In economics, hyperinflation occurs when a country experiences very high and usually accelerating rates of inflation, rapidly eroding the real value of the local currency, and causing the population to minimize their holdings of the local money. The population normally switches to holding relatively stable foreign currencies. Under such conditions, the general price level within an economy increases rapidly as the official currency quickly loses real value. The value of economic items remains relatively more stable in terms of foreign currencies.
Unlike low 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 in nominal prices, the nominal cost of goods, and in the supply of money. But typically the general price level rises even more rapidly than the money supply since people try to get rid of the devaluing money as quickly as possible. The real stock of money, that is the amount of circulating money divided by the price level, decreases.
Hyperinflations are usually caused by large persistent government deficits financed primarily by money creation (rather than taxation or borrowing). As such, hyperinflation is often associated with wars, their aftermath, sociopolitical upheavals, or other crises that make it difficult for the government to tax the population. A sharp decrease in real tax revenue coupled with a strong need to maintain the status quo, together with an inability or unwillingness to borrow, can lead a country into hyperinflation.
What is 'Hyperinflation'
Hyperinflation is extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Hyperinflation is a situation where the price increases are so out of control that the concept of inflation is meaningless.
BREAKING DOWN 'Hyperinflation'
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. Left unchecked this causes prices to increase, as the currency loses its value.
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 arisk premium to accept the currency, and they do this by raising their prices.
One of the most famous examples of hyperinflation occurred in Germany between January 1922 and November 1923. By some estimates, the average price level increased by a factor of 20 billion, doubling every 28 hours.
Inflation is a sustained increase in the aggregate price level. Hyperinflation is very high inflation. Although the threshold is arbitrary, economists generally reserve the term “hyperinflation” to describe episodes when the monthly inflation rate is greater than 50 percent. At a monthly rate of 50 percent, an item that cost $1 on January 1 would cost $130 on January 1 of the following year.
Hyperinflation is largely a twentieth-century phenomenon. The most widely studied hyperinflation occurred in Germany after World War I. The ratio of the German price index in November 1923 to the price index in August 1922—just fifteen months earlier—was 1.02 × 1010. This huge number amounts to a monthly inflation rate of 322 percent. On average, prices quadrupled each month during the sixteen months of hyperinflation.
While the German hyperinflation is better known, a much larger hyperinflation occurred in Hungary after World War II. Between August 1945 and July 1946 the general level of prices rose at the astounding rate of more than 19,000 percent per month, or 19 percent per day.
Even these very large numbers understate the rates of inflation experienced during the worst days of the hyperinflations. In October 1923, German prices rose at the rate of 41 percent per day. And in July 1946, Hungarian prices more than tripled each day.
What causes hyperinflations? No single shock, no matter how severe, can explain sustained, continuously rapid growth in prices. The world wars themselves did not cause the hyperinflations in Germany and Hungary. The destruction of resources during the wars can explain why prices in Germany and Hungary would be higher after the wars than before. But the wars themselves cannot explain why prices would continuously rise at rapid rates during hyperinflation periods.
Hyperinflations are caused by extremely rapid growth in thesupply of “paper” money. They occur when the monetary and fiscal authorities of a nation regularly issue large quantities of money to pay for a large stream of government expenditures. In effect, inflation is a form of taxation in which the government gains at the expense of those who hold money while its value is declining. Hyperinflations are very large taxation schemes.
During the German hyperinflation the number of German marks in circulation increased by a factor of 7.32 × 109. In Hungary, the comparable increase in the money supply was 1.19 × 1025. These numbers are smaller than those given earlier for the growth in prices. What does it mean when prices increase more rapidly than the supply of money?
Economists use a concept called the “real quantity of money” to discuss what happens to people’s money-holding behavior when prices grow rapidly. The real quantity of money, sometimes called the “purchasing power of money,” is the ratio of the amount of money held to the price level. Imagine that the typical household consumes a certain bundle of goods. The real quantity of money measures the number of bundles a household could buy with the money it holds. In low-inflation periods, a household will maintain a high real money balance because it is convenient to do so. In high-inflation periods, a household will maintain a lower real money balance to avoid the inflation “tax.” They avoid the inflation tax by holding more of their wealth in the form of physical commodities. As they buy these commodities, prices rise higher and inflation increases. Figure 1 shows real money balances and inflation for Germany from the beginning of 1919 until April 1923. The graph indicates that Germans lowered real balances as inflation increased. The last months of the German hyperinflation are not pictured in the figure because the inflation rate was too high to preserve the scale of the graph.
Hyperinflations tend to be self-perpetuating. Suppose a government is committed to financing its expenditures by issuing money and begins by raising the money stock by 10 percent per month. Soon the rate of inflation will increase, say, to 10 percent per month. The government will observe that it can no longer buy as much with the money it is issuing and is likely to respond by raising money growth even further. The hyperinflation cycle has begun. During the hyperinflation there will be a continuing tug-of-war between the public and the government. The public is trying to spend the money it receives quickly in order to avoid the inflation tax; the government responds to higher inflation with even higher rates of money issue.
