Inflation and Hyperinflation

Inflation is an expansion of the money supply which ultimately shows up in an increase in prices. The rise in prices is a symptom produced by the increase in the supply of money.

To properly understand inflation and hyperinflation, it is necessary to understand Money, specifically the Supply of Money and the Demand for Money.

The Federal Reserve controls the Supply of Money. The Banking System has influence via the amounts of Fed credit/money they choose to lend out. However, the Fed ultimately controls the outer bounds of the supply of money via the reserves they supply to the banking system and the reserve requirements they impose on banks. While banks can choose to lend less than restricted by law, they cannot lend more.

The Demand for Money is independent of direct Federal Reserve or banking system control. It is controlled by the users of money. They decide how much to hold, how rapidly to spend, etc. Innumerable factors influence the demand for money. Some of them can be influenced by the Fed like interest rates. These influences are marginal in the sense that they can affect demand but not determine it. The Fed can control the supply, but not the demand, for money.

As any Econ 101 student has learned, it is the interaction between supply and demand that determines price. Money is no different from any other “product” in that sense. It is this relationship that is necessary to understanding how an economy goes from inflation to hyperinflation.

As prices rise, it makes economic sense for people to “advance” purchase. That is, economic actors will spend money faster in order to avoid coming price increases. This represents a decline in the demand for money. People choose to hold less because its purchasing power is depreciating. They spend faster. In economist terms, the “velocity” of money increases. Velocity is nothing more than a proxy measure for the demand for money.

Once demand begins to decline, it produces effects similar to an additional increase in the supply. That is, the existing money becomes more powerful in the sense that it is used to create more transactions. This increased turnover in money acts as an increased demand for goods, further accelerating price rises. The stable relationship between the Monetary Base (Fed created money) and prices is disrupted.  At this point, the Fed has lost policy control. The decrease in the demand for money speeds up price increases, prompting more decreases in demand.

In order to get to hyperinflation, increases in the supply of money are necessary but not sufficient. Hyperinflation comes when people begin to expect that inflation will continue, possibly at an accelerating rate. Individuals then attempt to protect themselves from inflation by decreasing their holding of money (demand decreases). Once this cycle begins, it doesn’t take long for the demand for money to go to zero. At that point, people refuse to hold money and hyperinflation occurs.

Hyperinflation ends in a Depression when merchants refuse to accept money. Commerce then shrinks to a level sustainable via barter, a level less than required to sustain a modern economy.

A reader sent the following in. The original author is unknown. His/her comments add to mine above:

One of the great misconceptions of modern economics is that inflation and hyperinflation are different degrees of the same thing.

Or possibly, hyperinflation is the most improperly named phenomenon in economics.

Rising prices are a symptom of inflation. Inflation itself is an increase in the money supply, usually caused by a credit bubble. During this phase credit is increasing and everybody wants more money. People love money.

Hyperinflation, on the other hand is due to people coming to hate money. It is an abandonment of the currency; everyone trades all their money for hard assets driving up their price.

In this world, credit dries up too because you will be paid back in worthless currency (not assets), and the interest rate you would need to charge is astronomical. But if credit has dried up, doesn’t the money supply shrink? Well, nominal terms the money supply is increasing, but in real terms it is shrinking.

What causes hyperinflation is the government pouring money into the system to offset the lack of credit. But they can never keep up, and they just keep printing until the currency is worthless. The end game is a death spiral that cannot be escaped from, except by reissuing the currency.

Nominally, in hyperinflation, the GDP is going up, but in real terms it is going down.

That’s right, hyperinflation is form of DEFLATION.

In fact, it is created from a normal deleveraging process that the government, for whatever reason, tries to stop by printing money.

Hyperinflation begins during deflation and hides the deflation nominally, but actually makes it worse in real terms.

In fact, money system becomes so dysfunctional, the whole economy grinds to a halt.

Obviously, the Fed is going down this path. However, the US dollar is the world’s reserve currency. Everybody knows that, but what does it really mean?

It means the world’s money begins as dollars, and gets mirrored in other currencies. Like the Fed creating base money and the banks multiplying it up through fractional reserve lending, US banks create money that other countries use as collateral to multiply up in their own currencies. That is, all the world’s money is backed by dollars, and if the dollar collapses, the collateral for everything evaporates. A collapsing dollar will take everything down with it. That means SDRs based on a basket of currencies would be worthless too.

So the world has always hated the dollar because it is the reserve currency. But the fact is we need a reserve currency, and nothing else is as solid as the dollar. The world would NEVER accept the Yuan, Yen or Euro as a new reserve currency. So to get rid of the dollar is desirable, but there is NO alternative … except GOLD.But the very idea of a gold reserve is so hated by central banks, it will be a long time before they would accede to it.

So dollar hyperinflation means global hyperinflation, sparing nobody.

It’s the logical outcome of a “race to the bottom”.

And you can see it: everybody is deleveraging and is fighting the consequent deflation with money printing. We’re all circling the same drain.

Right now we are all beginning to get some stagflation, but that’s just a polite word for incipient hyperinflation. Only when the abhorrence of money gets bad enough, and commodity prices go to the moon, will the world be forced back to some kind of modern gold standard. Not that GOLD is so great, it’s just always there, and has always been the money of last resort.