a
Stabilization Program
Hyperinflation needs to be stopped through a
stabilization program, which may include the
following elements:
Fiscal reform and credible budget deficit
reduction.
Taking credible steps that will demonstrate the
commitment of the central bank to no longer
monetize the debt.
Some economists argue that incomes policies
that is, wage and/or price guidelines or
controls - should be used, in addition to fiscal
and monetary measures.

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Chapter 23: High Inflation

The Elements of a
Stabilization Program
Stabilization programs that do not include
income policies are called orthodox;
those that do are called heterodox
(because they rely on both monetary
fiscal changes and incomes policies.

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Chapter 23: High Inflation

Can Stabilization Programs Fail?

Can stabilization programs fail? Yes, they can

fail, and they often do.
Sometimes failure comes from a botched or halfhearted effort at stabilization.
Failure can also come from the anticipation of
failure.

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Chapter 23: High Inflation

The Costs of Stabilization

We argued that there were three reasons why

inflation might not decrease as fast as nominal
money growth, leading to a recession:
Wages are typically set in nominal terms for
some period of time, and, as a result, many of
them are already determined when the
decision for disinflation is made
Wage contracts are typically staggered,
making it difficult to implement a slow-down in
all wages at the same time.
The change in monetary policy may not be
fully and instantaneously credible.

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Chapter 23: High Inflation

23-5

Conclusions

Although output fluctuates around its natural level

in the short run, it tends to return to this natural
level in the medium run. But it does not always
happen this way:
Sometimes, the adjustment mechanism that
is supposed to return the economy to its
natural level of output breaks down.
Monetary and fiscal policy may prove unable
to help.
Governments may lose control of both fiscal
policy and monetary policy.

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Chapter 23: High Inflation

The Bolivian
Hyperinflation of the
1980s

The stabilization plan was organized around the

elimination of the budget deficit. Its main features
were:
Fiscal policy
Monetary policy
Reestablish international creditworthiness
Table 1

Revenues, Expenditures, and the Deficit, as a Percentage of Bolivian GDP

1981

1982

1983

1984

1985

9186

Revenues

9.4

4.6

2.6

2.6

1.3

10.3

Expenditures

15.2

26.9

20.1

33.2

6.1

7.7

Budget Balances (-:deficit)

-5.7

-22.3

-17.5

-31.6

-4.8

2.6

Revenues and expenditures of the central government

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The Bolivian
Hyperinflation of the
1980s

Chapter 23: High Inflation

Figure 1
Bolivian Monthly Inflation
Rate, January 1984 to
April 1976

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Chapter 23: High Inflation

Key Terms

hyperinflations
debt monetization
seignorage
barter
dollarization
Laffer curve

2006 Prentice Hall Business Publishing

inflation tax
Tanzi-Olivera effect
stabilization program
income policies
orthodox stabilization program,
heterodox stabilization program

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