1. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University LECTURE 7: SEIGNORAGE & HYPERINFLATION Key Question: Government attempts to stimulate the economy might explain moderate levels of money growth and inflation. But why do very high rates of inflation -- even hyperinflation -- sometimes occur?

2. The world’s most recent hyperinflation: Zimbabwe, 2007-08 It reached 2,600% per mo. in mid-2008. Inflation reached 50% per month in March 2007, meeting definition of hyperinflation.

3. API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Nov. 2008: inflation rate p.a. supposedly estimated at 89.7 sextillion (10 21 ) %. Dec. 2008: inflation p.a. estimated at 6.5 quindecillion novemdecillion % (6.5 x 10 108 %, or 65 followed by 107 zeros – 65 million googols %) The new world record for hyperinflation In April 2009, printing of the Zimbabwean dollar stopped; the S.Afr. Rand & US $ became the standard currencies for exchange.

4. The driving force? Increase in money supply: The central bank monetized government debt.

5. The exchange rate increased along with the price level. Both increased far more than the money supply. Why? When the ongoing inflation rate is high, the demand for money is low, in response. For M/P to fall, P must go up more than M.

6. API-120 – Prof. Frankel, Harvard Kennedy School How do governments finance spending? Taxes Borrowing ● Domestic † ● Abroad Seignorage ≡ creating money to finance deficits Money creation in excess of increased money demand from real growth ≡ inflation tax. † If you finance a budget deficit by borrowing, -- “Ricardian” debt neutrality (Barro): people know taxes eventually will rise. So S ↑. -- Fiscal theory of the price level (Woodford): people know that eventually you will have to monetize the outstanding debt. So P ↑.

7. API-120 - Macroeconomic Policy Analysis I Prof. Jeffrey Frankel, Kennedy School of Government, Harvard University But a government that relies on seignorage to raise real resources risks “killing the goose that lays the golden egg.” High money growth eventually gets built into expected inflation; and so the public reduces money demand –whether because π e is built into i (Fisher effect) –or because π e enters the money demand function directly. Bond markets often break down in hyperinflations. –So M/P = L( π e, Y) When demand for real money balances falls, there is less of a “tax base” that the government can exploit.

8. API-120 - Macroeconomic Policy Analysis I, Prof. J.Frankel, Harvard Kennedy School Real money supply = real money demand. In “steady state,” the actual & expected rates of inflation = the rate of money growth. If π e rises, real money demand falls, as households protect themselves against the loss in purchasing power. The fall in real M takes the form of a rise in P > rise in nominal M. The government gets to spend at rate dM/dt in nominal terms. A higher “tax rate” (inflation) lowers the “tax base” (real money holdings). π e = π = g M, where g M ≡, => Seignorage = = g M L(π, ) INFLATION TAX “Inflation ↑ ↑ tax = “tax “tax revenue” rate” base” In LR: Y = and Divide by P to see what that buys in terms of real resources.

9. Where π went the highest, P went up the most, even relative to the increase in M: M/P ↓ 27.2 π

10. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Inflation tax revenue is “tax rate” times “tax base”

11. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University If money growth = 0, seignorage = 0. If inflation is very high, seignorage is very low. You have killed the goose that laid the golden eggs. The seignorage- maximizing rate of money growth 11.7

12. API-120 - Prof J Frankel,, Kennedy School of Government, Seignorage = π L(π,Y) E.g., following Cagan, we choose exponential functional form: Let L(, ) ≡ e a-λπ Y. Set derivative = 0. We thereby find that revenue- maximizing π is inversely related to λ, i.e., the sensitivity of money demand to π. => d L(,)/dπ = - λe a-λπ Y= -λ L(,). = L(,) – π λ L(,) = L(, ) [1– π λ] =0 when π = 1/ λ E.g., if λ=1/2, revenue-maximizing π=200%. Or higher, if in, SR λ is lower. For govt. to maximize seignorage,

13. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University The seignorage-maximization approach doesn’t get to true levels of hyperinflation, if the revenue curve peaks at lower levels of inflation. One needs a dynamic process, where money-holders respond more adversely to inflation over time than they do in the short run, and the central bank chases a receding seignorage target. Cagan (1956) modeled adjustment in continuous time. (Or Romer, 4 th ed., pp. 572-576)

14. API-120 - Macroeconomic Policy Analysis I Prof. J. Frankel, Harvard Kennedy School Consider a stylized example of the dynamic process, which could end up at hyperinflation Assume –Elasticity rises over time from short run to long, and –Government instructs CB to finance a real budget target by seignorage. In VSR, elasticity is low. Seignorage target can be reached with moderate rates of money creation & inflation π 1.. Then, in SR, elasticity rises. => demand for money falls => π 1 no longer raises enough real revenue.  CB raises money growth & inflation to π 2 to attain required revenue. In MR, elasticity rises more => π 2 no longer raises enough revenue.  CB raises money growth & inflation to π 3. In LR, elasticity rises more => π 3 no longer raises enough revenue.  CB raises money growth & inflation to π 4, which is now past the revenue-maximizing hump. A foolish government might chase its target indefinitely.

15. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University VSR SR MR LR · ·· ? Seignorage = π L(π) with functional form L(π) =e a-λπ Y. inflation rate π Assume govt. requires seignorage 92% of GDP ·

16. Appendix: Exchange rates in hyperinflations S.Hanke Increases in the exchange rate