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Cagan : Money and Hyperinflation. In post-WWI Germany ... and other episodes of hyperinflation The demand for real balances was stable The higher the opportunity cost of holding money, the less money people chose to hold The hyperinflation was not self-generating

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Cagan money and hyperinflation

Cagan: Money and Hyperinflation

In post-WWI Germany ... and other episodes of hyperinflation

The demand for real balances was stable

The higher the opportunity cost of holding money, the less money people chose to hold

The hyperinflation was not self-generating

In self-generating inflation, a small rise in prices causes a flight from money:

High inflation  Higherexpected inflation  Higher inflation

The rates of money creation and inflation exceeded the real-revenue maximizing rate

Weak, desperate government relied on an inflation tax ... but couldn’t even get the tax rate right

Cagan s model
Cagan’s Model

  • The demand for real balances depends on

    • Real wealth

    • Real income

    • The opportunity cost of holding money—the “interest rate”

  • When inflation (C)is high and variable

    • real wealth and income don’t vary nearly as much as inflation and can be ignored

    • the opportunity cost of holding real balances is the expected rate of inflation (E)

      ln(M/P)d = - γ – α E or (M/P)d = e- γ – α E

  • Adaptive expectations: Expected inflation increases to extent actual inflation exceeds what was expected

    dE/dt = β(C – E)

  • Cagan s model critical features
    Cagan’s Model: Critical Features

    • Expected inflation is a weighted average of past inflation

      • Inflation in more recent months weighted more heavily than inflation in less recent months

    • The elasticity of real balance demand with respect to expected inflation increases with expected inflation

      [d(M/P)/(M/P)]/[dE/E] = -αE

    • If money growth is independent of inflation, inflation is self-generating when αβ > 1.

      δC/C = - β/[1 - αβ]

      If inflation is not self-generated, it must be driven by money inflation

    • An “inflation tax” is levied on real balances:

      • Steady state tax revenue is R = C x (M/P)

      • Steady state tax revenue is maximized when C = 1/α

    Parameter estimates for germany august 1922 november 1923
    Parameter Estimates for Germany, August 1922 – November 1923

    • Ignoring outliers toward end of the German hyperinflation

      α = 5.46 β = .15

    • Toward end of the hyperinflation period, people held real balances in excess of what the model predicts

       People anticipated currency reform and stabilization

    Cagan conclusions
    Cagan 1923 Conclusions

    • Money demand (the demand for real balances) is stable even in the face of hyperinflation

      • Parameters αandβare estimated with confidence

      • Money is “scarce” in times of hyperinflation—real balances become vanishingly small

    • Inflation is not self-generated

      As Milton Friedman would have it, “Inflation is always and everywhere a monetary phenomenon.”

    • Weak, desperate government inflates too rapidly for its own good

      • Initial increases in money inflation rates yield high real tax revenues because of lags in real balance adjustments

      • But such high rates of inflation tax cannot be sustained

    Sargent 1982 the ends of big inflations
    Sargent (1982): 1923The Ends of Big Inflations

    Drivers of big inflations: “printing money for your friends”

    Austria, 1919 – 1922

    • ... expansion of central bank notes stemmed mainly from the bank’s policy of discounting treasury bills. .. [but] also from it’s practice of making loans and discounts to private agents at nominal interest rates of between 6 and 9% per annum.

      Hungary, 1919 – 1924

    • The government of Hungary ran substantial budget deficits...financed by borrowing from the State Note Institute...An additional cause in the increase in liabilities of the institute was the increasing volume of loans that it made to private agents.

      Germany, 1919 – 1923

    • During 1923 (actually beginning summer 1922), the Reichsbank began discounting large volumes of commercial nominal rates of interest far below the rate of inflation, amounting virtually to government transfer payments to the recipients.

    Sargent 1982 rat x and the ends of big inflations
    Sargent (1982): Rat-X and The 1923Ends of Big Inflations

    • Firms and workers strike inflationary bargains in light of expectations of high inflation.

    • They expect high rates of inflation because ... current and prospective monetary and fiscal policies warrant these expectations.

    • The current rate of inflation and people’s expectations of future rates may well seem to respond slowly to isolated actions of restrictive monetary and fiscal policies that are viewed as temporary.

      Thus inflation only seems to have a momentum of its own. It is actually the long-term government policy of persistently running large deficits and creating money at high rates which imparts the momentum to the inflation rate.

    • ... eradicating inflation would require far more than a few temporary restrictive fiscal and monetary actions.

    • It would require a change in the policy regime: there must be an abrupt change in the continuing government policy, or strategy, for setting deficits now and in the future that is sufficiently binding to be widely believed.

    Germany from 1923 hyperinflation to 1924 stabilization
    Germany: From 1923 Hyperinflation to 1924 Stabilization 1923

    • Rentenmark issued by Rentenbank

      • 1 trillion Mark = 1 Rentenmark

      • Quantity of Rentenmark limited by law respected by Rentenbank

      • Maximum Rentenmark available to government limited by law

    • Budget swung to balance

      • Taxes raised

      • Gov’t workers/Railroad workers discharged/those over-65 retired

      • Postal workforce reduced/Reichsbank workforce reduced

    • Dawes Plan implemented (Chas Dawes: VP ‘25, Nobel Prize)

      • Reparations restructured

      • Reichsbank put under Allied supervision: Parker Gilbert, Agent

      • Stabilization loan obtained

    • Stabilization crisis: sharp but short-lived

    Sarah Crown 1923Inflation and Currency Depreciation in Germany, 1920-1923: A Dynamic Model of Prices and the Exchange Rate

    Giuseppe Tullio – a professor of monetary economics at the University of Brescia, Italy

    Brief survey problems of the literature
    Brief 1923Survey/Problems of the Literature

    • The Quantity Theory of Money

      • Bresciani-Turroni (1937)

      • Cagan (1956)

      • Graham (1930)

      • Jacobs (1975, 1976)

      • Khan (1975, 1977a, 1977b, 1980)

    • Exchange Rate

      • Frenkel (1976)

    • Rational Expectations

      • Sargent and Wallace (1973)

      • Sargent (1977)

    Tullio s correct model
    Tullio’s 1923 “Correct” Model

    • Domestic and foreign currency substitution in the demand for real money balances

    • A dynamic mechanism allowing short-run deviation of the exchange rate from PPP

    • A feedback from prices to money

    Dynamic model
    Dynamic Model 1923

    TABLE 1


    • The Exchange Rate

      D ln S = (1)

      where the partial equilibrium level of the exchange rate, (Ŝ) is Ŝ = (1a)

      and bu is the demand for real cash balances:

      bȗ = (1b)

      2. Prices

      Dlnp = (2)


      D = ƛ (d ln p - )(2a)

      3. Supply of nominal cash balances


      where y is potential output:

      Ӯ = (4)