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VOL. 9, NO. 6 • JUNE 2014­­


Inflation Is Not Always and
Everywhere a Monetary Phenomenon
by Antonella Tutino and Carlos E.J.M. Zarazaga

Fiscal policy is as
significant as, and
sometimes more
important than,
monetary policy in
determining the price
level and, therefore,
the dynamics of


he United States should be
experiencing abnormally high
inflation—at least that’s what
the quantity theory of money
says should be occurring, given the large
amounts of money the Federal Reserve
has put into the nation’s financial system
during its series of “quantitative easing”
programs following the Lehman Brothers
collapse almost six years ago.
Quantitative easing helped expand
the money base at an average annual rate
of 32.3 percent from November 2008 to
September 2012 (Chart 1).
According to the quantity theory of
money, the annual inflation rate also
should have been around 30 percent. Yet
the corresponding average annualized
inflation rate over that same period (also
shown in Chart 1), as measured by the
personal consumption expenditures price
index, not only didn’t rise, but showed
signs of declining.
There are also historical examples of
the opposite situation, in which the inflation rate was several times higher than the
money supply growth rate. The German
hyperinflation of 1921–23 is one such
During that episode, prices on average
quadrupled each month over a 16-month
period,1 but the money supply grew considerably less than that (Chart 2).

Scientists typically welcome extreme
cases as a natural magnifying lens that
may expose previously unnoticed flaws
in existing theories. In that regard, the
German hyperinflation seems to validate
the hints from the more recent U.S. experience that something is wrong with Nobel
laureate Milton Friedman’s famous observation that inflation is “always and everywhere a monetary phenomenon.”2

Fiscal Theory of Price Level
The fiscal theory of the price level,
pioneered by, among others, Christopher
Sims, the cowinner of the 2011 Nobel
Memorial Prize in economics, holds
that the conventional monetarist interpretation of inflation misses the mark.
Instead, fiscal policy is as significant as,
and sometimes more important than,
monetary policy in determining the
price level and, therefore, the dynamics
of inflation. For example, the end of the
interwar German hyperinflation coincided with the introduction of a bold fiscal measure—a new currency backed by
real estate.
The fiscal theory of the price level further implies that primary surpluses—that
is, the value of government surpluses
before debt-interest payments—are also
a key determinant of the price level and
thus of inflation.

Economic Letter


Rapid Money Growth Since 2008 Hasn’t Yielded Higher Inflation

Percentage change, year to year


The fiscal theory


of the price level


further implies that




primary surpluses—


that is, the value of


government surpluses
before debt-interest
payments—are also a


2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

NOTE: Shaded bars indicate recessions.
SOURCES: Federal Reserve Bank of St. Louis; Bureau of Economic Analysis; NBER; Haver Analytics.

key determinant of the



price level and thus of

Money base growth

Inflation Consistently Above Money Growth
During 1921–23 German Hyperinflation

Inflation/money growth










NOTE: The inflation/money growth ratio results from dividing the monthly inflation rate plus one by the monthly money base
growth rate plus one.
SOURCE: The Economics of Inflation, by Costantino Bresciani-Turroni, Appendix of Tables, Table III and Table V,
Northampton, England: Augustus Kelley Publishers, 1937.

Inflation as a Fiscal Phenomenon
As a first step to understanding why
excessive money growth may not drive
speculative hyperinflation, consider the
motivation for households and businesses
to hold money. Why would they stay with
cash when they could instead hold bonds
and securities that, unlike money, pay
One reason is that money facilitates
transactions in ways that alternative means
of payment cannot. If households carried
less money, more output (or effort) would


be needed to acquire goods and services,
leaving less output available for consumption. This is why households and firms
avoid carrying around too little money
relative to consumption.
Conversely, there are reasons households and firms will not want to hold too
much money. First, there is opportunity
cost—that is, the earnings that are forgone
by holding cash instead of interest-bearing
securities. Second, inflation may induce
households to minimize money holdings
because rising prices reduce purchasing

Economic Letter • Federal Reserve Bank of Dallas • June 2014

Economic Letter
power and, therefore, the relative advantage of cash as a means of payment.3
Finally, households and businesses
are assumed to be intelligent and forwardlooking. Seeking to maximize their welfare,
they take into consideration these opposing forces when deciding how much to
consume in any given period and how
much money to carry from one period to
the next.
In equilibrium, the nominal interest
rate and prices adjust in each period to
guarantee that the demand for money
equals the money supply, and that the
desired level of consumption equals output minus the associated transaction costs.
That is, the optimizing behavior of households and businesses along with market
prices jointly determine consumption,
nominal money holdings and, therefore,
inflation and real money balances.

