Defining "hyperinflation"; its causes, Stability of Money Demand and Velocity, Shortage of Money

This note was originally posted on Wednesday, 6 February 2013 at 00:39

2011 ZA 14b

Is it possible to establish when a very rapid and continuing inflationary process becomes a hyperinflation?

2010 ZA 16a (Part 1) 

When is the rise in prices over a particular period considered a hyperinflation? 

Hyperinflations are periods where inflation is very high, accelerating and explosive (other terms used includes "out of control", "runaway", "unstoppable"). 

However there is no official definition of hyperinflation. The International Accounting Board employs a few rule of thumb, one of which is "hyperinflation takes place when the cumulative inflation rate over three years exceeds 100%". 

Cagan (1956) defined hyperinflations as periods when the rise in price exceeds 50% per month, which translates into an annual rate of more than 12000%. The hyperinflation ends when the rise in prices falls below 50% per month for at least a year (becoming "normal" inflation).  

Latin American countries such as Argentina and Brazil have experienced annual level of inflation greater than 100% for many years. However the process has not necessarily been explosive- the inflation increases continuously and rapidly but it is still much lower than the 12000% per annum threshold stated by Cagan. As such, their experiences are not classified as "hyperinflation"

2010 ZA 16a (Part 1) 

What has been the most important causes of hyperinflation?

There are a few sources of hyperinflation. Firstly, it could be triggered by a pronounced depreciation of the domestic currency against its foreign counterparts, which raises its cost of imports and cost of living. This is especially exacerbated if the country has a sizable tradable sector. 

Secondly it could be due to strong Union pressures for upward adjustments of wages across the board. This upward adjustment perpetuates itself as follows: an initial acceleration of inflation (cost-push or demand-pull inflation) will lead to the Union bargaining for higher nominal wages vis-a-vis employers (firms) to at least maintain the workers' real wages. If firms accede to the Union's request and has sufficient market power to determine prices, the nominal wage increase will result in higher prices (since prices are a markup on costs of production, with wages being one key component). The workers, rationally anticipating further increase in prices, will bargain for higher nominal wages, which in turn feeds into higher prices in the successive periods. This phenomenon is known as the "wage-price spiral"- prices increase as part of a vicious cycle due to Union pressure and market power of firms.  

Hyperinflation is usually due to the excessive money creation to fund government deficits- the rapid growth of money stock is not supported by a corresponding growth in output. This has a cascade effect- rapid inflation erodes the revenue base of the government and raises nominal expenditure, necesstating an even greater rate of money creation to fund the widening deficit. The sustained increase in money supply, which leads to further increase in prices, is known as "monetary inflation". The successive rounds of positive feedback- printing more money to sustain rising nominal expenditure- leads to hyperinflation. 

2010 ZB 14a

Can hyperinflation lead to the collapse in the demand for money?

Classical theorists tend to assume that the velocity of circulation as a relatively stable variable over time. This crude approach predicts the proportionality between price movements and changes in money. However it was observed that during periods of hyperinflation, price increase tend to rapidly outpace money growth- the German episode (1922 to 1923) concludes with real balances falling to 3% of their initial value.

Hyperinflation erodes the purchasing power of money over time. Specifically, it undermines money's role as a store of value. This will lead to widespread unwillingness to hold money, even when the acceleration of inflation is fully anticipated. Households will spend increasing portions of money receipts, and money changes hands (turnovers) at a quicker rate. This will be reflected in the rise in velocity of circulation. 

The quantity theory variant of the money demand function, Md/P = Y/V will not be a stable function where Y and V are assumed to be constant. Instead, the acceleration of inflation is not only due to monetary inflation- it will also be amplified by a higher velocity of circulation. 

The velocity of circulation is not static- it will actually increase further as rapidly accelerating inflation induces the households to spend their money faster. The change in velocity is endogenized because households modify their spending pattern based on adaptive expectations which are formed from observing inflation and injections of money in previous periods.

2010 ZB 14c

Is it possible to observe a shortage of money? Explain. 

Interestingly, the response of agents amidst hyperinflations seems to be a result of two contradictory effects. 

Firstly, rapidly accelerating inflation increases the opportunity cost of holding money, undermining its role as a store of value and eroding its purchasing power. Agents will substitute away real balances for real goods, fearing that its value will diminish further in future periods. This is the ''substitution effect'' of hyperinflation which has a negative effect on the agents' demand for money. The agents will spend a greater proportion of their real balances to purchase real goods, choosing to hold less real balances. 

Secondly there is an ''income effect''. Agents have a desired ratio of real balances to real income. When inflation accelerates rapidly, it diminishes the real balances held by agents. Therefore agents will seek to hold more nominal money to restore their initial level of real balances- the increase in nominal money held must be matched by the agents' expectations of the inflation rate. This will have a positive effect on the agents' demand for money.

If the "income effect" outweighs the "substitution effect", the economy will observe a shortage of money. The rate of money creation fails to meet the demand for nominal balances.