High Inflation• Hyperinflation: very high inflation

• Inflation is high usually due to high nominal money growth

• Nominal money grows usually because of high budget deficits

• High budget deficits get financed with money creation

High Inflation

• Government can finance its deficit by:– Borrowing: issuing government bonds– Have the central bank buy its bonds using created

money

• Debt Monetization: having government debt purchased by central bank by printing money

• Usually debt is purchased by the private sector

High Inflation• How to start hyperinflation:

– There is a budget crisis (an adverse shock that leaves with low tax revenues and high expenditures; aftermath of a war; shock to raw material prices for exporting economy…)

– Government becomes unable to borrow from the public of from abroad. Higher interest rates are demanded to lend or lending stops completely

– Money creation as desperate measure

High Inflation

• Seignorage = M/P (change in real money stock to finance the deficit)

M/P = (M/M)(M/P)

• Seignorage in % of GDP:

(M/P)/Y = (M/M)(M/P)/Y

• The rate of nominal money growth times real money balance

High Inflation

• Example: let Y = 1(a flow); and M/P = 2 (a stock). To finance a deficit of 10% with seignorage money must grow at 5%.

• This DOES NOT take into consideration changes in prices.

• Money growth leads to inflation which leads to people holding less money.

High Inflation

• How much will money demand be in the presence of inflation?

M/P = YL(i) L’ < 1M/P = YL(r + e)

• Expected inflation will move much more that r or Y during hyperinflation

• As expected inflation increases real money balance decrease

High Inflation

• Example: 100% monthly inflation means that after a month a currency will be worth half

• People start to barter or use foreign currency (even if usually illegal)

• Dollarization: use of another currency in a country’s domestic transactions.

High Inflation

• Seignorage is money growth times real money balance.

• Real money balance is inversely related to expected inflation

Seignorage = (M/M)YL(r + e)

• Resorting to seignorage leads to high and increasing inflation

High Inflation

• Assume that money grows at a constant rate• Expected inflation will be equal to money

growthSeignorage = (M/M)YL(r + M/M)

• Money growth increases and decreases seignorage

• At low money growth seignorage increases• At high money growth seignorage decreases

High Inflation

• Seignorage functions as a tax (at low rates its return increases; at high rate its return decreases)

• Laffer curve: decreasing return to tax rates (based on argument that lower taxes increase tax revenues)

• Inflation tax: (M/P). The tax base is real money balance. The tax rate is inflation

High Inflation

• When money growth is constant then inflation tax equals seignorage

inflation tax=(M/P)

seignorage=(M/M)(M/P)