Ed Dolan's Econ Blog

Venezuela on the Brink of Hyperinflation

The Central Bank of Venezuela recently reported an inflation rate for May of 6.9 6.1 percent, equivalent to an annualized rate of more than 100 percent. Does this mean that Venezuela is on the brink of hyperinflation? A quick look at the relevant economic concepts suggests that hyperinflation is in fact a real danger.

What is hyperinflation and where does it come from?

Hyperinflation has a long history, but no official definition. In an influential 1956 paper, Phillip Cagan suggested limiting the term to a rate of inflation of 50 percent per month or more, which is equivalent to an annual compound rate of about 14,000 percent. That would fit extreme cases like Weimar Germany, Hungary after World War II, or, more recently, Zimbabwe, in which inflation rates reached millions or trillions of percent per year.

Although some economists still adhere to Cagan’s guideline, others prefer a more flexible definition. I like to apply the term hyperinflation to any case in which inflation seriously undermines the ability of money to serve its classic functions as a store of value, a unit of account, and a medium of exchange. That can begin to happen at rates of inflation of 100 percent per year or even less. Less extreme cases like Russia, Argentina, and Bulgaria in the 1990s would qualify, even though inflation reached only the low thousands of percent per year. Venezuela may well be approaching such an episode now.

So where does hyperinflation come from? The popular explanation of “too much money chasing too few goods” has an element of truth to it. Still, it is seriously incomplete because it ignores the other elements of the equation of exchange, MV=PQ.  In that equation, M stands for the quantity of money, V for velocity, P for the price level, and Q for the level of real GDP.

Velocity is the least familiar term. Intuitively, we can think of it as the rate at which the stock of money circulates through the economy, but formally, it is more accurately defined as the ratio of nominal GDP (that is, P times Q) divided by the money stock, M. We can define money itself more or less broadly (M1, M2, and so on), but for purposes of understanding hyperinflation, it is probably best to use the narrowest definition, the monetary base, consisting of currency in circulation plus bank reserves.

Defining velocity as the ratio of nominal GDP to the money stock makes it clear that the equation of exchange is a simple accounting identity that has no inherent causal interpretation. If we rewrite the equation of exchange in the form P=MV/Q, we can see that an increase in the price level can, by definition, arise either from an increase in the money stock, an increase in velocity, a decrease in real GDP, or some combination of those factors. I like to call this version of the equation of exchange the inflation accounting equation.

The inflation accounting equation holds for any rate of inflation, positive or negative. Hyperinflation is more than just very rapid inflation, however. What gives hyperinflation a distinctive character is the existence of three feedback pathways that link the variable P, on the left-hand side of the equation, and the variables M, V, and Q on the right-hand side. The feedbacks mean that not only does the rate of inflation depend on the rate of change of M, V, and Q, but that the rates of change of those three variables themselves depend on the rate of inflation. Let’s look at each of the pathways in turn.

Feedback via velocity

The first feedback pathway, the one that acts through velocity, arises from the function of money as a temporary store of value. If you get your pay on the first Friday of each month, you can put some cash in your pocket and spend the money on gas and groceries at any time during the month as you see fit. Hyperinflation undermines the store of value function because it causes money to lose a noticeable amount of purchasing power over even a few days. During a period of hyperinflation, instead of putting your pay in your pocket, it is best to run out and spend it quickly before prices go up. The velocity at which money moves through the economy increases accordingly.

Economists call this behavior asset substitution. You stop using currency or bank balances as a safe temporary store of value and instead, exchange it as quickly as you can for some other asset that will hold its value.

Basic consumer goods are one alternative. I remember seeing a good example when I was living in Russia during that country’s hyperinflation of 1992. One day, an economist I was visiting pointed to a neighbor’s balcony, where we could see a pile of several cases of a popular kind of canned beef called tushonka. “That’s hyperinflation at work,” my colleague said. The neighbor, I could see, was no fool to recognize that tushonka–compact, durable, and hard to counterfeit—was a much better store of value than the rapidly depreciating Russian ruble.

Once people have stocked up on consumer goods to the limit of their storage space, asset substitution turns to foreign currency. People exchange their rubles, bolivars, or whatever for dollars or euros as fast as they can . That happened in Russia in the 1990s and it is reportedly happening in Venezuela today, to the extent there are any dollars or euros that people can get their hands on.

