Some Implications of Alternative Expectations Hypotheses in the Monetary Analysis of

Hyperinflations
Author(s): J. L. Evans and G. K. Yarrow
Source: Oxford Economic Papers , Mar., 1981, New Series, Vol. 33, No. 1 (Mar., 1981), pp.
61-80
Published by: Oxford University Press

Stable URL: https://www.jstor.org/stable/2662757

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide
range of content in a trusted digital archive. We use information technology and tools to increase productivity and
facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at
https://about.jstor.org/terms

Oxford University Press is collaborating with JSTOR to digitize, preserve and extend access to
Oxford Economic Papers

This content downloaded from

:ffff:ffff:ffff:ffff:ffff:ffff on Thu, 01 Jan 1976 12:34:56 UTC
All use subject to https://about.jstor.org/terms
 SOME IMPLICATIONS OF ALTERNATIVE
EXPECTATIONS HYPOTHESES IN THE
MONETARY ANALYSIS OF HYPERINFLATIONS

By J. L. EVANS and G. K. YARROW*

I. Introduction

IT IS well known that the substitution of the rational expectations hypothesis

for expectation-formation processes based on error-learning mechanisms
can radically affect the predictions, and hence the policy implications, of
simple macro-economic models. Thus, for example, in a model incorporat-
ing an aggregate supply function relating output to productive capacity and
unanticipated inflation, Sargent and Wallace [7] have shown that the level of
output is independent of the particular money-supply rule in operation-a
result which does not hold when expectations are formed adaptively. While
recent contributions to this literature have tended to follow Sargent and
Wallace in focusing upon the dynamics of output and employment, in this
paper we are concerned with the effects of alternative expectations hypoth-
eses on price-level movements during hyperinflations; the latter being
defined as periods during which fluctuations in prices are considered suffi-
ciently large as to be analysed independently of output changes. Specifically,
we are interested in the differences in price level behaviour between models
based upon error-learning and rational-expectations hypotheses. Although a
number of the results to be obtained below are already known, full deriva-
tions are set out in each case to facilitate comparisons between the models.
The analysis is based upon a continuous, non-stochastic version of
Cagan's model [2], extended to include an explicit price-adjustment equa-
tion and a government budget equation.' The components of the analysis,
with the exception of the expectations hypothesis, are outlined in Section II,
which also includes a discussion of comparative statics results under two
different money-supply regimes. In Section III an adaptive expectations
equation is added and the stability of the model's equilibria are explored.
Similar stability conditions for the case in which expectations are generated
by a second-order error learning process are then quoted (proofs are
relegated to the Appendix). Section IV moves on to consider the conse-
quences of replacing the error-learning equations with the hypothesis that
expectations are formed rationally. Finally, in Section V we discuss the

* We are grateful to D. A. Peel and two anonymous referees for helpful comments.
1Note that Cagan's model is a special case of the Fisherian adjustment process i
financial securities play no essential role in the equilibrium/disequilibrium properties of the
model. This would seem to be a reasonable approximation for the study of hyperinflations
where most financial markets break down.

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
62 MONETARY ANALYSIS OF HYI1ERINFLATIONS

reasons for the differences between the models and suggest some further
possible developments.

11. The basic model

The cornerstone of monetary analyses of hyperinflation is the assumption

that there exists a stable demand for money function of the form

m= g(lT) (1)
P

where Md - desired nominal money balances, P = price level, ir = expected

rate of inflation, and gl(ir) < 0.2 Some analyses further assume that the
money market is always in equilibrium, implying that desired real balances
are always equal to actual real balances. Here, however, we prefer to work
with a slightly more general formulation which allows money market dis-
equilibrium. Thus, let the rate of inflation be equal to the expected rate of
inflation plus some increasing function of the excess demand for goods,
which in the present context is equal to the excess supply of real balances, so
that

_5 f(M )+- (2)

where p=d(log(P))/dt (1/P)(dP/dt), M supply of money, f(O)=O and

f'(* ) > 0. This formulation implies that actual and expected rates of inflation
are equal if and only if excess demand for goods is zero, the unit coefficient
on the expectations variable indicating an absence of money illusion.
Equations (1) and (2) contain four endogenous variables (the price level,
money supply, expected rate of inflation and desired nominal balances) and
hence a further two equations, at least, are required to complete the model.
The first of these is the government budget equation, given by the assump-
tion that some fraction a of government's real expenditure G is financed by
money creation. This leads to

M = aGP (3)

Two money supply regimes satisfying (3) will be analysed. Initially aG will
be taken to be an exogenously determined constant, in which case it can be
seen that the rate of money creation is proportional to the price level.
Dividing both sides of (3) by the supply of money, the equation can be
expressed in the alternative form

at = aG/(M/v1P) (3a)
2Most studies, particularly those of an empirical nature, also go on to specify g(Tr) as an
exponential function, although there is evidence suggesting that this is not always appropriate
[1]. For our purposes it will be more illuminating to leave the specific form of g('Tr) undefined at
this stage.

