Science Fair Project Encyclopedia
In economics, hyperinflation is is "an inflationary cycle without any tendency toward equilibrium." inflation which is "out of control", a condition in which prices increase rapidly as a currency loses its value.
Characteristics of hyperinflation
In 1956, Phillip Cagan wrote "Monetary Dynamics of Hyperinflation", generally regarded as the first serious study of hyperinflation and its effects. In it he defined hyperinflation as a monthly inflation rate of at least 50%.
International Accounting Standard 29 describes four signs that an economy may be in 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; and the cumulative inflation rate over three years approaches, or exceeds, 100%.
Rates of inflation of several hundred percent per month are often seen. Extreme examples include Germany in the early 1920s when the rate of inflation hit 3.25 million percent per month; Greece during its occupation by German troops (1941-1944) with 8.55 billion percent per month; and Hungary during the same approximate time period at 41.9 quadrillion percent per month (%). Other more moderate examples include Eastern European countries such as Ukraine in the period of economic transition in the early 1990s, in Latin American countries such as Bolivia and Peru in 1985 and 1988-1990, and in Brazil in the early 1990s.
Hyperinflation did not directly bring about the Nazi takeover of Germany; the inflation ended with the introduction of the Rentenmark and the Weimar Republic continued for a decade afterward. The inflation did, however, call into question the competence of liberal institutions. It also produced resentment of Germany's bankers and speculators (many of them Jewish) who were blamed for the inflation.
Hyperinflation is generally associated with paper money because the means to increasing the money supply with paper money is the simplest: add more zeroes to the plates and print, or even stamp old notes with new numbers. It also is the most dramatic. The history of paper money is replete with episodes of hyperinflation, followed by a return to "hard money". Older economies would revert to hard currency and barter when the circulating medium became excessively devalued, generally following a "run" on the store of value.
Unlike inflation, which some economists feel can be a justifiable policy choice, hyperinflation is always regarded as destructive - it effectively wipes out the purchasing power of savings held as paper assets of the country afflicted with it, distorts the economy in favor of extreme consumption and hoarding of real assets - causes the monetary base, whether specie or hard currency - to flee the country, and makes the afflicted area anathema to investment. Hyperinflation is met with drastic remedies, whether shock therapy of slashing government expenditures or altering the currency basis. An example of the latter is placing the nation in question under a currency board as Ecuador has now in 2005, which allows the central bank to print only as much money as it has in foreign reserves.
The aftermath of hyperinflation is equally complex, as hyperinflation has always been a traumatic experience for the area which suffers it, the next policy regime almost always enacts policies to prevent its recurrence. Often this means making the central bank very aggressive about maintaining price stability as is the case with the German Bundesbank, or the move to some hard basis of currency for example the gold standard or a currency board. Many governments have enacted extremely stiff wage and price controls in the wake of hyperinflation, which is, in effect, a form of forced savings: goods become unavailable, and hence people hoard cash, as was the case in the People's Republic of China under "Great Leap Forward" and "Cultural Revolution".
Root causes of hyperinflation
For a variety of reasons, governments have occasionally resorted to literally printing money to meet their expenses. Hyperinflation can be sarcastically defined as the point in time when a monetary authority can't even do that: theories of hyperinflation generally look for a relationship between seignorage and the inflation tax. Seignorage is the profit made from coining money, named because it was one of the rights of nobility. The inflation tax is the amount of improvement in a government's position from its own inflationary actions - since governments are almost always net debtors, reducing the value of previous borrowing reduces their debt load as percentage of revenues, and, in effect, reduces the amount of time it will take the government to pay those debts. However, "there is no such thing as a free lunch" (See TINSTAAFL), those holding government debt, directly or indirectly, have less buying power. Governments also owe money to other people, and must maintain control, or fiat over their territory. The root causes of hyperinflation, whether in Cagan's model or in the neo-classical models, focus on the point in time when the increase in money supply, or drop in basic money stock, make it impossible for a government to improve its position by seignorage and the inflation tax. That is, when government obligations, which are not denominated as money, have a cost which, when fiat money is printed, increase in cost by more than the gain for printing the money.