Most economists agree that inflation lowers economic welfare even when allowing for revenue from the inflation tax and the distortion that would be created by alternative taxes that raise the same revenue.
Figure 1 During the German Hyperinflation, the Real Quantity of Money Fell as Inflation Increased
How do hyperinflations end? The standard answer is that governments have to make a credible commitment to halting the rapid growth in the stock of money. Proponents of this view consider the end of the German hyperinflation to be a case in point. In late 1923, Germany undertook a monetary reform, creating a new unit of currency called the rentenmark. The German government promised that the new currency could be converted on demand into a bond having a certain value in gold. Proponents of the standard answer argue that the guarantee of convertibility is properly viewed as a promise to cease the rapid issue of money.
An alternative view held by some economists is that not just monetary reform, but also fiscal reform, is needed to end a hyperinflation. According to this view, a successful reform entails two believable commitments on the part of government. The first is a commitment to halt the rapid growth of paper money. The second is a commitment to bring the government’s budget into balance. This second commitment is necessary for a successful reform because it removes, or at least lessens, the incentive for the government to resort to inflationary taxation. If the government commits to balancing its budget, people can reasonably believe that money growth will not rise again to high levels in the near future. Thomas Sargent, a proponent of the second view, argues that the German reform of 1923 was successful because it created an independent central bank that could refuse to monetize the government deficit and because it included provisions for higher taxes and lower government expenditures. Another way to look at Sargent’s view is that hyperinflations end when people reasonably believe that the rate of money growth will fall to normal levels both now and in the future.
What effects do hyperinflations have? One effect with serious consequences is the reallocation of wealth. Hyperinflations transfer wealth from the general public, which holds money, to the government, which issues money. Hyperinflations also cause borrowers to gain at the expense of lenders when loan contracts are signed prior to the worst inflation. Businesses that hold stores of raw materials and commodities gain at the expense of the general public. In Germany, renters gained at the expense of property owners because rent ceilings did not keep pace with the general level of prices. Costantino Bresciani-Turroni argues that the hyperinflation destroyed the wealth of the stable classes in Germany and made it easier for the National Socialists (Nazis) to gain power.
Hyperinflation reduces an economy’s efficiency by driving people away from monetary transactions and toward barter. In a normal economy, using money in exchange is highly efficient. During hyperinflations people prefer to be paid in commodities in order to avoid the inflation tax. If they are paid in money, they spend that money as quickly as possible. In Germany, workers were paid twice per day and would shop at midday to avoid further depreciation of their earnings. Hyperinflation is a wasteful game of “hot potato” in which people use up valuable resources trying to avoid holding on to paper money.
Hyperinflations can lead to behavior that would be thought bizarre under normal conditions. Gerald Feldman’s book The Great Disorder shows a photo of a small firm transporting wages in a wheelbarrow because the number of banknotes required to pay workers grew very large during the hyperinflation (Feldman 1993, p. 680). Corbis, an Internet source of photos (www.corbis.com), shows an image of a German woman burning banknotes in her stove because doing so provided more heat than using them to buy other fuel would have done. Another image shows German children playing with blocks of banknotes in the street.
More-recent examples of very high inflation have occurred mostly in Latin America and former Eastern bloc nations. Argentina, Bolivia, Brazil, Chile, Peru, and Uruguay together experienced an average annual inflation rate of 121 percent between 1970 and 1987. In Bolivia, prices increased by 12,000 percent in 1985. In Peru, a near hyperinflation occurred in 1988 as prices rose by about 2,000 percent for the year, or by 30 percent per month. However, Thayer Watkins documents that the record hyperinflation of all time occurred in Yugoslavia between 1993 and 1994.2
The Latin American countries with high inflation also experienced a phenomenon called “dollarization,” the use of U.S. dollars in place of the domestic currency. As inflation rises, people come to believe that their own currency is not a good way to store value and they attempt to exchange their domestic money for dollars. In 1973, 90 percent of time deposits in Bolivia were denominated in Bolivian pesos. By 1985, the year of the Bolivian hyperinflation, more than 60 percent of time deposit balances were denominated in dollars.
What caused high inflation in Latin America? Many Latin American countries borrowed heavily during the 1970s and agreed to repay their debts in dollars. As interest rates rose, all of these countries found it increasingly difficult to meet their debt service obligations. The high-inflation countries were those that responded to these higher costs by printing money.
The Bolivian hyperinflation is a case in point. Eliana Cardoso explains that in 1982 Hernán Siles Suazo took power as head of a leftist coalition that wanted to satisfy demands for more government spending on domestic programs but faced growing debt service obligations and falling prices for its tin exports. The Bolivian government responded to this situation by printing money. Faced with a shortage of funds, it chose to raise revenue through the inflation tax instead of raising income taxes or reducing other government spending.