Budget Deficits, Stability and the Dynamics of Hyperinflation
Journal article by Miguel A. Kiguel; Journal of Money, Credit & Banking, Vol. 21, 1989
Journal Article Excerpt
Budget deficits, stability, and the dynamics of hyperinflation. by Miguel A. Kiguel Budget Deficits, Stability, and the Monetary Dynamics of Hyperinflation LARGE BUDGET DEFICITS FINANCED BY MONEY CREATION are widely believed to be the primary force sustaining prolonged high inflation processes. The relationship appears to be closer for hyperinflationary episodes, which are usually associated with the presence of massive budget deficits. Hyperinflation, understood in this paper as a process of accelerating inflation, in fact occurs because governments have unsustainably large budget deficits.(1) A correction of the fiscal imbalance has been crucial for stopping hyperinflation. This factor is well documented in the works of Yeager (1981), Sargent (1982), and Webb (1986) on the hyperinflation episodes in the central European countries during the 1920s and by Sachs (1987) on the more recent Bolivian episode. Substantial reductions in the budget deficit, monetary reform, and a fixed exchange rate were crucial for the successful stabilization policies in those countries. Indeed, fiscal restraint, which in most cases meant outright elimination of the budget deficit, was probably the most important of these policy measures. One distinctive feature of hyperinflationary episodes is that the rate of inflation accelerates over time,(2) thus suggesting that these processes are inherently unstable. Cagan's seminal work on this issue provides an alternative interpretation. In Cagan's view hyperinflationary episodes could only be unstable if they were "self-generating," and he considered that although "there is no reason why (self-generating inflations) could not occur; so far they have just not been observed" (p. 73). However, Cagan's stability analysis only considers the case in which the money process was exogenous. If one extends Cagan's seminal paper through the introduction of money-financed budget deficits and rational expectations, and then analyzes the dynamic properties of the system, as was recently done by Evans and Yarrow (1981), Kiguel (1986), and Buiter (1987), the results are astonishing. Large money-financed budget deficits could be the source of instability; however, they could only lead to hyperdeflation. These deficits can never be the source of hyperinflation. The presence of large budget deficits in a perfect foresight framework has a surprising effect on the dynamic behavior of inflation. Auernheimer (1976), Evans and Yarrow (1981), and Kiguel (1986) showed that in order to obtain a hyperinflationary process one needs to assume adaptive expectations. In other words, in Cagan's framework, large budget deficits could result in hyperinflation only when agents make systematic mistakes in forecasting the rate of inflation. It has been recognized for some time that it is very difficult to justify the use of adaptive expectations in macroeconomic models. Economic agents eventually learn the process that generates inflation, and they will use that information in the formation of their forecasts on inflation. As a result, it is difficult to accept that large budget deficits would lead to accelarating inflation only in the presence of systematic mistakes. In this paper we show that under plausible assumptions regarding the adjustment of the money market it is possible to find conditions under which large money-financed deficits can lead to hyperinflation even when agents have perfect foresight. The basic analytical framework is similar to the one used in Sargent and Wallace (1973), Evans and Yarrow (1981), Bruno and Fischer (1986), Dornbusch and Fischer (1986), and Buiter (1987). It assumes that budget deficits are entirely financed through seigniorage, a Cagan-type demand for money function and rational expectations (which in the present model, given the absence of uncertainty, is equivalent to perfect foresight). The main difference is that in the present model the money market does not clear instantaneously. The paper is organized as follows. The next section introduces the basic analytical framework and discusses the dynamics of the model under a lagged adjustment in the money market. It will be argued that hyperinflation is an unstable process triggered by the government's attempt to obtain seigniorage in excess of the revenue-maximizing inflation tax. Since there is no stable rate of inflation at which the government can finance its deficit, it is financed in an unstable fashion. Section 2 discusses in more detail the potentially destabilizing effects of budget deficits and the problems that policymakers face in controlling inflation. In section 3 we allow for the presence of lags in government revenues and show that in this case the economy is more likely to experience an unstable path of prices. 1. A MODEL OF HYPERINFLATIONIn this section we present the basic analytical framework and discuss the dynamic behavior of prices. Throughout the paper we assume a closed economy, that output ... |
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