quantitive easing as a highway to inflation

Quantitative Easingas a Highway toHyperinflation

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August 10, 2013 8:54 9in x 6in Quantitative Easing as a Highway to Hyperinflation b1571-fm

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N E W J E R S E Y L O N D O N S I N G A P O R E BE IJ ING S H A N G H A I H O N G K O N G TA I P E I C H E N N A I

World Scientific

Quantitative Easingas a Highway toHyperinflation

Imad A MoosaRoyal Melbourne Institute of Technology, Australia

8797hc_9789814504911_tp.indd 2 1/2/13 9:12 AM

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Moosa, Imad A.

Quantitative easing as a highway to hyperinflation / by Imad A Moosa (Royal Melbourne Inst of

Technology, Australia).

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Includes bibliographical references and index.

ISBN 978-9814504911

1. Quantitative easing (Monetary policy) 2. Monetary policy. 3. Inflation (Finance) I. Title.

HG230.3.M686 2014

339.5'3--dc23

2013022981

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To Nisreen and Danny

v


CONTENTS

List of Figures xiii

List of Tables xix

List of Abbreviations xxi

Preface xxiii

About the Author xxvii

1. Inflation, Deflation, Disinflation and All That 1

1.1 What is Ination? . . . . . . . . . . . . . . . . . . . . . 11.2 Ination and Related Concepts: A Graphical

Illustration . . . . . . . . . . . . . . . . . . . . . . . . . 41.3 The Causes of Ination . . . . . . . . . . . . . . . . . . 141.4 Experience with Ination . . . . . . . . . . . . . . . . . 171.5 More Ination-Related Concepts . . . . . . . . . . . . . 231.6 Concluding Remarks . . . . . . . . . . . . . . . . . . . 26

2. The Measurement of Inflation 29

2.1 The Ination Rate . . . . . . . . . . . . . . . . . . . . . 292.2 Ination, Income Growth and Money Illusion . . . . . . 322.3 Measuring the General Price Level . . . . . . . . . . . . 332.4 Core Ination . . . . . . . . . . . . . . . . . . . . . . . 362.5 The Consumer Price Index . . . . . . . . . . . . . . . . 372.6 The GDP Deator . . . . . . . . . . . . . . . . . . . . . 422.7 Other Price Indices . . . . . . . . . . . . . . . . . . . . 452.8 Concluding Remarks . . . . . . . . . . . . . . . . . . . 48

vii


viii Quantitative Easing as a Highway to Hyperinflation

3. The Monetary Theory of Inflation 49

3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 493.2 The Meaning of Money and Credit . . . . . . . . . . . . 503.3 Money Creation under a Fractional

Reserve System . . . . . . . . . . . . . . . . . . . . . . 523.4 The Quantity Theory of Money . . . . . . . . . . . . . 583.5 Facts and Figures . . . . . . . . . . . . . . . . . . . . . 643.6 Further Remarks on the Monetary Theory

of Ination . . . . . . . . . . . . . . . . . . . . . . . . . 703.7 Central Bank Independence . . . . . . . . . . . . . . . . 723.8 Concluding Remarks . . . . . . . . . . . . . . . . . . . 74

4. Other Theories of Inflation and Some Extensions 75

4.1 Demand-Pull Ination . . . . . . . . . . . . . . . . . . . 754.2 Cost-Push Ination . . . . . . . . . . . . . . . . . . . . 784.3 A Combined Demand-Cost Model . . . . . . . . . . . . 794.4 Inationary Shocks, Monetary Accommodation

and Monetary Validation . . . . . . . . . . . . . . . . . 834.5 The Fiscal Theory of Ination . . . . . . . . . . . . . . 854.6 The Political Theory of Ination . . . . . . . . . . . . . 864.7 The Other Side of the Coin: Deation . . . . . . . . . . 874.8 Concluding Remarks . . . . . . . . . . . . . . . . . . . 89

5. The Consequences and Costs of Inflation 91

5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 915.2 The Positive Eects of Ination . . . . . . . . . . . . 935.3 Arbitrary Redistribution of Income . . . . . . . . . . . 955.4 Business Planning and Investment . . . . . . . . . . . . 985.5 Miscellaneous Business Costs . . . . . . . . . . . . . . . 1005.6 Distortion of the Eect of Taxes . . . . . . . . . . . . . 1005.7 The Adverse Eect of Ination on Saving . . . . . . . . 1015.8 The Eects of Ination on Financial Markets . . . . . . 1035.9 The Eect of Ination on Competitiveness . . . . . . . 1085.10 Currency Depreciation . . . . . . . . . . . . . . . . . . 1095.11 The Eect of Ination on Unemployment

and Growth . . . . . . . . . . . . . . . . . . . . . . . . 1115.12 Ination-Triggered Social Unrest . . . . . . . . . . . . . 1125.13 The Eect of Ination on Morality . . . . . . . . . . . . 116


Contents ix

5.14 The Optimal Ination Rate . . . . . . . . . . . . . . . . 1185.15 Hedging the Risk of Ination . . . . . . . . . . . . . . . 1195.16 Concluding Remarks . . . . . . . . . . . . . . . . . . . 119

6. The Phenomenon of Hyperinflation 121

6.1 What is Hyperination? . . . . . . . . . . . . . . . . . . 1216.2 Hyperination as an Extension

of Moderate Ination . . . . . . . . . . . . . . . . . . . 1236.3 The Measurement of Hyperination . . . . . . . . . . . 1276.4 The Syndrome of Hyperination . . . . . . . . . . . . . 1296.5 The Hyperinationary Process

and Feedback Eects . . . . . . . . . . . . . . . . . . . 1316.6 Hyperination and the Death of a Fiat Currency . . . . 1336.7 The Monetary, Condence and Fiscal Models

of Hyperination . . . . . . . . . . . . . . . . . . . . . . 1366.8 The Role of Expectations . . . . . . . . . . . . . . . . . 1386.9 Other Approaches to Hyperination . . . . . . . . . . . 1406.10 The Behavior of Exchange Rates

under Hyperination . . . . . . . . . . . . . . . . . . . 1416.10.1 The basic model . . . . . . . . . . . . . . . . . 1426.10.2 The role of expectations . . . . . . . . . . . . . 1436.10.3 Currency substitution . . . . . . . . . . . . . . 145

6.11 The Empirical Evidence . . . . . . . . . . . . . . . . . . 1466.12 The Consequences of Hyperination . . . . . . . . . . . 1526.13 Dealing with Hyperination: Business Issues . . . . . . 1566.14 Dealing with Hyperination: Macroeconomic

Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1586.14.1 Cold turkey versus gradualism . . . . . . . . . 1606.14.2 Currency boards . . . . . . . . . . . . . . . . . 1606.14.3 Dollarization . . . . . . . . . . . . . . . . . . . 162

6.15 Concluding Remarks . . . . . . . . . . . . . . . . . . . 163

7. The History of Fiat Money and Hyperinflation 165

7.1 Fiat Money, Monetary Debasementand Hyperination . . . . . . . . . . . . . . . . . . . . . 165

7.2 The Early History of Fiat Moneyand Hyperination . . . . . . . . . . . . . . . . . . . . . 170


x Quantitative Easing as a Highway to Hyperinflation

7.2.1 The ancient Chinese experience . . . . . . . . . 1707.2.2 The experience of ancient Rome . . . . . . . . . 1727.2.3 The Persian experience . . . . . . . . . . . . . . 173

7.3 Fiat Money and Hyperination in Europe Priorto World War I . . . . . . . . . . . . . . . . . . . . . . 1737.3.1 Fiat money in France: The story

of John Law . . . . . . . . . . . . . . . . . . . . 1747.3.2 Hyperination in France

after the revolution . . . . . . . . . . . . . . . . 1757.3.3 Hyperination and monetary debasement

in England . . . . . . . . . . . . . . . . . . . . 1767.4 Fiat Money and Monetary Debasement

in the U.S. . . . . . . . . . . . . . . . . . . . . . . . . . 1777.5 The Classical Hyperinations of the 20th Century . . . 182

7.5.1 Austria . . . . . . . . . . . . . . . . . . . . . . 1837.5.2 China . . . . . . . . . . . . . . . . . . . . . . . 1867.5.3 The free city of Danzig . . . . . . . . . . . . . . 1867.5.4 Greece . . . . . . . . . . . . . . . . . . . . . . . 1867.5.5 Hungary . . . . . . . . . . . . . . . . . . . . . . 1877.5.6 Japan . . . . . . . . . . . . . . . . . . . . . . . 1897.5.7 Poland . . . . . . . . . . . . . . . . . . . . . . . 1917.5.8 Russia . . . . . . . . . . . . . . . . . . . . . . . 1917.5.9 Taiwan . . . . . . . . . . . . . . . . . . . . . . . 1937.5.10 Germany . . . . . . . . . . . . . . . . . . . . . 194

