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Understanding Hyperinflation: Patterns, Dynamics, and Links to Budget and Money Growth, Study notes of Dynamics

The concept of hyperinflation, defining it as a rate of inflation above 1,000 percent per year. the relationship between inflation, money growth, and the budget deficit, as well as the dynamics of real money demand in response to inflation. The document also touches upon the role of expectations and the impact of shocks on high inflation economies.

What you will learn

  • How does inflation affect the budget and money growth?
  • How does real money demand respond to inflation?
  • What is the definition of hyperinflation?
  • What are the consequences of shocks to high inflation economies?
  • What is the role of expectations in high inflation economies?

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RUDIGER DORNBUSCH
Massachusetts Institute of Technology
FEDERICO STURZENEGGER
Massachusetts Institute of Technology
HOLGER WOLF
Massachusetts Institute of Technology
Extreme Inflation: Dynamics
and Stabilization
WAR AND REVOLUTION
were once the settings
in which extreme inflation
might
occur: France
in the period
of the assignats; Europe
in the 1920s;
Greece, Hungary,
and China
in the aftermath of World War
II.
I In the
1980s, the inflation net is cast wider. Israel had its high inflation
experience in the early 1980s. Eastern Europe, in its transition to a
market
economy, is currently having
its share: Poland and Yugoslavia
have already
had
double-digit monthly
inflation; Bulgaria
and the Soviet
Union may be next. In Latin
America
high
inflation
is the rule: Bolivia
in 1984-85; Argentina,
Brazil,
and
Peru are now experiencing
wild price
instability.
In many
of these cases, the fiscal
consequences
of a political
transition,
a terms of trade
shock, or a debt crisis can be offered as the
initiating disturbances.
Well over a thousand papers have been written about extreme
inflation, including early analyses by Costantino Bresciani-Turroni,
We are indebted to our discussants, members
of the panel, and to Eliana
Cardoso,
Phillip Cagan,
Daniel
Dantas,
Hans Genberg, Danny
Quah,
and Steve Webb for helpful
comments and suggestions.
Miguel
Cantillo contributed excellent research assistance.
Financial
support
was provided
by grants
from the National Science Foundation and
the Alfred
P. Sloan Foundation.
1. See Seligman (1921) for the experience prior to the First World War; Cagan
(1956),
Yeager(1981), Young (1925), Sargent (1982), Dornbusch and Fischer(1986), and Harberger
(1978, 1988) for later experiences.
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Download Understanding Hyperinflation: Patterns, Dynamics, and Links to Budget and Money Growth and more Study notes Dynamics in PDF only on Docsity!

RUDIGER DORNBUSCH

Massachusetts Institute of Technology

FEDERICO STURZENEGGER

Massachusetts Institute of Technology

HOLGER WOLF

Massachusetts Institute of Technology

Extreme Inflation: Dynamics

and Stabilization

WAR AND REVOLUTIONwere once the settings in which extreme inflation

mightoccur: Francein the periodof the assignats; Europein the 1920s;

Greece, Hungary,and Chinain the aftermathof WorldWarII.

I

In the

1980s, the inflation net is cast wider. Israel had its high inflation

experience in the early 1980s. Eastern Europe, in its transition to a

marketeconomy, is currentlyhaving its share:Polandand Yugoslavia

have alreadyhad double-digitmonthlyinflation;Bulgariaand the Soviet

Union may be next. In Latin Americahigh inflationis the rule: Bolivia

in 1984-85;Argentina,Brazil,and Peruare now experiencingwild price

instability.In many of these cases, the fiscal consequences of a political

transition,a terms of trade shock, or a debt crisis can be offered as the

initiatingdisturbances.

Well over a thousand papers have been written about extreme

inflation, including early analyses by Costantino Bresciani-Turroni,

We are indebtedto our discussants, members

of the panel,

and to

Eliana Cardoso,

PhillipCagan,

Daniel Dantas, Hans Genberg,Danny Quah,

and Steve Webbfor helpful

commentsand suggestions. Miguel Cantillocontributedexcellent research assistance.

Financialsupportwas providedby grants from the National Science Foundationand

the AlfredP. Sloan Foundation.

  1. See Seligman(1921)for the experiencepriorto the FirstWorldWar;Cagan(1956),

Yeager(1981),Young(1925),Sargent(1982),DornbuschandFischer(1986),andHarberger

(1978,1988)for laterexperiences.