The government can slow asset substitution by imposing consumer price controls and foreign exchange controls, and the Venezuelan government uses both. However, doing so has drawbacks. First, such controls  tend to be leaky; people find a way to accumulate goods and foreign currency anyway. Second, the controls increase the cost of doing business and slow growth of the economy (more on this below). Third, even if controls are initially effective, they create repressed inflation, which will break out even more virulently when controls are withdrawn or spontaneously collapse. That is exactly what happened in Russia. During Mikhail Gorbachev’s perestroika, up to the end of 1991, price controls held measured inflation to single digits, but at the cost of ever-growing repressed inflation. When the controls were lifted at the beginning of 1992, inflation jumped to a rate of more than 2,000 percent per year in a matter of days.

Other than spying on people’s balconies, how can we tell whether asset substitution is causing velocity to increase? The inflation accounting equation, P = MV/Q, provides the answer. At present, Q, or real GDP, is near a standstill in Venezuela, so it contributes little to inflation one way or another. Holding Q constant, any increase in velocity will reveal itself as a rate of inflation that exceeds the rate of growth of the money stock. That is just the case in Venezuela. According to the latest data, the money stock is growing at about 3 percent per month, equivalent to a compounded rate of about 40 percent per year. Meanwhile, as noted above, the price level is increasing by about 100 percent per year. An increase in velocity accounts for the difference. What we see, then, is a feedback loop in which higher velocity causes higher inflation, and accelerating inflation, in turn, induces asset substitution that causes velocity to increase still more.

Feedback via real GDP

The second feedback pathway that fuels hyperinflation operates through the effect of inflation on the growth of real output.  The relationship differs from that implied by the familiar Phillips Curve, according to which higher inflation is associated with lower unemployment, which in turn, other things being equal, would be associated with faster growth. However, the inflation-growth relationship implied by the Phillips curve is  applicable only to relatively moderate rates of inflation. As suggested by the following chart, based on data from an IMF study by Atish Gosh and Steven Phillips, inflation in the double-digit range tends to be associated with slower, not faster, growth of real GDP. Inflation of 100 percent per year or more tends to be associated with negative GDP growth.


The 100-percent threshold in this chart is just a statistical relationship, not to be taken as an economic law. Still, the underlying idea that hyperinflation disrupts the real economy is not hard to understand. High inflation makes business planning difficult, especially since inflation is usually variable and unpredictable when it is high. Hyperinflation disrupts financial intermediation, as banks become reluctant to lend for more than very short periods. It disrupts the payments system because it strengthens incentives to pay late. It leads to labor strife, social disruption, and political instability. All of the above promote capital flight. If the government uses price controls and currency controls to combat inflation, those measures further disrupt normal market processes.

Venezuela may be showing the first signs of a feedback from higher inflation to slower growth. Official data indicate that the economy grew at an annual rate of just 0.7 percent in the first quarter of 2013, down from nearly 6 percent in 2012. Since the rate of economic growth, Q, appears in the denominator on the right-hand side of the inflation accounting equation, any slowdown in growth, or negative growth, causes inflation to accelerate, thus completing the second feedback pathway.

Feedback via money

The third feedback mechanism operates through the effect of inflation on the rate of growth of the money stock. The mechanism is less direct than that for velocity or GDP growth, but under conditions of hyperinflation, it can be quite powerful.

The first link in this third feedback pathway arises from the effect of inflation on real tax revenue. No government has yet figured out a way to collect taxes instantly. The tax revenues a government receives are always based on economic activity (income, retail sales, property values or whatever) in some previous period. If there is no inflation, the delay in receiving tax revenue does not affect its real value. However, when there is inflation, the real purchasing power of the tax revenue falls between the base period for which taxes are calculated and the time the government receives the tax payments. If expenditures are constant in real terms, the reduction in the real value of revenues means a larger budget deficit. Economists call the tendency of inflation to increase the real budget deficit the Olivera-Tanzi effect.

The next link is the effect of an increased budget deficit on the money stock. When governments spend money on current purchases or transfer payments, the money stock increases, but that increase is usually offset by reductions of the money stock that take place when the government collects taxes or sells securities. During hyperinflation, however, the offsets do not work as well. The Olivera-Tanzi effect, as we have seen, tends to reduce the real value of tax revenues as inflation accelerates. Furthermore, as moderate inflation shades into hyperinflation, governments find it harder to borrow by selling securities. In extreme cases (say, war or revolution), the government may not be able to sell securities at all so that the increase in the money stock in any period and the budget deficit are equal.

