Nominal and Real Disturbances and Money Demand in Chinese Hyperinflation

Article excerpt

I. INTRODUCTION

The analysis of historical episodes of hyperinflation typically concentrates on the impact on money demand from anticipated inflation arising from the overissuance of fiat money. Yet it is possible that prices increase at different rates across sectors, giving rise to redistribution effects. In theoretical models of money and inflation, it is generally assumed that all prices change equiproportionately. As a consequence, the potential effect of real disturbances through relative price changes on money demand is usually ignored. Although this omission was questioned over two decades ago by Policano and Choi (1978), little attention has been paid to assessing the importance relative price effects on money demand during hyperinflation in addition to the influence of anticipated inflation. (1)

The present article reexamines money demand during hyperinflation using a model that allows the relative price of capital goods to vary. We assume that fluctuations in the relative price reflect interactions between the real and monetary sectors. In particular, we propose alternative estimates for Caganian money demand, taking into account both anticipated inflation and relative price effects in a nonlinear fashion based on a dynamic monetary model. This exercise highlights how conventional money demand econometric investigations overlook nonlinear interactions between the real and monetary activities and hence may underestimate the true welfare costs of hyperinflation. We develop a dynamic model with infinitely lived, perfect foresighted agents. Money is introduced into the model through a general cash-in-advance constraint. (2) In contrast to Lucas (1980) and Stockman (1981), we follow Wang and Yip (1992), assuming that all consumption goods and a fraction of capital goods require cash services prior to the ir transactions. Thus capital and consumption goods are distinct goods, so there is a nontrivial relative price of the capital good in terms of the consumption good. In this model, we also incorporate the variable velocity setup developed in Tallman and Wang (1995) to capture the explosive hyperinflationary spiral, including among others the debt-inflation spiral implicitly. Thus the theoretical framework in this article generalizes the models extant in the literature.

In accordance with the conventional literature, we regard hyperinflations as primarily monetary phenomena. For analytic convenience, we assume that the money creation process is exogenous, which greatly simplifies our analysis. Hence the monetary authority is assumed not to respond directly to fiscal authority's demand for seigniorage revenue. Although this eliminates the possibility of a debt-inflation spiral, the model can account for a debt-inflation spiral without qualitatively altering the theoretical predictions. Although the anticipated inflation rate reflects intertemporal price changes, the relative price of the capital good captures contemporaneous price variations. Our theory concludes that money demand depends negatively on both the anticipated inflation rate and the relative price of the capital good to the consumption good. But there may also be interactive effects among these factors. As a consequence, relative price movements have an ambiguous effect on how money demand responds to anticipated inflation. On one hand, an increase in the relative price raises the effective cost inflation, resulting in a higher interest rate elasticity of money demand. On the other hand, an asset substitution effect implies the associated increase in the capital cost encourages money holdings, thus dampening the negative effect of anticipated inflation on the demand for money.

We employ data from the Chinese hyperinflation (January 1946 to April 1949) to uncover empirical evidence concerning the importance of the relative price effect on money demand. Among episodes of hyperinflation, the Chinese hyperinflation was the most explosive hyperinflationary experience over a prolonged three-year period in recorded human history. …