I

2 Brookings Papers on

Economic Activity,

2:

FrankGraham,andPhillipCagan.

Furthermore,interestgrows as more

is learnedabout the systematicpatternsof high inflation,especially

for

countrieswhereinflationis bothchronicandextreme, thoughlower than

the extravagantlevels studiedby Cagan.The formalizationof concepts

such as credibility and reputationhas also increased interest in high

inflationexperiencesby providing

cleaneranalyticalmodels.3The polit-

ical economy literature,too, has contributedto the debateby explaining

how hyperinflationsstart

up, why their terminationis so difficult,and

what ultimatelystops them.

This paperexaminesthese issues and addressestwo questions:

What

do we know about the process of high inflation-its sources, catalysts,

and explosive behavior?Whatuseful prescriptionsare there for stabili-

zation?

Extreme Inflation

Highinflationmeansdifferentthingsto differentpeople. In Germany,

it means 3 percent or more per year; in Mexico, 20 percent per year; in

Brazil, 15 percent per month; and in Argentina, 6 percent per week.

WhileCagandefinedhyperinflationas an inflationrate of 50 percentper

month, or 12,875percentper year, our thresholdis a moremodest 1,

percent per year.4In particular,we take extreme inflationto be rates

above 15 to 20 percentper month, sustainedfor several months.

In either 1988 or 1989, 35 countriesexperiencedannualinflationrates

exceeding 20 percent. Of these countries, 9 experiencedannualinflation

above 100 percent, and only 5 had annual inflationrates above 1,

percent.5Clearly,extreme inflationis not a commonoccurrence.A first

task, therefore,is to isolatethose factorsthatexplainwhy mostcountries

do not cross the thresholdto extreme inflation.

StabilizingFactors

A majorshock to the budget,the terms of trade, or the exchange

rate

is an essential ingredientfor high inflation.An event such as a political

  1. Bresciani-Turroni(1937);Graham(1930);Cagan(1956).
  2. See, for example,BarroandGordon(1983),Bruno(1990),andKiguelandLiviatan

(1990b).

Cagan(1956).

  1. See IMF, International Financial Statistics.

4 Brookings Papers on Economic Activity, 2:

Table 1. Annual Rates of Inflation in Selected High Inflation Countries,

1975-

Percent

Most recent

Country

1975-80 1980-85 1986-89 12 monthsa

Argentina 193 323 588 14,

Bolivia 17 611 15 15

Brazil 51 149 610 6,

Israel 61 195 19 20

Mexico 21 61 81 27

Nicaragua 19 54 3,130 10,

Peru 50 102 693 2,

Poland 7 32 90 994

Yugoslavia 18 47 343 1,

Source: IMF, International Financial Statistics, 1990 Yearbook and October 1990 editions, except 1989 data for

Nicaragua, which was provided by the Nicaraguan authorities.

a. The average inflation rate over the most recent twelve months for which

data are available for each country

is

shown.

financialmarkets. But this same indexationmay prevent the economy

from effectively absorbingshocks to relative prices and may leave the

economy proneto hyperinflation.Whenindexingadjustmentsare infre-

quent, there is a long lag between shocks and theirimpacton wages. By

contrast, when indexation occurs monthly or more frequently, the

automaticfeedbackof disturbancesto wages andprices, andbackto the

exchange rate, amounts to a rapid, vicious cycle of rising prices. The

financialadaptationalready in place-the easy availabilityof interest-

bearingassets-facilitates the flightfrom money.

The second possible scenario arises when a country with moderate

inflation suffers a rapid, uncontrolled explosion in inflation due to a

shock to the budget or the external balance. In table 1, Mexico could

provideanexample.

In this situation,anoutburst

of inflation

will surprise

money-holdersand may

find the authorities unprepared

for the rapid

adjustmentsthat the private

sector makes.

Finally, an extreme inflationcan occur in a country where inflation

has been repressed and where deficit finance has built up a monetary

"overhang."

In this case,

there is not only

the ordinary

flow problem

of

a budget

deficitfinanced by money

creationbut also a stock problem

in

that the money supply

is already

too high

relative to nominal income

at

controlled prices. Once prices

are freed up,

inflation gets rapidly

under-

way. In the absence of strongstabilizingfactors, it can become extreme

RudigerDornbusch,Federico Sturzenegger,and Holger Wolf 5

very quickly.The fear of this type of explosive inflationled to pervasive

monetaryreform in Germanyand elsewhere in the 1940s.6 Poland, in

1989, is a more recent example. The Soviet Union and Bulgariamay

providethe next examples.