7.6 Concluding Remarks . . . . . . . . . . . . . . . . . . . 198

8. Hyperinflationary Episodes since the 1970s 201

8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 2018.2 Angola . . . . . . . . . . . . . . . . . . . . . . . . . . . 2028.3 Argentina . . . . . . . . . . . . . . . . . . . . . . . . . . 2048.4 Belarus . . . . . . . . . . . . . . . . . . . . . . . . . . . 2088.5 Bolivia . . . . . . . . . . . . . . . . . . . . . . . . . . . 2108.6 BosniaHerzegovina (Yugoslavia) . . . . . . . . . . . . 2128.7 Brazil . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2148.8 Congo (Formerly Zaire) . . . . . . . . . . . . . . . . . . 2178.9 Croatia . . . . . . . . . . . . . . . . . . . . . . . . . . . 2198.10 Ecuador . . . . . . . . . . . . . . . . . . . . . . . . . . 220


Contents xi

8.11 Georgia . . . . . . . . . . . . . . . . . . . . . . . . . . . 2228.12 Iraq . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2248.13 Israel . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2258.14 Mexico . . . . . . . . . . . . . . . . . . . . . . . . . . . 2278.15 Nicaragua . . . . . . . . . . . . . . . . . . . . . . . . . 2288.16 Peru . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2308.17 Poland . . . . . . . . . . . . . . . . . . . . . . . . . . . 2338.18 Romania . . . . . . . . . . . . . . . . . . . . . . . . . . 2358.19 Russia . . . . . . . . . . . . . . . . . . . . . . . . . . . 2398.20 Turkey . . . . . . . . . . . . . . . . . . . . . . . . . . . 2418.21 Ukraine . . . . . . . . . . . . . . . . . . . . . . . . . . . 2438.22 Zimbabwe . . . . . . . . . . . . . . . . . . . . . . . . . 2448.23 Iran . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2488.24 The Overall Picture . . . . . . . . . . . . . . . . . . . . 2498.25 Concluding Remarks . . . . . . . . . . . . . . . . . . . 253

9. The Status Quo: Heading Towards Hyperinflation? 255

9.1 The Road to Hyperination . . . . . . . . . . . . . . . 2559.2 Fiscal and Monetary Indicators Worldwide . . . . . . . 257

9.2.1 Monetary indicators . . . . . . . . . . . . . . . 2639.2.2 The situation in general . . . . . . . . . . . . . 2659.2.3 Another indicator: The price of gold . . . . . . 267

9.3 Quantitative Easing . . . . . . . . . . . . . . . . . . . . 2689.3.1 QE1, QE2 and QE3 . . . . . . . . . . . . . . . 272

9.4 Hyperination in the U.S.: Why and Why Not . . . . . 2749.5 Concluding Remarks . . . . . . . . . . . . . . . . . . . 280

10. Leading Indicators of U.S. Hyperinflation 281

10.1 The Fiscal Balance . . . . . . . . . . . . . . . . . . . . 28110.2 The Spending Side . . . . . . . . . . . . . . . . . . . . . 28410.3 The Revenue Side . . . . . . . . . . . . . . . . . . . . . 29010.4 The Outlook for the U.S. Fiscal Position . . . . . . . . 29210.5 Public Debt . . . . . . . . . . . . . . . . . . . . . . . . 29310.6 Monetary Aggregates . . . . . . . . . . . . . . . . . . . 29910.7 Lessons from Theory . . . . . . . . . . . . . . . . . . . 30210.8 Lessons from History . . . . . . . . . . . . . . . . . . . 30710.9 When and How It Will Happen? . . . . . . . . . . . . . 30910.10 Concluding Remarks . . . . . . . . . . . . . . . . . . . 312


xii Quantitative Easing as a Highway to Hyperinflation

11. Concluding Thoughts 313

11.1 The Highway Network . . . . . . . . . . . . . . . . . . . 31311.2 Fire or Ice? . . . . . . . . . . . . . . . . . . . . . . . . . 31611.3 The Unthinkables . . . . . . . . . . . . . . . . . . . . . 32011.4 The Big Unthinkable: Break-Up of the U.S. . . . . . . . 32211.5 The Day of Reckoning is Inevitable . . . . . . . . . . . 324

References 327

Index 343


LIST OF FIGURES

1.1 Price stability . . . . . . . . . . . . . . . . . . . . . . . . . . . 51.2 Moderate (creeping) ination . . . . . . . . . . . . . . . . . . 61.3 Accelerating ination . . . . . . . . . . . . . . . . . . . . . . . 71.4 Volatile ination . . . . . . . . . . . . . . . . . . . . . . . . . 81.5 Hyperination . . . . . . . . . . . . . . . . . . . . . . . . . . . 91.6 Disination . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101.7 Deation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111.8 Big discrete jumps in the general price level

(inationary bursts) . . . . . . . . . . . . . . . . . . . . . . . 121.9 Reation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131.10 Stagation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141.11 Ination in the U.S . . . . . . . . . . . . . . . . . . . . . . . . 181.12 Ination in Sweden . . . . . . . . . . . . . . . . . . . . . . . . 201.13 Ination around the world . . . . . . . . . . . . . . . . . . . . 221.14 Ination in high-ination countries . . . . . . . . . . . . . . . 241.15 Most recent ination gures (September/October 2012) . . . 251.16 The price level under open and suppressed inations

(simulated data) . . . . . . . . . . . . . . . . . . . . . . . . . 252.1 Measures of the ination rate

(simulated data) . . . . . . . . . . . . . . . . . . . . . . . . . 312.2 Nominal and real incomes at various ination rates

(simulated data) . . . . . . . . . . . . . . . . . . . . . . . . . 332.3 The CPI, PPI and GDP deator for the U.S . . . . . . . . . . 342.4 Ination rates calculated from the CPI

and GDP deator . . . . . . . . . . . . . . . . . . . . . . . . . 352.5 Total and core ination rates for the U.S . . . . . . . . . . . . 382.6 The U.S. CPI and components . . . . . . . . . . . . . . . . . 412.7 Variants of the U.S. CPI . . . . . . . . . . . . . . . . . . . . . 43

xiii


xiv Quantitative Easing as a Highway to Hyperinflation

2.8 The U.S. GDP at current and constant prices with dierentbases periods . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

2.9 Price indices for apparel and medical care . . . . . . . . . . . 473.1 The composition of M1 and M2 in the U.S.

(December 2011) . . . . . . . . . . . . . . . . . . . . . . . . . 513.2 The composition of bank credit in the U.S.

(December 2011) . . . . . . . . . . . . . . . . . . . . . . . . . 523.3 Money and credit in the U.S . . . . . . . . . . . . . . . . . . . 533.4 The money supply corresponding to monetary base

(simulated data) . . . . . . . . . . . . . . . . . . . . . . . . . 563.5 Monetary base, ratios and multipliers for M1 and M2 . . . . 573.6 The eect of the velocity of circulation (simulated data) . . . 613.7 Velocity of circulation in the U.S . . . . . . . . . . . . . . . . 613.8 Money versus prices in the U.S. (scatter plots) . . . . . . . . 653.9 Money and prices in the U.S. (time plots) . . . . . . . . . . . 663.10 Money and prices in the U.S. (percentage changes) . . . . . . 673.11 Ination rates and monetary growth rates adjusted

for output growth . . . . . . . . . . . . . . . . . . . . . . . . . 683.12 Monetary growth and house prices . . . . . . . . . . . . . . . 694.1 Actual and potential GDP with the corresponding gaps

in the U.S . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 764.2 Unemployment, ination and gaps in the U.S . . . . . . . . . 774.3 Maintaining protability by passing costs to consumers

(simulated data) . . . . . . . . . . . . . . . . . . . . . . . . . 804.4 Oil price and the U.S. GDP deator . . . . . . . . . . . . . . 814.5 The U.S. wages and GDP deator . . . . . . . . . . . . . . . 824.6 Wageprice spiral (simulated data) . . . . . . . . . . . . . . . 834.7 Shocks without monetary accommodation and validation

(simulated data) . . . . . . . . . . . . . . . . . . . . . . . . . 845.1 Real and nominal values of an invested amount of 100

(simulated data) . . . . . . . . . . . . . . . . . . . . . . . . . 955.2 Real and nominal values of invested amounts at the U.S.

interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . 965.3 Real and nominal interest rates (simulated data) . . . . . . . 1025.4 Real and nominal amounts (simulated data) . . . . . . . . . . 1035.5 The U.S. nominal short-term interest rates and ination . . . 1045.6 Real U.S. short-term and long-term interest rates . . . . . . . 1055.7 Nominal interest rates and ination

(cross-sectional data) . . . . . . . . . . . . . . . . . . . . . . . 105


List of Figures xv

5.8 GDP deator and stock prices in the U.S . . . . . . . . . . . 1085.9 The eect of ination on the trade balance

(three scenarios) . . . . . . . . . . . . . . . . . . . . . . . . . 1105.10 Currency depreciation under ination (simulated data) . . . . 1115.11 Ination, growth and unemployment in the U.S.

