Principles of Macroeconomics / Unit 16 MAC 1517 worked example, 60 to 90 seconds
Trace a Hyperinflation
The idea
Work a hyperinflation from its fiscal cause to its monetary effect, then say what indexing does and does not protect. The chain is short: a deficit that cannot be funded by borrowing or taxing is covered by creating money, the money stock rises far faster than output, and the price level follows.
In practice
Take an economy whose money stock quadruples in a year while real output is flat. Unit twelve's equation says the price level must rise roughly fourfold if velocity holds. But velocity does not hold: people expecting prices to rise spend money faster, so velocity rises too and prices rise by more than the money stock did. Now apply indexing. A worker whose wage is indexed to prices keeps roughly her real wage; a worker whose wage is not indexed sees it fall in real terms every month. A lender who indexed the loan is repaid in real terms; a lender who did not is repaid in currency worth a fraction of what was lent.
Where people slip
Indexing protects the terms of a contract, not the economy. Countries have grown steadily while indexing wages and loans against inflation of ten to thirty percent, so this is a survivable arrangement rather than a solution. What indexing cannot do is restore what unit six said inflation costs: the effort everyone spends protecting themselves against price changes is effort not spent producing anything.
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