A country's starting point is important because it bears on the

dynamicsof highinflation.Countrieswith chronicinflationtend to have

a financialstructurethatis adaptedto inflation;capitalflight,the resulting

exchange rate collapse, and the consequent explosive inflationmay be

stretched out over time. By contrast, in countries that have little

experiencewithhighinflation,primitivefinancialstructures,andentirely

unindexedfiscal institutions,an inflationaryshock can set the house on

firein no time. Becausethe financialstructureis so unadaptedto inflation,

therewill typicallybe an initialphase in which real balancesrise rapidly

as a result of deficit finance. If no interest-bearingassets are available

anddollar-holdingis uncommon,little adjustmentto realbalancestakes

place initially.Later, as escalatinginflationbecomes apparent,

the flight

frommoney into foreignassets acceleratesdramatically.

Are All Hyperinflations Alike?

High inflationexperiences have many common, systematicfeatures

includingdemonetization,growingdeficits,andacceleratingfrequencies

of wage

and price adjustment. High

inflations also differ from one

another.For example, the great inflationsof the 1920swere considered

extreme aberrations,which could be remediedby a returnto the gold

standard. By contrast, the current inflationin some Latin American

countriesremainsendemic, and has no certaincure.

The recent LatinAmericanexperiencediffersfromthose of the 1920s

in three ways. First, the inflationsin Latin America, and also in Israel

priorto the 1985 stabilization,have lasted longer. They have extended

overa decadeormorethroughthe intermittentbutpersistentacceleration

of inflation.Second, currentinflationrates remainfar below those of,

for example, Germany in the second half of 1923, where inflation

averaged4,551 percentper month.Third,in recent times there has been

a stop-gopatternof inflation-temporary stabilizationsare followed by

majorblowups. The temporarystabilizationsinitially seem to prevent

  1. DornbuschandWolf(1990).

Rudiger Dornbusch, Federico Sturzenegger, and Holger Wolf 7

Figure 1. Adjustment to a Sustained Increase in Money Growth

Inflation

Actual

" rate of

inflation (IT)

~- __ Rate of

moneygrowth(,u)

, Expected

,' rate of

Time

threeissues: the expectationsmechanism,the assumptionsaboutmoney

growth, and the assumptionsabout the determinantsof inflation.Criti-

cism of the expectations mechanism,notablythe rationalexpectations

attack, has focused on the serial correlationof forecast errors in the

adjustmentprocess. An alternativemodelwouldemphasizefullyrational

expectations.9Whenperfectforesightis assumed, two differenceswith

the previous analysis emerge. First, the price level is allowed to jump.

Second, actualand anticipatedinflationare equal,

r = r*.

In this forward-lookingmodel of inflation,an increase

in the growth

rate of nominalmoney immediately

raises both the price

level and the

rate of inflation. Thus, real

balances instantly decline

to the level

appropriateto the highergrowthrate

of nominal money

and prices. Full

adjustmentto an increase

in money growth

occurs immediately;

there

areno protracteddynamics.Anticipated,future

money growth

stillleads

  1. Sidrauski(1967),SargentandWallace(1973a),Black(1974),Sargent(1977),Salemi

andSargent(1979),andFlood andGarber (1980).

8 Brookings Papers on Economic Activity, 2:

to ajumpin the currentpricelevel, but now inflationrises graduallyuntil

money growthincreases.

A New Approach

We departfromthe Caganmodel and the relatedliteraturein several

ways. Although the rationalexpectations formulationis theoretically

attractive,it does not reflectthe facts. Increasedmoney growthinitially

tends to raise real balances; only later does inflation build up and

overshoot for a while.

Figure 2 shows the exampleof Peruafter 1985.

In our model, we emphasizethat prices are set ratherthan determined

by an invisible, money market-clearinghand. The price setting, in turn,

is dependenton the prevailinginflationaryregime.

A second difference in our model concerns financialmarkets. The

assumptionthat money is

the only asset

is patently misleading.Some

countries do have domestic financialmarkets. When they

do not,

the

dollar usually plays a conspicuous role as an alternative asset. The

availabilityof alternativeassets influencesthe dynamicsof inflation.