From this, it might be wondered why any state would engage in actions that lead, or continue, hyperinflation. One reason is that often the alternative to hyperinflation is depression. In late 2001, the Argentine Peso collapsed in value. Rather than printing sufficient money for people to withdraw from banks (which they feared would start a run on the banks), the government took the peso off of its dollar peg. Many international economists predicted that they would have to either get a new loan from the IMF and institute shock therapy or hyperinflatcurrency controls were imposed, tariffs instituted, and the economy was allowed to fall into a severe recession: unemployment hit 25%; homelessness and crime spiraled upwards and the poverty rate peaked at over 50%.
In general, hyperinflation is associated with fiat money and/or very rapid debasement of currency such as the 1834-1839 debasement of the akše, the standard silver coin of the Ottoman empire, which saw its value drop by five fold - increasing the nominal amount of circulating medium. Episodes of hyperinflation produce staggering increases in price -- and bank notes denominated in millions, billions and trillions, coins denominated in the millions, or withdrawn from circulation all together. The vicious cycle of borrowing to meet all expenses begins, and the monetary authority does not act to contain the cycle and may indeed accommodate it. Hyperinflation is often the result of governments using unbacked currency during war time to pay the expenses of the conflict, such as the United States in the 1770s and the Republic of China in the 1940s.
The root cause is a matter of more dispute. For both economists of the classical school as well as monetarists, it is always the result of the monetary authority's irresponsibility (or stupidity), "running the printing presses." These models focus on the unrestrained seignorage of the monetary authority, and the gains from the inflation tax. For neo-liberal economists, hyperinflation is considered to be the result of a crisis of confidence, where the monetary base of the country flees, producing widespread fear that individuals will not be able to convert local currency to some more transportable form -- for example gold, or an internationally recognized hard currency such as the US Dollar. See below for more discussion. These models are based on the neo-classical synthesis and chart the drop in the country's money stock against hyperinflation.
Hyperinflation can also occur in the absence of a central monetary authority. One case is when there is "free banking" and banks are allowed to print their own notes without strong regulatory authority. These episodes are often brief, as there is then a run on banks, a panic, and a collapse in the money supply leading to a depression and deflation. An example of this is the Mississippi Company "bubble" under John Law.
Less commonly, hyperinflation may occur when there is debasement of the coinage -- wherein coins are consistently shaved of some of their silver and gold, increasing the circulating medium and reducing the value of the currency. The "shaved" specie is then often restruck into coins with lower weight of gold or silver. Hyperinflation occurs in such a circumstance when "token" coins begin circulating, with no relationship to the par value of gold or silver.
One common cause of hyperinflation is warfare, civil war, or intense internal conflict of other kinds: governments needing to do whatever is necessary to continue fighting, since the alternative is defeat. They cannot cut outlays, because the main outlay is for armaments to fight the war itself. Further, a civil war may make it difficult to raise taxes or to collect the existing taxes. In normal times, a deficit is financed by borrowing, that is selling government bonds. But under conditions of war or civil war, it is typically difficult and expensive to borrow, especially if the war is going poorly for the government in question. The banking authorities, whether central or not, "monetize" the deficit, printing money to pay for the government's efforts to survive. The hyperinflation under the Chinese Nationalists from 1939-1945 is a classic example of a government printing money to pay civil war costs. By the end, currency was flown in over the Himalaya, and then old currency was flown out to be destroyed.
In the United States, hyperinflation was seen during the Revolutionary War and during the Civil War, especially on the Confederate (losing) side. Many other cases of extreme social conflict encouraging hyperinflation can be seen, as in Germany after World War I and in Yugoslavia after the death of Marshall Tito.
Models of 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. Either one or both of these encourage inflation and hyperinflation. 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 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 either model, the second effect then follows from the first - either too little confidence forcing an increase in the money supply, or too much money destroying confidence.
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 in preference to holding notes which will lose value. 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. War is one commonly cited cause of crisis of confidence, particularly losing in a war, as occurred during Napoleanic Vienna, and capital flight, sometimes because of "contagion" is another. In this view, the increase in the circulating medium is the result of the government attempting to buy time without coming to terms with the root cause of the lack of confidence itself.
