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Macroeconomics Report on Hyperinflation


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Macroeconomics Report on Hyperinflation

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Macroeconomics Report on Hyperinflation

  1. 1. PT-MBA 2nd year, 4th Trimester, NMIMS Macroeconomics – Group assignment report on HYPERINFLATION 6th September, 2013 Submitted to : Prof. Souvik Dhar Submitted by : Div – A Bhavika Shah Chandan Shah Dipika Dedhia Hemant Manglani Milind Sawant Neha Kumar Rainu Rawat Rashi Kapur Sonal Rajadhyax Tarannoom Rahmani Yuvraj Tandon 10 11 15 20 27 29 36 39 50 53 59
  2. 2. Contents Hyperinflation – definition 2. Warning signs of Hyperinflation 3. Causes a. Money Supply b. Supply Shocks 4. Models to understand Hyperinflation a. Crisis of Confidence Model b. Monetary Model 5. Units of Measurement 6. The costs of Hyperinflation 7. Most severe hyperinflations in world history a. Germany b. Zimbabwe c. Hungary 8. Latest Updates – Venezuela hit by fears of hyperinflation 9. Surviving the Aftermath 10. Conclusion 11. References 1.
  3. 3. Hyperinflation In economics, hyperinflation occurs when a country experiences very high and usually accelerating rates of inflation, causing the population to minimize their holdings of money. Under such conditions, the general price level within an economy increases rapidly as the official currency quickly loses real value. Meanwhile, the real value of economic items generally stays the same with respect to one another, and remains relatively stable in terms of foreign currencies. Unlike regular inflation, where the process of rising prices is protracted and not generally noticeable except by studying past market prices, hyperinflation sees a rapid and continuing increase prices and in the supply of money and the cost of goods. When associated with depressions, hyperinflation often occurs when there is a large increase in the money supply not supported by gross domestic product (GDP) growth, resulting in an imbalance in the supply and demand for the money. When associated with wars, hyperinflation often occurs when there is a loss of confidence in a currency's ability to maintain its value in the aftermath. Because of this, sellers demand a risk premium to accept the currency, and they do this by raising their prices. Warning signs of Hyperinflation Phillip Cagan in The Monetary Dynamics of Hyperinflation, defined hyperinflation as starting in the month when the monthly inflation rate exceeds 50%, and it ending when the monthly inflation rate drops below 50% and stays that way for at least a year. Economists usually follow Cagan’s description that hyperinflation occurs when the monthly inflation rate exceeds 50%. But if a country had just below 50% inflation, it's hard to argue that it's anything other than hyperinflation. The International Accounting Standards Board does not establish an absolute rate at which hyperinflation is deemed to arise. Instead, it lists factors that indicate the existence of hyperinflation: The general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency. Amounts of local currency held are immediately invested to maintain purchasing power The general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable foreign currency. Prices may be quoted in that currency. Sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during the credit period, even if the period is short. Interest rates, wages, and prices are linked to a price index The cumulative inflation rate over three years approaches, or exceeds, 100%.
  4. 4. More importantly, International Financial Reporting Standards (IFRS) does not put an exact number on what defines hyperinflation. They define it when the local population keeps most of their assets in non-monetary assets, or a stable foreign currency and local transactions take place in a stable foreign currency. The exact % of inflation is open to interpretation. Causes Money Supply This theory claims that hyperinflation occurs when there is a continuing (and often accelerating) rapid increase in the amount of money that is not supported by a corresponding growth in the output of goods and services. Firstly, what is the reason for an increase in the money supply? Usually, the excessive money supply growth results from the government being either unable or unwilling to fully finance the government budget through taxation or borrowing, and instead it finances the government budget deficit through the printing of money. Once the hyperinflation is under way, the fiscal problems become even more severe. Because of the delay in collecting tax payments, real tax revenue falls as inflation rises. Thus, the government’s need to rely on seigniorage is self-reinforcing. This results in an imbalance between the supply and demand for the money, causing rapid inflation, which leads to a larger