Speculative Hyperinflation
An interesting aspect of economic
models with these features is that they give
rise to hyperinflation quite easily, even if
money supply is kept constant.4 The reason:
Nothing in the internal logic of these models anchors the evolution of inflation. As a
result, the dynamics of inflation are entirely
determined by household expectations.
If they anticipate the inflation rate to
fluctuate around zero, this is exactly what
will happen, seemingly validating the predictions of the monetarist tradition when
the money supply growth rate is zero as
By the same token, if households
anticipate ever-rising inflation, they will
try to get rid of their money balances and
exchange them for goods. The resulting
increase in the demand for goods accelerates inflation even further, which in turn
gives households further incentive to
reduce money holdings in exchange for
whatever goods they can buy as the value
of money rapidly declines. This self-fulfilling expectation feeds into itself, driving real
(inflation-adjusted) money balances all the
way down to zero.
This hyperinflationary process cannot
be categorized as “monetary” in the usual
sense, because that would have required
an equally explosive expansion of money
supply, which was kept constant. Although
not initially obvious, hyperinflation is fiscal

in nature because it can only happen if the
fiscal authority—the central government—
remains on the sidelines.
An active stance could have been
accomplished by the fiscal authority committing to redeem the stock of money for
a certain minimum amount of goods and
services—setting a level at which the government will retire the money stock from
It follows that self-fulfilling, speculative hyperinflation can only happen in
economies in which the fiscal authority is
not in position to make such a commitment. That could be the case, for example,
if inflation rises faster than the real value
of tax revenue. The amount of goods the
government could offer in exchange for the
money stock keeps shrinking; the money
stock is implicitly backed by fewer and
fewer goods.
German hyperinflation ended when
an active fiscal policy replaced a passive
one and guaranteed that the government
would always be in position to collect a
positive amount of revenue, independently
of the inflation rate.
To mimic the historical hyperinflation
in Germany, a model is constructed that
assumes a tax policy in which the real revenues collected by government decline as
the price level rises.5 Real money balances
also fall as the price level rises because the
money supply is kept constant throughout
the analysis to make clear the nonmon-



etary nature of speculative hyperinflation.
The results of the simulation in terms
of inflation are shown in Chart 3. The solid
line shows the level of the constant money
supply. The dotted line, showing inflation
over time, is reminiscent of its trajectory
during the German hyperinflation depicted in Chart 2.6
The inflation path in Chart 3 suggests
that speculative hyperinflation, like the
German episode, won’t occur if the fiscal
authority stands ready to do something to
stop it. If the fiscal authority commits to
keeping prices below a given upper bound,
it could successfully convince the private
sector that runaway inflation won’t occur.
Such a commitment implies that the government can raise the required revenue
through taxes or the sale of state-owned
If households and business believe that
such a fiscal policy will indeed be implemented if necessary, they will never expect
inflation to spiral out of control. Thus,
fiscal policy, not monetary policy, is ultimately responsible for the resulting price
The end of German hyperinflation is
evidence this insight from the fiscal theory
of the price level is more than just theoretical speculation. The particular fiscal measure that ended the German hyperinflation
was the introduction on Nov. 15, 1923, of
the Rentenmark, a currency backed by
real estate revenues. The government’s

Inflation Persistently Above Money Growth in a Simulation

Gross growth rate

Gross inflation rate


Gross money growth rate













Number of years
NOTE: The gross inflation (money growth) rate is one plus the inflation (money growth) rate.
SOURCE: Authors’ calculations.

