Monetary Economics II

Lecture 7:
Model of Hyperinflation
Undergraduate Program
Faculty of Economics and Business
Universitas Gadjah Mada

2022
Model of Hyperinflation

Hyperinflation

The Cagan’s Model I

The Cagan’s Model II

Model of Hyperinflation

Hyperinflation

The Cagan’s Model I

The Cagan’s Model II

Background
▪ Hyperinflation occurs when the inflation rate is extremely
high.
▪ At such high rates of inflation, the volatility of inflation is also
typically high, so there is a great deal of misallocation of
resources in the economy because households and firms
have difficulty determining relative prices of goods and
services.
Definition
▪ Hyperinflation is often defined as inflation that exceeds 50
percent per month, which is over 1 percent per day.
▪ An inflation rate of 50 percent per month implies a more than
100-fold increase in the price level over a year and a more
than 2-million-fold increase over three years.
The Cost of Hyperinflation
▪ Hyperinflation makes the economy run less efficiently (i.e. the
shoe-leather costs)
▪ Firms have to change price so often (i.e. menu costs also
become larger)
▪ Relative prices do not do a good job of reflecting true scarcity
▪ Tax systems are also distorted by hyperinflation
The Causes of Hyperinflation
▪ Most hyperinflations begin when the government has
inadequate tax revenue to pay for its spending.
▪ The ends of hyperinflations almost always coincide with fiscal
reforms.
The Causes of Hyperinflation
▪ While hyperinflations are caused by rapid increases in the
money supply, ultimately, hyperinflations are typically due to
persistently large budget deficits.
Model of Hyperinflation

Hyperinflation

The Cagan’s Model I

The Cagan’s Model II

Background
Phillip Cagan (1956) developed a simple model which does
surprisingly well at accounting for the behavior of inflation and
the demand for money even the midst of such dramatic events.

Main question: How does the expected money supply process

determine the price path?
Background
Cagan (1956) found that the average inflation rate in many
hyperinflations was beyond the optimal rate of seigniorage, thus
concluding that money supply was the cause of hyperinflations.
The Cagan’s Model
The Cagan’s model consists of two equations:
(1) equation of individuals’ demand for money and
(2) equation which describes the evolution of inflation
expectations over time.
Deriving Demand for Money
Consider the exchange equation relating money, velocity and
expenditure:
𝑀𝑉 = 𝑃𝑌
𝑀𝑉 = 𝑃𝐶
The log-linear representation:
𝑚+𝑣 =𝑝+𝑐
Where 𝑚 = 𝑙𝑜𝑔𝑀, 𝑣 = 𝑙𝑜𝑔𝑉, 𝑝 = 𝑙𝑜𝑔𝑃, 𝑎𝑛𝑑 𝑐 = 𝑙𝑜𝑔𝐶
Deriving Demand for Money
The velocity of money is increasing in the nominal interest rate as
specified below:
𝑣 𝑖 =𝛼 𝑖
where 𝛼 > 0
Deriving Demand for Money
The velocity of money is increasing in the nominal interest rate as
specified below:
𝑣 𝑖 =𝛼 𝑖
where 𝛼 > 0
Intuition:
The nominal interest foregone is the opportunity cost of holding
money because bonds and money are both safe assets (in
nominal terms).
Deriving Demand for Money
The velocity of money is increasing in the nominal interest rate as
specified below:
𝑣 𝑖 =𝛼 𝑖
where 𝛼 > 0
Intuition:
If the nominal interest rate increases, money should turn over
more quickly (velocity should rise) as individuals substitute away
from money towards bonds.
Demand for Money
Since the nominal interest rate is the real interest rate plus
expected inflation (i.e. the Fisher equation), we can write
𝑚𝑡 − 𝑝𝑡 = 𝑐𝑡 − 𝛼𝑟𝑡 − 𝛼𝜋𝑡𝑒
Demand for Money
In episodes of hyperinflation — that is periods where nominal
values are changing very rapidly but where real values are much
more stable — we can simplify calculations by assuming that real
consumption and the real interest rate are constant.

𝑚𝑡 − 𝑝𝑡 = −𝛼𝜋𝑡𝑒
The Evolution of Inflation Expectations
The second part of the Cagan model is that he assumed adaptive
expectations, meaning that expected inflation is a weighted
average of current inflation and past expectations of inflation:

𝑒
𝜋𝑡𝑒 = 𝜆𝜋𝑡−1 + (1 − 𝜆) 𝑝𝑡 − 𝑝𝑡−1

where 0 < 𝜆 < 1.

The Evolution of Inflation Expectations
The second part of the Cagan model is that he assumed adaptive
expectations, meaning that expected inflation is a weighted
average of current inflation and past expectations of inflation:

