1. CHAPTER 23 © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard High Inflation Prepared by: Fernando Quijano and Yvonn Quijano

2. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard2 of 29 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.

3. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard3 of 29 High Inflation Table 23-1 Seven Hyperinflations of the 1920s and 1940s CountryBeginningEndP T /P 0 Average Monthly Inflation Rate (%) Average Monthly Money Growth (%) AustriaOct. 1921Aug. 1922704731 GermanyAug. 1922Nov. 19231.0 x 10 10 322314 GreeceNov. 1943Nov. 19444.7 x 10 6 365220 Hungary 1Mar. 1923Feb. 1924444633 Hungary 2Aug. 1945Jul. 19463.8 x 10 27 19,80012,200 PolandJan. 1923Jan. 19246998272 RussiaDec. 1921Jan. 19241.2 x 10 5 5749 P T /P 0 : Price level in the last month of hyperinflation divided by the price level in the first month.

4. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard4 of 29 High Inflation Table 23-2 High Inflation in Latin America, 1976-2000 Average Monthly Inflation Rate, (%) 1976-19801981-19851986-19901991-19951996-2000 Argentina9.312.720.02.30.0 Brazil3.47.920.719.00.6 Nicaragua1.43.635.68.50.8 Peru3.46.023.74.80.8

5. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard5 of 29 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. 23-1

6. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard6 of 29 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.

7. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard7 of 29 Budget Deficits and Money Creation The rate of nominal money growth required to generate a given amount of seignorage is: In words, seignorage is the product of the rate of nominal money growth and real money balances.

8. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard8 of 29 Inflation and Real Money Balances What determines the amount of real money balances people will hold? 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. 23-2

9. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard9 of 29 Inflation and Real Money Balances  In times of hyperinflation, the amount of money balances people will hold depends primarily on expected inflation.  When the expected rate of inflation is very high, people will try to get rid of their money holdings as soon as possible.

10. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard10 of 29 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 dollarization—the use of dollars in another country’s transactions.

11. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard11 of 29 Inflation and Real Money Balances 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. Figure 23 - 1

12. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard12 of 29 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.

13. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard13 of 29 Deficits, Seignorage, and Inflation We have derived two relations:  The relation between seignorage, nominal money growth, and real money balances  The relation between real money balances and expected inflation 23-3

14. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard14 of 29 Deficits, Seignorage, and Inflation Combining the two equations gives:

15. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard15 of 29 The Case of Constant Nominal Money Growth Nominal money growth has two opposite effects on seignorage:

16. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard16 of 29 The Case of Constant Nominal Money Growth Seignorage and Nominal Money Growth Seignorage is first an increasing function, then a decreasing function of nominal money growth. Figure 23 - 2

17. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard17 of 29 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.

18. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard18 of 29 The Case of Constant Nominal Money Growth In all seven hyperinflations, the actual average nominal money growth far exceeded the rate of nominal money growth that maximizes seignorage. Table 22-3 Nominal Money Growth and Seignorage Country Rate of Money Growth Maximizing Seignorage (% per month) Implied Seignorage (% of output) Actual Rate of Money Growth (% per month) Austria121331 Germany2014314 Greece2811220 Hungary 1121933 Hungary 232612,200 Poland544.672 Russia390.549

19. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard19 of 29 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.

20. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard20 of 29 Hyperinflations and Economic Activity In the short run, the effects of higher nominal money growth are expansionary: 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.

21. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard21 of 29 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. 23-4

22. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard22 of 29 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.

23. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard23 of 29 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.

24. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard24 of 29 Can Stabilization Programs Fail? Can stabilization programs fail? Yes, they can fail, and they often do. Sometimes failure comes from a botched or half- hearted effort at stabilization. Failure can also come from the anticipation of failure.

25. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard25 of 29 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.

26. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard26 of 29 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. 23-5

27. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard27 of 29 The stabilization plan was organized around the elimination of the budget deficit. Its main features were:  Fiscal policy  Monetary policy  Reestablish international creditworthiness The Bolivian Hyperinflation of the 1980s Table 1 Revenues, Expenditures, and the Deficit, as a Percentage of Bolivian GDP 198119821983198419859186 Revenues9.44.62.6 1.310.3 Expenditures15.226.920.133.26.17.7 Budget Balances (-:deficit)-5.7-22.3-17.5-31.6-4.82.6 Revenues and expenditures of the central government

28. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard28 of 29 The Bolivian Hyperinflation of the 1980s Figure 1 Bolivian Monthly Inflation Rate, January 1984 to April 1976

29. Chapter 23: High Inflation © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard29 of 29 Key Terms  hyperinflations  debt monetization  seignorage  barter  dollarization  Laffer curve  inflation tax  Tanzi-Olivera effect  stabilization program  income policies  orthodox stabilization program, heterodox stabilization program