Oscar Chipoka. Student ID: a1740567. Wednesday. 1pm -2pm TUTORIAL No.

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Section 1:

Q. 1. 1. The causes of hyperinflation in Germany in the 1920s was the excessive use of
seigniorage to as a revenue measure to finance government expenditures. For example, In
1923 the government budget deficit increased by 100 percent to about US$1.5 billion and
the government then resorted to excessive printing of money to finance this deficit. The
defeat of Germany in the First World War in 1981 was one of the causes of hyperinflation.
During the Treaty of Versailles in 1919, the victories countries which included the US, U.K
and France made Germany to pay reparations for the war damages. These reparations made
Germany to have a huge external public debt which was worth more than three (3) times its
national income or GDP and this external debt had severe effects on its current account
balances. Again, the government resorted to printing excessive amount of currency in order
to pay for the war damages. The State was bankrupt. Printing money to finance the cost of
the war and the reparation damages as the war led to shortage of commodities, which
made the government to borrow from the central bank which increased the money supply,
thereby increasing people’s long run inflation expectations and the fall in the demand for
money as well as the increase in the general price level

When Germany defaulted on its reparation payments, troops from Belgium and France
unilaterally took occupation of its main industrial area namely the Rhur in order to get the
said payments. In protest, the German (Weimar) government (formed in late 1918) directed
the workers to go on strike which resulted in the shutting down of the mines and iron
factories. This in turn caused Germany’s economy to quickly shrink. Again, the government
responded by printing more money.

At the heart of the German hyperinflation is was a miscalculation. Hyperinflation was

caused by the fundamental malfunction of the country’s political economy namely the
Weimar government which lacked legitimacy to govern. Due to this lack of legitimacy, the
Weimar government tax system was so weak which resulted in reduced tax revenue
collection between 1919 and 1920 as high-income groups refused to pay taxes imposed on
them, and coupled with reckless government expenditure like large public sector wage
increments caused a large government budget deficit. This was one of the domestic political
cause of the monetary crisis.

Political miscalculation was another cause in that the country’s economic and political
policy-makers believed that a large currency depreciation would cause the victorious
powers to reconsider the terms of the Versailles Treaty as the depreciation would make the
German exports cheaper and more competitive relative to the Allied powers. However, this
strategy also eventually backfired as the country experienced a huge increase in imports
relative to exports due to post-war recession in UK, USA, etc.

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The other reason was that huge speculative capital inflows (hot money) into Germany after
the First World War which was suddenly removed from the economy by speculative
investors in 1921 after the total reparation bill was fixed by the victorious countries had a
destabilising inflationary pressure on the economy.

Q.1. 2. Practical consequences of hyperinflation in people’s lives include the following: loss
of jobs; people resorting to barter system as a medium of exchange as currency would have
lost its value; workers’ salaries and retirees’ pension benefits become decimated; tax
distortions are more severe during hyperinflation; distorts relative prices as some prices
adjust to inflation faster than others; Shoe leather costs of inflation; demand for money for
the hyperinflated currency decreases almost to zero; menu costs which are the costs of
changing prices frequently. For example, prices doubled every 3.7 days in October 1923 in
Germany when the monthly inflation rate was 30,000 % (inflation reached it’s peak of 182
billion percent sometime in 1923), in November 2008 Zimbabwe’s inflation rate was 8 x 10 10
percent and prices were doubling every 25 hours. Inflation in Hungary in July 1946 was 4 x
1016 percent and prices were doubling every 15 hours. Money loses its key functions of
being the medium of exchange and store of value and brings a lot of inconvenience to
people who have to carry huge amounts of money in wheelbarrows, bags, etc just to buy
even basic necessities; unemployment rises rapidly, the economy shrinks due to loss in
productivity resulting in acute shortage of essential commodities. The concept of pricing
loses its meaning as people can not plan or budget for anything as prices keep changing at a
very fast speed. Severe shortage of commodities