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
 J. L. EVANS AND G. K. YARROW 63

where tt = MIM. That is, the propor

inversely proportional to the level of real balances. The alternative money
supply regime to be considered is that in which the governmental financing
requirement varies directly with the level of real balances. That is, aG =
y(M/P), where y is constant. This may be achieved by appropriate changes
in either the level of real expenditure or the proportion of real expenditure
financed by money creation or both.3 Substitution into equation (3) yields

tk = ly (3b)

In this case, then, the proportionate rate of growth of the money supply is
constant.
The final relationship of the model is that specifying the manner in which
expectations are formed. However, since in this section we are concerned
solely with equilibrium and comparative statics, for the moment it can
simply be assumed that actual and expected rates of inflation are equal,
leaving discussion of expectations-generating mechanisms until later.
Along with the equality of actual and expected inflation rates, at equilib-
rium points real balances are constant and equal to their desired level. Thus

M M d
M M = g(w) = g(ft) (4)

On substituting from (4) into (3a) we have

aG = ,u g(,u ) (5)

Equation (5) specifies how variations in the government financing require-

ment affect the equilibrium rate of monetary growth and, hence, the
equilibrium rate of inflation. However, since desired real balances are a
decreasing function of the expected inflation rate, the possibility of multiple
solutions to (5) arises, leading in turn to ambiguities in the directional effect
of changes in the government financing requirement on the equilibrium
inflation rate.
The problem is perhaps best explained by means of a diagram. To simplify

3 These two monetary rules merely reflect the ability of governments to resort to printing
money when their expenditure outstrips the resources of public revenue. Now studies of the
causes of hyperinflation suggest that a major 'prompt' is a large budget deficit (often created by
the requirements of war finance e.g. military outlays and servicing of foreign debts). To this
extent one might consider (3a) the more suitable regime. Furthermore this regime received
some empirical support in Sargent and Wallace [6]. On the other hand, a characteristic of
hyperinflation is that the government attempts to maintain a given level of real expenditure
throughout the economy. Insofar as this is the case, regime (3b) may seem appropriate. It may
also be of interest to note that with (3b) the monetary authorities are pursuing a policy of
constant monetary expansion, an assumption of several papers which discuss the dynamic
behaviour of simple monetary models. Thus the inclusion of this regime should facilitate
comparison.

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
64 MONETARY ANALYSIS OF HYPERINFIATIONS

the analysis, let M/P y and differentiate with respect to time:

Y = YI[L - P] (6)
The locus on which y is stationary is plotted in Fig. 1 together with
equation (4), defining the equilibrium points where real balances are equal
to their desired level.4
With increasing financing requirements the locus of stationary money
balances shifts away from the origin. Thus, there is a maximum value of the
financing requirement consistent with equilibrium. However, for all smaller
financing requirements there are two inflation rates OA' and OB' at which
the government budget is balanced by revenue from the inflation tax. It is
easily verified that at A(B) the elasticity of demand for real balances is less
(greater) than unity. Moreover, it can be seen that an increase in the
financing requirement is associated with a higher (lower) inflation rate and
therefore proportional rate of monetary expansion at A(B).
This latter result is somewhat counter intuitive and it might be hoped that
equilibria with demand elasticities greater than one are always unstable.
Such a result can in fact be proved for the error-learning mechanisms
discussed in the next section, but unfortunately does not generalise to the
rational expectations case where it turns out to be equilibria of type A
which are always unstable.

; -A~~~~B

0 A' B'

FIG. 1

4 Illustrated is the semi-logarithmic form of the function, a common assumption of these

types of models. See Yarrow [8] for a discussion of some implications of relaxing this
assumption.

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
 J. L. EVANS AND G. K. YARROW 65

A ~~~~=O

Y=g (7r)

0 Y 7

FIG. 2

Before proceeding to consider stability problems, we have, however, to

complete the comparative statics analysis by returning to the second of the
money supply regimes outlined earlier. Substituting (3b) for (3a) leads to
results which are extremely straightforward since it has already been shown
that y is the proportionate rate of monetary expansion. An increase in the
value of the parameter y is therefore associated with an equivalent increase
in the equilibrium rate of inflation. The locus of stationary real balances now
takes the form illustrated in Fig. 2. From this figure it can be seen that for
given y, the equilibrium is unique.