𝑒
𝜋𝑡𝑒 = 𝜆𝜋𝑡−1 + (1 − 𝜆) 𝑝𝑡 − 𝑝𝑡−1

If 𝜆 is close to one, then individuals expectations are slow to update, they place a lot of
weight on past expectations and little weight on current expectations.
If 𝜆 is close to zero, individuals place a lot of weight on current experience.
Solving the Model
A solution to the model is an equation based on the evolution of
prices over time in terms of
▪ the past behavior of prices,
▪ the monetary policy, and
▪ the parameters of the model.
Solving the Model
We solve the model as follows:
1. Inverting money demand equation
2. Rewriting the inflation expectations equation
3. Formulating the price equation
Solving the Model
We solve the model as follows:
1. Inverting money demand equation
𝑒
1
𝜋𝑡 = − 𝑚𝑡 − 𝑝𝑡
𝛼
2. Rewriting the inflation expectations equation
3. Formulating the price equation
Solving the Model
We solve the model as follows:
1. Inverting money demand equation
2. Rewriting the inflation expectations equation
1 𝜆
− 𝑚𝑡 − 𝑝𝑡 = − 𝑚𝑡−1 − 𝑝𝑡−1 + (1 − 𝜆) 𝑝𝑡 − 𝑝𝑡−1
𝛼 𝛼
3. Formulating the price equation
Solving the Model
We solve the model as follows:
1. Inverting money demand equation
2. Rewriting the inflation expectations equation
3. Formulating the price equation
𝜆 − 𝛼(1 − 𝜆) 1 𝜆
𝑝𝑡 = 𝑝𝑡−1 + 𝑚𝑡 − 𝑚𝑡−1
1 − 𝛼(1 − 𝜆) 1 − 𝛼(1 − 𝜆) 1 − 𝛼(1 − 𝜆)
Solving the Model
The price equation is linear equation and we could estimate its
parameters with regression methods so that we could study
inflation and expected inflation over time.
𝑝𝑡 = 𝛽1 𝑝𝑡−1 + 𝛽2 𝑚𝑡 + 𝛽3 𝑚𝑡−1
Where
𝜆 − 𝛼(1 − 𝜆) 1 𝜆
𝛽1 = 𝛽2 = 𝛽3 = −
1 − 𝛼(1 − 𝜆) 1 − 𝛼(1 − 𝜆) 1 − 𝛼(1 − 𝜆)
Implications
The most important properties of the solution are governed by
the coefficient 𝛽1 :
▪ If −1 < 𝛽1 < 1 : the inflation dynamics of the system are said
to be ‘dynamically stable,’ meaning that if the government
stabilizes the money supply process 𝑚𝑡 , then the price
dynamics will stabilize too.
▪ In this case, once a government gets control of the money
supply process, inflation will eventually come under control
too.
Implications
The most important properties of the solution are governed by
the coefficient 𝛽1 :
▪ If 𝛽1 is too large, then even a stable monetary process may
lead to hyperinflations driven purely by ‘momentum’ — by
individuals extrapolating from past inflation behavior.
Model of Hyperinflation

Hyperinflation

The Cagan’s Model I

The Cagan’s Model II

Alternative to the Inflation Expectation
Model
In the previous section, the second part of the Cagan model is
based on the assumption of adaptive expectations, like the
following:
𝑒
𝜋𝑡𝑒 = 𝜆𝜋𝑡−1 + (1 − 𝜆) 𝑝𝑡 − 𝑝𝑡−1
Alternative to the Inflation Expectation
Model
We can change the second part of the Cagan model as follow:
𝜋𝑡𝑒 = 𝜆 𝑝𝑡+1 − 𝑝𝑡

By doing this, we are assuming a perfect foresight.

Solving the Model
Therefore we solve the model as follows:
1. Rewriting money demand equation
2. Formulating the price equation
Solving the Model
We solve the model as follows:
1. Rewriting money demand equation
−𝜆 𝑝𝑡+1 − 𝑝𝑡 = 𝑚𝑡 − 𝑝𝑡
In this part, what do we need to assume?
2. Formulating the price equation
Solving the Model
We solve the model as follows:
1. Rewriting money demand equation
2. Formulating the price equation
𝑚𝑡 𝜆
𝑝𝑡 = + 𝑝𝑡+1
1+𝜆 1+𝜆
Solving the Model
We solve the model as follows:
1. Rewriting money demand equation
2. Formulating the price equation
The next period’s price level will be determined the same way as this period’s
price level
𝑚𝑡+1 𝜆
𝑝𝑡+1 = + 𝑝𝑡+2
1+𝜆 1+𝜆
𝑚𝑡+2 𝜆
𝑝𝑡+2 = + 𝑝𝑡+3
1+𝜆 1+𝜆
Solving the Model
Solving the model, we get the current price level is a weighted
average of the current money supply, the next period’s money
supply, and the following period’s price level:

𝑚𝑡 𝜆 𝜆2 𝜆3
𝑝𝑡 = + 𝑚
2 𝑡+1
+ 𝑚
3 𝑡+2
+ 3
𝑝𝑡+3
1+𝜆 1+𝜆 1+𝜆 1+𝜆
Solving the Model
If we do this an infinite number of times, we find:
2 3
1 𝜆 𝜆 𝜆
𝑝𝑡 = 𝑚𝑡 + 𝑚𝑡+1 + 𝑚𝑡+2 + 𝑚𝑡+3 + ⋯
1+𝜆 1+𝜆 1+𝜆 1+𝜆

the current price level is a weighted average of the current money supply and all
future money supplies.
Implications
Note the importance of 𝜆 (the parameter governing the sensitivity
of real money balances to inflation):
𝜆
▪ If 𝜆 is small, then is small, and the weights decline
1+𝜆
quickly. In this case, the current money supply is the primary
determinant of the price level.
𝜆
▪ If 𝜆 is large, then is close to 1, and the weights decline
1+𝜆
slowly. In this case, the future money supplies play a key role
in determining today’s price level.
FINAL REMARKS
▪ Some economists use Cagan model (either model I or II) to
argue that credibility is important for ending hyperinflation.
▪ Credibility is often achieved by:
1. Credible fiscal reform: the need for fiscal discipline and
2. Credible monetary policy by having an independent central bank (i.e.
it is to prevent monetized deficits that can allow a hyperinflation to get
started).
FINAL REMARKS
▪ Some economists use Cagan model (either model I or II) to
argue that credibility is important for ending hyperinflation.
▪ The other message from Cagan model is the need for
individuals’ inflation expectations to be ‘anchored’ — and
thereby relatively unlikely to lead to a momentum-driven
inflation break-out.
THANK YOU