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

7 Hyperinflation

Hyperinflation is defined as a rate of inflation of at least 50% per month that lasts more than two months. It is a relatively modern phenomenon: the first recorded case was in France in 1795–1796, during the French Revolution, but the vast majority of cases have happened since the beginning of the twentieth century. There were eight cases across seven countries between 1920 and 1946, none between 1947 and 1984, and 18 cases across 16 countries between 1985 and 2024.¹

Under hyperinflation, domestic currency loses its function as money.

Recall the three uses of money (Section 1): as a store of value, as a unit of account, and as a means of exchange. When inflation reaches excessive levels then all three of these roles are compromised.

Domestic currency loses its role as a store of value for the obvious reason that it buys less and less, declining at an alarming rate. Moreover, this applies not just to cash but also to bonds denominated in domestic currency: their nominal interest rate can fall far behind inflation, implying that their real value collapses. For this reason, people no longer want to hold on to assets denominated in domestic currency. Instead, people will try to hold alternatives like ‘hard currency’, meaning some currency that tends to retain its value over time—most often US dollars because of their availability and universal acceptance.

Money under hyperinflation loses its role as a unit of account for the same reason: today the unit means something very different from tomorrow or next week. The problem is exacerbated by the fact that very high inflation also tends to be very variable. If inflation was 15% last month then it might easily be 10%, or 30%, this month. That makes it very difficult for firms to know by how much they should raise their own prices, leading to mispricing, or the situation where prices no longer reflect relative scarcity. Recall that the efficient allocation of goods via markets depends on prices reflecting relative scarcity. When many goods are mispriced, markets fail to clear: goods fail to sell, or they sell out very quickly.

Various strategies arise to address this problem. Dollarization is one common approach. This means that people start using dollars instead of domestic currency, whether for everyday transactions or for saving. Another is to use some commodity as a reference. For example, one parents’ group at a primary school in Argentina had an arrangement whereby when a child in the class had a birthday, instead of every family buying a small present, families would take turns buying a single large present on behalf of the class. In order to ensure that the presents retained the same value over time they agreed that it should cost the same as 100 litres of petrol (which ranged between about USD75 and USD100).

Finally, under extremely high inflation, domestic currency loses its effectiveness as a means of exchange. Seeing prices rise every week, every day, or even several times per day, leads people to buy goods as quickly as they can. The Argentine economist Mercedes d’Alessandro, who was a child during the hyperinflation episodes of 1989–1990, records her and her friends’ experiences of hunting for goods in the supermarket whose prices had not yet been updated that day. Families would stock up on spaghetti as soon as their wages came in, knowing that the next day it would be more expensive. One witness recalls seeing someone buying four table fans at the supermarket because that’s what there was: ‘people bought whatever they could … They didn’t know what to spend their money on. Holding onto it made no sense.’²

As D’Alessandro notes, when domestic currency loses its function as money, people no longer want to hold onto it. They do not want to save in it, and when they want to spend, they spend it as fast as they can. This leads to a collapse in what is often called ‘money demand’: the demand people have to hold domestic currency. This is a somewhat misleading term for two reasons. First, people still want money—what they don’t want is domestic currency, precisely because it has lost its role as money. Instead, demand for alternative forms of money like US dollars will increase as demand for domestic currency falls. Second, it is not just domestic cash that people don’t want to hold—demand may collapse for any financial asset denominated in domestic currency if expected inflation is higher than the nominal interest rate. But declining money demand, when understood as demand for domestic currency, is fundamental to explaining hyperinflation.

The mechanisms sustaining hyperinflation

Before we examine how hyperinflation episodes begin, we identify a set of mechanisms that explain why hyperinflation is self-reinforcing, and why it is so difficult to halt once it takes off.

The first three mechanisms are related to the collapse in demand for domestic currency that we have just described.

First, the desire to spend currency as quickly as possible pushes up nominal aggregate demand. This signals to firms that they can keep raising prices.