(19612011) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1135.12 Ination, growth and unemployment in a cross-section

of countries (averages) . . . . . . . . . . . . . . . . . . . . . . 1145.13 The FAO food price index . . . . . . . . . . . . . . . . . . . . 1156.1 Growth under hyperination (rank correlation) . . . . . . . . 1266.2 The monthly rates corresponding to annual rates . . . . . . . 1286.3 Years for prices to double at various annual

ination rates . . . . . . . . . . . . . . . . . . . . . . . . . . . 1286.4 Years it takes to add a zero and currency

re-denomination . . . . . . . . . . . . . . . . . . . . . . . . . 1296.5 A typical hyperinationary process . . . . . . . . . . . . . . . 1326.6 Price level and currency in circulation in some 1920s

hyperinations . . . . . . . . . . . . . . . . . . . . . . . . . . 1346.7 Hyperination and the death of a at currency . . . . . . . . 1356.8 The eect of ination on the exchange rate

(simulated data) . . . . . . . . . . . . . . . . . . . . . . . . . 1436.9 The eect of ination and expectations on the exchange rate

(simulated data) . . . . . . . . . . . . . . . . . . . . . . . . . 1466.10 Erosion of receivables under ination (simulated data) . . . . 1537.1 The history of money in the U.S . . . . . . . . . . . . . . . . 1787.2 The purchasing power of confederate treasury notes

(1 May 18611 May 1865) . . . . . . . . . . . . . . . . . . . . 1807.3 The Austrian hyperination of the 1920s

(logarithmic scale) . . . . . . . . . . . . . . . . . . . . . . . . 1847.4 The Hungarian hyperination of the 1920s

(logarithmic scale) . . . . . . . . . . . . . . . . . . . . . . . . 1887.5 The Polish hyperination of the 1920s

(logarithmic scale) . . . . . . . . . . . . . . . . . . . . . . . . 1927.6 The Russian hyperination of the 1920s

(logarithmic scale) . . . . . . . . . . . . . . . . . . . . . . . . 1947.7 German wholesale prices (logarithmic scale) . . . . . . . . . . 1978.1 The consumer price index and money supply Angola . . . 2048.2 The consumer price index and money

supply Argentina . . . . . . . . . . . . . . . . . . . . . . . 207


xvi Quantitative Easing as a Highway to Hyperinflation

8.3 The consumer price index and money supply Belarus . . . 2098.4 The consumer price index and money supply Bolivia . . . 2118.5 The consumer price index and money supply Brazil . . . . 2158.6 The consumer price index and money supply Congo . . . . 2188.7 The consumer price index and money supply Croatia . . . 2208.8 The consumer price index and money supply Georgia . . . 2238.9 The consumer price index and money supply Israel . . . . 2268.10 The consumer price index and money supply Mexico . . . 2298.11 The consumer price index and money

supply Nicaragua . . . . . . . . . . . . . . . . . . . . . . . 2318.12 The consumer price index and money supply Peru . . . . . 2348.13 The consumer price index and money supply Poland . . . 2368.14 The consumer price index and money

supply Romania . . . . . . . . . . . . . . . . . . . . . . . . 2388.15 The consumer price index and money supply Russia . . . . 2408.16 The consumer price index and money supply Turkey . . . 2428.17 The consumer price index and money

supply Ukraine . . . . . . . . . . . . . . . . . . . . . . . . 2458.18 The consumer price index and money

supply Zimbabwe . . . . . . . . . . . . . . . . . . . . . . . 2478.19 The overall picture in terms of growth rates . . . . . . . . . . 2508.20 The overall picture in terms of correlations . . . . . . . . . . 2518.21 Number of days for prices to double in the worst

hyperinations . . . . . . . . . . . . . . . . . . . . . . . . . . 2539.1 Fiscal balance as a percentage of GDP . . . . . . . . . . . . . 2589.2 Actual and projected scal balances as a percentage

of GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2599.3 Cyclically-adjusted and underlying scal balances

as a percentage of GDP . . . . . . . . . . . . . . . . . . . . . 2609.4 Gross public debt as a percentage of GDP (2012) . . . . . . . 2619.5 Actual and projected gross public debt as a percentage

of GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2629.6 Tax revenue as a percentage of GDP . . . . . . . . . . . . . . 2639.7 Net operating balance as a percentage of spending . . . . . . 2639.8 Monetary indicators (indices) . . . . . . . . . . . . . . . . . . 2649.9 The price of gold ($/ounce) . . . . . . . . . . . . . . . . . . . 2679.10 Average annual rise in gold price in currency terms

(20032012) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268


List of Figures xvii

9.11 Total foreign ownership of the U.S. treasuries ($ billion) . . . 2769.12 The U.S. scal balance and trade balance . . . . . . . . . . . 27710.1 The U.S. government revenue, spending and scal balance

($ million) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28210.2 The U.S. government revenue, spending and scal balance

(% of GDP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28310.3 The U.S. scal balance as a percentage of spending . . . . . . 28410.4 Interest payments with forecasts until 2017 . . . . . . . . . . 28510.5 Military spending: An international comparison . . . . . . . . 28710.6 The U.S. military spending since 1940 . . . . . . . . . . . . . 28810.7 The U.S. gross public debt with forecasts until 2017 . . . . . 29510.8 The U.S. public debt holdings ($ million) . . . . . . . . . . . 29610.9 The composition of foreign holdings of the U.S.

treasury securities . . . . . . . . . . . . . . . . . . . . . . . . 29710.10 The U.S. personal saving rate (%) . . . . . . . . . . . . . . . 29810.11 The U.S. monetary aggregates ($ billion) . . . . . . . . . . . . 30010.12 The U.S. public debt held by the Fed . . . . . . . . . . . . . . 30110.13 Timing of hyperination in the U.S.: The credit

card approach . . . . . . . . . . . . . . . . . . . . . . . . . . . 31011.1 The macroeconomic highway network . . . . . . . . . . . . . 314


LIST OF TABLES

1.1 Year-on-year ination rate in the U.S. (19142012) . . . . . . 191.2 Year-on-year ination rate in Sweden (18302011) . . . . . . 211.3 Year-on-year ination rates in country groups and Japan

(19702011) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233.1 Growth factors of P , M , Y and V (19902011) . . . . . . . . 703.2 Correlation of growth rates . . . . . . . . . . . . . . . . . . . 716.1 Average ination and growth rates in hyperinationary

countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1266.2 The empirical evidence on hyperination . . . . . . . . . . . . 1477.1 A history of monetary debasement . . . . . . . . . . . . . . . 1678.1 Growth factors of prices, the money supply, output

and velocity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2529.1 Annualized monthly growth rates

of monetary aggregates . . . . . . . . . . . . . . . . . . . . . . 26510.1 Annualized monthly growth rates of the U.S. monetary

aggregates (%) . . . . . . . . . . . . . . . . . . . . . . . . . . 30110.2 Factors recognized in previous studies of hyperination . . . . 307

xix


LIST OF ABBREVIATIONS

AUD Australian dollarBRIC BrazilRussiaIndiaChinaCAD Canadian dollarCBO Congressional Budget OceC-CPI-U Chained consumer price index for urban consumersCDO Collateralized debt obligationCDS Credit default swapCHF Swiss francCNY Chinese yuanCOLA Cost-of-living adjustmentCPI Consumer price indexCPI-U Consumer price index for urban consumersCPI-U-RS Consumer price index for urban consumers-research seriesCPI-U-X1 Consumer price index with a rental equivalence approach

to homeownersECB European Central BankEFT Exchange-traded fundEUR EuroFAO Food and Agriculture OrganizationFIFO First in rst outGAAP Generally accepted accounting principlesGBP British poundGCC Gulf Co-operation CouncilGDP Gross domestic productGNP Gross national productHICP Harmonized index of consumer pricesIMF International Monetary FundINR Indian rupeeITA International Tin Agreement

xxi


xxii Quantitative Easing as a Highway to Hyperinflation

JPY Japanese yenLIFO Last in rst outNIA National Ination AssociationNIFO Next in rst outNPV Net present valueNRL National Rie AssociationOECD Organisation for Economic Co-operation and DevelopmentOPEC Organization of Petroleum Exporting CountriesPIMCO Pacic Investment Management CompanyPPI Producer price indexPPP Purchasing power parityQE Quantitative easingRBZ Reserve Bank of ZimbabweSDR Special drawing rightsTB Treasury billTIPS Ination protected securitiesUBS Union Bank of SwitzerlandUCLA University of California at Los AngelesUIP Uncovered interest parityUNCTAD United Nations Conference on Trade and DevelopmentUSD U.S. dollarVAR Vector autoregressionVAT Value-added taxWPI Wholesale price index


PREFACE

In the aftermath of the global nancial crisis, the European crisis andthe recessions associated with these crises, one tends to think that therisk of deation is greater than the risk of ination as things stand atthe end of 2012. This is a valid argument insofar as demand-pull factorsand cost-push factors are associated with economic booms, when thereis unutilized capacity in the economy. However, hyperination tends tobe associated with economic depression hence, it cannot be ruled outeven at the current levels of unemployment and spare capacity. There areindeed more reasons to believe that hyperination, rather than deation,is forthcoming, particularly in the U.S. where quantitative easing has beenpursued vigorously and intensied signicantly in December 2012.