Economic Letter • Federal Reserve Bank of Dallas • June 2014


Economic Letter

ability to raise revenues from the real
estate market, by their very nature indexed
to inflation, successfully broke the link
between mutually reinforcing lower fiscal
revenues—implying higher fiscal deficits—
and rising price levels.
This fiscal policy regime change
successfully restored confidence in the
German currency and almost immediately
brought inflation down to normal levels by
international standards.8

Fiscal Policy and Inflation
The fiscal theory of the price level
argues that what’s true about hyperinflation is valid more generally: Fiscal policy
can prevent inflation from rising or falling
too much by backing all outstanding nominal government liabilities—interest bearing or not—with a stable level of expected
future primary government surpluses. By
formally incorporating fiscal policy in the
analysis of price-level dynamics, the fiscal
theory of the price level is better equipped
than the conventional monetarist approach to explain why the recent large
expansion of the money supply in the U.S.
has not caused higher inflation.
The theory implies that the quantitative
easing programs, which created money to
purchase mortgage-backed securities from
the public, preserved price stability because
that money is backed by the returns from
real estate investments. Similarly, Germany
restored price stability after its interwar
hyperinflation with its real-estate-backed
Likewise, any money created to purchase government debt from the public
at market prices is backed by the same


primary surpluses that the public already
expected would service that debt. As long
as the expected primary surpluses backing existing government liabilities haven’t
changed, there is no reason for the price
level to change either.9
Aspects of the U.S. tax code provide
further insight into the logic of the fiscal
theory of the price level. For example,
capital gains taxes cover all the nominal
increase in asset value, even if that increase
is entirely induced by inflation. As a result,
a surge in inflation leaves the government
with more, not less, fiscal revenue in real
terms from this particular source of taxation and, therefore, in better position to
redeem the currency for some minimum
amount of goods and services.
Tutino is a senior research economist and
Zarazaga is a senior economist and policy
advisor in the Research Department at the
Federal Reserve Bank of Dallas.

The Economics of Inflation, by Costantino BrescianiTurroni, Northampton, England: Augustus M. Kelley
Publishers, 1937; English translation.
The quote comes from “The Counter-Revolution in
Monetary Theory,” by Milton Friedman, the first Wincott
Memorial Lecture, University of London, Sept. 16, 1970.
The argument that challenges this view is in “A Simple
Model for Study of the Determination of the Price Level
and the Interaction of Monetary and Fiscal Policy,” by
Christopher A. Sims, Economic Theory, vol. 4, no. 3,
1994, pp. 381–99.
It is assumed that not all output will be absorbed by
transaction costs when the economy operates without
money. This is a critical assumption because it limits the
damage of driving real money balances to zero and doing

Economic Letter

is published by the Federal Reserve Bank of Dallas. The
views expressed are those of the authors and should not
be attributed to the Federal Reserve Bank of Dallas or the
Federal Reserve System.
Articles may be reprinted on the condition that the
source is credited and a copy is provided to the Research
Department of the Federal Reserve Bank of Dallas.
Economic Letter is available on the Dallas Fed website,

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2200 N. Pearl St., Dallas, TX 75201

all business instead with alternative, less convenient
means of payment.
This assumption rules out the possibility of inflation
arising from monetization of fiscal deficits.
The underlying model is taken from Sims 1994. See
note 3.
The model-generated path of inflation leads to a sharp
reduction in consumption.
Rigorous arguments of this can be found in “Ruling Out
Speculative Hyperinflations: The Role of the Government,”
by Juan Pablo Nicolini, Journal of Economic Dynamics
and Control, vol. 20, no. 5, 1996, pp. 791–809.
The new currency gained wide acceptance because, in
principle, it could be exchanged for mortgages on private
sector real estate. The measure may have been successful
for its value as a signal of the fiscal authority’s ability to
raise revenues and, thus, to garner the goods and services
required to honor its commitment to retire the new currency from circulation on the expected terms. See note 2,
Fischer, p. 67.
By contrast, the purchase of newly issued government
debt directly from the fiscal authority at face value—that
is, monetization of the fiscal deficit—would be inflationary
because it would be equivalent to the government issuing
new debt not backed by a corresponding increase in
primary surpluses.

Mine Yücel, Senior Vice President and Director of Research
E. Ann Worthy, Senior Vice President, Banking Supervision
Anthony Murphy, Executive Editor
Michael Weiss, Editor
Jennifer Afflerbach, Associate Editor
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