Second, the desire to exchange domestic currency for dollars pushes up the demand for dollars relative to domestic currency, implying a depreciation or devaluation. This fuels the depreciation–inflation or devaluation–inflation spiral we analysed above.

The third mechanism involves the dynamics of seigniorage and money printing. Section 6 showed that governments print money both in order to cover a fiscal deficit and in response to rising demand for base money due to rising nominal GDP. Under hyperinflation, nominal GDP is multiplying quickly, and the government is printing money at a very rapid rate. But at a certain point prices tend to rise faster than the government is printing money, implying that real seigniorage revenue falls even as money printing accelerates. Using the seigniorage equation \(\text{seigniorage} = \frac{\mathrm{\Delta}M}{M} \times \frac{M}{P}\), if \(P\) rises faster than \(\mathrm{\Delta}M\), then real seigniorage is falling. This is why seigniorage does not just rise with inflation. For example, in Figure 8, seigniorage peaked in Bolivia in 1984 when inflation was nearly 1,300%, and seigniorage fell in 1985 when inflation exploded to over 117,000%.

Another way to understand the third mechanism is to recall that seigniorage is driven by the inflation tax (setting aside the small amount of seigniorage due to real growth), and that this is a tax on holdings of domestic currency and domestic bonds. When demand for domestic currency falls, people are holding less real currency. This means the base for the inflation tax falls in real terms, and any given level of inflation will yield less seigniorage revenue in real terms. If the government cannot close its fiscal deficit or borrow to reduce the amount of real revenue that it needs, then it will need an ever-higher rate of inflation on a shrinking real monetary base, leading to accelerations in both money printing and prices.

There are three other key mechanisms that sustain hyperinflation.

First, more frequent wage bargaining leads to higher inflation, as discussed in Section 2. This occurs as inflation gets higher because workers see their real wages deteriorating more rapidly, and demand more frequent adjustments. This might involve frequent indexing, or automatic upgrading of contracts including wages, which can cause very rapid price acceleration.

Second, under high and rising inflation, any inflation target or other nominal anchor becomes highly implausible: people know that it won’t be achieved. Expectations become ‘unanchored’. As inflation begins to rise, expectations might become adaptive. But as inflation rises further and people notice that inflation at time \(t\) tends to be even higher than inflation at time \(t - 1\), inflation expectations might even exceed the previous period’s actual inflation rate. As in the example of Luciana’s ice cream shop in Argentina (Section 1), sometimes expectations become anchored to the price of the dollar: if the dollar rises by 10% this month, then everyone assumes inflation will be 10%, and raises their own prices accordingly. This also implies that a real devaluation is impossible—every depreciation is followed by an equal rise in prices, so that the real exchange rate does not depreciate, guaranteeing that the depreciation–inflation spiral will continue, as discussed in Section 4.

Third, real tax revenues are likely to collapse because of the ‘Olivera–Tanzi effect’,^3 4 discovered by the Argentine economist Julio H. G. Olivera and later elaborated by the IMF economist Vito Tanzi. This refers to the fact that tax revenue tends to be charged retrospectively (after the taxed transaction occurs). Value added taxes may be transferred to the government 30 or 60 days after the relevant transaction. Personal income taxes are often calculated at the end of the tax year. But under hyperinflation, waiting a month, let alone a year, will slash the real value of the tax by the time the government receives it. This worsens the fiscal deficit, further increasing the pressure to print money to raise seigniorage revenue.

The path to hyperinflation

These mechanisms explain why high inflation can be self-sustaining and lead to rising inflation and hyperinflation. We now ask what can kick-start this process.

The most immediate driver of hyperinflation is typically a combination of an unmanageable fiscal deficit leading to high levels of money printing, and a depreciation–inflation spiral (or its fixed exchange rate equivalent, the devaluation–inflation spiral). But more important is the underlying cause of the fiscal deficit. In cases like the French Revolution or the US Civil War, it was due to the need to increase expenditure to finance the conflict, combined with grave constraints on tax collection: in the absence of effective infrastructure, conflict makes it very difficult for the state to collect taxes from its citizens.