Hyperination is basically a scal phenomenon resulting from scalrecklessness and the tendency to make up for this recklessness by monetizingthe decit that is, by printing money to nance the decit. This is whatquantitative easing is all about, although some economists argue that it isbenign because it does not involve direct buying of government bonds bythe central bank from the Treasury. While most major countries have acutescal problems and have resorted to quantitative easing, the U.S. is in amore vulnerable position for at least two reasons. The rst is that the extentof quantitative easing in the U.S. is far greater than in other countries, asindicated by the available statistics on monetary aggregates. The secondis that there are indications that the U.S. dollar is gradually losing itsinternational status, which will force more and more money printing asthe U.S. Treasury nds it increasingly dicult to borrow from abroad. It isactually a vicious circle whereby money printing leads to a loss of condencein the dollar and the loss of condence leads to more printing.

In this book, it is demonstrated that theory, historical experience andeconomic indicators point to the likelihood that the U.S. is sliding intohyperination. It seems that the U.S. government and lawmakers are not

xxiii


xxiv Quantitative Easing as a Highway to Hyperinflation

able or willing to sort out their scal mess for ideological reasons. Thenegotiations that took place between the Obama administration and theRepublicans who control the House of Representatives, in the run-up tothe deadline for the scal cli of January 2013, were more like a circusthan a serious attempt to ll the scal gap. Agreement or no agreementon the scal cli, the U.S. is heading towards nancial meltdown.

Since this is a topic of general interest, I started by writing the book forthe general reader by attempting to avoid technical jargon and equations.It worked at the beginning but then I thought that it was not possible. Tounderstand ination and hyperination one has to have some understandingof the quantity theory of money and the money multiplier model. Thelatter is important for understanding why quantitative easing has notbeen inationary so far. Furthermore, any discussion of hyperination isinadequate unless the role of inationary expectations is taken care of.This task proved rather dicult without the use of equations. At the end,I decided to go for a compromise whereby I write the text in as easy languageas possible, explaining rst principles for the general reader, while puttingin some equations that can only be understood by a trained economist. Ina sense, therefore, the book is written for both the general reader, who canignore equations, and the trained economist who can ignore rst principles.

Following Chapter 1 which is an introduction of the concepts ofination, deation and others Chapter 2 deals with the measurement ofination. Chapters 3 and 4 are about the causes of ination Chapter 3explains the monetary theory of ination whereas Chapter 4 is about othertheories of ination and some extensions. The consequences and costs ofination are discussed in Chapter 5, before we move on to elaborate onthe concept of hyperination in Chapter 6. The history of hyperinationis the subject matter of Chapters 7 and 8, dealing respectively with thehyperinationary episodes that took place before and after the 1970s. Thecore of this book is Chapters 9 and 10, in which arguments are presentedfor why hyperination will hit America. Some concluding remarks arepresented in Chapter 11 to reinforce the arguments found in Chapters 9and 10 as well as summarizing and evaluating the arguments involved inthe ice or re debate.

Writing this book would not have been possible without the help andencouragement I received from family, friends and colleagues. My utmostgratitude must go to my wife and children who had to bear the opportunitycost of writing this book. My wife, Afaf, was also the person drawing thediagrams shown in this book, particularly the complex diagram of the


Preface xxv

highway network presented in Chapter 11. I am grateful to Kelly Burnswho provided excellent research assistance, particularly the extraction andmanipulation of data.

I would also like to thank my colleagues and friends at RMIT,particularly Tony Naughton, Larry Li, George Tawadros, Vikash Ramiah,Bruce Cowling, Michael Schwartz, Marie-Anne Cam and Mark Stewart.I should not forget the people I socialize with, including John Vaz, SteenJoeris, Pashaar Halteh, Mike Dempsey, John Watson, Liam Lenten andBrien McDonald. In preparing the manuscript, I beneted from an exchangeof ideas with members of the Table 14 Discussion Group, and for thisreason I would like to thank Bob Parsons, Greg OBrien, Greg Bailey,Bill Breen, Rodney Adams, Paul Rule, Peter Murphy, Bob Brownlee andTony Paligano. My thanks also go to friends and former colleagues wholive far away but provide help via means of telecommunication, includingKevin Dowd (to whom I owe an intellectual debt), Razzaque Bhatti, NabeelAl-Loughani, Bob Sedgwick, Sean Holly, Dave Chappell, Dan Hemmingsand Ian Baxter. Last, but not least, I would like to thank Ms Lum Pui Yee,of World Scientic, who encouraged me write this book.

Naturally, I am the only one responsible for any errors and omissionsthat may be found in this book. It is dedicated to my beloved children,Nisreen and Danny.

Imad A. Moosa


About the Author

Imad Moosa is currently a professor of Financeat RMIT, Melbourne, Australia. He holds a BAin economics, MA in the economics of nancialintermediaries and a PhD in nancial economicsfrom the University of Sheeld (UK). He hasreceived formal training in model building,exchange rate forecasting and risk managementat the Claremont Economics Institute (USA),Wharton Econometrics (USA), and the Interna-tional Center for Monetary and Banking Stud-ies (Switzerland). Until 1991, Imad had workedas a nancial analyst, nancial journalist and

a professional economist/investment banker. He was also an economistat the Financial Institutions Division of the Bureau of Statistics at theInternational Monetary Fund (Washington, DC). Imad has served in anumber of advisory positions, including his role as an advisor to the USTreasury. He has published 15 books and over 180 papers in scholarlyjournals.

xxvii

August 10, 2013 8:54 9in x 6in Quantitative Easing as a Highway to Hyperinflation b1571-ch01

Chapter 1

INFLATION, DEFLATION,

DISINFLATION AND ALL THAT

1.1. What is Inflation?

It is often said that ination is inevitable, like death and taxes. This isprobably because, as Sir Frederick Keith-Ross mentions, ination is likesin; every government denounces it and every government practices it(Makochekanwa, 2007). Historical stories about inationary episodes provesthat it is a phenomenon that has existed ever since money was used as amedium of exchange. Ination is a topic that receives signicant attentionin the media, with regular features, reports and interviews. It is an issuethat is often debated by politicians in Parliament and election campaigns,let alone economists and business executives.

The reason why ination is treated with respect is that it aectseverybody in various ways. It is an important consideration during mort-gage payments and in determining the cost of essential goods and servicesrequired for survival and those that make our lives more pleasant. Weanticipate news about whether the central bank will decide to cut or raiseinterest rates, with ination typically being the prime consideration (atleast for some central banks). Most of us are fascinated by documentarieson the great ination in Germany during the 1920s and how it relates tothe rise of Adolf Hitler. Ination has broad implications for the state of theeconomy and whether or not we can keep our jobs or nd new ones. Whileit is regarded as one of the four macroeconomic variables closely monitoredby policymakers (the others being growth, employment and the balanceof payments), it is often the prime indicator that triggers drastic policyactions. Ination targeting is a more common concept than outputtargeting, employment targeting or balance of payments targeting.

1


2 Quantitative Easing as a Highway to Hyperinflation

Ination is dened in dierent ways, but, in general, the phenomenon isabout rising prices of goods and services (hence, the cost of living). As theprices of goods and services rise, the value (or purchasing power) of moneyfalls in the sense that a monetary unit (say a dollar) buys less and lessgoods and services resulting in a diminishing basket. This is why inationis viewed as a persistent erosion of the value of the money. While it cost60 pounds to purchase a rst class ticket on the Titanic in 1912, there is noway these days that this amount can buy a ticket to cross the Atlantic (letalone the Pacic) in a rst class cabin on an ocean liner (perhaps 10,000pounds can do the job). It is for this reason that we give our children morepocket money than what our parents gave us. People are typically nostalgicto the good old days when things were very cheap the culprit beingination.

