The sky’s the limit: The economics of inflation and hyperinflation

1 Introduction

The year is 2023. Luciana runs an ice cream business in Buenos Aires, Argentina, serving both her local regulars and the many tourists who travel to her neighbourhood of Palermo. But her day-to-day work involves more than just the usual concerns of purchasing her ingredients, making her products, paying her employees, and serving her customers. In addition, like all Argentine businesspeople, she must decide how to respond to rapidly changing prices, which have recently been rising at around 7% a month.

This month, a particularly important price has changed: the US dollar has gone up by 10% in Argentine pesos—another of the sporadic depreciations that the local currency has been suffering. Not much of what Luciana uses is imported, but the Argentine milk and sugar that she buys are tradable—meaning that the companies that produce them have the option of exporting their products instead of selling to locals like Luciana. So when the price of the dollar goes up by 10%, the milk- and sugar-producing companies get 10% more pesos if they export their products. In response, they raise their peso prices by the same amount.

If milk and sugar account for 15% of Luciana’s costs, then a 10% increase in those prices will raise her total costs by 15% times 10%, which is just 1.5%. So far, a modest impact.

But it doesn’t stop there.

Luciana also knows that this increase in the prices of milk and sugar is likely to follow for most food products, so food in general is likely to rise by 10%. And with food prices rising by 10%, workers’ unions will push for wage rises of 10% to maintain their real wage (the amount of goods and services their wages can buy)—raising the wage bill in Luciana’s ice cream shop. Moreover, if wage rises are happening across the economy, her customers’ incomes also go up by 10%, so they probably won’t mind paying 10% more for ice cream. (And the tourists won’t even notice, since they are changing dollars into pesos at the new higher rate.) What about her competition? They are in the same boat as Luciana, so she can safely assume they will raise their prices too.

Luciana decides to stick to a simple rule of thumb: she raises her prices by 10% … and so does everyone else.

The dollar has become the price anchor: the reference price that people take as the baseline in their pricing decision.

Money matters

To learn more about the three functions of money, read Section 6.5 of The Economy 2.0: Macroeconomics.

store of value

One of the characteristics of money is that it can be used as a store of value: people can store their wealth in this form until they want to use it to buy goods and services.

unit of account

A standard unit that is used to measure and compare the market value of different goods and services. One of the functions of money in the economy is to act as a unit of account.

means of exchange

One of the characteristics of money is that it serves as a means of exchange: something that buyers and sellers are willing to exchange for goods and services.

Luciana’s pricing decisions have come to depend not just on the value of ice cream, but on the value of money itself. Money is one of the foundations of a market economy. Economists have identified three functions that it serves. First, it is a store of value: if you earn income today but want to spend it later, you can save the money and spend it in the future. Second, it is a unit of account, meaning it is the measure of value of commodities in the market. Third, it is a means of exchange in that you can spend it on goods and services in general (because sellers in general are willing to accept your money).

Inflation directly erodes money’s function as a store of value: an increase in prices, like in Luciana’s situation, means that the same amount of money can now buy fewer goods and services. In this Insight, we will show how extreme levels of inflation can also undermine its roles as a unit of account and means of exchange.

In countries with low inflation, economic actors rarely think about it. Some prices go up, some go down, and over time they rise a little bit on average. But when inflation is running very high, it can be hard to think about anything else. Businesses have to change their prices more and more frequently, and long-term planning, including commitments to long-term contracts, becomes difficult or impossible.

Since 1960, 29 countries have experienced episodes of inflation above 100% for at least one year.¹ Figure 1 shows the 12 episodes across 9 countries of inflation exceeding 100% over at least 10 months since the late 1990s.^2 3 4 5

Hyperinflation, defined as inflation of at least 50% per month for more than two months,⁶ has afflicted 16 countries over the same period. Hyperinflation can lead to prices multiplying to millions of times their initial levels, typically leading to redenominations that remove multiple zeros from valuations. For example, Venezuela’s currency, the bolivar, experienced decades of moderate to high inflation before being replaced in 2008 by the bolívar fuerte (strong bolivar), which removed three zeros from its predecessor. Inflation then rose, exceeding 100% in 2015 and peaking at the hyperinflationary rate of 65,374% per year in 2019. That year they introduced a third currency, the bolívar soberano (sovereign bolivar), which removed a further five zeros. With annual inflation remaining above 2,000% in 2020 and 1,500% in 2021, the bolívar digital removed another six zeros—although domestic currency was in little practical use by this time as people switched to the dollar for most monetary transactions. In Zimbabwe, hyperinflation during 2007–2008 was so extreme that by 2009 redenomination had removed 25 zeros from the currency.

Despite these extreme cases, inflation worldwide has declined over the last several decades. Figure 2 shows that in the mid-1970s, average regional inflation in sub-Saharan Africa, Latin America, and today’s European Union was between about 10 and 23%. The two low- and middle-income regions suffered considerable volatility until the 1990s but by 2000 average inflation was below 5%. Since then it has rarely exceeded 7%. In the EU it fell steadily from the early 1980s onwards, and since the mid-1990s it has exceeded 5% only once, in 2022—an exceptional year driven by both recovery from the COVID-19 pandemic and war in Ukraine.

Figure 3 presents inflation rates by income levels, indicating that inflation has been highest and most volatile in the low-income countries, and lowest and most stable in the high-income countries. Again there is a notable decline in inflation rates since about 2000.

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https://books.core-econ.org/insights/economics-of-inflation-and-hyperinflation/01-introduction.html#figure-2

Figure 2 Regional inflation in consumer prices (1960–2023).

World Bank Development Indicators.

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https://books.core-econ.org/insights/economics-of-inflation-and-hyperinflation/01-introduction.html#figure-3

Figure 3 Inflation in consumer prices by income levels (1976–2023).

World Bank Development Indicators.

This Insight explores the multiple mechanisms that underlie inflation, from low to extremely high levels. At the heart of the inflationary process we find social conflict. Firms want higher profits and workers want higher real wages, and these goals are in opposition to one another. Firms are in conflict with each other as suppliers and users of intermediate goods. Importers are in conflict with exporters over the exchange rate. And taxpayers are in conflict with the recipients of government expenditures, leading to pressure on the fiscal budget. In each case, when the sum of the conflicting demands is greater than the value of available output, it leads to rising prices and inflation.