Policy Responses to Unemployment and Inflation

• Module 40: Inflation, Disinflation, and Deflation
• Module 41: The Phillips Curve
• Module 42: Crises and Consequences

BRINGING A SUITCASE TO THE BANK

The African nation of Zimbabwe achieved a dubious distinction in 2008: it exhibited one of the highest inflation rates ever recorded, peaking at around 500 billion percent.

Although the government kept introducing ever-larger denominations of the Zimbabwe dollar—for example, in May 2008 it introduced a half-billion-dollar bill—it still took a lot of currency to pay for the necessities of life: a stack of the cash worth $100 U.S. dollars weighed about 40 pounds. The currency was worth so little that some people making bank withdrawals brought suitcases along in order to be able to walk away with enough cash to pay for basic living expenses. In the end, the Zimbabwe dollar lost all value—literally. By October 2008, the currency more or less vanished from circulation, replaced by U.S. dollars and South African rands.

Zimbabwe’s experience was shocking, but not unprecedented. In 1994 the inflation rate in Armenia hit 27,000%. In 1991 Nicaraguan inflation exceeded 60,000%. And Zimbabwe’s experience was more or less matched by history’s most famous example of extreme inflation, which took place in Germany in 1922–1923. Toward the end of the German hyperinflation, prices were rising 16% a day, which—through compounding—meant an increase of approximately 500 billion percent over the course of five months. People were so reluctant to hold paper money, which lost value by the hour, that eggs and lumps of coal began to circulate as currency.

German firms would pay their workers several times a day so that they could spend their earnings before they lost value (lending new meaning to the term hourly wage). Legend has it that men sitting down at a bar would order two beers at a time, out of fear that the price of a beer would rise before they could order a second round!

The United States has never experienced that kind of inflation. The worst U.S. inflation in modern times took place at the end of the 1970s, when consumer prices were rising at an annual rate of 13%. Yet inflation at even that rate was profoundly troubling to the American public, and the policies the Federal Reserve pursued in order to get U.S. inflation back down to an acceptable rate led to a very deep recession.

In this section we look at the reasons inflation rises and falls. We’ll see that the causes of very high inflation, the type of inflation suffered by Zimbabwe, are quite different from the causes of more moderate inflation. We’ll also learn about disinflation, a reduction in the inflation rate, and the special problems associated with a falling price level, or deflation. Finally we’ll look at the causes and consequences of banking crises and discuss policy options for helping an economy recover from them.