Some points must be borne in mind, though. Ination does not meanthat all prices rise simultaneously some actually fall. People complainabout the rising cost of healthcare and higher education in the past 20 yearsor so, but during this period the prices of electronic calculators, personalcomputers and international phone calls declined drastically. In more recentyears, the prices of laptops, plasma TVs and DVD players have gone down.Furthermore, those prices that rise do not rise at the same rate. Whenwe talk about rising prices, we do not mean the prices of particular goodsand services, but rather we talk about the average price of the goods andservices that we buy the so-called general price level. This is an indexthat shows how the price of a (hypothetical) basket of goods and services(called the market basket) changes over time. Another point to bear inmind is that not all price rises are inationary. For example, prices mayrise because of the imposition of new taxes or rising tax rates. Yet anotherobservation is that ination refers to a sustained or long-term rise in thegeneral price level, not a one-o increase resulting, say, from a temporarybad harvest or a one-o hike in the price of crude oil. Ination is, therefore,a continuous rather than discrete process.1 Some economists, however, donot share this view, describing one-o price hikes as inationary bursts.2

1For example, Bernholz (2003) denes ination as an increase of the price levelextending over a longer period, usually several years, as measured by one or severalprice indices.2The proponents of the monetary view of ination typically advocate the propositionthat ination is a continuous process because they attribute ination totally to monetarygrowth, arguing that the money supply (unlike wages and commodity prices) can increasepractically without a limit.


Inflation, Deflation, Disinflation and All That 3

Ination is a dynamic process it is about rising prices over time, notabout prices being high at a particular point in time. Prices could be highbut the ination rate could be zero; or, prices could be low but inationcould run at a high rate. Naturally, ination leads over time to a high levelof prices.

As we are going to see, some economists believe that ination is purely amonetary problem resulting solely from monetary growth, which is nothingbut an increase in the money supply over time. While not all economistssubscribe to this view, most economists believe that (at least in the longrun) ination, whatever its cause may be, must be validated by an increasein the money supply (otherwise it will be suppressed ination). The extrememonetary view is that there is a proportional relation between growth inthe money supply (monetary growth) and ination. The idea is actuallyintuitive. An increase in the money supply makes money less valuable interms of goods and services whose prices rise. Those who believe in thisprocess tend to dene ination as a sustained increase in the money supplycausing a sustained decline in its value. If a proportional relation betweenmonetary growth and the corresponding rise in the price level is discarded,distinction may be made between monetary ination and price ination.Those who believe that ination may be caused (at least in part) by risingwages over time refer to the link between price ination and wage ination.

Because of the connection between money and credit, the term creditination also arises. The money supply increases when the central bankissues currency and commercial banks use the currency to grant credit.Credit creation leads to money creation because a bank loan is not given incash but rather it is extended by crediting the borrowers account with theamount of the loan. This shows as an increase in the money supply, in thiscase through the increase in the value of bank deposits (which constitutethe major part of the money supply in a modern economy). Thus, monetaryination materializes out of credit ination.3 Out of this term appearsanother term that of debt deation. When credit ination comes to anend, because banks are no longer willing to lend and/or borrowers do notwish to borrow, there will be a process of deleveraging on the repaymentof debt without new borrowing. This will have the opposite eect to that

3While credit appears on the assets side of the balance sheet of the granting bank, thecorresponding deposit appears on the liabilities side. This is how the balance sheet of abank grows under a fractional reserve banking system.



of credit ination as the money supply shrinks, the economy would gointo deation.

1.2. Inflation and Related Concepts: A GraphicalIllustration

The ination rate determines the severity of ination, its eects on theeconomy and the ease or otherwise (and cost) of stabilizing it. What mattersare two characteristics of the ination rate: how high and how volatile it is.We will illustrate some of the patterns of ination with the help of Figs. 1.1to 1.10, which display hypothetical (simulated) data on the price level, i.e.,the value of money and the ination rate (calculated as the period-to-periodpercentage change in the price level). The patterns actually have names.The explanations of the patterns are as follows:

Price stability is shown in Fig. 1.1, where the ination rate is very low,albeit not zero. The price level remains stable while the value of moneyis maintained; therefore, both move within a narrow range. While thereis no agreement on the range of values assumed by the ination rate thatdenes price stability, there seems to be an agreement that an inationrate of zero is neither achievable nor desirable.

Moderate or creeping (or mild) ination is exhibited in Fig. 1.2, wherethe ination rate is between zero and 3%. The price level rises steadilywhile the value of money falls at the same rate. Some central banks adopta policy to keep the ination rate within a narrow range such as 23% this is called ination targeting.

In Fig. 1.3, we see a case of accelerating (or galloping) ination wherethe ination rises over time. The price level goes up at an increasing ratewhile the value of money declines at the same rate.

In Fig. 1.4, we observe volatile ination where the ination rate is positivebut it rises and falls from one point in time to another. The general pricelevel rises and the value of money declines but not at steady rates.

Hyperination, the subject of this book, is shown in Fig. 1.5 as indicatedby the big numbers assumed by the price level and exhibited on thevertical axis in the top graph. Hyperination is a case of very rapidincrease in the price level, spiraling beyond control.

In Fig. 1.6, the price level rises at a decreasing rate that is, a decliningination rate. This is called disination, a state of aairs where theination rate is positive but falling.



General Price Level

90

95

100

105

110

115

0 5 10 15 20 25 30 35 40 45 50

Value of Money

90

95

100

105

110

115

0 5 10 15 20 25 30 35 40 45 50

Inflation Rate

-3

-2

-1

0

1

2

3

0 5 10 15 20 25 30 35 40 45 50

Fig. 1.1. Price stability.

When the price level falls over time, or when the ination rate isnegative, we have a case of deation, as shown in Fig. 1.7. Deationis often confused with disination but they are certainly dierent. Underdisination, the ination rate is positive while the price level rises. Underdeation, the ination rate is negative while the price level falls.



General Price Level

80

100

120

140

160

180

200

220

0 5 10 15 20 25 30 35 40 45 50

Value of Money

40

50

60

70

80

90

100

110

0 5 10 15 20 25 30 35 40 45 50

Inflation Rate

0

2

4

6

8

10

0 5 10 15 20 25 30 35 40 45 50

Fig. 1.2. Moderate (creeping) ination.

In Fig. 1.8, we see two big discrete jumps in the price level cor-respondingly two big discrete falls in the value of money. The inationrate is otherwise close to zero and the price level is stable. Although theprice level has almost doubled while money has lost almost half of its



General Price Level

0

100

200

300

400

500

600

700

800

900

0 5 10 15 20 25 30 35 40 45 50

Value of Money

0

20

40

60

80

100

0 5 10 15 20 25 30 35 40 45 50

Inflation Rate

0

2

4

6

8

10

0 5 10 15 20 25 30 35 40 45 50

Fig. 1.3. Accelerating ination.

value, some economists do not describe these price jumps as inationary.We will call them inationary bursts.

Figure 1.9 represents a case of reation. This phenomenon is a con-sequence of a policy measure aimed at raising the general price level



General Price Level

0

5000

10000

15000

20000

25000

0 5 10 15 20 25 30 35 40 45 50

Value of Money

0

20

40

60

80

100

0 5 10 15 20 25 30 35 40 45 50

Inflation Rate

0

5

10

15

20

25

0 5 10 15 20 25 30 35 40 45 50

Fig. 1.4. Volatile ination.

(through expansionary policy) to counteract deationary pressures. InDecember 2012, the newly elected Japanese prime minister promisedto reate the economy, having been in a deationary spiral for manyyears.



General Price Level

0

30000000

60000000

90000000

120000000

150000000

0 5 10 15 20 25 30 35 40 45 50

Value of Money

0

20

40

60

80

100

0 5 10 15 20 25 30 35 40 45 50

Inflation Rate

0

20

40

60

80

100

0 5 10 15 20 25 30 35 40 45 50

Fig. 1.5. Hyperination.

In Fig. 1.10, the unemployment rate is added to illustrate thephenomenon of stagation, which is a combination of ination, sloweconomic growth and high unemployment (the last two go together).This phenomenon became evident in the 1970s, when ination and



General Price Level

100

150

200

250

300

350

0 5 10 15 20 25 30 35 40 45 50

Value of Money

20

40

60

80

100

0 5 10 15 20 25 30 35 40 45 50

Inflation Rate

0

5

10

15

20

25

0 5 10 15 20 25 30 35 40 45 50

Fig. 1.6. Disination.

unemployment occurred simultaneously. Traditionally, it was believedthat ination could only happen when the economy was booming andunemployment was low (in other words, when the economy was producingat higher level than full capacity). This shows the existence of the



General Price Level

20

40

60

80

100

0 5 10 15 20 25 30 35 40 45 50

Value of Money

100

150

200

250

300

350

400

0 5 10 15 20 25 30 35 40 45 50

Inflation Rate

-8

-6

-4

-2

0

0 5 10 15 20 25 30 35 40 45 50

Fig. 1.7. Deation.

belief that high unemployment was associated with deation rather thanination.