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, central or otherwise, produce currency to pay spiralling 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 start factoring the decay of the currency's value into prices. The issuer must then accelerate its expansion to cover these prices, which pushes the currency value down even faster. According to this model the 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. This policy, combined with reductions of pensions, wages, and government outlays, formed part of the Washington consensus of the 1990s.
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 the increasing the money stock, by which ever agencies are allowed to do so, is universal. Because this practice increases the supply of currency without any matching increase in demand for it, the price of the currency, that is the exchange rate, naturally falls relative to other currencies. 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 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.
That is, rapidly rising prices undermine money's role as a store of value, so that 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 rise endogenously as a result of the excessive increase in the money supply. At the point where ordinary purchases are affected by inflation pressures, hyperinflation is out of control, in the sense that ordinary policy mechanisms, such as increasing reserve requirements, raising interest rates or cutting government spending will all be responded to by shifting away from the rapidly dwindling currency and towards other means of exchange.
During a period of hyperinflation, bank runs, loans for 24 hour periods, switching to alternate currencies, the return to use of gold or silver or even barter becomes common. Many of the people who hoard gold today expect hyperinflation, and are hedging against it by holding specie. There is, also, extensive capital flight or flight to a "hard" currency such as the U.S. dollar. These are sometimes met with capital controls, an idea which has swung from standard, to anathema, and back into semi-respectability. All of this constitutes an economy which is operating in an "abnormal" way, which may lead to decreases in real production. If so, that intensifies the hyperinflation, since it means that the amount of goods in "too much money chasing too few goods" formulation is also reduced. This is also part of the vicious circle of hyperinflation.
Once the vicious circle of hyperinflation has been ignited, dramatic policy means are almost always required, simply raising interest rates is insufficient. Bolivia, for example, underwent a period of hyperinflation in 1985, where prices increased 12,000% in the space of less than a year. The government raised the price of gasoline, which it has been selling at a huge loss to quiet popular discontent, and the hyperinflation came to a halt almost immediately, since it could bring in hard currency by selling its oil abroad. The crisis of confidence ended, and people returned deposits to banks. The German hyperinflation of the 1920s was ended by producing a currency based on assets loaned against by banks, called the rentenmark. Hyperinflation often ends when a civil conflict ends with one side winning. Though sometimes used, wage and price controls to control or prevent inflation, no episode of hyperinflation has been ended by the use of price controls alone, though they have sometimes been part of the mix of policies used to halt hyperinflation.
Hyperinflation and the currency
As noted, in countries experiencing hyperinflation, the central bank often prints money in larger and larger denominations as the smaller denomination notes become worthless. This can result in the production of some interesting banknotes, including those denominated in amounts of 1,000,000,000 or more.
- By late 1923, the Weimar Republic of Germany was issuing fifty-million-mark banknotes and postage stamps with a face value of fifty billion marks. The highest value banknote issued by the Weimar government's Reichsbank had a face value of 100 Billion marks (100,000,000,000,000 or One Hundred Trillion US/UK) . 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 largest denomination banknote ever officially issued for circulation was in 1946 by the Hungarian National Bank for the amount of 100 quintillion Pengő (100,000,000,000,000,000,000, or 1.0 × 1020). image (There was even a banknote worth 10 times more, i.e. 1.0 × 1021 Pengő, printed, but not issued image.) The Post-WWII hyperinflation of Hungary holds the record for the most extreme monthly inflation rate ever - 41,900,000,000,000,000% (4.19 × 1016%) for July, 1946.
One way to avoid the use of large numbers is by declaring a new unit of currency (so, instead of 10,000,000,000 Dollars, a bank might set 1 New Dollar = 1,000,000,000 old Dollars, so the new note would read "10 New Dollars".) While this does not lessen actual value of a currency, it is called revaluation .
Some banknotes were stamped to indicate changes of denomination. This is because it would take too long to print new notes. By time the new notes would be printed, they would be obsolete (that is, they would be of too low a denomination to be useful).
(To be inserted)
The contents of this article is licensed from www.wikipedia.org under the GNU Free Documentation License. Click here to see the transparent copy and copyright details