III. Stability with error-learning expectations hypotheses

To analyse the stability of the equilibria discussed in the previous section

the model must be completed by the addition of an expectations hypothesis.
Initially, let it be assumed that expectations are formed by the first-order
error-learning (adaptive expectations) process

Xi = 010[ - 'I] (7)

where X is a positive constant measuring the speed at which the expected
rate of inflation adjusts towards the actual rate. Combining (7) with (1), (2),
(3a) and the requisite initial conditions fully determines the time paths of the
endogenous variables for the case of a constant government financing
requirement. Hence, the question of the stability of equilibrium can be
answered from these four equations.
For ease of exposition we reproduce

;t=yIII.-p] (6)

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
66 MONETARY ANALYSIS OF HYPERINFLATIONS

Substituting for the proportionate rate of monetary expansion from (3a), for
the rate of inflation from (2), and using (1)

= =aG - yf(y - g(IT))- y (8)

Similarly, combining equation (7) with (1) and (2)

i-r =f(y - g(T)) (9)

The system has therefore been reduced to a pair of differential equations in
real money balances and the expected rate of inflation. Figure 3 is a phase
diagram which illustrates the behaviour of the expected inflation rate and
the real balances when out of equilibrium.
From the diagram it is easily seen that the nature of equilibrium A cannot
be settled without calculation, and the equilibrium at B is a saddle point. To
proceed further on the nature of the solutions, attention is directed upon the
local stability of the model. This is achieved by taking the linear terms of the
Taylors series expansions of (8) and (9) around an equilibrium point,
denoted by (y*, r *), noting that f(y* -g(,*)) = f(O) = 0 and ye = g(r*)

K] a1 jr g(T.*)fP(0) - en g(-.*)f'(0)g'({*)- g(-.*) I Y - *1 (

Lir PRf'O) - f'(0)9'(7*) r L- 7*]
Necessary and sufficient conditions for the linear system given by (10) to be
stable are that the trace of the coefficient matrix is negative and that the
determinant of the coefficient matrix is positive. That is,

g(7r*)f/(0) + sre + 3f/(0)g/(7*) > 0 (1 1)

3*fP(0)g '(W*) + Of,(0)g(WT*) > 0 (12)

BR

. ~2 Y~
0 Y=g.(7f) 7F

FIG. 3

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
 J. L. EVANS AND G. K. YARROW 67

By assumption, the coefficients f3

second condition, (12), reduces to

7*gP(X.*) + g( .*) = g( a*)[1 - e] > 0 (13)

For stable equilibria, then, the elasticity of demand for real balances must be
less than unity, implying that points of type B in Fig. 1 are always unstable.
Equilibrium A, however, satisfies (13) and, hence, paths in its neighbour-
hood will converge to A if inequality (11) is also satisfied.
Now condition (11) places further restrictions on the range of values of
the equilibrium inflation rate, and of the corresponding financing require-
ment, compatible with stability. For positive Tr*, by multiplying throughout
by x*Ig(wT*), (11) can be rewritten as

e 3 [1 g(,.)f(O)] (14)

Combining (13) and (14), a necessary and sufficient condition for the
stability of equilibrium is that

e <min {1, 13 [ g (zn*)fP(O)ll (15)

The right side of (14), plotted as OAB in Fig. 4, takes the value zero, and
has derivative 1/,3, when -a* = 0. For all other non-negative inflation rates it
slope exceeds 1/13. Representing the line e = 1 by DAD', it can be seen that
(15) is equivalent to the restriction that the elasticity of demand for real
balances is less that OAD' at the relevant point in Fig. 4. The lines OC1,

e B C3

C2

Cl

D A

* *
0 7r 1r3 7r7FG 4

FIG. 4

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
68 MONETARY ANALYSIS OF HYPERINFLATIONS

OC2 and OC3 show the elasticity functions of the semilogarithmic demand
for money relationship, Md/P = Noo exp (- +1X -iT), for three values of tf1. W
qfr1 < 1I/3, 0C1 illustrates that equilibria are stable if ir* < r*, the latter bei
equivalent to the inflation rate which yields the maximum revenue. On the
other hand, OC2 and OC3 represent cases where qjl> 11(3, the form
producing stable equilibria when 4*< r* < V * and the latter implying
instability everywhere. The diagram can, of course, also be used to examine
the stability implications of alternative demand for money functions by
plotting their elasticities and comparing with OAD'. Finally, it is trivial to
restate the necessary and sufficient conditions derived above as restrictions
on the equilibrium rate of growth of the money supply or, where approp-
riate, on the size of the government financing requirement.
To round off the discussion of the adaptive expectations case, we now
return to the second of the money supply regimes, (3b), in which the
government maintains a constant proportionate rate of monetary expansion
by variations in either its expenditures or its tax yields from other sources.
Proceeding in the same way as before, let y = MIP, differentiate with respect
to time, and substitute for the rate of growth of the money supply, the rate
of inflation and real balances from (3b), (2) and (1) respectively, giving

y = ye -f(y - g(r))y - -y (16)