The third difference in our model concerns the process of money

growth,and the motivationa governmentmay have to create or accom-

modateinflation.As a theoryof inflationaryfinance,the Cagan-Chicago

traditionhas emphasized that governmentsuse inflationas a rational

means of raising revenue for deficit finance. This approachhas led to

models of optimalinflation,which balancerevenue considerationsand

various constraints or costs associated with inflationaryfinance.1'In

their simplestform, such models predictthat a governmentmaximizes

seigniorageby choosing the rate of inflationat which the elasticity

of

real money demandwith respect to anticipatedinflationequals unity,

or

the peak of the Laffercurve.

MartinBailey has questionedthe use of the seigniorageapproachas

a positivetheoryof extremeinflation.

12 Because taxationis analternative

to money creationandbecause the marginalcost of taxationis moderate

relative to the welfare costs of extreme inflation,high money growth

(and therefore high inflation)strategies are not optimal. In our view,

  1. FriedmanandSchwartz(1982)set out this pattern.
  2. See Cagan(1956),Bailey(1956),Friedman(1971),

Barro (1972a,1983),

andBruno

(1990).

  1. Bailey(1956).

10 Brookings Papers on Economic Activity, 2:

economy approach that analyzes the difficulty in bringing about a

balancedbudgetand illustrateshow extreme inflationis a negative sum

game. With the seigniorageapproachone would expect stable, steady-

state inflation.The politicaleconomy approach, however, may explain

why inflationexplodes, only to be stabilized later, and why rational

governmentsmake U-turnsin economic policy. 13

In conclusion,the view thatinflationis abouttoo muchmoneychasing

too few goods is not totally wrong, but

it fails to give a useful idea of

whatin fact happens.First, the influenceof inflationon the budgetdeficit

is a critical element in the inflation. Second, the inflationprocess is

significantlyaffected by the adaptationof financial institutions. The

emergenceof new financialproductssuch as overnight,interest-bearing

depositsaffects

the government'sability

to collect seigniorage

andhence

shapes

the inflationprocess. Third,

the inflationprocess

is drivenin part

by the pricingrules of economic agentsin the goods andfactor markets.

A shorteningof adjustmentintervalsbecomes a factorin inflationthat is

independentof aggregatedemand. Finally, as we discuss below, the

external sector can play a critical role in the inflationprocess because

real exchange rates are not constant. Indeed, the assumptionof pur-

chasingpower parityis empiricallyunwarranted.As a result, shocks to

the real exchange rate can precipitatehighinflation.

Inflation, Money Growth, and the Budget

In this section we discuss the linksbetween the growthrateof nominal

money, the budget deficit, and the rate of inflation.We emphasize two

factors. First, money growth is endogenous;money passively finances

budgetdeficits. Second, the realbudgetdeficitis not exogenous because

inflationaffects the real level of revenues.

The inflationaryequilibriumis described by monetary equilibrium

and the link between money creationand the budgetdeficit: 14

(4) MIP = OY,

  1. For explorationsin this direction, see Alesina and Drazen (1990), Cukierman,

Edwards,and Tabellini(1989), Orphanides(1990);and, in anothercontext, Fernandez

andRodrik(1990).

  1. We note thatthe budgetdeficitincludesthe "quasi-fiscal"deficitthatarisesfrom

the credit and foreignexchange operationsof the centralbank. Also, money issued by

state and local governments,by corporations,andeven by privateentrepreneursis often

significant.The seigniorage shared by the banking system and other money issues

necessarilyincreasesthe inflationrate associated

with any given budgetdeficit.

Rudiger Dornbusch, Federico Sturzenegger, and Holger Wolf 11

where 0 is the budgetdeficitas a shareof realGDP, Y.Supposenow that

velocity is a linearfunctionof inflation,V = cx+ 131r.Imposingmonetary

equilibriumand the steady-stateconditionthat velocity be constant (so

that inflationequals nominalmoney growth), we obtain an expression

for steady-stateinflation:

(5) rr= cX0/(1 - (0).

It is apparentfrom the functionalform that inflationis an increasing,

nonlinearfunctionof the budgetdeficit. 15

The interactionbetween the budget and prices-both their level and

theirrate of change-may go in one of two directions. Eitherfiscal drag

and the reduction of

the real value of debts dominate,

in which case

inflation reduces deficits. Or, inflation worsens deficits because of

collection lags that reduce real revenues. During

the hyperinflation

of

the 1920s,it was generallyacknowledgedthat inflationreducedthe real

revenue of governments and that, by implication, deficits would be

smallerif inflationcould be reduced. 16 The adverse response of deficits

to inflationis now known as the Tanzi effect. 17

We identifyfive channelsthroughwhich inflationaffects the deficit.