Zimbabwe’s hyperinflation from 2007 on was driven by poorly executed land reforms in the 1990s that led to a collapse in food production. This caused a general decline in output, and hence a decline in government revenue. Foreign debt soon began to play a role as well: exports dropped from USD3.2 billion in 1997 to USD1.9 billion in 2003, causing a rise in the current account deficit, which led to rising foreign debt, and further rises in debt payments. This exacerbated the fiscal deficit, the need for the government to acquire dollars, devaluations, and the pressure to print money.

In many cases, foreign debt has been the primary driver of hyperinflation episodes. The 1922–1923 hyperinflation episode in Germany was caused by an excessive debt burden of what Germany owed to the victors of World War I; the multiple hyperinflation episodes in Latin American countries in the 1980s and early 1990s were the result of the debt crisis that began around 1980. In this crisis, unsustainable foreign debt led to very high inflation or hyperinflation through the two mechanisms discussed: high debt payments led to loss of reserves that drove devaluation–inflation spirals, and to fiscal deficits that could be financed only by printing money. We now examine this episode in detail.

The 1980s debt crisis

The 1980s debt crisis was caused by two key developments. First, in the 1970s many low- and middle-income countries took out debt in foreign currency (dollars), borrowing from international banks. They did so because the international interest rate was relatively low and, encouraged by the World Bank and the International Monetary Fund, they believed this borrowing would enable them to reduce poverty, increase investment, and raise their growth rates.

Second, in 1979 the US Federal Reserve started increasing interest rates to unprecedented levels in response to high inflation in the US. The federal funds rate rose from around 5% in the mid-1970s to 15% at the beginning of 1980, reaching 16.4% in 1981.

Average spending on education in OECD countries was about 4.8% in the 1980s, according to World Bank data.

While US policymakers were motivated by the domestic effect of this rise, it had enormous international implications. Most of the international debt issued in the 1970s had interest rates linked to international rates, so when the largest economy in the world increased its own interest rate, these rates jumped alongside it. Figure 9 shows the spike in debt repayments that this caused for countries in low- and middle-income regions. The spike was particularly dramatic in Latin America, where debt repayments jumped from around 1% of GNI in the mid-1970s to over 5% in the early 1980s. For comparison, this was more than average spending on education in OECD countries.

The first clear indication of crisis was in August 1982, when Mexico became the first country to declare that it could not meet its debt repayment obligations. It was forced to devalue, with the exchange rate (the price of dollars in pesos) more than doubling. By the end of the year approximately 40 countries had fallen into arrears. But while they could not meet all their debt obligations, ongoing payments remained high enough to cause large current account and fiscal deficits, a situation that continued through the 1980s.

Figure 10 presents Mexico’s interest payments and fiscal deficit as shares of GDP, and the level of inflation. All three variables are very closely correlated, rising dramatically at the beginning of the 1980s. In 1982 inflation jumped to 59% as interest payments rose to 4.3% of GNI and the fiscal deficit reached 10.8% of GDP. Both inflation and interest payments reached their peaks in 1987, with inflation reaching 132% and interest payments 18.3% of GNI, while the fiscal deficit was 13.5%.

What does this mean for the government’s accounts? The primary fiscal balance is defined as what the fiscal balance would be excluding debt payments. So it is equal to government revenue minus government expenditure on goods and services (including salaries of public employees, public investment, and so on). Thus in 1982 with a fiscal deficit of 10.8% and interest payments of 4.3%, there was a primary deficit of \(10.8 \: – \: 4.3 = 6.5\%\). By 1987, after a great deal of fiscal tightening, the primary balance was actually in surplus, at \(18.3\% \: – \: 13.5 = 4.8\%\). It was the debt payments of 18.3% of GDP that pushed the overall fiscal balance negative.