Irrespective of the patterns observed in Figs. 1.11.10, a number ofstylized facts can be put forward to describe movements of the price level



General Price Level

80

100

120

140

160

180

200

0 5 10 15 20 25 30 35 40 45 50

Value of Money

40

60

80

100

120

0 5 10 15 20 25 30 35 40 45 50

Inflation Rate

0

10

20

30

40

0 5 10 15 20 25 30 35 40 45 50

Fig. 1.8. Big discrete jumps in the general price level (inationary bursts).

and the corresponding ination rate. The general price level rises as longas the ination rate is positive. If it is stable, the general price level risessteadily; otherwise it rises at varying paces. How the ination rate behaveshas implications for the consequences of ination. It is important to realize



General Price Level

60

70

80

90

100

110

120

0 5 10 15 20 25 30 35 40 45 50

Value of Money

80

90

100

110

120

130

140

150

160

0 5 10 15 20 25 30 35 40 45 50

Inflation Rate

-3

-2

-1

0

1

2

3

4

5

0 5 10 15 20 25 30 35 40 45 50

Fig. 1.9. Reation.

that the ination rate may be high and rising, high and stable, high andfalling, low and rising, low and falling and low and stable. It may alsobe negative or positive, which makes the dierence between ination anddeation.



General Price Level

90

100

110

120

130

140

150

160

0 5 10 15 20 25 30 35 40 45 50

Unemployment Rate (Stagflation)

3

4

5

6

0 5 10 15 20 25 30 35 40 45 50

Unemployment Rate (Normal Conditions)

2

3

4

5

0 5 10 15 20 25 30 35 40 45 50

Fig. 1.10. Stagation.

1.3. The Causes of Inflation

There is not a single, agreed-upon answer as to what causes inationbut, as Keynes (1920) put it, even the weakest government can enforce



ination when it can enforce nothing else. There are, however, a numberof theories suggesting various factors that play some role in the inationaryprocess. Like almost everything in economics, the empirical testing of thesetheories has not produced a consensus view on the causes of ination andhow the inationary process evolves. Perhaps this is a normal state ofaairs because inationary episodes dier across time and space, whichmeans that no single explanation is always the right explanation. Studiesof ination suggest a variety of explanatory factors such as policy mistakes(Taylor, 1997; Sargent, 1999), rising oil and food prices (Blinder, 1982),political factors (Nordhaus, 1975; Rogo and Sibert, 1988), scal policy(Calvo, 1988; Friedman, 1994), the exchange rate regime (Mohanty andKlau, 2001), and the international transmission of ination (Darby, 1983;Turovsky et al., 1988).4 In a comprehensive empirical study, Vansteenkiste(2009) identies as the origin of inationary episodes a combination ofpolicy mistakes, global shocks and structural factors, adding that too loosemonetary policy and/or a xed exchange rate regime signicantly increasethe probability that a country will enter into a prolonged period of risingination.

Economists generally agree that high ination rates are caused by anexcessive growth of the money supply excessive relative to the growthrate of the economy (measured by real output). Views on what causes low tomoderate inations are more divergent: it may be attributed to uctuationsin the demand for goods and services, changes on the supply side and/or(moderate) growth in the money supply. Ination, therefore, may comefrom the supply side or the demand side of the economy. However, theconsensus view is that continuous and sustained ination arises when themoney supply grows faster than output. For some economists, ination (nomatter what causes it), must be accompanied by a rise in the money supply.Thus, we have the monetary theory of ination, demand-pull theories,and cost-push theories. Goldstone (1991) explains ination in the earlymodern world in terms of demographic factors such as the resumption ofpopulation growth following a halt brought about by disease, which causedrising demand for essentials such as food, housing and energy. While Fischer(1996) acknowledges the role of demographic factors in initiating ination,he attributes long-term ination to the institutionalization of inationary

4The nding of a variety of factors causing ination means that not all economists thinkthat only monetary factors matter. Recognizing the role of oil and food prices meansthat some economists believe that discrete price jumps are indeed inationary.



psychology by indulging in practices such as trimming coins and hoardinggoods.

Historically, ination has been viewed as a monetary phenomenon asinfusions of gold and silver into an economy also led to ination. Fromthe second half of the 15th century to the rst half of the 17th century,Western Europe experienced a major inationary cycle referred to as theprice revolution, as prices rose by a factor of six over 150 years. This waslargely caused by the sudden inux of gold and silver from the New World.Some economic historians dispute the view that the inux of gold and silverwas the only reason for ination, suggesting other explanatory factors suchas cost-push factors, rising prices imposed by new monopolies, wars andpopulation growth (Bernholz, 2003). Demographic factors contributed toupward pressure on prices, as population growth resumed following thedepopulation caused by the Black Death pandemic.

By the 19th century, economists identied three separate factors thatcaused changes in the prices of goods: a change in the value or productioncosts of the good, a change in the price of money (which was typicallycaused by uctuations in the commodity price of the metallic content ofthe currency), and currency depreciation resulting from increasing supplyrelative to the quantity of the redeemable metal backing the currency.Following the emergence of private paper money during the American CivilWar, the term ination started to appear as a direct reference to thecurrency depreciation that occurred as the quantity of redeemable papermoney outstripped the quantity of metal available for redemption. At thattime, the term ination referred to the depreciation of the currency, notto a rise in the price of goods.

The observation that the over-supply of paper money led to decliningvalue of money was noted by classical economists such as David Humeand David Ricardo. They examined and debated what eect currencydepreciation had on the prices of goods, giving rise to the conceptsof monetary ination and price ination. Subsequently, the termination on its own prevailed. According to Bernholz (2003), the useof the word inflation for an expansion of the money supply or an increasein prices, quite in contrast to the rst occurrence of ination as historicalevents, is of rather recent origin. Specically, he suggests that the termwas rst used in 1838 in the context of an ination of the currency.

From the 18th century onwards, a tendency emerged for countries toadopt at money (paper money that is not backed by any commodityreserve asset), which made much larger variations in the money supply



possible. As a result, huge increases in the supply of paper money tookplace in a number of countries, producing hyperination. As things standearly in the second decade of the 21st century, there is talk about the re-emergence of hyperination as a result of the monetary expansion pursuedby central banks in the U.S. and elsewhere through quantitative easing.This is what this book is about.

1.4. Experience with Inflation

To demonstrate the international experience with ination we examineination in the U.S. going back to 1914 and in Sweden by going back to1830. We also examine ination gures over the period 19702011 for theworld as a whole, developed countries, emerging countries and Japan.5 Wealso look at high ination/hyperination episodes in four Latin Americancountries in the 1980s and 1990s. A full examination of the most notoriouscases of hyperination is reserved for later chapters. The objective behindthe use of this collection of cases is to demonstrate that the inationpatterns we observed in the hypothetical data displayed in Figs. 1.11.10do actually appear in the real world they are not just in the imaginationof economists.

We start with an examination of the general price level (measured bythe consumer price index, CPI) in the U.S. over the period 19142012,which is depicted in Fig. 1.11. As in the graphs showing the hypotheticalnumbers, Fig. 1.11 displays movement of the general price level over timeand the corresponding value of money and ination rate. As Table 1.1shows, ination was high and volatile during the period 19141921, highand unstable in 19671982, moderate and stable in 19831996 and low andextremely stable in 19571966 and 19972012. The highest ination rate of20.43% was registered in 1919 in the aftermath of World War I, while thelowest rate was recorded soon after (in 1922) when the economy experienceddeation as the price level fell by 10.82% (an ination rate of 10.82%).Since 1914, the U.S. economy experienced 12 years of deation.

Figure 1.12 is a time plot of the ination data in Sweden going back to1830. As reported in Table 1.2, the country experienced severe deationduring the period 19201923 following the high and volatile inationexperienced during World War I. Two other periods of deation can beobserved: 18571901 and 19241933. Ination was low in 18301942 and

5Japan is an interesting case because of the deation of recent years.



General Price Level

0

500

1000

1500

2000

2500

1914 1924 1934 1944 1954 1964 1974 1984 1994 2004 2013

Value of Money

0

20

40

60

80

100

1914 1924 1934 1944 1954 1964 1974 1984 1994 2004 2013

Inflation Rate

-15

-10

-5

0

5

10

15

20

25

1914 1924 1934 1944 1954 1964 1974 1984 1994 2004 2013

Fig. 1.11. Ination in the U.S.

19021913. The highest average year-on-year ination rate was registeredduring the period 19701982. The highest rate was 34.96% in 1915 whilethe lowest was 18.45% in 1921. The country experienced year-on-yeardeation 48 times and zero ination three times.



Table 1.1. Year-on-year ination rate in the U.S.(19142012).

StandardPeriod Mean Deviation Range

19141921 10.19 8.18 19.4319221933 3.10 4.91 14.2919341956 3.25 4.66 20.9019571966 1.72 0.74 2.3119671982 7.05 3.43 10.2519831996 3.57 1.20 5.0119972012 2.44 1.01 3.98

Figure 1.13 shows ination in the whole world, in developed countries,in emerging countries and in Japan over the period 19702011. The inationrates for country groups are calculated (by the IMF) as weighted averages ofthe ination rates in individual countries where the weights are representedby the size of the economy measured by GDP. A trend line is super-imposedto indicate the possible direction of ination. If we are to believe in technicalanalysis as applied to ination, this means that ination is expected torise in developed countries. While this may be plausible as a result ofquantitative easing, we do not give much credence to evidence basedon tted trend lines. Notice, however, how the location of the peak diersbetween developed countries, where the highest ination rate occurred inthe 1970s and in emerging countries where ination peaked in the early1990s.