-Lags in collection in a less thanfully indexedtax system lead to the

erosion of real revenues, not only automatically, but also from the

additionalerosion thatresults frommanipulateddelays in payment.

-Tax compliance deteriorates, and so the tax yield of a given tax

structuredeclines. This effect is a by-productof inflationand public

demoralization;it is not a mechanicaleffect.

-The real value of payments on long-term debt, fixed in nominal

terms, declines. This mechanism was importantin the 1920s but is

marginalin the experiences of the 1980s.

-With increased inflation and unchanged indexation intervals for

wages, the average real public sector wage between adjustmentdates

declines.

-Nominal interest payments on short-termdomestic debt come to

  1. An alternativespecificationis the Caganform which yields 0 = w-reX,.

Because

the right-handside has the Laffercurveproperty,thereare two equilibriaunlessthe deficit

is too largeto be financedby moneycreationat constantinflation.See Evansand Yarrow

(1981),Cardoso(forthcoming),Kiguel(1989),andespeciallyBrunoandFischer (1990)on

the implicationsof the Laffercurve.

  1. See Bresciani-Turroni(1937),Graham(1930),andLeagueof Nations (1946).
  2. See Olivera(1967),Dutton(1971),andTanzi(1977, 1978).

Rudiger Dornbusch, Federico Sturzenegger, and Holger Wolf 13

Table2. Peru:PublicFinanceData, Expressed

as Percentof GDP,

1985-

Percent

1985 1986 1987 1988 1989

Tax collection 13 11 9 7 4

Publicenterpriserevenue 26 18 14 12 10

Budgetdeficit 6 10 12 14 11

Source: Unpublished World Bank data.

tax revenue collected today decays exponentially

with a mean lag

of a.

In that case, the deficitratio

is

(6) 0

g - v/(1 + C T),

where g denotes real governmentspendingas a fractionof GDP, and a

can assume a value between zero and infinity(the closer to zero, the

more currentthe collection). Equation 6 shows that the more current

the tax collection, the higheris the real revenue. It also shows that the

higherthe rateof inflation,the lowerthe realyieldof a giventax structure.

For a given collection lag, an extreme increase in the rate of inflation

will basicallywipe out revenue.

Given the velocity equationand the noninflationarydeficit (g

v),

the longerthe averagelag in tax collection, the higheris the steady-state

rateof inflation.Moreover,giventhe nonlinearities,

even small increases

in the deficit can producelargechanges

in inflation.

Equation 6 focuses on the case of a constant-inflation history. Yet,

when inflationhas been rising, the currentreal value of tax collection

will depend on the history of inflationacceleration. The sharper

the

accelerationbecomes, relative to the lag

in tax collection,

the further

realrevenuefalls comparedto the constant-inflation-rateformula.In the

simulations below,

this complicationemerges as

a critical destabilizing

element.

To summarize,the endogeneityof the money stock is an important

featureof hyperinflation.In economieswheremoneycreationis the only

means of deficit finance, the budget deficit becomes a principaldeter-

minant of money growth.

In addition,

faster money growth

leads to

  1. It is apparentfromthe nonlinearitiesin equations 2 and 3 thatequilibrium

need not

be unique.

14 BrookingsPapers on Economic Activity, 2:

higherinflationwhich, in turn,determinesthe deficit.The interactionis

highly nonlinear,which helps explain the sharp escalation of inflation

that can occur once a certainthresholdis crossed. A simulationmodel

presented below displays that characteristicin a setting where pricing

decisionsandthe velocity responseto inflationareoptimized.It becomes

evident that extremeinflationemergesin those cases where the govern-

ment has lost controlover money growthbecause the deficitis financed

automatically.To make things worse, the deficit itself responds posi-

tively to the rate of inflation.

Pricing

The interactionbetween inflationand the frequency

of price adjust-

ment represents the second building block of inflationarydynamics.

