1. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/eOlivier Blanchard Prepared by: Fernando Quijano and Yvonn Quijano 23 C H A P T E R High Inflation

2. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard High Inflation Table 23-1Seven Hyperinflations of the 1920s and 1940s CountryBeginningEnd P 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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard High Inflation Table 23-2 High Inflation in Latin America, 1976-2000 Average Monthly Inflation Rate (%) Country1976-19801981-19851986-19901991-19951996-2000 Argentina 9.312.720.02.30.0 Brazil 3.47.920.719.00.6 Nicaragua 1.43.635.68.50.8 Peru 3.46.023.74.80.8

5. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Budget Deficits and Money Creation 23-1  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.

6. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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 times real money balances.

8. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Inflation and Real Money Balances 23-2  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.

9. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

12. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Deficits, Seignorage, and Inflation  Recall from chapter 9 that, in the medium run., then:  If nominal money growth is constant, then inflation and expected inflation must be constant and equal to nominal money growth. Then: 23-2

13. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Deficits, Seignorage, and Inflation  Nominal money growth has two opposite effects on seignorage:

14. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Deficits, Seignorage, and Inflation Seignorage and Nominal Money Growth Seignorage is first an increasing function, then a decreasing function of nominal money growth.

15. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Deficits, Seignorage, and Inflation  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.

16. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Deficits, Seignorage, and Inflation  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

17. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

18. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

19. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard How Do Hyperinflations End? 23-4  Hyperinflation needs to be stopped through a stabilization program, which may include the following elements:  Fiscal reform and credible budget deficit reduction.  Reducing government subsidies and obtaining temporary suspension of interest payments.  Changing the composition of taxation—replacing the inflation tax with other taxes.  Taking credible steps that will demonstrate the commitment of the central bank to no longer monetize the debt.

20. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard How Do Hyperinflations End?  Income policies, such as wage and price guidelines or controls may also be part of the stabilization package.  Stabilization programs that do not include income policies are called orthodox; those that do are called heterodox (because they rely on both monetary and fiscal policy as well as on income policies).

21. © 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Key Terms  hyperinflations, hyperinflations,  debt monetization, debt monetization, debt monetization,  seignorage, seignorage,  barter, barter,  dollarization, dollarization,  Laffer curve, Laffer curve, Laffer curve,  inflation tax, inflation tax, inflation tax,  Tanzi-Olivera effect, Tanzi-Olivera effect, Tanzi-Olivera effect,  stabilization program, stabilization program, stabilization program,  income policies, income policies, income policies,  orthodox stabilization program; heterodox stabilization program, orthodox stabilization program; heterodox stabilization program, orthodox stabilization program; heterodox stabilization program,