Table 1.3 reports the mean, standard deviation and range of the year-on-year ination rates. We can see that ination has been much higherin emerging economies where a rate of over 100% was registered in 1990.The dierence is likely to be the tendency to monetize the decit (thatis, printing money to nance the decit) in emerging countries. Althoughthe average ination rate in Japan has been higher than that in developedcountries as a whole, Japan has been experiencing deation not witnessedanywhere else in the developed world. In 1974, Japan experienced anination rate of over 23% that attributed to the rise in oil prices.

So far we have not shown an example of high ination or hyperination,but here it is. In Fig. 1.14, we see the year-on-year ination rates duringthe period 19831993 in Argentina, Bolivia, Brazil and Mexico. In 1989, theination rate in Argentina was 4,154%, but it fell subsequently. By 1992, itwas 22%. In Bolivia the ination rate hit a high of 8,175% but it declined



General Price Level

0

2000

4000

6000

8000

1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

Value of Money

0

20

40

60

80

100

1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

Inflation Rate

-20

-10

0

10

20

30

40

1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

Fig. 1.12. Ination in Sweden.

very sharply in subsequent years. In 1986, the ination rate fell from thathigh to only 14.6%. In Brazil, the ination rate hit a high of 1759% in1989 but, unlike Argentina and Bolivia, the ination rate persisted at highlevels. And in Mexico, the ination rate hit a high of 159% in 1987, but that



Table 1.2. Year-on-year ination rate inSweden (18302011).

StandardPeriod Mean Deviation Range

18301842 0.94 2.39 7.3818431856 2.01 4.75 17.0018571901 0.36 4.59 18.4319021913 0.87 2.60 15.6819141919 18.44 11.76 33.6419201923 9.68 9.63 20.3219241933 1.39 1.87 5.2919341952 4.25 5.17 17.3519531969 3.31 1.72 5.9619701982 9.35 6.13 27.3719832011 3.33 3.09 10.75

was followed by a period of disination.6 This disparity in the behavior ofination in the four countries reects dierences in policy. These episodesshow how easy it is to put an end to hyperination, but what the picturedoes not show is how easy it is to start hyperination.7 Although cases ofhyperination may seem like unusual events, this is actually not the case.While there was no hyperination in the world between 1950 and 1983,there were seven in the second half of the 1980s. The 1980s also witnessed20 episodes of hyperination (dened as annual rates exceeding 100).

If it is easy to start hyperination, why is it that we are witnessingsubdued ination worldwide despite the use of quantitative easing inthe aftermath of the global nancial crisis? The latest gures (Septem-ber/October 2012) for the annual CPI rates shown in Fig. 1.15 areexceptionally low by historical standards.8 They show that Switzerlandand Japan are in deation. The highest rates shown in Fig. 1.15 are forVenezuela, India and Turkey. China has an ination rate of 1.9%, despitethe widespread talk about mounting inationary pressures in the Chineseeconomy.

6These gures are taken from Rogers and Wang (1993). Some of these gures may notbe consistent with the gures reported in Chapter 8 because of dierent sources anddierent measures of the ination rate.7Putting an end to hyperination is not easy in the strict meaning of the word. Whileappropriate policy action may be easy, the underlying costs, in terms of human economicsuering, are invariably enormous.8These gures were obtained from the 3 November issue of The Economist, p. 88.



World

0

4

8

12

16

20

24

28

32

1970 1980 1990 2000 2010

Developed Countries

0

4

8

12

16

1970 1980 1990 2000 2010

Emerging Countries

-20

0

20

40

60

80

100

120

1970 1980 1990 2000 2010

Japan

-8

-4

0

4

8

12

16

20

24

28

1970 1980 1990 2000 2010

Fig. 1.13. Ination around the world.

Low ination rates worldwide may be explained in terms of theslowdown in economic activity following the global nancial crisis. In 2009,immediately after the crisis, the U.S. economy was in deation. Europeis experiencing low ination because of the ongoing credit crisis, so there



Table 1.3. Year-on-year ination rates in countrygroups and Japan (19702011).

StandardCountry/Group Mean Deviation Range

World 11.01 6.80 28.06Developed Countries 4.86 3.52 14.53Emerging Countries 26.55 23.65 100.44Japan 2.97 4.67 14.53

is no wonder that the ination rate in Greece is only 0.9%. However, aphenomenon that has been puzzling economists and general observers isthat of low ination in the U.S. and U.K. (2% and 2.2%, respectively), twocountries that have been implementing quantitative easing robustly.9 Thisis a major issue that will be discussed in Chapter 9.

1.5. More Inflation-Related Concepts

We have so far come across a number of ination-related concepts such asdeation, disination and stagation. But there are more, and we start withthe concepts of open ination and repressed or suppressed ination(also called disguised ination).

Open ination occurs when prices are allowed to move freely. Whenprice controls hold prices below their market equilibrium values, suppressedination prevails because prices are not allowed to move according to theforces of supply and demand. The same outcome results from subsidies. Theimposition of price controls is often observed under hyperination or highination, giving rise to severe shortages and the emergence of vibrant blackmarkets. Moral deterioration is associated with these conditions becausepeople cannot buy as much as they would like at the control prices andoften it is only a lucky few with inside connections who get to buy at thecontrol prices. Those without connections and those who want more thanwhat they get at the control price must pay the higher black market price.Such suppression, nevertheless, can only be temporary. Figure 1.16 showshow the general price level moves under open ination and suppressedination using two levels of control prices. The ination rate is higherunder open ination because alternatively the control prices are used tocalculate price indices and the ination rate. Since the imposition of price

9The Bank of England has put an end to quantitative easing in May 2012.



Argentina

0

1000

2000

3000

4000

5000

1983 1985 1987 1989 1991 1993

Bolivia

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

1983 1985 1987 1989 1991 1993

Brazil

0

400

800

1200

1600

2000

1983 1985 1987 1989 1991 1993

Mexico

-20

20

60

100

140

180

1983 1985 1987 1989 1991 1993

Fig. 1.14. Ination in high-ination countries.

controls leads to shortages, we also have the concepts of shortageationand hypershortageation.

Another concept is that of asset price ination, which is an undueincrease in the prices of real or nancial assets, such as stocks and real



-4 0 4 8 12 16 20

Switzerland

Japan

Canada

China

U.S.

Germany

U.K.

Spain

Singapore

Mexico

Brazil

South Africa

Hungary

Russia

Turkey

India

Venezuela

Fig. 1.15. Most recent ination gures (September/October 2012).

0

100

200

300

400

500

600

700

800

900

0 5 10 15 20 25 30 35 40 45 50

Open Inflation Suppressed Inflation (1) Suppressed Inflation (2)

Fig. 1.16. The price level under open and suppressed inations (simulated data).



estate. Central bankers have traditionally ignored asset price ination whileconcentrating on goods price ination. However, a view has emerged to theeect that it would be better to aim at stabilizing a wider general price levelination measure that includes some asset prices, instead of stabilizing CPIor core ination only. The reason is that by raising interest rates when stockprices or real estate prices rise, and reducing them when these asset pricesfall, central banks might be more successful in avoiding bubbles and crashesin asset prices. Asset price ination produces articial wealth, encouragingconsumers and rms to borrow beyond their means. In the aftermath of theglobal nancial crisis, it has become an acceptable view that price stabilityis insucient to maintain overall economic stability.

There is also the concept of biation (also called mixation), whichis a state of the economy where the processes of ination and deationoccur simultaneously. Under biation, the prices of commodity/earnings-based assets rise while the prices of debt-based assets fall. Biation occursbecause a greater amount of money is allocated to the purchase of essentialitems, away from buying non-essential items. It can also be seen in termsof the prices of essential items (food, energy, etc.) and luxury items such astop-end cars and other typically debt-based assets. Unlike stagation, thereis no reference in the denition of biation to the state of the economy. Theconcept has emerged as a result of the debate the world economy as a wholeis facing ination or deation (the re or ice debate).

Nouriel Roubini has coined the term stag-deation, where a recessionis associated with deationary forces (Roubini, 2008). In 2008, Roubinipredicted that the U.S. economy was heading towards stag-deation forfour main reasons: (i) a slack in goods markets, (ii) a re-coupling of the restof the world with the U.S. recession, (iii) a slack in labor markets, and (iv) asharp fall in commodity prices. He concluded that the conditions prevailingthen would reduce inationary forces and lead to deationary forces inthe global economy. The main theme of this book is that hyperination ismore likely than deation.