The local stability of the unique equilibrium point of the model, denoted by
(y*, v*) = (g(y), y) can be analysed by expanding equations (16) and (
linearly around (y*, Tr*):

-0 Yl_ z)P'() g(zf (o)g (,)- g(7,l y _y* 1

liT WM -to Of' (0) g' () m 1vX*l
Necessary and sufficient conditions for (17) to be stable are:

g(y)f'(0) + Of'(0)g'(y) > 0 (18)

3g(y)f'() > 0 (19)

The second of these is always satisfied by virtue of assumptions already

made. Dividing (18) throughout by f'(O) leads to the familiar Cagan stability
condition, showing that the equilibrium will tend to be unstable when
desired real balances are highly sensitive to expected inflation rates and
when expected inflation rates adjust very rapidly to actual rates. Note that,
in this case, the velocity of response of price increases to excess demand has
no effect on the stability properties of the -model (for a constant government
financing requirement, (14) shows that a high value of f'(0) tends to
contribute towards instability).
For positive rates of growth of the money supply, (18) can be re-expressed

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
 J. L. EVANS AND G. K. YARROW 49

as a restriction on the elasticity of demand for real balances of the form

e < yI3 (20)

which is analogous to (15). Thus, in Fig. 5, equilibrium will be stable for all
points at which the elasticity function lies below a ray through the origin of
the slope 1/13. For the elasticity curve shown in the diagram, equilibrium is
stable if and only if the proportionate rate of monetary expansion exceeds
Yi.5
Inequalities (15) and (20) indicate that, for both the models analysed,
equilibrium will tend to be unstable when the elasticity of demand for real
balances is "high" and expected inflation adjusts "quickly" to the actual rate
of change of prices, The remainder of the present section is concerned with
the question of whether or not these results remain true when more general
error-learning expectations hypotheses are used in place of (7). It will be
shown that, for second-order error-learning processes at least, the answer is
in the affirmative. Attention is restricted to this single extension of the
model because of the rapid increase in the mathematical complexity of the
stability conditions as higher-order equations are used. Although the conclu-
sions are therefore necessarily limited, examination of the second-order
process is of interest because (a) it is more general than the frequently used
adaptive expectations hypothesis, incorporating the latter as a special case,
and (b) recent evidence on inflation expectations supports the view that it is
a more appropriate specification than (7) in periods when inflation rates are
increasing to levels well in excess of previous historical averages (see, for
example, [4]).

Stable region

0 Y' Y

FIG. 5

5 For a more extensive discussion of this case see Yarrow [8].

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
70 MONETARY ANALYSIS OF HYPERINFLATIONS

Suppose then that equation (7) is replaced by

Xi~ = jq(p - iT) + 5(p - W) (21)

where 13 and 8 are positive constants.6 Note that when 8 = 0 integration of
(21) leads back to the adaptive expectations equation (7). Incorporating (21)
into the analysis in place of (7) produces the following results, proofs of
which are outlined in the Appendix.
(i) Necessary and sufficient conditions for the local stability of equilibrium
in the model composed of equations (1), (2), (3a), (6) and (21) are

f'(0)g(r*) + s* + Pf(0)g'(W ) > 0 (22a)

5fR(0)[r*g'(W*) + g(w*) > 0 (22b)
f(0)[fri*gP(T*) + 3g(W*) + g(W*)]> 5fR(0)[r*
fR() g(ir*) + W* + Pf (22c)w
(ii) Necessary and sufficient conditions for the local stability of equilib-
rium in the model composed of equations (1), (2), (3b), (6) and (21) are

f'(0)g(y) + f3f'(0)g'(y) > 0 (23a)

5f'(0)g(y) > 0 (23b)
f'(?)g(y) + 8f'(0)g'(y) > 5g(y)I[g(y) + 3g'(y)] (23c)
Since 3 >0, (22a) and (22b) are equivalent to (11) and (12), while (23a) and
(23b) are equivalent to (18) and (19). Thus, as in the adaptive expectations
case, high values of 13 and e tend to lead to instability. In particular, note
that equilibria of type B in Figs. 1 and 3, where the elasticity of demand for
real balances exceeds unity, are again always unstable.
The effect of the change to the second-order error learning process is the
introduction of the additional constraints ((22c) and (23c)) on the parame-
ters required for stability. In principle these could be plotted in Figs. 4 and 5
but, since the functional forms are rather intricate, this line of analysis will
not be pursued further. Two points regarding the additional constraints are,
however, worth noting. First, assuming the first two conditions are satisfied
(for each model), the right hand sides of (22c) and (23c) will be positive
numbers.7 However, the left hand sides of these inequalities tend to zero
with f'(0), implying that when prices respond relatively slowly to excess
demand then each of the equilibrium positions will tend towards instability.
Second, for given 8, the left hand sides of (22c) and (23c) become negative
as 13 tends to zero. The equilibria will therefore tend to be unstable for

6 The restrictions on the coefficients ensure that the expected rate of inflation would co
to the actual rate if the latter were held constant.
7 In the case where the proportionate rate of monetary expansion is constant, the right hand
side of (23c) is independent of f'(0).