The final link in the feedback pathway is the effect of an increase in the money stock on the price level. As proponents of modern monetary theory like to point out, the inflation accounting equation, P=MV/Q does not imply a one-to-one causal relationship between the rate of money growth and the rate of inflation. The recent experience of the United States provides a case in point. When inflation is moderate and when the economy is operating below full employment, a budget deficit is not necessarily inflationary even if it is fully “monetized,” that is, if the monetary base is allowed to increase by the full amount of the deficit. Instead, the impact of the increase in the money stock may be absorbed, at least in part, by faster growth of real GDP induced by the Keynesian multiplier effect of the higher deficit. A further part of the impact may be absorbed by a decrease in velocity, if people accumulate money balances without spending them.

However, as the rate of inflation accelerates, we can no longer count on falling velocity and rising GDP growth to absorb the impact of faster money growth. Instead, when true hyperinflation sets in, we are more likely to see rising velocity and falling real GDP. In that case, all the links in this feedback pathway come into play: Faster inflation increases the budget deficit via the Olivera-Tanzi effect. The larger deficit is monetized because inflation makes it harder for the government to sell bonds. And faster money growth feeds back to more inflation, because changes in velocity and real output exacerbate the impact on the price level instead of offsetting it.

To be certain that all of this is happening today in Venezuela would require better data and more thorough analysis than are possible here. However, the fragmentary data we do have seem consistent with this scenario. Inflation, as we have seen, is increasing. So is the rate of growth of the money stock. And so is the budget deficit. As reported by Trading Economics, the Venezuelan budget deficit was 8.5 percent of GDP in 2012, up from 5.3 percent the year before. Other sources put the deficit as high as 17 percent of GDP as of early 2013.

What lies ahead?

It is too early to call Venezuela a truly hyperinflationary economy, but it looks to be on the brink. We can see early signs of all of the feedback pathways that make hyperinflation potentially so explosive. It is true that something could yet defuse the process. For example, a sharp increase in global oil prices could provide an unexpected increase in revenue for the budget. Alternatively, although it seems unlikely, the government of Nicolas Maduro could turn away from the populist policies of Hugo Chavez and impose stringent austerity measures. Doing so would be hard on the real economy, but it could bring inflation down.

It is more likely, however, that the Venezuelan government will continue its dysfunctional blend of free spending, socialist mismanagement, and administrative restrictions on foreign exchange and retail prices. If so, the near future could see the first real outbreak of hyperinflation in Latin America since the 1980s. As blogger Billy Mitchell once wrote in reference to hyperinflation in Zimbabwe, “Bad Governments will wreck any economy if they want to.”



23 Responses to “Venezuela on the Brink of Hyperinflation”

Big EdJune 14th, 2013 at 11:50 am


M, P & Q can all be objectively measured. V cannot, so it becomes a fill number. That makes the 'equation' a truism.

Mike SproulJune 14th, 2013 at 12:03 pm

money spent=money received
That's not an explanation of anything, including inflation. It's a tautology.
The explanation of inflation is that the money issued by the government (which is the government's liability) is rising RELATIVE to the government's assets.

Ed Dolan EdDolanJune 14th, 2013 at 12:18 pm

In reply to Mike Sproul and Big Ed:

Yes, you both are right, the equation MV=PQ is a "trusim" that "does not explain anything."

As I clearly wrote in the post: "Defining velocity as the ratio of nominal GDP to the money stock makes it clear that the equation of exchange is a simple accounting identity that has no inherent causal interpretation."

