As South American country faces soaraway prices, what is hyperinflation and why is it bad for the economy?

This article is more than 2 years old

This article is more than 2 years old

Venezuela is introducing economic reforms including new banknotes that lop five zeros off its fast-depreciating currency as the country battles hyperinflation.

Banks will close on Monday as they prepare to release the new “sovereign bolívar” amid warnings from International Monetary Fund economists that Venezuela’s inflation rate could exceed 1,000,000% this year.

What is hyperinflation?

Hyperinflation is the term used to describe prices spiralling out of control, accompanied by plunging currency values – leading consumers to require wheelbarrows full of money to buy everyday essentials.

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In theory, prices should always fluctuate depending on supply and demand. Inflation is the term for rising prices, while deflation describes prices falling. Hyperinflation occurs when prices rise so wildly as to render the concept of inflation absurd.

The problem comes when the supply of paper money in an economy outstrips demand for goods and services, causing the value of the currency to fall. This occurs when governments create new money to finance spending above their income from taxation.

The labelling of hyperinflationary episodes can be arbitrary, although the economist Phillip Cagan suggests prices rising by more than 50% a month could be used for determining the start of a period, with monthly price growth below that level for at least a year marking the end.

Why is it bad for an economy?

Hyperinflation in effect destroys purchasing power and encourages hoarding of goods, as people and businesses anticipate further price increases. Periods of hyperinflation tend therefore to be self perpetuating, as shortages further drive up prices.

Lack of certainty over prices removes the incentive for buyers and sellers. The Times reports that restaurant owners in Venezuela no longer have menus with printed prices, while supermarkets have also removed prices from shelves. Many people use cards to buy goods rather than cash.

How do workers get paid?

Hyperinflation removes the certainty that a paycheck will be enough to meet living requirements, as prices rise to erode the value of wages. People can be forced to collect their wages in suitcases, although online bank accounts mean this is less of an issue than in the past.

Aware of this problem, some Venezuelan companies have started offering unusual compensation packages, such as bonuses paid in eggs. Foreign currencies, retaining their stability, can also be used.

Facebook Twitter Pinterest A employee accounts bolivar bills at a petrol station in Caracas. Photograph: Ariana Cubillos/AP

What happens to bank notes and coins?

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Lower denomination currency becomes next to worthless. Over decades, inflation has the power to render some low denomination notes and coins irrelevant, such as 1p and 2p coins in the UK, where the government has considered scrapping them. Hyperinflation speeds this progress to unsustainable levels.

There are often cash shortages and long queues at banks and cash machines as people require more money to make payments.

What are the examples of it in history?

Although considered rare by economists, there have been several occurrences of countries being gripped by hyperinflation in recent history.

Weimar Germany in the 1920s is the most famous example. Hungary after the second world war had some of the most extreme rates of inflation ever recorded, at about 41,900,000,000,000,000%.

Russia experienced hyperinflation after the collapse of the Soviet Union, while Zimbabwe is among more recent examples, with soaraway inflation and the eventual abandonment of its domestic currency in 2009 in favour of the US dollar.

How do you get rid of it?

Governments can use price controls to help manage periods of hyperinflation, yet goods at these prices can be scarce and black markets often emerge. Scrapping the old currency and replacing it with a new one or a foreign currency is one way out.

Ultimately governments must restore stability through economic reforms and commitments to reduce the money supply. Boosting economic growth to balance the budget deficit, or using austerity and privatisations to raise money for the state to close the gap, are among the options available.