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
 J. L. EVANS AND G. K. YARROW 71

relatively low values of 13 as well as for high values. Indeed, the relative
magnitudes of 13 and 8 are important for establishing the stability of the
equilibria e.g. if one assumes the first two conditions are met, the higher is 8
relative to (3, the more likely it is for the third condition to be unsatisfied. A
precise relationship between the two coefficients which characterises the
brink of stability/instability cannot be established due to the presence of
both stabilising and destabilising forces via the expectation formation
mechanism. This latter issue receives further attention in Section V where
the different models are compared.

IV. Hyperinflation with rational expectations

One objection to the use of the error-learning hypotheses (7) and (21) is
that, for models of the type under discussion, they imply "irrationality" on
the part of economic agents in that the latter are assumed not to change
their forecasting methods in the face of systematic forecasting errors. For
example, starting from a position in which expectations are correct, the
adaptive expectations equation produces underestimates (overestimates) of
the inflation rate whenever the latter is rising (falling). Since the model does
not lead to changes in the inflation rate which are random, agents should be
able to perceive that they are making systematic forecasting errors and, if
the mistakes are costly, attempt corrective action. In other words, the
expectations equation is likely to be structurally unstable.
Now in the analysis of hyperinflations it is not clear how much weight
should be attached to this argument since the durations involved are often
very short (sometimes only a few months), leaving little time to improve
forecasting methods. Nevertheless, whatever the empirical relevance of the
criticism in particular cases, it is certainly of theoretical interest to explore
the implications of expectations formation processes which cannot be bet-
tered. In the present context of deterministic models this means considering
the case where the actual and expected rates of inflation are equal. That is,

or = p (24)

Equation (24) is usually referred to in the literature as the rational expecta-

tions hypothesis, although the term "perfect myopic foresight" is also used
in work on equilibrium growth theory.
An immediate consequence of (24) is that, from the price-adjustment
equation (2),

M Md
M _ M(25)
P P

Thus, both the product and money markets are in equilibrium at each

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
72 MONETARY ANALYSIS OF HYPERINFLATIONS

moment. Combining (1) and (25)

M
- = g(r) (26)
P

Taking logarithms of (26), differentiating with respect to time and substitut-

ing for p from (24)

_ g (")ir (27)

Finally, substituting from (26) into the first of the money supply rules (3a)
and then into (27) yields the first-order differential equation

aG - wg(w) (28)

g'(X)
The numerator of (28) is the difference between the government financing
requirement and the tax yield. The expected inflation rate will be constant at
the two points A and B of Fig. 6, corresponding to A and B respectively in
Fig. 1. Since g'(i) <0, it can be seen that the right hand side of (28) is
positive between A and B, and negative elsewhere. Thus, the expected
(= actual) rate of inflation is falling to the left of A and to the right of B, bu
rising between A and B, implying that equilibrium A is unstable and B is
stable.
Again a phase diagram may prove useful; see Fig. 6. Equation (26)
immediately puts the economy on the locus y = g(i) and the direction of

FIG.B

R~=o
\ =g )

FIG. 6

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
 J. L. EVANS AND G. K. YARROW 73

movement suggests that the equilibrium at B is now stable whereas that at

A is unstable.
At this juncture, it may be helpful to remind the reader that expectations
are still fully realised on the unstable paths for rational expectations.
Instability here simply reflects the fact that, in the neighbourhood of the
equilibrium, actors' responses do not move them toward that equilibrium.
More formally, a necessary and sufficient condition for an equilibrium s*
of (28) to be stable is that, at 7rT,

a aoG - wg(w) ]< 0 (29)

as g (X)

Differentiating and making use of the equilibrium condition oG = wg(w),

this leads to

0> g( *),i ,*g(, ) (30)

and hence to

e = -g * g(r*)/g(W*) > 1 (31)

In marked contrast to the error-learning cases, therefore, equilibrium is

stable if and only if the elasticity of demand for real balances exceeds unity.
One important feature of this result is the implication it carries for compara-
tive statics analysis. Recalling the discussion in Section II, it follows from
(31) that, at any stable equilibrium of the model, small increases (decreases)
in the government financing requirement are associated with falls (rises) in
the equilibrium rate of inflation.
For the alternative monetary rule given by (3b), equation (27) becomes

g'(1r)/g(r) (32)

Since the denominator of the expression is always negative, it can be seen

that when the rate of growth of the money supply exceeds (falls short of) the
expected or actual rate of inflation the latter is falling (rising). Thus, the
unique equilibrium of the model is unstable, a result which has been noted
elsewhere and has apparently been felt to be somewhat disquieting Sargent
and Wallace [5].