budget deficit, which leads to even more rapid money creation. Very high inflation rates can result in a loss of confidence in the currency and lead to hyperinflation. Secondly, how does the increase in money supply cause prices of commodities to increase? There are a few reasons. The first is basic economics. There is more money (supply) with no change in demand. When hyperinflation is in progress, people don't want money (they want bread or gold or other commodities) which decreases the demand for money. This causes supply to go up and demand down, both make the currency worth less. The currency is also supposed a represent a portion of GDP. As more currency notes are printed, they each represent a smaller portion of GDP. This makes each currency unit (e.g. Dollar or Rupee) worth less and each commodity more. Thus the prices of commodities go on increasing. How does the increase in price of commodities make the currency lose its value? The price increases that result from the rapid money creation creates a vicious circle, requiring ever growing amounts of new money creation to fund government activities. Hence both monetary inflation and price inflation proceed at a rapid pace. Such rapidly increasing prices cause widespread unwillingness of the local population to hold the local currency as it
  5. 5. rapidly loses its buying power. Instead they quickly spend any money they receive, which increases the velocity of money flow; this in turn causes further acceleration in prices. If excessive money supply causes hyperinflation, why do some governments engage in such action? Governments have sometimes resorted to excessively loose monetary policy, as it allows a government to devalue its national debts and reduce or avoid a tax increase. Inflation is effectively a regressive tax on the users of money, but less overt than levied taxes and is therefore harder to understand by ordinary citizens. Monetary inflation can become hyperinflation if monetary authorities fail to fund increasing government expenses from taxes, government debt, cost cutting, or by other means. From this, it might be wondered why any rational government would engage in actions that cause or continue hyperinflation. One reason for such actions is that often the alternative to hyperinflation is either depression or military defeat. Supply Shocks A lot of the hyperinflations that occurred in the past were said to be caused by some sort of extreme negative supply shock, often associated with wars or natural disasters. Description of the effects of a supply shock (contraction) scenario: Assume the horizontal axis is real output (GDP) and full-employment potential output is shown by the vertical green line. The vertical axis is spending or demand in real terms. Consider that the price level is held constant. The 45 degree line is the fixed-price aggregate supply curve indicating that firms will supply whatever is demanded at the fixed price up to capacity (Point A). After A, supply capacity would be exhausted and inflation would then enter the picture.
  6. 6. The red line (top) which intersects Point A is the aggregate demand line and shows the current state of spending in the economy at different real income levels. It is upward sloping because consumption rises with national income and it is less than 45 degrees because not all income is consumed (as there is some saving). So the red line it is the sum of all demand components (consumption, investment, net exports and government spending). Thus at Point A, there will be full capacity output, stable prices, some non-government saving and a budget deficit to match. Now imagine a devastating natural calamity strikes the nation, which will affect the morale of the working population, the level of goods and services produced and thus ultimately the GDP. The potential output would steadily contract. If you think about current demand levels in relation to that new dramatically reduced supply potential you quickly see there is a huge excess demand (spending) measured by the gap between Points B and D. But, in fact, as the income levels fall, the economy would actually contract along the top red aggregate demand line (as income falls, so does consumption and saving). At Point C there is still excessive demand (spending) in relation to the new potential capacity. So demand would have to be reduced downward (red line shifting down) until it intersected the new supply constraint at the 45 degree line at Point D. Point C could theoretically be associated just as much with a budget surplus as a budget deficit – that is, we cannot directly implicate the conduct of fiscal policy with the excess spending automatically or even necessarily.The upshot is that the price level would be rising in this economy long before it reached Point D from Point A because of the chronic excess spending relative to the dramatically lower capacity.
