Pathologies II: High Inflation

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Pathologies II High Inflation
Common Characteristics of Post-WWI Hyperinflations

• Short duration (about one year)
• Very intense, monthly inflation of 50 or more
• Had not occurred before or since
• Caused by money creation to finance large
  government deficits
• Budget Deficit and Money Creation
• A government can finance its deficit in two ways
  by--
• Borrowing
• Money creation (debt monetization)

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Pathologies II High Inflation
Budget Deficit and Money Creation
A Scenario for Hyperinflation...

• First A government borrows to finance a budget
  deficit and a social or economic upheaval
  creates a budget crisis.Three Examples
• A revolution that destroys the ability to collect
  taxes (Nicaragua 1980s)
• Aftermath of war (Germany 1922 and 1923)
• The collapse in the price of major export and
  revenue source (Bolivia 1980s decline in the
  price of tin)
• Second The government becomes unwilling or is
  unable to borrow to finance its deficit.
• Third The government finances its growing
  deficit with money creation.

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Pathologies II High Inflation
How much money creation is needed?
Seignorage Money Growth X Real Money
Balances
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Pathologies II High Inflation
Budget Deficit and Money Creation
How much money creation is needed?
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Pathologies II High Inflation
How much money creation is needed?

• If the deficit is 10 of Y, the seignorage 10
  of Y and if (M/P)/Y2, then the monthly growth
  rate of money 10/2 5.
• What do you think
• Can the government finance a deficit of 20 of Y
  with moneygrowth of 10 and a deficit of 40 of
  Y with 20 money growthand so on?
• The answer is NO!
• Because inflation increases
• Opportunity cost of keeping money increases
• People reduce their real money balances
• Increase in money growth does not generate a
  proportional increase in seignorage

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Pathologies II High Inflation
Inflation and Real Money Balances
What determines the real money balance people
want to hold?
Recall the relation between the nominal and the
real interest rate, Ch. 18
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Pathologies II High Inflation
What determines the real money balance people
want to hold?
During hyperinflation
Movements in ?e exceed movementsin Y and r

• Interpretation As ?e increase, the cost of
  holding also increases and people will reduce
  their real money balances.
• REDUCING REAL MONEY BALANCES DURING
  HYPERINFLATION
• Barter
• More frequent payment for wages
• Increase holdings of foreign currencies

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Pathologies II High Inflation
How much do real money balances decrease as
inflation increases--The Evidence from Hungary
(Nov. 1922 Feb. 1924)
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Pathologies II High Inflation
Deficits, Seignorage, and Inflation
The Case of Constant Money Growth
Assume the government maintains a constant rate
of moneygrowth forever. How much seignorage
will it generate?
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Pathologies II High Inflation
Deficits, Seignorage, and Inflation
The Case of Constant Money Growth (Continued)
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Pathologies II High Inflation
Deficits, Seignorage, and Inflation
Seignorage and Money Growth (The Empirical
Evidence)

• Money growth between O A increases
  seignorage

This is imilar to your Laffer curve!
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Pathologies II High Inflation
Deficits, Seignorage, and Inflation
Consider inflation as a tax on money balances
Tax rate ?
Tax base M/P
Inflation tax ?M/P (Constant money growth)
Question What rate of money growth maximize
seignorage? Econometric estimation by Philip
Cagan See Table 23 - 3
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Pathologies II High Inflation
Deficits, Seignorage, and Inflation
Money Growth and Seignorage
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Pathologies II High Inflation
Observation In all hyperinflations, money
growth exceeded the growth rate that would
maximize seignorage. Question Why such a high
money growth rate?
Dynamics of Increasing Inflation
Short run

• generates large amount of seignorage

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Pathologies II High Inflation
Dynamics of Increasing Inflation (Continued)
Over time

• Tanzi-Olivera Effect Higher inflation creates
  large deficits
• The adverse effects of high inflation include...
• The transaction system becomes less efficient
• Price signals become less useful
• Swings in the inflation rate become larger and
  investment falls

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How Do Hyperinflations End?

• Fiscal reform and credible deficit reduction
• Spending reform suspension of debt payments
• Taxation change the structure of the tax system
• Central Bank must make a credible commitment to
  no longer monetize the government debt
• Incomes Policies Wage and price guidelines
  (heterodox program)
• Can Stabilization programs fail?
• What are the costs of stabilization?
• Hyperinflations share a common causes and
  characteristics
• They are intense and short-lived.
• They are caused by monetizing a growing debt that
  was typically created by a shock.
• They are characterized by accelerating inflation
  and progressively larger real costs until a
  successful stabilization program is implemented.