High Inflation Hyperinflation: very high inflation Inflation is high usually due to high nominal money growth Nominal money grows usually because of high budget deficits High budget deficits get financed with money creation

High Inflation Government can finance its deficit by: –Borrowing: issuing government bonds –Have the central bank buy its bonds using created money Debt Monetization: having government debt purchased by central bank by printing money Usually debt is purchased by the private sector

High Inflation How to start hyperinflation: –There is a budget crisis (an adverse shock that leaves with low tax revenues and high expenditures; aftermath of a war; shock to raw material prices for exporting economy…) –Government becomes unable to borrow from the public of from abroad. Higher interest rates are demanded to lend or lending stops completely –Money creation as desperate measure

High Inflation Seignorage =  M/P (change in real money stock to finance the deficit)  M/P = (  M/M)(M/P) Seignorage in % of GDP: (  M/P)/Y = (  M/M)(M/P)/Y The rate of nominal money growth times real money balance

High Inflation Example: let Y = 1(a flow); and M/P = 2 (a stock). To finance a deficit of 10% with seignorage money must grow at 5%. This DOES NOT take into consideration changes in prices. Money growth leads to inflation which leads to people holding less money.

High Inflation How much will money demand be in the presence of inflation? M/P = YL(i) L’ < 1 M/P = YL(r +  e ) Expected inflation will move much more that r or Y during hyperinflation As expected inflation increases real money balance decrease

High Inflation Example: 100% monthly inflation means that after a month a currency will be worth half People start to barter or use foreign currency (even if usually illegal) Dollarization: use of another currency in a country’s domestic transactions.

High Inflation Seignorage is money growth times real money balance. Real money balance is inversely related to expected inflation Seignorage = (  M/M)YL(r +  e ) Resorting to seignorage leads to high and increasing inflation

High Inflation Assume that money grows at a constant rate Expected inflation will be equal to money growth Seignorage = (  M/M)YL(r +  M/M) Money growth increases and decreases seignorage At low money growth seignorage increases At high money growth seignorage decreases

High Inflation Seignorage functions as a tax (at low rates its return increases; at high rate its return decreases) Laffer curve: decreasing return to tax rates (based on argument that lower taxes increase tax revenues) Inflation tax:  (M/P). The tax base is real money balance. The tax rate is inflation

High Inflation When money growth is constant then inflation tax equals seignorage inflation tax=  (M/P) seignorage=(  M/M)(M/P)