Lecture 5.

3: Economics of Hyperinflation- Introduction and Meaning and Inflation and

Monetary Policies.

• IS INFLATION A MONETARY PHENOMENON?

• The answer to the question of whether inflation is a monetary phenomenon
in the long run is yes. No major inflation can take place without rapid money
growth, and rapid money growth will cause rapid inflation.
• Further, any policy that determinedly keeps the growth rate of money low
will lead eventually to a low rate of inflation.
• But in the short run of a few years, the link between money growth and
inflation may well be weak.
• Although there is no precise definition of the rate of inflation that deserves
the star ranking of hyperinflation rather than
• high inflation, a working definition is that a country is in hyperinflation when
its annual inflation rate reaches 1,000 per cent per annum.
1. Note that in the 1990s many Latin American countries successfully
stabilized the inflation rate at non hyperinflationary levels.
2. In contrast, several of the countries emerging out of the former Eastern
bloc saw very high rates of inflation. In a hyperinflationary economy,
inflation is so pervasive and such a problem that it completely dominates
daily economic life.
3. People spend significant amounts of resources minimizing the inflationary
damage.
4. They have to shop often to get to the stores before the prices go up; their
main concern in saving or investing is how to protect themselves against
inflation; they reduce holdings of real balances to a remarkable extent to
avoid the inflation tax but have to compensate by going to the bank more
often—daily or hourly instead of weekly, for example—to get currency.
1. Wages are paid very often—at the end of the German hyperinflation,
several times a day.
2. It seems difficult to believe that countries can function for any length of
time with inflation rates of several hundred per cent or more.
3. In fact, they do not function well, and sooner or later they will stabilize a
high inflation simply because the economy turns chaotic.
4. Thus, Israel successfully stabilized in 1985, as did Bolivia. However, such
experiences do not seem to prevent other countries from entering
hyperinflations.
5. Although true hyperinflations have been rare since 1947, there have been
many instances of 100 percent annual inflation rates. (Bad enough!) Such
high inflations are frequently associated with high budget deficit.
• Did India ever suffered from hyperinflationary pressure?
1. The proximate cause of hyperinflation is always massive growth in the
money supply.
2. But it is also true that the hyperinflationary economies all suffered from
large budget deficits.
3. In several cases the origin of the budget deficit was wartime spending,
which generated large national debts and also destroyed the tax-gathering
apparatus of the country.
4. But there is a two-way interaction between budget deficits and inflation.
Large budget deficits can lead to rapid inflation by causing governments to
print money to finance the deficit.
5. In turn, high inflation increases the measured deficit..
1. There are two main mechanisms through which inflation increases budget
deficits: tax collection effects and increases in nominal payments on the
national debt.
2. As the inflation rate rises, the real revenue raised from taxation falls
3. The reason is that there are lags in both the calculation and payment of
taxes. Suppose, to take an extreme example, that people pay taxes on April
15 on the income they earned the previous year.
4. Consider someone who earned $50,000 last year and has a tax bill of
$10,000 due on April 15. If prices have in the meantime gone up by a
factor of 10, as they might in hyperinflation, the real value of the taxes is
only one-tenth of what it should be.
5. The budget deficit can rapidly get out of hand. The measured budget
deficit includes the interest payments on the national debt. Since the
nominal interest rate tends to rise when inflation increases, higher
inflation generally increases the nominal interest payments that are made
by the government, and the measured deficit therefore increases.