The Dynamics of Inflation and Hyperinflation

San José State University Department of Economics explains The Dynamics of Inflation and Hyperinflation:

The Dynamics of Inflation
and Hyperinflation

Very early in history astute observers noted that there was some relationship between the amount of money in circulation and the level of prices. At first these observers postulated a direct proportional relationship between the amount of money in circulation and the level of prices. This became explicit in the sixteenth century when gold and silver from Mexico and Peru entered the Spanish economy. For an investigation of the effects of this treasure on the price level in Spain see Spanish Treasure.

The notion that the amount of money in circulation determines the price level is called the quantity theory of money. A more sophisticated approach replaced the notion that the price level is simply proportional to the amount of money in circulation. This old theory of a simple proportional relationship became known as the crude quantity theory of money.

The more sophisticated approach is involves the the equation of exchange.

M*V = P*T
where

· M is the amount of money in circulation

· V is the velocity of money,
the number of times per
year that on average
a unit of money enters
into transactions

· P is the price level

· T is the level of transactions

Originally the equation involves the total transactions, intermediate as well as final sales, used goods as well as newly produced goods and so on. It was not feasible to get statistics on total transactions so T was replaced with Q the level of gross domestic product and the concept of P and V were similarly restricted. Thus the equation of exchange is

M*V = P*Q

The equation of exchange may be solved for P; i.e.,

P = M*V/Q

It is convenient to represent the equation of exchange in terms of the ratios of the variables at two different times, say time 1 and time 2. Thus in this form the equation of exchange is

(P2/P1) = (M2/M1)*(V2/V1)/(Q2/Q1)

Now the source of the astronomical prices increases involved in hyperinflation can be explained. Suppose the amount of money in circulation doubles; i.e., M2/M1=2. This will lead to an increase in the velocity of money, say 50 percent, so V2/V1=1.5. Furthermore suppose the level of output drops by 50 percent so Q2/Q1=0.5. The ratio of price levels is then

P2/P1 = 2(1.5)/(0.5) = 6

Thus a doubling of the money supply could lead not just to a doubling of the price level but instead an increase by six fold.

Suppose the monetary authorities then create money to allow the government to cope with the higher prices. Let us say that the money supply is increased by six fold. The velocity of money may then triple and let us say the quantity of production drops by 50 percent. This would lead to a ratio of price levels of 6(3)/(0.5)=36. An increase in the money supply by a factor of 36 might lead to an increase in the velocity of money by a factor 10 and let us again suppose the level of output falls by 50 percent. This would lead to an increase in the price level of 36(10)/(0.5)= 720. One can see that it would not take very long for the price levels to reach astronomical levels. There is an Americanism that expresses the effect quite well. In hyperinflation prices get hit by a triple whammy due to the increase in the money supply, the increase in the velocity of money and the decrease in production.

The rate inflation in terms of the equation of exchange may be expressed as

p = µ + ? - ?

Here p is the rate of inflation, µ is the rate of growth of the money supply, ? is the rate of growth of the velocity of money and ? is the rate of growth of real output of the economy.

It is this concatenation of increases that accounts for some inflations, the extreme ones called hyperinflations reaching astronomical numbers. For examples of these see Episodes of Hyperinflation.

In reality for hyperinflations in countries with well established market economies the level of output does not decrease but remains constant until the very last stages when the economy falls apart. For countries making a transition from central control to market-orientation the output does decrease drastically because some state enterprises which are operating at a financial loss have to cut back production drastically.

The Real Value of the Money Supply in a Hyperinflation

It is surprising but explanable that the monetary authorities during episodes of hyperinflation have the feeling that there is a shortage of money. The monetary authorities compare the amount of money in circulation to the price level and it seems that there is relatively little money in circulation. They are looking at the real value of the money supply, M/P. In fact, the real value of the money supply does become small during a hyperinflation and the equation of exchange explains why.

M/P = Q/V

Because money velocity V increases during the hyperinflation while the production Q stays constant or declines the ratio Q/V becomes very small. Monetary authorities may also look at the ratio of the real value of the money supply compared to the level of output. This would be

(M/P)/Q = 1/V

Thus in normal, noninflationary times the money supply might be equivalent to three months of output but in a hyperinflation it might drop to two weeks worth of output.


My reaction: Important points to note from the above explanation of monetary theory:

1) If investors lose confidence in the solvency of the US government, hyperinflation is the guarantied outcome.

2) The dramatic increase in the velocity of money caused by a "crisis of confidence" can produce hyperinflation despite a shrinking money supply.

Also, here is another extract on the importance of confidence from Wikipedia's entry on hyperinflation:

In the confidence model [of hyperinflation], 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.


Confidence in the solvency of the United States is in the early stages of a collapse. Hyperinflation is imminent. Buy physical gold and silver.

(for more on currency collapses, read Episodes of Hyperinflation)

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0 Responses to The Dynamics of Inflation and Hyperinflation

  1. Anonymous says:

    I am a little confused as to why it's assumed that money put into circulation increases money velocity automatically. I don't think you can make that assumption especially in todays economic climate where tremendous amounts of money have recently been put into circulation only to sit in a bank vault filling up an otherwise empty balance sheet in the recipients account, thats the short term condition. I believe that money is a time bomb for sure, but until it finds a new speculative instrument to latch onto,it will most likely just sit in government bonds (like the current bubble we have in bonds? 4 week treasuries at 0 percent? Can you say final bubble?) When that one pops it will be an undermining of the very financial system and will crash the dollar.

