Causes of Hyperinflation: Explanations and Examples

Causes of Hyperinflation: Explanations and Examples

Hyperinflation is a phenomenon or situation that occurs when the prices of goods and services rise more than 50 percent per month. It is specifically characterized by a rapid and accelerating increase in nominal prices and the supply of currency in circulation. The situation has devastating impacts on the involved economy. These include erosion in the real value of the local currency, decline in economic activity and unemployment, poverty prevalence, social and political unrest, and even mass migration of people to other countries.

Understanding How Hyperinflation Happens: A Look Into the Causes and Specific Processes that Lead to a Sharp and Rapid Rise in the Price of Goods and Services

There are several notable examples of hyperinflation in history. These include the specific events in Venezuela and Zimbabwe, the hyperinflationary experiences of Germany and Hungary, and the economic crisis in Sri Lanka. Examining these examples would bring forth three main causes of hyperinflation. These are excessive money supply in circulation, demand-pull inflation, and government inefficiencies.

1. Excessive Money Supply

Central banks are responsible for controlling the supply of money in circulation. There are circumstances that compel a particular central bank to increase the money supply through printing. An economic recession or depression is an example. Introducing new money in circulation entices commercial banks to borrow money from the central bank while also encouraging them to increase their lending activities to businesses and consumers. This specific monetary policy stimulates business activities and consumer spending.

However, while increasing the money supply can help address economic downturns, a central bank should determine and adhere to the optimal and maximum level at which it could print and introduce new money in circulation. The increase in money supply should be in line with economic growth. A mismatch between the two means that there is an excessive money supply. This can lead to inflation and further cause hyperinflation.

Excess money supply can specifically result in hyperinflation when the amount of money in circulation significantly outpaces the available goods and services in an economy or the productive capacity of the economy. This creates an imbalance of supply and demand because more money is chasing the same or fewer products. High demand lures producers and sellers to raise their prices to maximize their profits.

The increase in prices further increases demand as consumers spend and acquire more in anticipation of probable price increases in the future. The result is continuous and accelerating instances of rising prices, diminishing purchasing power, and further devaluation of the local currency. Producers are left with no choice but to adjust their prices multiple times per day to keep up with the eroding value of the currency. A vicious cycle emerges from these interlocking reactions of producers and consumers.

Increasing the money supply in circulation does not inherently lead to inflation and hyperinflation as long as the central bank adheres to its predetermined limits. However, in certain cases, particularly when printing and introducing new money are not intended to revitalize a sluggish economy or when the government overlooks the productive capacity of the economy, the likelihood of hyperinflation becomes more pronounced

Some countries resort to printing more money to finance their wartime efforts. Consider Zimbabwe as an example. The country increased its money supply not only to stimulate its economy but also to finance its involvement in the Second Congo War. The German Hyperinflation of 1923 was rooted in its massive debt from World War I while Hungary experienced the same hyperinflation in 1946 due to its World War II debts.

2. Demand-Pull Inflation

There are several theories of inflation. Each also corresponds to a particular type of inflation. One of which is demand-pull inflation which occurs when there is an overall increase in demand for goods and services due to specific factors affecting demand or the presence of demand shifters. To be specific, if demand grows faster than supply and beyond the productive capacity of the economy, prices will increase. High aggregate demand also demonstrates that consumers are willing to pay more for the same goods and services.

Strong consumer spending or heightened purchasing power of the public is one of the causes of demand-pull inflation. This happens when consumers have more disposable income due to significant increases in wages and salaries or when they have easier access to credit. Either of these two increases their spending habits and overall consumption activities. The surge in consumer spending can put pressure on prices.

Increased government spending can also drive up prices. This happens when the government finances its expenditures through the expansion of the money supply or borrowing from the debt market. The result is that more money is injected into the economy while also increasing the demand for goods and services. Lowering interest rates can also boost demand and increase prices. This happens because lower interest rates stimulate business expansion activities and consumer spending due to the cheaper cost of borrowing.

Excess aggregate demand emerges when the combined effect of consumer spending, government spending, and business activities exceeds the productive capacity of the economy. The situation can drive up prices as producers struggle to meet the heightened demand and increased overall consumption activities. Limitations in the production capacity or availability of production inputs can constrain further the supply of goods and services.

Addressing high prices due to excess aggregate demand or demand-pull inflation requires implementing contractionary monetary and fiscal policies designed to slow down economic activities. These measures aim to reduce aggregate demand, restrain spending, and restore a balance between supply and demand in the economy. However, when left unchecked due to shortcomings and inefficiencies in governance, prolonged excess aggregate demand and supply-demand imbalance can trigger hyperinflation.

3. Government Inefficiencies

Hyperinflation is considered a rare occurrence for developed countries because it often results from excessive money supply and demand-pull inflation going hand-in-hand or if a particular country is severely exposed and embroiled in a global crisis that leaves it with no choice but to resort to printing and introducing new money in circulation as a last-ditch effort. Several instances of hyperinflation are often a product of government inefficiencies or shortcomings and inadequacies of relevant government officials.

The root cause of hyperinflation in Zimbabwe was mismanagement. Interventionist policies and underinvestment negated its growth potential in the 1990s and created a myriad of economic problems. Even its agricultural sector collapsed beginning in 2000 and resulted in food shortage and insecurity due to inapt land reform policies. The government under the Mugabe administration also overprinted the local currency to fuel its corrupt practices.

Venezuela also experienced hyperinflation due to governance problems. Corruption in the government, economic mismanagement, an undiversified nationalized economy heavily reliant on oil production, strong dependence on imports for basic commodities, and absence of central bank independence are the specific causes of hyperinflation in the country. These causes can be traced back further to the inefficiencies of the Venezuelan government.

It is interesting to note that Venezuela has the largest oil reserves in the world. Its reserves are even larger than the combined reserves of Iraq and Kuwait. However, despite this natural resource, the poverty rate in the country has been over 90 percent. This means that more than 90 percent of Venezuelans live below the poverty line. Hyperinflation is one of the reasons behind the prevalence of poverty but several economists also have a strong argument that both poverty and hyperinflation stem further from the shortcomings of the government.

The country suffered from a Dutch disease because the Chávez administration focused primarily on its oil industry and neglected its manufacturing and agriculture sectors. This made it vulnerable to oil price shocks. Nevertheless, when foreign currency reserves ran out due to declining revenues from oil exports, Venezuela had a problem importing food and consumer goods. This accelerated inflation and worsened hyperinflation.

Keeping inflation in check is one of the responsibilities of an effective and efficient government. Remember that the government has the greater role of ensuring economic growth through policies and programs. Hence, as illustrated in several examples, it is possible for a government to become the root cause of hyperinflation. Certain decisions and actions can set in motion a series of events that create an inflationary environment.