V. The models compared

We have analysed two types of monetary model which are similar in all
respects save in their assumptions regarding expectations formation, yet
which yield radically differing results concerning the stability, and hence the
comparative statics properties, of their equilibrium points. Given these

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
74 MONETARY ANALYSIS OF HYPERINFLATIONS

differences, and, in particular, the counter-intuitive results in the rational

expectations case, it is of interest to explore in a little more detail, and
rather less formally, the ways in which price level movements in the two
models are generated.
For convenience the results may be summarised in a matrix:

Expectation of Inflation Monetary Rule

Proportionate rate of Proportionate rate of
monetary expansion monetary expansion
proportional to level a constant
of real balances
Adaptive without second a b
order effects
Adaptive with second c d
order effects
Rational f g
The Stabilit

a =unstable if the elasticity of the demand for real balances (e) is suffi-
ciently high.
b = unstable if the product of e and the coefficient of adaptive expectations
((3) is greater than y (the constant rate of monetary expansion) i.e.
edd>y.
c = unstable for high values of e. Also slow velocity of price adjustment and
a low (3 relative to 8 in the second-order mechanism will tend to induce
instabilities.
d = unstable for high values of e and (3. Also, both a slow velocity of price
adjustment and a low (3 relative to 8 in the second-order mechanism will
tend to induce instabilities.
f = unstable for e < 1.
g = always unstable.

Now consider first the adaptive expectations case with a constant propor-
tionate rate of monetary expansion, and assume that, initially, the variables
are at their equilibrium levels. From this position, let the rate of growth of
the money supply increase to a higher (constant) level, implying that real
balances start to rise. Ceteris paribus, an increase in real balances leads to
excess supply of money and, hence, to excess demand for goods. Through
the price adjustment equation for the goods market (2) the latter produces
an increase in the rate of inflation, reducing the rate of increase of real
balances and tending to abate the inflationary pressure. If price expectations
remained unaffected, this real balance effect would continue to raise the
inflation rate until it reached the higher rate of monetary expansion, at

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
 J. L. EVANS AND G. K. YARROW 75

which point the process would stop. It can be said, therefore, that price
adjustment in response to excess demand for goods, of the type embodied in
equation (2), is a stabilising feature of the models.
In contrast, adjustments in the asset (money) market tend to have
opposite effects. Thus, in the presence of excess supply of money (excess
demand for goods) the actual rate of inflation will exceed the expected rate
(see equation (2)), implying, from the adaptive expectations equation, that
the expected rate of inflation will be increasing. Now the expected rate of
inflation is the negative of the rate of return on money balances. We have,
therefore, a situation in which excess supply of real balances leads to a fall in
the yield on money, reducing desired real balances and, ceteris paribus,
increasing the excess supply. This process, which is illustrated in Fig. 7, is
clearly destabilising. Its impact is greater (a) the more rapidly expectations
change for a given excess supply of real balances, and (b) the more sensitive
are desired money holdings to variations in the expected rate of inflation
(see Fig. 7).
Whether or not the equilibrium point of the model under discussion is
stable depends upon the relative strengths of the counteracting forces
outlined in the previous two paragraphs. A rapid response of prices to
excess demand in the product market (which, in the neighbourhood of an
equilibrium, can be taken to mean a high value of f'(O)) will strengthen the
first tendency, but also produces faster changes in expected inflation for
given excess supply of real balances (see equation (9)). Conditions (18) and
(19) show that, as far as stability is concerned, these effects cancel each
other out, leaving the two factors mentioned earlier (the value of the

Excess
supply,
\ r rising

____V~~~~~~~~~~M ~

Excess demandM/

M M/P

FIG. 7

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
76 MONETARY ANALYSIS OF HYPERINFLATIONS

