Hyperinflation
Prerequisite: Inflation
Recently, this has floating around the tubes. Brian commented on it, so I figured some economic background was in order. The article makes it sound as if hyperinflation is some random event that only tomfoolery can solve, but the causes of and solutions for hyperinflation are quite well understood.
Hyperinflation gets started when the government prints a lot of money. If a private supplier of money tries to hyperinflate their currency, people will simply switch to another unit of value. The supplier of hyperinflated currency must have a near monopoly on the use of violence to force people to accept their notes.
When a government adds to the money supply, they reallocate value from the previous holders of money to themselves. Suppose they double the quantity of money.
Period 1: Citizens: 100 units of money and all value. Government: 0 units of money
Period 2: Citizens: 100 units of money. Government: 100 units of money. Each group holds half of the value.
Change in Prices = (new money)/(total money supply)
(under these assumptions)
Value of tax captured = [(currency printed) x (value of money)]/(new price level)
At high inflation rates, the money is losing value as soon as it is printed, so the time it takes to print and spend it becomes an ever increasing loss of value.
Suppose the velocity of money remains constant. What will happen to prices? Using the equations of exchange (MV = PY), we can figure out that prices will double, holding output constant. So far so good. With these assumptions, the more a government prints, the more value they will get. Even if the government wants to spend 50% of GDP and not collect any taxes, prices will "only" double every year. We know from history that more must be going on, since Brazil topped 2000% inflation. That would imply that the government was collecting 95% of the economy's value through the inflation tax!
Money is just like any other economic good. There is a supply and a demand for it. The higher inflation is, the less money people will hold, and the faster they will spend the money they have. In hyperinflations, no one saves money more than a few days, since its value is dropping so rapidly. People start to get paid daily, and they must also shop daily so they can afford something close to what they earned. In equation of exchange terms, V increases dramatically.
MV = PY
So, in a hyperinflation, M is going up rapidly, V is going down rapidly, and Y is dropping due to the difficulty of production during periods of high inflation. That leaves one variable to adjust - P. As prices increase more rapidly and people hold less money, the government gains less and less money from printing money. This somewhat paradoxical outcome is an example of the Laffer Curve. If the government printed no money, they would earn no seigniorage revenue. If the inflation rate were infinite, they would earn no money at all from printing money, since no one would accept the currency as having any value. Thus, there must be an inflation rate between 0 and infinite that maximizes revenue.
Laffer Curve
Strangely enough, the highest possible revenue might actually occur at extremely low inflation rates, because of the international demand for a currency which appreciates. If a country has an extremely reliable value on their currency, like the U.S. or Japan, people from other countries might use that currency as a store of value, even though they can't spend it readily. Few countries can build such a reputation, since there will always be a temptation to cheat and unexpectedly inflate quickly to capture the value of the money abroad. Think of it like diluting a pool of value. The more money is being held and valued by other people, the larger the value can be had without resulting in high inflation. For example, if others hold $1 million of your currency, you can print $10,000 and have 1% inflation. If others hold $1 billion of your currency, you can print $10,000,000 and get 1% inflation. If others know you intend to inflate, they get rid of the currency - which leads us to the importance of expectations.
Expected changes in the future money supply are quickly reflected in the current price level, even if the money supply change never takes place. Imagine you are a worker in a hyperinflating economy. Prices are 100, and your wages are 1000, so you can buy 10 goods. You expect the government to double the price level. How much are you now willing to work for? In order to afford 10 goods tomorrow, you must demand a wage of 2000 today. This is true not only for workers, but for everyone in the economy. As people get used to inflation, they react faster and faster to increasing amounts of currency. For governments relying on seigniorage as a source of revenue, this can be devastating, since inflation must increase at an accelerating rate in order to surprise people into accepting the money. In order to end hyperinflation, the government must not only stop printing money, they must convince people that they have stopped. So, that's why the economists needed to convince people that money wasn't going to lose its value.
