Hyperinflation

1
Hyperinflation

• Under the Fisher hypothesis and in the long run
  when clasical model is relevant
• money demand depends only on inflation rate ?
• ?P/P??M/M quantity theory is true
• then ?M/M - ?P/P 0
• money growth is the same as inflation rate
• r R- ? both real and nominal rates are
  constant their difference is the steady inlfation
  rate

2

• In hyperinflationary environments
• prices grow faster then money supply
• ?M/M - ?P/P lt0 ?m/m decreases
• people hold less and less money
• the conditions leading to hyperinflation is
  difficult to drive in this course

3
How do we correct the IS-LM model in case of
persistent inflation

• Assume there is steady inflation
• government raises M constantly every year which
  causes a constant increase in prices
• real interest nominal r - inflation
• r R - ?
• r real interest
• R nominal interest
• ? inflation or expected inflation

4

• Note that money demand depends on nominal
  interest rate
• mdL(R,y)
• but investment demand or consumption demand I or
  C depends on real interests
• I I(r) I(R- ?) and
• C C(r) C(Y,m,R- ?)
• How can we draw the IS and LM on the same graph
  R-y graph

5
How IS changes

• IS curve a relation between r and y when the good
  market is in eq.
• Solve it for r
• r IS(y)
• but r R- ? so
• R- ?IS(y) or R IS(y) ?
• the effect of steady inflation on the IS curve is
  to shift the curve upwards by ?

6
In a steady inflation IS curve shifts up by ? so
eq interest rate is higher then before
R
LM
?
IS when inflation ?
IS ? 0
y
7
In the clasical model
Initially there is no inflation Suddenly
government increase M by some amount MDS shit
upwards to MDS Initially Rr ?0 but increase in
?P/P ? ?M/M
AS
p
MDS
LM
R R ?
MDS
LM
ISIS?
r
y
If this is apersistent change IS shifts to IS?
to preserve Output at yp LM has to shift LM
IS
yp
8

• So at the new equilibrium
• Output level is the same Yp but since there is
  steady inflation ? eq. Interest rates become R
  ?r so
• Nominal interest rates increased from r to R
• Real money balance decreased mM/P?

9
What happens next
Suppose government increase M by the same rate
steadily each period MDS shits upwards
to MDS increase in ?P/P ? ?M/M
AS
p
MDS
MDS
LM
R r?
y
IS
yp
10

• In the new eq
• Output is Yp
• Nominal interest rates R
• Real interest rates rR- ?
• At each period
• ?P/P ? ?M/M

11
Inflation money and deficits

• Government deficit at time t
• Gt - NTt DPt
• where DPt is debt paid during period t
• Governments finance deficits by
• borrowing or
• printing money or
• combination of the two
• Gt - NTt DPt Bt ?Ht/Pt
• where Bt is borrowing in t
• is real money printed

12
Questions

• Is printing money to finance budget deficits the
  source of inflation?
• Note that
• Borrowing from the public does not create money
• governments can finance some portion of their
  deficits by borrowing and the remaining by
  printing money

13

• Budget deficits cause inflation if they are
  financed by printing money
• financing the deficit by borrowing does not cause
  inflation in the short run but
• borrowing also has its own limits
• can not be continued forever

14
Example

• Real government expenditures and taxes are
  constant for a couple of periods as given below
• G 200, NT100 ,r10 or 0.10
• initially no debt payment
• in the first period
• B1 200-100100
• in the second period
• B2 200-100(10.1)100 210

15

• In the third period
• B3 200-100(10.1)210 331
• note that even in the third period the budget
  deficit is negligible compared to the debt
  payments
• a major part of borrowing requirement is to
  borrow to pay previous periods debts

16

• In the forth period
• government has to raise the interest rate to be
  able to find more funds
• B4 200-100(10.2)331 100397.2
• notice that the composition of debt is changing
• the fraction of interest and previous debt
  payments is increasing

17

• After some point part or all of the deficit has
  to be financed by printing money
• The steady increase in money supply may lead to
  hyperinflation

18
Seigniorage Inflation tax and hyperinflation

• Seigniorage is value of real resources acquired
  by the government through its ability to print
  money
• BD G - NT
• if government is unable to raise taxes to finance
  its deficit
• prints money
• BD G - NT?H/P

19

• Dividing and multiplying by H
• ?H/PH/H ?H/H(H/P) ?P/Ph
• Inf tax ?P/Ph?h
• Where h is real cash demand or balance hH/P
• Note that HCR hH/P real cash
• It is different from real money demand mM/P
• inflationreal money demand or real cash
• may be considered as a kind of tax
• inflation rate being the tax rate
• Real cash demand is the tax basis
• Then by high inflation government can collect as
  much as tax it desires!

20
No!

• As inflation raises ?? R? m? h ?
• So at higher inflation rates h decreases

Inflation tax
?
?m is increasing first But at high ? m
decrease So inf tax starts falling
21

• There is a trade off between inflation and
  inflation tax
• Note that there are two possible inflation rates
  to collect the amount of tax d
• One a higer rate and the other a lower one

22
Exercise

• Find the little mistake in the previous analysis
  and repat the exercise with the corrected
  version
• The books presentation is wrong
• Why?

23
Inflation and deficits in Turkey

• In Turkey budget deficits of the government was
  financed by public borrowing in the last 15 years
• This increased the percentage of real outstanding
  debt to GDP ratio dramatically
• debt/GDP ratio is also high in many of the
  European countries but
• the term of debt is very short in Turkey compared
  to their term of debt

24
Inflation and deficits in Turkey

• Turkish governments raised interest rates even
  the real interest rates were very high compared
  to developed economies
• This increased the burden of debt farther
• if money printing is used in financing the
  deficit there is the danger of hyperinflation

25
Solutions

• What are possible solutions
• reducing G
• increasing NT
• possible only in the long run
• printing money
• most probably cause hyperinflation
• consolidation
• increases the term of the debt
• possible if the domestic borrowing can be
  substituted with foreign borrowing
• privatization
• provides extra but temporary revenue
• may provide potential reduction in transfers