1.6. Concluding Remarks

This chapter is about some preliminary clarications pertaining to theconcept of ination and many related concepts. Simulated data were usedto demonstrate a variety of patterns of behavior assumed by the generalprice level and the implications for ination. It was also shown that thetheoretical patterns appearing in simulated data do appear in reality.



In the following three chapters, we examine the measurement, causesand consequences of ination. While terms such as CPI and inationrate are used in this chapter, the denition of these terms will be presentedin Chapter 2. This will help us to discuss the causes and consequences ofination in Chapters 35.


Chapter 2

THE MEASUREMENT OF INFLATION

2.1. The Inflation Rate

The ination rate is a measure of the pace of ination, the speed at whichprices rise. It is the period-to-period percentage change in the general pricelevel measured as a price index. If the general price level rises betweentwo points in time, t 1 and t, from Pt1 to Pt, the ination rate, , iscalculated as

= 100[Pt Pt1

Pt1

]. (2.1)

An important point to bear in mind here is that the ination rate, unlikethe price level, is not observable at a point in time. It is a measure of whathappens between two points in time (last year and this year, for example).In the jargon of economics, while the price level is an instantaneous (or astock) variable, the ination rate is a ow variable.

If the unit of time represented by t and t1 is a year, then Eq. (2.1) isan expression for the annual ination rate. Data on the general price level(measured by some index) are typically reported on a quarterly and monthlyas well as annual basis. Confusion, therefore, could arise in determining howto measure the annual ination rate from quarterly and monthly data onthe general price level. Consider quarterly data rst, and suppose that Pt1is the general price level observed at the end of the fourth quarter of 2011while Pt is the general price level at the end of the rst quarter of 2012. Inthis case, Eq. (2.1) can be used to calculate the ination rate for the rstquarter of 2012. It may be tempting in this case to annualize the rate bymultiplying the expression by 4, which gives

= 4 100[Pt Pt1

Pt1

]. (2.2)

29



After all, this is what we do when we annualize interest rates. However,Eq. (2.2) is not a true reection of the annual ination rate in the rstquarter of 2012. The annual (as opposed to annualized) rate is thepercentage change in the price level between the rst quarter of 2011 andthe rst quarter of 2012 in general, the percentage change in the pricelevel relative to its value four quarters ago. In this sense, the annual inationrate is calculated as

= 100[Pt Pt4

Pt4

], (2.3)

where Pt4 is the price level at the end of the rst quarter of 2011. Likewise,we can calculate the annual ination rate in January 2012 as the percentagechange in the general price level at the end of January 2012 relative to whatit was at the end of January 2011 (12 months previously). In this case, theannual ination rate is calculated from monthly data as

= 100[Pt Pt12

Pt12

]. (2.4)

One advantage of measuring the annual ination rate from monthly andquarterly data relative to the value of the price index in the correspondingperiod of the previous year is that it produces a less volatile ination seriesthat represents the ination trend, which is what matters most for policy.Calculating the annual ination rate by annualizing the correspondingmonthly or quarterly rates produces highly volatile ination series, whichreect seasonal variation in prices if the general price level is not seasonallyadjusted.

For the purpose of cross-country comparisons, we may nd it usefulto calculate the average annual ination rate from data on the price levelover a period of many years. If Pt and Ptn represent the general pricelevel observed in years t and t n, the average annual ination rate over aperiod of n years is

= 100[(

PtPtn

)1/n 1]. (2.5)

In Chapter 6, which is about hyperination, more formulas will be presentedon the measurement of the ination rate and related metrics that show thespeed of extreme ination. Figure 2.1 illustrates, for a given set of simulated


The Measurement of Inflation 31

Price Level

0

500

1000

1500

2000

2500

3000

0 10 20 30 40 50 60

Annualized Inflation Rate

0

10

20

30

40

50

0 10 20 30 40 50 60

Annual Inflation Rate

0

10

20

30

40

50

0 10 20 30 40 50 60

Average Annual Inflation Rate

0

10

20

30

40

50

0 10 20 30 40 50 60

Fig. 2.1. Measures of the ination rate (simulated data).

price time series, the dierence in the behavior of the ination rate measuredas the annualized rate, annual rate and average annual compound rate.As we can see, the annualized ination rate is much more volatile thaneither the annual rate or the average annual compound rate.



2.2. Inflation, Income Growth and Money Illusion

Another denition of ination is that it is a condition under whichnominal (or money) income rises faster than real income. Illustrating theseconcepts can be made easier by switching from income to output, whichare equivalent under national income accounting as national income canbe calculated from an income and output perspective. Real output is thephysical quantity of output, while nominal or money output is the dollarvalue of physical output. An increase in nominal output may result from arise in the physical quantity of output (real output) or a rise in the price ofoutput, which for the whole economy is the general price level. If we revertback to the concept of income, then we can dene real income as nominalincome adjusted for changes in prices that is, adjusted for ination.

This is how the process works. Let Yt1 and Yt be nominal incomesat points in time t 1 and t, respectively, while Pt1 and Pt are thecorresponding price levels. Real income is obtained by deating nominalincome by the corresponding price level. Hence, real income at t 1 andt is Yt1/Pt1 and Yt/Pt, respectively. Let the growth rates of nominal andreal incomes be gN and gR, respectively. Hence, we have

1 + gN =Yt

Yt1, (2.6)

1 + gR =Yt/Pt

Yt1/Pt1=

Yt/Yt1Pt/Pt1

. (2.7)

Under ination Pt > Pt1, hence, gN > gR. Ination occurs when nominalincome grows faster than real income. In Fig. 2.2, we show simulated datadescribing the time paths of nominal income and real income under inationrates ranging between 1% and 5%. As we can see, the higher the inationrate, the lower is the growth rate of real income. This is because from (2.7)

1 + gR =(1 + gN )(1 + )

, (2.8)

where is the ination rate. By manipulating Eq. (2.8), we obtain

gN = gR + (2.9)

because gR is approximately equal to zero under moderate ination. Aslong as > 0, gN > gR, which is what is shown in Fig. 2.2.

Those who cannot distinguish between nominal and real incomes (ornominal and real quantities in general) are said to exhibit money illusion.



0

50

100

150

200

250

300

350

400

450

0 5 10 15 20 25 30 35 40 45 50

Nominal Real (1%) Real (2%) Real (3%) Real (4%) Real (5%)

Fig. 2.2. Nominal and real incomes at various ination rates (simulated data).

For example, when a person experiences a 6% rise in nominal income as aresult of a salary increase, she may be under the impression that she hasbecome better o as a result of the pay rise. However, if ination is alsorunning at 6% this person is not better o, because being better o is afunction of real income that is how much she can buy with her income.With reference to Eq. (2.9), gN = = 6%, which gives gR = 0. With nogrowth in real income, there is no improvement in the standard of livingand a person experiencing no change in real income will not be better o.Money illusion is most likely to occur when ination is unanticipated, sothat peoples expectations of ination turn out to be far away from theactual level. When ination is fully anticipated, the risk of money illusionsubsides.

2.3. Measuring the General Price Level

Since the ination rate is the percentage change in the general price level,measuring ination requires the construction of an index that represents thegeneral price level. Hence, ination refers to a rise in a broad price indexrepresenting the overall price level for goods and services in the economy.



0

100

200

300

400

500

600

700

1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012

GDP Deflator CPI PPI

Fig. 2.3. The CPI, PPI and GDP deator for the U.S.

These indices include, among others, the consumer price index (CPI), theproducer price index (PPI), and the GDP deator. There are also sectoralor narrow price indices such as the price indices for food, medical care,housing and energy as well as indices for special groups. Figure 2.3 showsthe three main indices for the U.S. Figure 2.4 shows the ination ratescalculated from the CPI and GDP deator for some country groups andJapan. The indices produce dierent but highly correlated estimates of theination rate.

No matter which index is used to represent the general price level (andhence to measure ination), price indices typically suer from two problems:noise and bias. Noise refers to all transitory shocks that are assumed to addup to zero in the long run, but exert temporary and noticeable inuence onthe general price level in the short run (particularly when price statisticsare reported at high frequencies such as monthly). Noise encompasses allkinds of shocks that originate in the supply side of the economy, such asseasonal phenomena and broadly dened resource shocks as well as shocksrelated to exchange or tax rate changes and any other shocks inducingshifts in relative prices. These shocks cancel out when one looks at alonger horizon but introduce undesirable uctuations at high frequencies.



World

0

4

8

12

16

20

24

28

32

1970 1980 1990 2000 2010

CPI GDP Deflator

Developed Countries

0

4

8

12

16

1970 1980 1990 2000 2010

CPI GDP Deflator

Japan

-4

0

4

8

12

16

20

24

1970 1980 1990 2000 2010

CPI GDP Deflator

Emerging Countries

0

20

40

60

80

100

1970 1980 1990 2000 2010

CPI GDP Deflator

Fig. 2.4. Ination rates calculated from the CPI and GDP deator.



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quantitive easing as a highway to inflation

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