The function of the equation of exchange (or its restated version, the "inflation accounting equation") is not to explain anything. Instead, I use it simply as a framework to organize the discussion. The explanatory part of the hyperinflation model consists of the three feedback pathways. All three of them are substantive, falsifiable propositions.

benleetJune 14th, 2013 at 2:10 pm

Robin Hahnel wrote the following in 2007: "The most dramatic increase in social spending was in the area of health care. In 1998 there were over 14,000 Venezuelans for each primary healthcare physician, and few physicians worked in rural or poor urban areas. By 2007 there was one primary healthcare physician for every 1,300 Venezuelans, and many of the new physicians were working in clinics in rural areas and poor barrios that had never had physicians before.2 There are also now 16,000 stores in poor areas throughout the country selling staples at a 30% discount on average." See

Too often articles end up vilifying Chavez' government, an example is your comment about "socialist mismanagement". "Let them die," seemed to be the correct management policy of former governments, and by implication Ed Dolan's advice. I'd like to read a response by Hahnel, by other promoters of the Venezuelan experiment, and by MMT writers like L. Randall Wray. How many cans of toshunka are there in Venezuela or anywhere? Germans had buried lard during WWII to preserve value. Venezuela is fortunate to have its buried oil. Not to be harsh in my comment, but there has been some valuable progress made in Venezuela. Even the opposition party had to change its tune. But still they lost.

Ed Dolan EdDolanJune 14th, 2013 at 6:36 pm

Correction: There is a typo in the first paragraph; the inflation rate for May was reported as 6.1 percent (still compounds to over 100 percent per year).

BrianJune 14th, 2013 at 10:12 pm

nice article. If I understand correctly the inflation is mostly stoked by velocity of money, but what triggered this increase in velocity? Panic? Loss of faith in government?

Basically I'm trying to figure out if it could happen here too. I don't know if this would be included in your definition of velocity but lately. I have been taking money from my savings and putting it directly into stocks (assets) because the interest in the bank is simply too low. Could this kind of behavior trigger a hyperinflation here too?

Ed Dolan EdDolanJune 15th, 2013 at 11:57 am

Panic, I think. As inflation creeps up, people suddenly start to worry if it is safe to hold cash. The worry prompts them to exchange their local cash for dollars or consumer goods, and that makes their fears self-fulfilling.

Tomas KurianJune 23rd, 2013 at 11:28 am

I think it is mostly psychological, but depends also from the level of savings.

It may not be seen immediately, but higher the saving rate, higher the potential for inflation, as people who would try to realize all their saved money would not find enough goods to buy.

By individuals saving, economy is not stashing away certain amount of goods to be available at the time of potential spending spree. Only then people realize the true accumulated inflation potential.

More about it in my work:

jack strawJune 14th, 2013 at 11:25 pm

This is yet another wonderful article. I have a simple definition of hyper-inflation: "the difference between the people who have it and the people who don't." The first recorded one that i know of of a Great Economy (and Venezuela is a Great Economy in my view) is of course France under Louis the XIV. clearly "the Sun set under his financial folly." And so it may be with Venezuela. The nation with the largest oil reserves in the world is hyper inflating? Unbelievable. Anywho…Adam Smith gave us the the Law of Comparative Advantage. Great Britain had no problem becoming GREATER BRITAIN after France fell into hyperinflation. If you see something different happening this time (which i imagine you do not of course) i will look forward to that article as well.

EugenRJune 15th, 2013 at 4:26 am

Dear Ed,
If I may, I would like to quote from my book my experiences about hyperinflation.

………..Because the different segments of the production chain have lost confidence in the stability of the price system, the new round of price increase will necessarily be higher than the previous one. As expectations of further price increase among the people mount, everybody wants to be compensated not only for the last price increase, but also for the expected next price increase, which they believe will be higher than the last one. To secure their position, all the participants in the society ask for exaggerated price and wage increases. By this stage the price increase is gathering extra momentum and is driven by expectations rather than by realities. And the expectations tend to be self-fulfilling.

And so as the spiral winds ever upwards, first the employers and the employees and last the institutions of social benefits like social security, pension funds etc., create a system of indexation based on an agreed anchor for prices, wages, tariffs, fees, charges, expenses, fares, premiums, rates, tolls, whatever…

At first the indexed raises occur every quarter, but then they happen every month and at the end every week. Theoretically everybody – the employees, the pensioners, the exporters and even the producers – should get proportionately the same progressive increases in income, but that does not happen in practice because it is impossible for people to keep their bearings in the avalanche of numbers. Those with a strong negotiating position get more and the others get less. Some economic entities even cease to exist, either because they lack the means to cope with the frequent price increase, or because they just don't understand what is going on around them.