  7. 7. This is an example showing the extreme drop in the GDP of Zimbabwe during a severe drought (in the time period 1992 -1993) that is considered to be as a major contributor to the supply shock of goods and services in the nation. Models to understand Hyperinflation Since hyperinflation is visible as a monetary effect, models of hyperinflation center on the demand for money. Economists see both a rapid increase in the money supply and an increase in the velocity of money if the (monetary) inflation is not stopped. Either one or both of these together are the root causes of inflation and hyperinflation. 1. Crisis of Confidence Model A dramatic increase in the velocity of money as the cause of hyperinflation is central to the "crisis of confidence" model of hyperinflation, where the risk premium that sellers demand for the paper currency over the nominal value grows rapidly. The term ―velocity of money‖ can be defined as the average frequency with which a unit of money is spent on new goods and services produced domestically in a specific period of time. “Hyperinflation – Too much money chasing too few goods” In the confidence model, some event, or series of events, such as defeats in battle, or a run on stocks of the specie which back a currency, removes the belief that the authority issuing the money will remain solvent — whether a bank or a government. Because people do not want to hold notes which may become valueless, they want to spend them. Sellers, realizing that there is a higher risk for the currency, demand a greater and greater premium over the original value. Under this model, the method of ending hyperinflation is to change the backing of the currency, often by issuing a completely new one. 2. Monetary Model The second theory is that there is first a radical increase in the amount of circulating medium, which can be called the "monetary model" of hyperinflation. In the monetary model, hyperinflation is a positive feedback cycle of rapid monetary expansion. It has the same cause as all other inflation: money-issuing bodies produce currency to pay spiraling costs, often from lax fiscal policy, or the mounting costs of warfare. When businesspeople perceive that the issuer is committed to a policy of rapid currency expansion, they mark up prices to cover the expected decay in the currency's value. The issuer must then accelerate its expansion to cover these prices, which push the currency value down even faster than before. According to this model the
  8. 8. issuer cannot "win" and the only solution is to abruptly stop expanding the currency. Unfortunately, the end of expansion can cause a severe financial shock to those using the currency as expectations are suddenly adjusted. Because rapidly rising prices undermine the role of money as a store of value, people try to spend it on real goods or services as quickly as possible. Thus, the monetary model predicts that the velocity of money will increase as a result of an excessive increase in the money supply. At the point when money velocity and prices rapidly accelerate in a vicious circle, hyperinflation is out of control, because ordinary policy mechanisms, such as increasing reserve requirements, raising interest rates, or cutting government spending will be ineffective and be responded to by shifting away from the rapidly devalued money and towards other means of exchange. Whatever the cause, hyperinflation involves both the supply and velocity of money. Which comes first is a matter of debate, and there may be no universal story that applies to all cases. But once the hyperinflation is established, the pattern of increasing the money stock, by whichever agencies are allowed to do so, is universal. Hyperinflation is regarded as a complex phenomenon and one explanation may not be applicable to all cases. However, in both of these cases, whether loss of confidence in currency comes first, or increased supply of money relative to the supply of goods and services, the other phase is ignited — either too little confidence forcing an increase in the money supply, or too much money is destroying confidence. Units of measurement Inflation rate is usually measured in percent per year. It can also be measured in percent per month or in price doubling time. The Costs of Hyperinflation Inflation becomes hyperinflation when the increase in money supply turns specific areas of pricing power into a general frenzy of spending quickly before money becomes worthless. The
  9. 9. purchasing power of the currency drops so rapidly that holding cash for even a day is an unacceptable loss of purchasing power. As a result, no one holds currency, which increases the velocity of money, and worsens the crisis. Hyperinflation effectively wipes out the purchasing power of private and public savings, distorts the economy in favor of the hoarding of real assets, causes the monetary base to flee the country, and makes the afflicted area anathema to investment. Business executives devote much time and energy to cash management when cash loses its value quickly. By diverting this time and energy from more socially valuable activities, such as production and investment decisions, hyperinflation makes the economy run less efficiently. Menu costs also become larger under hyperinflation. Firms have to change prices so often that normal