expectations adjustment coefficient and the elasticity of demand for real

balances) as the determining influences.
Similar arguments to the above can also be applied when monetary rule
(3a) is in operation and when second-order error-learning assumptions are
relevant, but, as was noted in Section III, the conditions here are more
complex. Again, there is a stabilising influence in the goods market which is
stronger, the higher is the velocity of price adjustment. However, this is no
longer cancelled by the acceleration of expected inflation, for influences on
this are now twofold (equation (21)). Here lies an explanation for the
relative values of 8 and (3 being important. The excess supply of money
raises the unanticipated inflation (A3) which induces an acceleration of the
expected inflation rate (21). Yet this effect is partially hampered by the
depressive effect on the unanticipated acceleration prompted by the higher
level of real balances (A4). Respectively these effects are related to the
magnitude of the coefficients 8 and 13, thus clarifying the reasons why their
relative values become significant, and also why low values of (3 may lead to
instability.
However, much more notable are the very different situations which arise
on the introduction of rational expectations to the analysis. In this latter case
the money and goods markets are both in equilibrium at each moment and
the price-adjustment equation (2) becomes degenerate. The product market
then plays a purely passive role, the inflation rate being determined in the
asset (money) market only. Now when the supply of real balances is rising,
equilibrium in the money market implies that the yield on real balances will
be increasing to induce a willingness to hold the extra assets. Thus, when the
supply of money is increasing faster than the price level the rate of inflation
will be falling. Variations in the inflation rate in the rational expectations
models are linked to changes in the scarcity of money assets rather than to
excess demand in the product market (which is always zero). This may be
compared with the error-learning cases where actual and expected rates of
inflation can differ, and where the former is an increasing function of excess
demand for goods.
The above observations also go some way towards explaining why a stable
equilibrium can exist in the rational expectations model in which the
government operates with a fixed financing requirement. Equation (3a)
implies that the rate of growth of the money supply is inversely proportional
to the level of real balances. As already argued, the rate of inflation will be
falling whenever it is exceeded by the proportionate rate of monetary
expansion (i.e. whenever real balances are rising). However, the increase in
real balances will lead to a reduction in the rate of monetary growth through
the government budget equation, tending to counteract the growing abun-
dance of money balances and, hence, the falling inflation rate. The policy

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
 J. L. EVANS AND G. K. YARROW 77

can be stabilising precisely because it increases (decreases) the proportionate

rate of monetary expansion when the inflation rate is increasing
(decreasing).
The perverse results generated by the rational expectations hypothesis
when the rate of growth of the money supply is held constant have lead
Sargent and Wallace [5] and Calvo [3] to reformulate the model in such a
way as to avoid the dynamic instability problem. Specifically, they retain a
demand for money function of the type given by equation (1) but assume
that (a) the price level can change discontinuously, (b) the expected rate of
inflation at time t is given by the right derivative of the logarithm of the
price level at time t, (c) the latter always exists, and (d) economic agents
expect that if the rate of monetary expansion were constant through time a
process of continually accelerating or decelerating inflation would eventually
come to an end.8 The last assumption is clearly highly restrictive, and might
be regarded as a rather unsatisfactory way of sidestepping the stability
problem. In particular, by introducing discontinuous price jumps to preserve
stability, fully rational expectations must be violated. It is also far from clear
how discontinuities in the price level can be reconciled with the usual sorts
of models of price-setting behaviour at the microeconomic level. Since
instability appears to be closely linked to the degeneracy of the pricing
equation (2) in the rational expectations analysis, our own view is that
further research into alternative price-adjustment processes is required.
Until there has been some development of models which allow the coexis-
tence of excess demand and fully anticipated inflation, dynamic instabilities
or perverse comparative statics results are likely to remain an integral
feature of rational expectations models.

VI. Summary and conclusions

Two types of monetary model of hyperinflation have been developed and

compared. Both are based upon a demand for money function, a price-
adjustment mechanism and a government budget constraint; but differ in
respect of their assumptions concerning the generation of expectations. One
type incorporates error-learning expectations-formation behaviour, while
the other rests upon the assumption that inflation is fully anticipated. For
both types of model monetary regimes were considered in which either (a)
the government financed a fixed level of real expenditures by money
creation, or (b) maintained a constant rate of growth of the money supply
For the error-learning models the main results were that (i) equilibria tend
to be stable when the elasticity of demand for real balances is relatively low

8In the Sargent and Wallace paper the rate of growth of the money supply is always zero (i.e.
the money stock is constant), but (d) is the obvious generalisation of their final assumption for
the problem under discussion.

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
78 MONETARY ANALYSIS OF HYPERINFLATIONS

and expectations adjust relatively slowly to past forecasting mistakes, and

(ii) stable equilibria had "normal" comparative statics properties (e.g. a
higher government financing requirement is associated with a higher rate of
inflation). In the rational expectations models a stable equilibrium was
shown to exist in the constant financing requirement case, but it possessed
"perverse" comparative statics properties (e.g. a higher financing require-
ment is associated with a lower rate of inflation). On the other hand, given a
constant rate of growth of the money supply, equilibrium was found to be
always unstable in the rational expectations case.
Finally, it was argued that the counter-intuitive results generated by the
rational expectations models arose from the fact that the pricing equation
became degenerate, leaving inflation as a purely asset market phenomenon;
and it was suggested that further research might be directed towards the
development of price-setting models which allow the coexistence of excess
demand for goods and fully anticipated price rises.