The devaluation–inflation spiral was also severe, with the exchange rate continuing a rapid rise until 1988. From 1981 to 1990 prices had risen by a factor of 117 and the exchange rate by a factor of 115.

Some other countries fared even worse. Argentina (1989–1990), Bolivia (1984–1985), Brazil (1989–1990), and Nicaragua (1986–1991) all suffered hyperinflation episodes, lasting between four months and nearly five years, while many other countries experienced very high inflation for long periods.

The debt crisis was finally stabilized around 1990. In Figure 10 the decline in all three variables occurred after several years of failed debt negotiations culminated in the successful plan of Nicholas Brady, US Secretary of the Treasury. In this plan, debtor countries and creditor banks agreed to a substantial debt restructuring, amounting to an overall debt reduction of about 32% for 18 debtor countries.⁵ At the same time, governments, under pressure from creditor countries and international organizations like the IMF, privatized (sold) many public firms in order to raise money to pay off part of their stock of debt. This reduced the depth of restructuring required, meaning that it reduced the losses that creditors had to incur.

Escaping from hyperinflation: Adjustment and the nominal anchor

The restructuring of foreign debt was a necessary condition for cutting inflation. But it was not sufficient. First, cuts in spending and tax rises were needed in order to bring down the primary fiscal deficit (the fiscal deficit excluding debt repayments). (Mexico had already achieved a primary surplus by 1983.)

Second, governments needed to anchor expectations to a lower level of inflation. If people continue to expect 20% or 50% inflation per month, then it is extremely difficult to avoid writing contracts that fulfil this expectation. One way to do this is to implement a fixed exchange rate, where the government commits to exchange domestic currency for dollars at a fixed price. As discussed in Section 2, this can stabilize the prices of tradable goods via competition with imports, preventing firms from raising their prices. It will also break the depreciation–inflation spiral.

However, a new fixed exchange needs to be credible: the population must believe it is sustainable. If people do not believe the new fixed exchange rate is sustainable then they will sell domestic currency for dollars in anticipation of a devaluation. The government will lose reserves in the process, until the devaluation becomes inevitable, fulfilling the prediction and reigniting the devaluation–inflation spiral. For this reason, debt restructuring and the reduction in the fiscal deficit must make the new currency peg look sustainable, and interest rates must be maintained at a high enough level to maintain demand for the currency—saving in domestic currency (buying domestic currency bonds) has to become sufficiently attractive that people no longer want to save only in dollars.

One important risk for exchange rate-based programmes is that if the exchange rate is fixed but inflation does not come down quickly, then the rising price level implies an appreciating real exchange rate. As discussed in Section 4, this implies a decline in competitiveness and a rising current account deficit, causing the fixed exchange rate to become unsustainable. Thus a fixed exchange rate can be part of a stabilization programme, but is not sufficient on its own.

A new inflation target may also be implemented. But such a target tends not to be credible in a country with a history of high inflation if it is not also connected to a credible fixed exchange rate. A commitment to constrain the amount of base money that the government prints can also feature but, as discussed in Section 5, money printing is endogenous: it occurs automatically when nominal GDP grows. This means that inflation causes money printing as well as the other way around. So it too is unlikely to be credible in the absence of other complementary measures.

In addition to fiscal tightening and a nominal anchor to fix inflation expectations, a variety of other policies are sometimes implemented to help cut through the inflationary cycles, particularly policies to coordinate wage- and price-setting, such as the elimination of indexing of contracts.

The good news is that when all the other mechanisms have been interrupted, disinflation through recession (pushing unemployment above the supply-side equilibrium) may not be necessary. This is consistent with our original model: once expectations are brought down and anchored, the Phillips curve automatically shifts downwards. For this reason, effective stabilizations can lead to a rapid reactivation of the economy. In the ‘Find out more’ box below, we discuss the combination of policies that Brazil used to escape from hyperinflation. Once it had implemented the plan, the economy quickly returned to economic growth.