business practices, such as printing and distributing catalogs with fixed prices, become impossible. When prices change frequently by large amounts, it is hard for customers to shop around for the best price. Highly volatile and rapidly rising prices result in currency losing value quicker than assets purchased with it. Tax systems are also distorted by hyperinflation—In most tax systems there is a delay between the time a tax is levied and the time it is actually paid to the government. During hyperinflation, even a short delay greatly reduces real tax revenue. By the time the government gets the money it is due, the money has fallen in value. As a result, once hyperinflations start, the real tax revenue of the government often falls substantially. During a period of hyperinflation, bank may run loans for 24-hour periods or other short periods and offer higher interest rate for deposits. This is because they want to encourage people to deposit the currency in banks and reduce the money supply in economy. The return to use of gold or silver or even barter may become common. Switching to alternate currencies - extensive capital flight or flight to a ―hard‖ currency such as the US dollar which is relatively more stable. The savings of people in the currency that has lost value becomes worthless. Money loses its role as a store of value, unit of account, and medium of exchange. Increase in money supply – need to add more zeros to the plates and print, or even stamp old notes with new numbers. The central bank often prints money in larger and larger denominations as the smaller denomination notes become worthless. This can
  10. 10. result in the production of some interesting banknotes, including those denominated in amounts of 1,000,000,000 or more. Metallic coins are rapid casualties of hyperinflation, as the scrap value of metal enormously exceeded the face value. Hyperinflation – An Illustration Hyperinflation, as the word suggest is inflation going out of control. However at the onset it often appears to be only higher-than-normal conventional inflation. Let us use the price of a loaf of bread to illustrate this: In 1914, before World War I, a loaf of bread in Germany cost the equivalent of 13 cents. Two years later it was 19 cents, and by 1919, after the war, that same loaf was 26 cents - doubling the prewar price in five years. Bad, yes -- but not alarming. But one year later a German loaf of bread cost $1.20. By mid-1922, it was $3.50. Just six months later, a loaf cost $700, and by the spring of 1923 it was $1,200. As of September, it cost $2 million to buy a loaf of bread. One month later, it cost $670 million, and the month after that $3 billion. Within weeks it was $100 billion, at which point the German mark completely collapsed! The whole time the German government kept printing more money, so much so that people burned it in their fireplaces because it was cheaper than wood. Why didn't they just stop and try to stabilize the currency? A government in financial straits finds its easiest recourse is to issue more and more money until the money loses its value. They feared shutting off the monetary supply would lead to riots, civil war, and, worst of all, communism. So, realizing that what they were doing was destructive, they kept doing it out of fear that stopping would be even more destructive. Most severe hyperinflations in world history Highest monthly inflation rates in history Country Hungary Zimbabwe Currency name Month with highest inflation rate Highest monthly inflation rate Hungarian pengő Zimbabwe dollar July 1946 November 2008 January 1994 October 1923 October 1944 Yugoslavia Yugoslav dinar Germany German Papiermark Greece Greek drachma 4.19 × 1016 % 7.96 × 1010 % Equivalent daily inflation rate 207.19% 98.01% Time required for prices to double 15 hours 24.7 hours 3.13 × 108 % 29,500% 64.63% 20.87% 1.4 days 3.7 days 13,800% 17.84% 4.3 days
  11. 11. The effect of world’s 3 most severe hyperinflations is discussed below: 1. Germany Germany or the Weimar Republic went through its worst inflation in 1923. The highest denomination was 100,000,000,000,000 Mark(100 trillion) which was the equivalent of about 25 USD. The rate of inflation hit 3.25 × 106 percent per month (prices double every two days). Beginning on November 20, 1923, 1,000,000,000,000 old Marks were exchanged for 1 Rentenmark so that 4.2 Rentenmarks were worth 1 US dollar, exactly the same rate the Mark had in 1914. One of the firms printing these notes submitted an invoice for the work to the Reichsbank for 32,776,899,763,734,490,417.05 (3.28 × 1019, or 33 quintillion) Marks. The main cause of the Weimar Republic hyperinflation is believed to be because of the "London ultimatum" in May 1921 at the war’s end, when the Allies demanded that Germany pay substantial reparations in gold or foreign currency to be paid in annual installments of 2 billion gold marks plus 26 percent of the value of Germany's exports. These payments led to fiscal deficits in Germany, which the German government eventually financed by printing large quantities of money. Graph 1 shows the money supply and the price level in Germany from January 1922 to December 1924. The immense increases in the money supply and the price level provide a dramatic illustration of the effects of printing large amounts of money.
