Hyperinflation

Gaurav Bhattacharya

Gargi College University of Delhi

April 26, 2020

Gaurav Bhattacharya (Gargi College, DU) BA(H) GE Macroeconomics April 26, 2020 1 / 14 Overview

1 Seigniorage and inflation

2 Stabilisation programme

3 Role of the : Inflation targeting vs. financial stability

4 Inflation targeting: India’s experience

Gaurav Bhattacharya (Gargi College, DU) BA(H) GE Macroeconomics April 26, 2020 2 / 14 Seigniorage and inflation

A government can finance its budget deficit either through issue of bonds or creation by printing . However, the government cannot create money by itself. through printing of notes is done by the central bank. The central bank pays the government with money it creates and the government uses that money to finance its deficit. This is known as debt monetisation. It is now imperative for us to know what is the rate of nominal money growth needed to finance a given amount of budget deficit.

Gaurav Bhattacharya (Gargi College, DU) BA(H) GE Macroeconomics April 26, 2020 3 / 14 Seigniorage and inflation

Let ∆M denote the change in nominal money stock in a particular period. The revenue, in real terms, that the government generates through ∆M printing of notes is therefore P is know as seigniorage, σ, i.e., ∆M σ = (1) P Now, (1) can be written as ∆M M σ = (2) M P Equation (2) shows that seigniorage is the product of nominal money ∆M M growth rate M and real money balances P . Now, σ per unit of real GDP, Y can be written as ! σ ∆M M/P = (3) Y M Y

Gaurav BhattacharyaThe central (Gargi College, bank DU) pays theBA(H) government GE Macroeconomics with money it createsApril 26, and2020 the 4 / 14 government uses that money to finance its deficit. This is known as debt-monetisation. It is now imperative for us to know what is the rate of nominal money growth needed to finance a given amount of budget deficit. Seigniorage and inflation

σ In order to finance a deficit of Y , the rate of money growth should be ∆M M . The money market equilibrium condition gives M = L(i, Y ); where i = r + E(π); L < 0; L > 0 (4) P i Y Using (4) in (2), we get

∆M σ = L(r + E(π), Y ) (5) M Equation (5) shows that with rise in expected inflation, nominal rate rises, which results in a fall in real money balances and hence σ.

Gaurav Bhattacharya (Gargi College, DU) BA(H) GE Macroeconomics April 26, 2020 5 / 14 Seigniorage and inflation

Suppose that the rate of growth of nominal money is constant, say m. Under such circumstances, actual and expected inflation would be constant as well. From the quantity theory equation, we get

m = π = E(π) (6)

Using (6) in (5), we get

σ = m L(r + m, Y ) (7)

For a given r and Y , equation (7) provides an interesting relationship between σ and m.

Gaurav Bhattacharya (Gargi College, DU) BA(H) GE Macroeconomics April 26, 2020 6 / 14 Seigniorage and inflation

Differentiating (7) wrt m, we get

dσ = L(.) + m L (8) dm i

dσ Setting dm = 0, we get L(.) m¯ = − > 0; since L < 0 (9) L0 i Further, < 0; when m < − L(.) dσ  Li = 0; when m = − L(.) (10) dm Li > 0; when m > − L(.) Li

Gaurav Bhattacharya (Gargi College, DU) BA(H) GE Macroeconomics April 26, 2020 7 / 14 Seigniorage and inflation

The expression in (10) traces out a non-monotonic relation between σ and m. For any m < m¯, σ is rising; it reaches a maximum at m =m ¯ and falls thereafter. This shows that the nominal money growth has two opposing effects on seiniorage. A rise in the nominal money growth rate increases seiniorage, given by the first term on the right-hand side of equation (8), which is positive. The negative effect of rise in on seigniorage is given by the second term on the right-hand side of equation (8). As m increases, π and E(π) increase which leads to a rise in nominal interest rates. High nominal interest rates reduce real money balances and hence seigniorage [refer to equation (2)].

Gaurav Bhattacharya (Gargi College, DU) BA(H) GE Macroeconomics April 26, 2020 8 / 14 Seigniorage and inflation

When nominal money growth is low, an increase in nominal money growth leads to a small reduction in real money balances, which leads to an increase in seigniorage. When nominal money growth is very high, the reduction in real money balances induced by higher nominal money growth becomes larger and larger, thereby leading to a decrease in seigniorage. This is analogous to the relation between revenues and the tax rate, known as the Laffer curve. Now, inflation can be thought of as a tax on money balances, the tax rate being the rate of inflation π, which reduces the real value of money holdings. M Therefore, the inflation tax is given by the product of π and P , where real money balances form the tax base.

Gaurav Bhattacharya (Gargi College, DU) BA(H) GE Macroeconomics April 26, 2020 9 / 14 Seigniorage and inflation

Therefore, M Inflation tax = π (11) P Using (6) in (11), we get

M Inflation tax = m = Seigniorage (12) P Equation (12) shows that the inflation tax is nothing but the seiniorage. Till now, the entire analysis was based on the assumption that the budget deficit is given. In reality, the budget deficit becomes larger with a rise in inflation rate, primarily due to lags in tax collection. This is know as the Tanzi-Olivera effect.

Gaurav Bhattacharya (Gargi College, DU) BA(H) GE Macroeconomics April 26, 2020 10 / 14 Stabilisation policies

As inflation is costly, it is pertinent to have policies in place, in order to stabilise prices. One of the causes of hyperinflation being the government’s budget deficit, reforms need to take place on both the expenditure side and the revenue side of the budget. On the expenditure side, rationalising subsidies, and temporary suspension of interest payments on foreign debt could help. On the revenue side, there needs to be a change in the composition of taxation. There must be a regulation on debt monetisation. Heterodox policies like wage and price controls which help in coordinating expectations could help. Success of stabilisation policies lies in the complementarities of each of the above measures; further, political environment does matter.

Gaurav Bhattacharya (Gargi College, DU) BA(H) GE Macroeconomics April 26, 2020 11 / 14 Role of the central bank: Inflation targeting vs. financial stability

The theory of neutrality of money calls for price stability as an exclusive objective of . Price stability can be achieved through a mandate of the central bank in terms of inflation control, which is also known as inflation targeting. Under this mandate, the central bank is bound to maintain a pre-announced inflation targeting, say πT .

If the actual inflation π exceeds πT , then the central bank will adopt a contractionary monetary policy via, say, a hike in policy rates. Empirical evidence suggests that inflation targeting helps in reduction of inflation.

Gaurav Bhattacharya (Gargi College, DU) BA(H) GE Macroeconomics April 26, 2020 12 / 14 Role of the central bank: Inflation targeting vs. financial stability

However, the financial crisis of 2007-08 has raised questions on the aspect of central bank’s fixation over price stability. Price stability, per se, does not ensure financial stability. Financial stability, which refers to stability in the financial system like lack or limited failure of banks, existence of manageable non-performing assets (NPAs) or bad loans, limited presence of the asset price bubble, assumes special significance.

Gaurav Bhattacharya (Gargi College, DU) BA(H) GE Macroeconomics April 26, 2020 13 / 14 Inflation targeting: India’s experience

India, being a growing economy, inflation targeting is neither feasible nor advisable (recall the Phillip’s curve relation). Drivers of inflation in India emanate from the supply side; monetary policy affects the demand side. India faces rigidities in the financial market which inhibits smooth monetary transmission, and hence, complicates the adoption of an inflation targeting regime.

Gaurav Bhattacharya (Gargi College, DU) BA(H) GE Macroeconomics April 26, 2020 14 / 14