Economic agents incur costs in adjustingprices. Thus, the optimal

frequencyfor adjustingprices depends on these "menu costs" and the

trendrateof inflation.Thefrequencyof adjustmentbecomes endogenous

in a high inflation economy, with the shortening of the adjustment

intervalacceleratinginflationwhich, in turn,leadsto a furthershortening

of adjustmentintervals.Withoutmonetaryaccommodationthis process

could not go far. But, as already noted, money growth is endogenous

through budget deficit finance. Thus, the shortening of adjustment

intervals becomes another endogenous driving force in the inflation

process.

Strategic interactionamong price setters is an importantfeature of

the growing literatureon optimal price adjustmentin stochastic infla-

tionaryeconomies.20We are interestedin the fact that the frequencyof

adjustmentaccelerateswith inflation.We also wantto learnmoreabout

the thresholdsof inflationat which the shorteningof pricingintervals

occurs.

The Firm and the Industry

Individualfirms face the microeconomic decision of how often to

change prices. Considera loss functionfor an individualfirmin which

  1. See Barro (1972b), Mussa (1981a), Sheshinski and Weiss (1983), Rotemberg (1983),

Cecchetti (1986), Benabou (1988), and Diamond (1990) for models of optimal pricing rules.

16 BrookingsPapers on Economic Activity,

2:

Relative Prices

Whenaggregateinflationis moderate,firmandindustryprices change

infrequently,perhapsonce a year.

Withhigherinflation,priceadjustment

may be semiannual, quarterly, or ultimately monthly, weekly, even

daily. In the limit, indexationto the dollarbecomes the only way a firm

can judge its relative price position given the prohibitive costs of

ascertainingthe currentprice level. Because the pricing by firms and

industriestranslatesinto an aggregaterate of inflation,theirprices have

spillovereffects: on the pricingof labor,includingofficial

minimumwage

and public sector wage setting; on the adjustmentof prices for public

services; and, importantly,

on the exchangerate.

Public sector price adjustmentshouldfollow the same logic as firms'

pricingdecisions, though it rarely does. The data in table 2 give a fair

idea of the fiscal effects of misaligned relative prices in an extreme

inflationcountry, Peru. As inflationaccelerates, both tax revenue and

publicenterpriserevenue decline as a shareof GNP.

It is less evident that menu costs are importantfor exchange rate

adjustments.Therefore,governmentsmightchoose to move exchange

rates almost continuouslyin orderto maintaintheirreal value. Indeed,

several countries, for example Brazil in the 1970s, have done just that.

But, as with public sector prices, exchange rates are a seemingly

attractivemeans of dampeninginflation

in the shortrun, and so they are

abusedfor

that end.

Evidence on Pricing

The generalpattern

of price

adjustmentis shownbelow. We note that

with increasinginflationall price setting speeds up and slower-moving

prices would catch up.

Speed of adjustment

Frequent

Intermediate Slow

Exchangerate Publicprices Wages

WPI CPI

The increasingsynchronizationthat emerges during

a shift to high

inflationcan be seen from the cross correlations

of exchange

rates and

prices. In countries

withhistoriesof persistentinflation,

the linkbetween

Rudiger Dornbusch, Federico Sturzenegger, and Holger Wolf 17

Table 3. Correlation between Prices and the Current Exchange Rate,

Selected Inflationary Episodes

Consumerprices

Average

Ahead two Lagged inflation

Country

and time period

months Current two months rate (percent)

Bolivia

1980:1-1983:1 0.233 0.531 0.472 5.41a

1983:2-1986:2 0.870 0.

Israel

1980:1-1982:9 0.611 0.

6.20a

1982:10-1985:7 0.

0.999 0.839 11.

Argentina

1985:7-1989:1 0.878 0.993 0.866 10.

1989:1-1989:7 0.235 0.968 0.003 49.

Brazil

1960:1-1969:12 0.945 0.988 0.

1980:1-1985:2 0.

0.993 0.787 3.

1985:3-1990:

0.709 0.987 0.626 16.88a

Source: Authors'own calculationsand InternationalFinancialStatistics. The data are monthly,and prices are

the consumerpriceindexesfor each country.

a. The inflationrateis the averageover the periodsindicated,except wheredatawere available:the firstinflation

figurefor Bolivia is averagefrom May 1980 to January1983;the first figurefor Israel is from October 1980 to

September1982;and the last figurefor Brazilis fromMarch 1985 to April 1990.

the dollarand domestic prices is well developed. An increase in the rate

of inflationresults in a shorteningof the adjustmentlags, mirroredby a

tendency for the correlationsto become centered on the contempora-

neous value. By contrast,in countrieswithouta historyof exchangerate

indexation,acceleratinginflationleads to the developmentof indexation

mechanisms,resultingin a uniformincreasein correlationsacross leads

andlags.

