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Bernholz, Monetary Regimes and Inflation, 6 [ClearOnMoney]
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Commentary

Bernholz, Monetary Regimes and Inflation, 6

8 Sep 2010 by Jim Fickett.

Chapter 6 introduces a simple mathematical model of inflation. The model suggests that in any context where inflation may arise it is important to watch the relative demand for the currency which is possibly inflating and any alternate, more solid currencies.

Chapter 6 is titled, “Currency competition, inflation, Gresham's law and exchange rate”. This chapter presents a simple mathematical model. Bernholz introduces a short list of key variables:

  • Money supply
  • Budget deficit
  • Exchange rate
  • Real demand for money (and if there are two types of money, e.g. the inflating paper currency and gold, demand for each type)
  • Real national income
  • Foreign nominal interest rate

With a few intuitively plausible equations he shows that his model exhibits many of the properties of historical inflations. For me, most of this did not add any new insights about how inflation works.

Explicitly incorporating different levels of demand for two kinds of money, however, was interesting. The demand for a new paper money can often be strong at first, through patriotism, special laws, relief from a bad prior regime, etc. And demand for the new money may fall gradually, or erratically, in part depending on legal restrictions. Bernholz shows that the relative level of demand for each kind of money can drastically alter outcomes. None of this is too surprising, but it does point up the importance of watching carefully how people feel about an inflating currency (right now Treasuries and gold are apparently similarly desirable).

Previous chapter reviews

Bernholz, Monetary Regimes and Inflation, 1: This post is a review of the first chapter of Monetary Regimes and Inflation, by Peter Bernholz. Already in this first, introductory chapter it is clear that all material will be treated in an insightful manner and illustrated from the author's broad knowledge of history.

Bernholz, Monetary Regimes and Inflation, 2: The main message of Chapter 2 is that governments have a natural tendency to deficit spending and inflation, and inflation is only absent if somehow the hands of the leaders are bound. This happens most dependably with a gold standard, but an independent central bank, or a fixed exchange rate with another stable currency, can also help.

Bernholz, Monetary Regimes and Inflation, 3: Inflation can occur even under a precious metal standard, either by influx of more of the metal from abroad or, more usually, by debasement of the currency. Debasement has been accompanied, for thousands of years, by price and exchange controls. These never prevent inflation and hoarding, but do cause market disruption and considerable suffering. A precious metal standard can be introduced, and maintained for long periods, if it is in the economic interest of a government. The merchant city-states of Venice and Florence provide an example.

Bernholz, Monetary Regimes and Inflation, 4: There are several features typical of most moderate inflations. For example (1) the money supply typically rises earlier and faster then the price of better money, which rises earlier and faster than the prices of goods and services. And (2) because the money supply rises before unit values decrease, an economic stimulus is often an early effect.

Bernholz, Monetary Regimes and Inflation, 5: Hyperinflations are caused by excessive budget deficits – there is no other conclusion possible in light of the historical record. A fundamental feature of hyperinflations is that other, good currencies are overvalued, relative to prices, and the real value of all money in circulation goes almost to zero, compared to its value before the inflation. This means much of commerce is based on barter and, though pushed underground by extreme penalties, the use of foreign currencies or precious metals. There are ways, if one is prepared, to survive even hyperinflations.

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