At a certain stage the prices start to rocket exponentially, and this stage is called Hyperinflation. In Hyperinflation the prices change daily until nobody has any remaining sense of the relative value of products, for Money has lost its major function as the supreme measurer of the value of Product price. During hyperinflation if you ask someone how much a loaf of bread costs he will probably just shrug, or if he is more polite he will tell you the price in a foreign currency. This is the stage at which the market starts looking for an anchor for measuring prices other than the local currency. Usually the anchor is a stable foreign currency, for example the dollar, or some other form of indexation.

ThomasGrennesJune 15th, 2013 at 2:15 pm

Inflation also affects the value of the Venezuelan bolivar, which was devalued for the fifth time in nine years in February. The inflation resulted from printing money to finance the budget deficit that tripled during the last election year. The Chavez government imposed price controls to protect against "capitalist speculation", but inflation prevailed anyway.
The government also sought to fix the exchange rate, but in the black market, dollars sold
for three times the official rate in bolivars.

John1025June 16th, 2013 at 9:04 am

I believe Cullen Roche of Pragmatic capitalism has the best explanation of hyperinflation. He says his "research shows that hyperinflation is not merely the result of “money printing” or an expansion of the money supply and in fact tends to occur around very specific and severe exogenous economic circumstances which lead to an increase in the money supply ultimately leading to hyperinflaiton. Hyperinflation is not merely high inflation or a collapse in confidence, but is actually due to severe exogenous shocks with very real and provable transmission mechanisms. Historically, these events tend to be:

Collapse in production.
Rampant government corruption.
Loss of a war.
Regime change or regime collapse.
Ceding of monetary sovereignty generally via a pegged currency or foreign denominated debt."

You can read more here:

Ed Dolan EdDolanJune 16th, 2013 at 9:31 am

I think you (and Cullen Roche) make a good point here. Definitely the collapse in production (the Q in my inflation accounting equation) contributes to hyperinflation, and the others on Cullen's list contribute to the collapse in production.

I would point out also that Cullen's list is consistent with the feedback pathways that give hyperinflation its often sudden and explosive character. That happens, in part, because high inflation, once it gets started, creates a context in which corruption, war, regime collapse, etc. become increasingly likely and increasingly destructive of production.

SamJune 18th, 2013 at 10:56 am

First, a couple of questions. Would not hyperinflation wipe out retirement funds, both private and public, or just render them worthless? Second, I have noticed that grocery prices, low end restaurants, and fast food have experinced very rapid price increses, along with certain service organizations that service middle income people (Moose International, American Legions, etc.). Is not inflation becoming a problem, currently in the US?

jrj90620June 18th, 2013 at 11:15 am

Yes.But govt believes, they have no choice,but to lie to you.They have changed the method of calculating inflation,twice,since 1980,and are thinking of changing it again.According to John Williams(Shadowstats website),using the same methods of calculating inflation,as used in 1980,shows current inflation,over 6%.What do you think would happen to interest rates, bonds,stocks and the economy,if govt released honest inflation numbers?No politician wants to see the Titanic sink,while they are in office.Keep it afloat,for the next guy to worry about.

Ed Dolan EdDolanJune 19th, 2013 at 9:56 am

With respect to pension funds, etc. the answer is yes, they would wipe them out unless they are indexed to inflation. Some government pensions like Social Security are indexed. Private pensions like 401k are not. I don't know about Venezuela, but I suspect yes.

With regard to accuracy of inflation figures, I have a completely different persepctive than jrj's comment. I think credibility of shadow stats and similar is very low. In my view, what you are noticing is a difference between perceived inflation and measured inflation. They are two different things, as discussed in this earlier post:

kiersJune 18th, 2013 at 12:04 pm

Excellent article. The feedback explains how inflation RUNS away. Other explanations are too simplistic.

Also I'm curious, how many governments in the world rely on outsourced printing presses for their money production/manufacture? Isn't it true that the tech to produce a decent currency resides in only a few places or am i way off here?

odikhmantievichJune 20th, 2013 at 9:53 am

Hasn't this article been run by the Economist a hundred times? And wasn't it wrong every time?

odikhmantievichJuly 16th, 2013 at 10:50 am

So inflation has since receded modestly. Is the collapse still just around the corner, Ed? 15 years, still waiting…

VenkatJuly 23rd, 2013 at 6:51 am

Excellent perspective, could read only today with thanks. Could you also add an explanation on why Central Bank's usual policy actions turns ineffective in hyperinflationary conditions within the same framework?

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