Q.1.3. The medium to long term consequences of hyperinflation in Germany included the
following: a substantial increase in unemployment rates from about 3 percent to more than
20 percent as a lot of people lost their jobs; People started using barter system or foreign
currency when trading since fiat money lost its value as a medium of exchange, and trading
became almost impossible as the economy had collapsed; Civil servants like teachers and
other economic agents who had kept their money in form of government bonds and bank
deposits lost all their investments that they had worked for in a long period of time; The
members of the public lost confidence in the credibility of the central bank preserve the
value of money; The private businesses’ debts were wiped out by hyperinflation; it also
wiped out entire internal public debt that was acquired during and after the war;
persistently high interest rates that now took into account a substantial inflation risk
premium; banking crisis as loans were wiped out; the political and social consequences were
that it forced Germany to go into economic nationalism that also led to the rise of
dictatorship through Nazism and Adolph Hitler; All permanent relations between lenders
and borrowers became severely distorted and meaningless; a significant rise in prostitution
even from previously well-to-do families due to the loss of the source of livelihood; salaries
and pensions were decimated; it transformed the class structure of Germany in that rich
industrialists gained from their investments in real estates, factories, while upper middle
classes like rentiers, senior civil servants who held highly liquid money and all forms of
wealth and income fixed in terms of that money became paupers. This means that all the
economic agents who held more liquid forms of money like cash, and government bonds
moved down the social classes and became poor. Hence high levels of poverty and income

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distribution inequality were some of the consequences of hyperinflation. There were less
gainers and more losers from hyperinflation. Social and psychological trauma caused by the
crisis and citizens lost their self-esteem as they became impoverished within a short period
of time. Worthlessness was hyperinflation’s primary product. Arbitrary rearrangement of
riches and wealth.

Q.1.4. Yes the passages are there. One of them is the passage quoting Milton Friedman that
inflation is always and everywhere a monetary phenomenon because it always results from
the growth rate of money being faster than the growth rate of the demand for money or
real output. In the lectures, we learnt that the value of money is determined by the relative
demand for and supply of fiat money. Furthermore, Germany excessively used the printing
press to finance both its ballooning domestic budget deficits and also pay for the war
damages (i.e. seigniorage). In August 1923, the head of the German Central Bank Rudolf
Havenstein, whilst addressing parliamentarians that his institution now had the capacity to
increase money supply by more than 66 percent within a day. This was after he had
elaborated how fast he had been expanding the money supply. During lectures, we learnt
that as the excessive use of seigniorage to finance government expenditure approaches
infinite, the value of money approaches zero. This is what happened in German whereby
people abandoned fiat money and resorted to barter system and the use of foreign currency
as the excessive printing of money continued. The articles also indicate that hyperinflation is
always and everywhere a political phenomenon because it can’t happen without a
fundamental malfunctioning of the country’s political economy and complete collapse of
the currency and the economy itself. This is related to the concept of Central Bank
Independence which is an attempt to prevent fiscal considerations from causing excessive
inflation through the excessive use of seigniorage.

Q.1.5.) The key lessons for macroeconomic policies include the following: macroeconomic
targets should be set to limit the inflation targets or rates to low and stable levels, for
instance between 2 and 3 percent per annum. Such inflation targets are important for
preservation the value of money which is the principal function of the central bank.
Furthermore, the use of seigniorage as a source of revenue should be limited to very low
levels even when there are extremely adverse economic conditions in order to prevent the
entire economy from collapsing through money losing its value. Under no circumstances
should money supply grow more rapidly than money demand through resorting to printing
excessive money or any other expansionary monetary policy measure. Instead other
revenue measures such as increasing taxes or use of international capital markets should be
considered.

In terms of the institutional design of monetary authorities, the key lesson is that there
should be legal, institutional and operational independence of the monetary authorities
from the central government so that the central bank can professionally perform its
functions of preserving the value of money without undue influence for fiscal considerations
from the central government. The articles clearly indicate that there was no central bank
independence in Germany and the bank just kept on printing money whenever the central
government demand and the bank in fact the bank forgot its primary mandate. Fiscal and

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monetary authorities should be designed in such a manner that they perform their duties
autonomously of each other.