  12. 12. Graph 2 shows inflation and real money balances. As inflation rose, real money balances fell. When the inflation ended at the end of 1923, real money balances rose. 2. Zimbabwe Hyperinflation in Zimbabwe was one of the few instances that resulted in the abandonment of the local currency. At independence in 1980, the Zimbabwe dollar (ZWD) was worth about USD 1.25. Afterwards, however, rampant inflation and the collapse of the economy severely devalued the currency. Inflation was steady before Robert Mugabe in 1998 began a program of land reforms that primarily focused on taking land from white farmers and redistributing those properties and assets to black farmers, which disrupted food production and caused revenues from export of food to plummet.[54][55][56] The result was that to pay its expenditures Mugabe’s government and Gideon Gono’s Reserve Bank printed more and more notes with higher face values. The inflation peaked at an annual rate of 89.7 sextillion percent (89,700,000,000,000,000,000,000%) in mid-November 2008. The peak monthly rate was 79.6
  13. 13. billion percent, which is equivalent to a 98% daily rate. At that rate, prices were doubling every 24.7 hours. 3. Hungary - pengő hyperinflation Hungary went through the worst inflation ever recorded between the end of 1945 and July 1946. In 1944, the highest denomination was 1,000 pengő. The highest denomination in mid-1946 was 100,000,000,000,000,000,000 pengő. A special currency the adópengő – or tax pengő – was created for tax and postal payments. The value of the adópengő was adjusted each day, by radio announcement. By late July, one adópengő equaled 2,000,000,000,000,000,000,000 or 2×1021 (2 sextillion) pengő. When the pengő was replaced in August 1946 by the forint, the total value of all Hungarian banknotes in circulation amounted to1/1,000 of one US dollar. It is the most severe known incident of inflation recorded, peaking at 1.3 × 1016 percent per month (prices double every 15 hours). The overall impact of hyperinflation: On 18 August 1946, 4×1029 (four hundred quadrilliard on the long scale used in Hungary; four hundred octillion on short scale) pengő became 1 forint. 100,000,000,000,000,000,000 pengő currency note Latest Updates Venezuela hit by fears of hyperinflation and recession Hyperinflation is looming in Venezuela, with prices suffering their highest monthly rise on record in May, while the economy slides into recession Prices rose 6.1 per cent in May, compared with 1.6 per cent in the same period last year, bringing accumulated inflation for the first five months of 2013 to 19.4 per cent, almost as high as the annual figure for 2012 of 20.1 per cent. At present, the annualized rate of inflation (cumulative rate of inflation over three years) in Venezuela is 35.2 per cent. At the root of the OPEC country’s economic woes is a tangled web of price and currency controls which, together with problems in the oil industry that supplies 96 per cent of export revenues, have generated a shortage of foreign currency, on which the import-dependent economy relies. That has caused shortages of basic goods including food, in turn aggravating inflation further. Surviving the Aftermath - examples 1. Just as fiscal problems caused the German hyperinflation, a fiscal reform ended it. At the end of 1923, the number of government employees was cut by one-third, and the reparations payments were temporarily suspended and eventually reduced. At the same time, a new central bank, the Rentenbank, replaced the old central bank, the Reichsbank. The Rentenbank was committed to not financing the government by printing money.
  14. 14. 2. Once the vicious circle of hyperinflation has been ignited, dramatic policy means are almost always required. Bolivia, for example, underwent a period of hyperinflation in 1985, where prices increased 12,000% in less than a year. The government raised the price of gasoline, which it had been selling at a huge loss to quiet popular discontent, and the hyperinflation came to a halt almost immediately, since it was able to bring in hard currency by selling its oil abroad. The crisis of confidence ended, and people returned deposits to banks. 3. Hyperinflation is ended with drastic remedies, such as imposing the shock therapy of slashing government expenditures or altering the currency basis. One form this may take is dollarization, the use of a foreign currency as a national unit of currency. An example was dollarization in Ecuador, initiated in September 2000 in response to a 75% loss of value of the Ecuadorian Sucre in early 2000. Conclusion There have been 28 episodes of hyperinflation in national economies in the 20th century, with 20 occurring after 1980- all of which were caused by financing huge public deficits through monetary creation. The tipping point for hyperinflation occurs when the government's deficit exceeds 50% of its expenditures and is funded by money printing. The central bank becomes very aggressive about maintaining price stability to counter this crisis. Many governments have enacted extremely stiff wage and price controls in the wake of hyperinflation.In normal times when the Fed senses that inflationary pressures are growing they start to unwind their balance sheet by selling assets and shrinking the money supply. Thereby ensuring that all the excess money they injected to the market which is causing inflation can be cleaned up. The ends of hyperinflations almost always coincide with fiscal reforms. Once the magnitude of the problem becomes apparent, the government musters the political will to reduce government spending and increase taxes. These fiscal reforms reduce the need for seigniorage, which allows a reduction in money growth. Hence, even if inflation is always and everywhere a monetary phenomenon, the end of hyperinflation is often a fiscal phenomenon as well. References: th 1. Macroeconomics, 7 edition – N.Gregory Mankiw 2. 3. On the Explosive Nature of Hyper-Inflation Data - Economics E-Journal 4. 5. Episodes of Hyperinflation - San Jose State University 6. 7. Hyperinflation of the Weimar Republic in 1923 Germany - usagold 8. Hyperinflation and Stabilisation: Cagan Revisited (pages 441–454) › ... › The Economic Journal › Vol 107 Issue 441