Explosive Hyperinflation, Inflation-Tax Laffer Curve, and Modeling the Use of Money

Abstract

This paper analyzes the existence of an inflation tax Laffer curve (ITLC) in the context of two standard optimizing monetary models: a cash-in-advance model and a money in the utility function model. Agents' preferences are characterized in the two models by a constant relative risk aversion utility function. Explosive hyperinflation rules out the presence of an ITLC. In the context of a cash-in-advance economy, this paper shows that explosive hyperinflation is feasible and thus an ITLC is ruled out whenever the relative risk aversion parameter is greater than one. In the context of an optimizing model with money in the utility function, this paper firstly shows that an ITLC is ruled out. Moreover, it is shown that explosive hyperinflations are more likely when the transactions role of money is more important. However, hyperinflationary paths are not feasible in this context unless certain restrictions are imposed.

Modelling the Transaction Role of Money and the Essentiality of Money in an Explosive Hyperinflation Context

“…These limitations relate to sufficient money essentiality in the sense of SCHEINKMAN [1980]. Thereby this paper departs from GUTIERREZ AND VAZQUEZ [2004] and contributes to the understanding of failure of the Cagan inflationary finance models with perfect foresight. Secondly, it shows that the inclusion of the goods market equilibrium condition calls into question the validity of explosive hyperinflationary paths as equilibrium paths in the cash-in-advance model.…”

“…2 Therefore, recent analytical studies abandon Cagan's money demand function and consider optimizing monetary models. GUTIERREZ AND VAZQUEZ [2004], henceforth called GV, follow this approach with the aim of characterizing agents' preferences compatibly with explosive hyperinflation "where an economy is just in a high-inflation scenario, there is perfect foresight, money demand depends only on inflation, and money is essential" (p. 314).…”

The Monetary Analysis of Hyperinflation and the Appropriate Specification of the Demand for Money

“…Money is essential for the transactions. It is also worth noticing that, as pointed out by Gutierrez and Vazquez (2004, p. 312), money becomes more essential for purchasing goods during hyperinflation than during stable periods ‘because extreme inflation dramatically decreases credit transactions, and in general, the use of long‐term contracts’. Economic agents avoid long‐term contracts during hyperinflation because of the rapid depreciation of money.…”

“…We extend the basic setup of Gutierrez and Vazquez (2004) first, by considering general utility functions and second, by taking into account the goods market equilibrium condition. The optimizing monetary model is a continuous‐time model (assumption [A1]) where the economy consists of a large number of identical, infinitely lived, forward looking households endowed with perfect foresight (assumption [A2]).…”

“…The aim is to examine the requirements for the appropriate specification of the demand for money for the study of hyperinflation 3 . Building on the Gutierrez and Vazquez (2004) model, the paper studies two new monetary optimizing setups by applying general household's preferences while drawing systematically on actual hyperinflation experiences to complete the argumentation. In studying two different monetary settings to look for the robustness of the results, this paper demonstrates that, in both frameworks, monetary hyperinflation can arise consistently with perfect foresight under the similar condition.…”