quantitive easing as a highway to inflation
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Quantitative Easingas a Highway toHyperinflation
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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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World Scientific Publishing Co. Pte. Ltd.
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Library of Congress Cataloging-in-Publication Data
Moosa, Imad A.
Quantitative easing as a highway to hyperinflation / by Imad A Moosa (Royal Melbourne Inst of
Technology, Australia).
pages cm
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
British Library Cataloguing-in-Publication Data
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Copyright 2014 by World Scientific Publishing Co. Pte. Ltd.
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To Nisreen and Danny
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August 10, 2013 8:54 9in x 6in Quantitative Easing as a Highway to Hyperinflation b1571-fm
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
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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
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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
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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
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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
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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
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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
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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
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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
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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 ($/ounce) . . . . . . . . . . . . . . . . . . . 2679.10 Average annual rise in gold price in currency terms
(20032012) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
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List of Figures xvii
9.11 Total foreign ownership of the U.S. treasuries ($ 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
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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
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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
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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
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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
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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
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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
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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.
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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
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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.
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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.
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4 Quantitative Easing as a Highway to Hyperinflation
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.
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Inflation, Deflation, Disinflation and All That 5
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.
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6 Quantitative Easing as a Highway to Hyperinflation
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
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Inflation, Deflation, Disinflation and All That 7
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
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8 Quantitative Easing as a Highway to Hyperinflation
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.
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Inflation, Deflation, Disinflation and All That 9
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
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10 Quantitative Easing as a Highway to Hyperinflation
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
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Inflation, Deflation, Disinflation and All That 11
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
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12 Quantitative Easing as a Highway to Hyperinflation
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
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Inflation, Deflation, Disinflation and All That 13
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.
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14 Quantitative Easing as a Highway to Hyperinflation
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
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Inflation, Deflation, Disinflation and All That 15
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.
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16 Quantitative Easing as a Highway to Hyperinflation
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
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Inflation, Deflation, Disinflation and All That 17
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.
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18 Quantitative Easing as a Highway to Hyperinflation
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.
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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
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20 Quantitative Easing as a Highway to Hyperinflation
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
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Inflation, Deflation, Disinflation and All That 21
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.
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22 Quantitative Easing as a Highway to Hyperinflation
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
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Inflation, Deflation, Disinflation and All That 23
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.
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24 Quantitative Easing as a Highway to Hyperinflation
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
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Inflation, Deflation, Disinflation and All That 25
-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).
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26 Quantitative Easing as a Highway to Hyperinflation
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.
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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.
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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
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30 Quantitative Easing as a Highway to Hyperinflation
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
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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.
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32 Quantitative Easing as a Highway to Hyperinflation
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.
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The Measurement of Inflation 33
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.
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34 Quantitative Easing as a Highway to Hyperinflation
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.
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The Measurement of Inflation 35
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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36 Quantitative Easing as a Highway to Hyperinflation
Bias is either weighting bias