University of Durham
Hertford College, Oxford

APPENDIX

Consider the second-order expectations equation

X 3-(i-) + 8 (O -,) (Al)

and let

r =z (A2)

Now, from (2)

A - X = f~y - g ( w)) (A3)

Differentiating (A3) with respect to time and making use of (6)

0 -iX = f ( )[y - g (v) ir]

= f'( )[y - oy - g'(Ur) ir] (A4)
=RfKl -ay- Tr-f( )y -g'(,U)irr]
Substituting from (A2), (A3) and (A4) into (Al)

z = ORf ( Kiy -aTy - f ( )y - g,( T)iTr] + 8ff (AS)

Equations (A2) and (A5) together with (6) and either (3a) or (3b) constitute a set of first-order
differential equations in the variables -r, y and z.
Taking first the case of a constant government financing requirement, on substituting for ,u
from (3a) and linearising the differential equations around some equilibrium point
(,*, y,* z*) - * g(.*) 0), we have

r'r all a12 a13ir 1

Y = a21 a22 a23 Y - Y * (A6)
Z_ a3l a32 a33- z-z

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
 J. L. EVANS AND G. K. YARROW 79

where

all = a12 = a23 = 0

a13 = 1

a2l = (*)U'()g'(*)- 1]
a22 = - s* - f'(0)g( *)

a3l = RfO(O) g(a*)[f'(0) g'(*) - 1] - f'(0) g'(*)

a32 = - f'(0)[L7T* + f(O) g(7T*)] + 6f'(0)
a33 = - P3f'(O)g'(*)
The characteristic equation of the matrix is

X3+b2X2+b1X+bo=O (A7)
where

b2 = f(Og( 7T*) + W * + 3f'(0)g'(T*)

b1 = ,Bf'(0)7T*g(aT*) + O3f'(O)g(T*) + 6f
bo = 8f'(?)[u* g'(*) + g(a*)]

Necessary and sufficient conditions for the stability of (A6), from the Routh-Hurwitz theorem,
are

b2>0, b0 >0 and b1>bo/b2( > 0) (A8)

which lead directly to (22a), (22b) and (22c).

When the proportionate rate of monetary expansion is constant we can proceed in exactly the
same way to a set of differential equations of type (A6), the only difference being that (3a) is
replaced by (3b). In this case the coefficients of the matrix are as follows:

all = al2 = a23 = 0

a13 = 1

a2l = -(T*) U'(0) '(*T 1]

a22 = - f'(0) g(r*)

a31 = PRO) = (a*) U'(0) -'(a - 1] -8ff(0) g'(X*)

a32 = ]f'(0)[ Of(0)g(W 8I

a33 = - P3f (0)g(r*)

The characteristic equation can again be written as (A7), where

b2 = f(0)g(ir*) + O3f,(0)g'(I*)
bi = O, f(0) g(7T*) + 8f' (0) g'I(7*
bo = 8f'(0)g(ir*)

The stability conditions (A8) then yield inequalities (23a), (23b) and (23c) of the

REFERENCES

1. BISIGNANO, J. (1975). "Cagan's Real Money Demand Model with Alternative Error Struc-
tures", International Economic Review, vol. 16 (2), pp. 487-502.
2. CAGAN, P. (1956). "The Monetary Dynamics of Hyperinflation", in Studies in the Quantity
Theory of Money, ed. M. Friedman, Chicago, Ill.: Chicago University Press.
3. CALvO, G. A. (1977). "The Stability of Models of Money and Perfect Foresight: a
Comment", Econometrica, vol. 45 (7), pp. 1737-1739.

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms
80 MONETARY ANALYSIS OF HYPERINFLATIONS

4. CARLSON, J. A. and PARKIN, M. (1975). "Inflation Expectations", Economica, vol. 42 (166),

pp.123-138.
5. SARGENT, T. J. and WALLACE, N. (1973). "The Stability of Models of Money and Growth
with Perfect Foresight", Econometrica, vol. 41 (6), pp. 1043-1048.
6. SARGENT, T. J. and WALLACE, N. (1973). "Rational Expectations and the Dynamics of
Hyperinflation", International Economic Review, vol. 14 (2) pp. 328-350.
7. SARGENT, T. J. and WALLACE, N. (1975). "Rational Expectations, the Optimal Monetary
Instrument and the Optimal Money Supply Rule", Journal of Political Economy, vol. 83 (2),
pp.241-254.
8. YARROW, G. K. (1977). "The Demand for Money Function and the Stability of Monetary
Equilibrium", Economic Journal, vol. 87 (1), pp. 124-131.

This content downloaded from

170.239.168.67 on Sat, 15 Apr 2023 20:40:40 UTC
All use subject to https://about.jstor.org/terms