    By the way good call on the dollar. It just cut through its 50day moving average like a hot knife through butter. "Get ready for da pain!"

  2. Anonymous says:

    the st louis fed data showed that the money velocity has recently plunged. The hyperinflation spiral as described in your quoted text first needs an triggering event to get start the process. What will be that trigger? ha, a trillion dollar question.

  3. In the first place, the MV=PQ equation is applicable only to closed economies.

    Secondly, it's rather amazing that you just automatically assume that increasing the money supply will increase velocity. This assumption flies in the face of observed evidence.

    Thirdly, We are in a deflationary spiral; the Fed is running printing presses non-stop, yet prices keep falling, and money keeps being destroyed with each write-down or charge-off. The reason for this is that banks just aren't lending, and consumers/businesses are unable or unwilling to take on any additional debt. After Lehman was allowed to fail, the money markets seized up, and velocity has declined epically.

    Fourthly, hyperinflation is not the guaranteed outcome of a loss of investor confidence in the solvency of the government. Rather, the most likely outcome is sky-high interest rates for a time, as we had in 1982.

    Finally, it seems that you forget that the United States is not the only country affected by this mess. Many other countries are passing massive spending packages as well, or will in the near future. The central banks of many other nations are likewise running the printing presses, because they've also seen velocity fall off a cliff. I don't know if you've paid any attention to this debacle outside of some reactionary lusting for the collapse of the United States, but all of a sudden, a lot of those developing markets which looked invincible a year ago are now in even bigger trouble than the US. Check out, for instance, the rate at which Russia is burning through its forex reserves.

  4. Anonymous says:

    Sorry, these equations are "pulled out some academic's nether-regions" to put it politely. They are approximations to approximations that only apply at best in steady-state, equilibrium situations. Those conditions aren't even met in the best of economic times.

    Here's a test for any formula you (or the Fed or the US Government) must use in times like this, which is a time of extreme transient, non-equilibrium economic activity.

    If formula isn't a differential equation or it is not the actual solution to such a well-formed differential equation, it is completely worthless to predict any transient phenomena and thus completely wrong as a tool to imagine what man-made inputs will cause things to move in the desired direction.

    Further, if that differential equation is based on a model that makes any assumptions that include presumed equilibrium, instantaneous market clearing, or perfect open or closed market systems, then the formula is completely wrong as well.

    The bad news is that all endogenous growth models make these assumptions as do all monetary models! And they are all very wrong for any predictions of transient phenomena as a result.

    But even worse, differential equations and the systems such equations describe are finicky creatures. Pushing when you should be pulling can make things worse, sometimes much, much worse. Transient responses can especially be very counterintuitive.

    And that effect can be trivially shown with a 2nd order linear differential equation yet economic systems are distinctly nonlinear which is even worse.

    Misusing a poorly formed model in this way is like giving a loaded gun to 5-year old and not expecting bad things to happen.

    Or to put it another way: you brought a linear equation to a fight and nature brought a differential equation and its complete solution. Guess who loses.

  5. "Secondly, it's rather amazing that you just automatically assume that increasing the money supply will increase velocity."

    No, I have never said that increasing the money supply will increase velocity. The danger of hyperinflation lies in a dramatic increase in the velocity of money due to a loss of confidence, not in changes in the money supply. See how deflation creates hyperinflation

    "Thirdly, We are in a deflationary spiral; the Fed is running printing presses non-stop, yet prices keep falling, and money keeps being destroyed with each write-down or charge-off. The reason for this is that banks just aren't lending, and consumers/businesses are unable or unwilling to take on any additional debt. After Lehman was allowed to fail, the money markets seized up, and velocity has declined epically."

    Yes, we are in a deflationary spiral. But let me ask you this: do you know what a "deflationary spiral" does to a nation's economy, especially for a country like the US which is totally addicted to spending and debt? The credit crisis will crush our GDP, while our national debt grows by trillions. Do you really think the rest of the world is going to keep financing our trade deficits while our debt-to-GDP ratio gets increasingly absurd?

    Again, I address this in how deflation creates hyperinflation

    "Fourthly, hyperinflation is not the guaranteed outcome of a loss of investor confidence in the solvency of the government. Rather, the most likely outcome is sky-high interest rates for a time, as we had in 1982."

    There is no comparison between 1980s and today. Back then, we hadn't yet outsourced our manufacturing sector and we were not totally dependent on foreign oil (relative to today). The US also owed little money to foreign creditors. The annual inflation rate remained under 5 percent throughout most of the 1980s. There was never the risk of the dollar losing all value (hyperinflation).

    To produce true hyperinflation, a deflationary collapse is necessary. See how deflation creates hyperinflation

    Towards the end of the week, I will write a blog entry covering why the US faces hyperinflation and not high inflation like in the 1980s.

    "Finally, it seems that you forget that the United States is not the only country affected by this mess."

    I have not forgotten. I will address the issue in greater detail later this week. In the meantime, here are two questions for you:

    What types of goods get hurt the worst in a "deflationary spiral" (like the great depression)?
    What does the US make?

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