Recently, this has floating around the tubes. Brian commented on it, so I figured some economic background was in order. The article makes it sound as if hyperinflation is some random event that only tomfoolery can solve, but the causes of and solutions for hyperinflation are quite well understood.
Hyperinflation gets started when the government prints a lot of money. If a private supplier of money tries to hyperinflate their currency, people will simply switch to another unit of value. The supplier of hyperinflated currency must have a near monopoly on the use of violence to force people to accept their notes.
When a government adds to the money supply, they reallocate value from the previous holders of money to themselves. Suppose they double the quantity of money.
Period 1: Citizens: 100 units of money and all value. Government: 0 units of money
Period 2: Citizens: 100 units of money. Government: 100 units of money. Each group holds half of the value.
Change in Prices = (new money)/(total money supply)
(under these assumptions)
Value of tax captured = [(currency printed) x (value of money)]/(new price level)
At high inflation rates, the money is losing value as soon as it is printed, so the time it takes to print and spend it becomes an ever increasing loss of value.
Suppose the velocity of money remains constant. What will happen to prices? Using the equations of exchange (MV = PY), we can figure out that prices will double, holding output constant. So far so good. With these assumptions, the more a government prints, the more value they will get. Even if the government wants to spend 50% of GDP and not collect any taxes, prices will "only" double every year. We know from history that more must be going on, since Brazil topped 2000% inflation. That would imply that the government was collecting 95% of the economy's value through the inflation tax!
Money is just like any other economic good. There is a supply and a demand for it. The higher inflation is, the less money people will hold, and the faster they will spend the money they have. In hyperinflations, no one saves money more than a few days, since its value is dropping so rapidly. People start to get paid daily, and they must also shop daily so they can afford something close to what they earned. In equation of exchange terms, V increases dramatically.
MV = PY
So, in a hyperinflation, M is going up rapidly, V is going down rapidly, and Y is dropping due to the difficulty of production during periods of high inflation. That leaves one variable to adjust - P. As prices increase more rapidly and people hold less money, the government gains less and less money from printing money. This somewhat paradoxical outcome is an example of the Laffer Curve. If the government printed no money, they would earn no seigniorage revenue. If the inflation rate were infinite, they would earn no money at all from printing money, since no one would accept the currency as having any value. Thus, there must be an inflation rate between 0 and infinite that maximizes revenue.
Laffer Curve
Strangely enough, the highest possible revenue might actually occur at extremely low inflation rates, because of the international demand for a currency which appreciates. If a country has an extremely reliable value on their currency, like the U.S. or Japan, people from other countries might use that currency as a store of value, even though they can't spend it readily. Few countries can build such a reputation, since there will always be a temptation to cheat and unexpectedly inflate quickly to capture the value of the money abroad. Think of it like diluting a pool of value. The more money is being held and valued by other people, the larger the value can be had without resulting in high inflation. For example, if others hold $1 million of your currency, you can print $10,000 and have 1% inflation. If others hold $1 billion of your currency, you can print $10,000,000 and get 1% inflation. If others know you intend to inflate, they get rid of the currency - which leads us to the importance of expectations.
Expected changes in the future money supply are quickly reflected in the current price level, even if the money supply change never takes place. Imagine you are a worker in a hyperinflating economy. Prices are 100, and your wages are 1000, so you can buy 10 goods. You expect the government to double the price level. How much are you now willing to work for? In order to afford 10 goods tomorrow, you must demand a wage of 2000 today. This is true not only for workers, but for everyone in the economy. As people get used to inflation, they react faster and faster to increasing amounts of currency. For governments relying on seigniorage as a source of revenue, this can be devastating, since inflation must increase at an accelerating rate in order to surprise people into accepting the money. In order to end hyperinflation, the government must not only stop printing money, they must convince people that they have stopped. So, that's why the economists needed to convince people that money wasn't going to lose its value.