In table 3,

we divide inflationaryepisodes

into several parts and

present the correlationsbetween the currentexchange rate and both

currentprices and prices with leads and lags. The data broadlysupport

our hypothesis.

For Braziland Argentina,

it is interesting

to note that as

inflationincreases over time the correlationwith leads and lags falls off

sharply.

Inflation

and Price Adjustment

An importantaspectof pricinginvolves the basison whichadjustments

are made. At moderaterates of inflation,adjustmentwill be based on

past inflation.As inflationrises, the adjustmentintervalshrinks,though

Rudiger Dornbusch, Federico Sturzenegger, and Holger Wolf 19

usually based on formal or informal backward-looking indexation. This

practice implies that when inflation accelerates, and the indexation

interval does not decline nor are base wages raised, the average real

wage declines. Reuben Kessel and Armen Alchian refer to this phenom-

enon as the wage-lag hypothesis and contest its existence.24 At issue is

whether the real wage does decline in periods of accelerating inflation.

And, if so, should the decline be attributed to a fall in the equilibrium

real wage of a competitive labor market, or to features of wage setting

that show insufficient flexibility in the face of accelerating, and perhaps

incompletely anticipated, inflation?

The real minimum wage in Brazil, as shown in figure 3, provides an

example.25 The nominal minimum wage is officially set on the basis of

accumulated price increases, and applies to a significant part of the

Brazilian labor market, including household workers and the informal

sector. At the end of the 1970s, with annual inflation rates of 40-

percent, nominal wages were adjusted only once a year. In 1979, the

adjustment became semiannual (in May and November) even though

the rate of inflation had risen to more than 200 percent. By 1986, the

frequency of minimum wage adjustments became discretionary depend-

ing on which stabilization program, which invariably included wage-

price controls, was in effect. From 1989 to the present, adjustments have

been monthly or, at most, bimonthly. They continue to be backward-

looking, in that the adjustments equal the inflation that has accumulated

since the last readjustment.

In every high inflation, there is pressure to adjust wages more

frequently and more fully. The following quote from the German expe-

rience of 1919-24 characterizes the issues:

Therewas no lack of attemptsto make the index numberthe sole determining

factor in wage negotiations. The battle for the sliding wage scale began in

Germany in the middle of 1919, and never really quite stopped until the

introductionof the system of gold wages. In the continuedstruggleto maintain

the level of realwages, the workersshoweda comprehensiblepreferencefor the

system of complete automatic adaptation of wages.... The employers almost

unanimouslyrefused the sliding scale, which they feared would lead to rapid

andcompletedisaster,both monetaryand economic....

  1. Kessel andAlchian(1960).
    1. The same patterncan be shown for wages in manufacturing.Accordinglythe

propertiesarenot peculiarto administeredwages. Pazos(1972)commentedon this seesaw

patternof realwages.

  1. Stizler(1924,p. 648).

20 Brookings Papers on Economic Activity,

2:

Figure 3. Brazil: Real Minimum Wage, 1977-

Real minimum wage (index,

January 1978 - 100)

130

120-

110 1

100

90

80-

70-

60-

50-

,. , , , , , , ,

1978 1980

1982 1984 1986 1988 1990

Year

Source: BancoCentraldo

BrasilBoletim Mensual and Conjuntura

Economica, variousissues.

In the extreme stages of the hyperinflation,indexation

was complete.

The only issue was whetherthe index

numberof Monday'sprices,

which

was publishedon Wednesday, could

still be useful for wage payments

madelater in the week.

Why does the labor market accept

so much variability

in the real

wage? Since much of

the variability

is anticipated,

and since more

frequent adjustmentsof money wages (as

opposed to more frequent

payments) do not

have a resource cost beyond

checking the

latest

inflation figure,

there is a puzzle.

With a given

frequency of wage

adjustments,higher

inflation automatically

depressesaveragereal wages.

As such, firmsmightbe tempted

to resist a shortening

of the indexation

interval. But why should

workers not insist on higher

base wages,

and

what stops firmsfromcompeting

with moreeffective wage plans?

While

  1. See Stizler(1924,p. 655).