When the functions of money break down: Hyperinflation | AP Macroeconomics | Khan Academy

So in the last video, I was talking about various functions of money. You know, the first was that it's a medium of exchange. If you want to trade for things, typically you give someone money, and they give you the thing, rather than trying to barter, trading apples for oranges, or horses for legal services, or things like this.

The second is that it's a store of value. If you hold on to your money, its value isn't just going to evaporate. Whereas if you hold on to, you know, a bunch of apples, as they rot and degrade away, they're no longer valuable.

The third is that it's a unit of value. It's a way that we assign a number to items to say how valuable is this. You know that something that's $100 is about twice as valuable as something that's $50, and having this sort of number system for value makes it a lot easier to compare different goods.

What I want to do in this video is talk about a circumstance where these functions of money break down, and what I'm thinking of is the case of hyperinflation. Hyperinflation now, inflation means that prices are increasing. So if you look at the price of a carton of milk, and let's say it's $1 one day, it would be if it increases later on, so maybe it's $1.20. If the prices of all goods as a whole in the economy tend to be increasing, you know, it's not just milk that's getting rarer or something like that; it's called inflation.

Hyperinflation is basically a case where this is just happening really, really quickly. So I have some videos talking about inflation itself and the root causes, and I'm not going to go into that here. In this case, all you need to know is the idea that prices increase really, really quickly.

Just to give an example, there's been lots throughout history, and this isn't necessarily the starkest example, but it'll be interesting to us in terms of what the ultimate solution was: Brazil in the 1980s and early 1990s.

So the 1980s, and a little bit into the 1990s, was undergoing very fast inflation. To give a feel for the kind of rates we're talking about, at its peak, it was around 80% per month. What this means is that every month the prices of general goods, you know, a carton of milk or a share or the price of land, things like that, would generally get multiplied by a factor of 1.8.

Now, if you compound this over a full year, and every month it's increasing by 1.8, so you multiply it in 12 different times, this is actually an increase by more than a factor of a thousand. So that would mean if you have something that costs $100 one day, it's going to cost, after a year if inflation increases at this rate, $100,000. So the annual inflation rate, the percentage per year, would actually be 100,000% per year.

Now, there have been inflation rates in history faster than this, but this is still really insane. Just to get our minds around what it might feel like to be in an economy like this, let's just imagine a super simplified economy where you have only four different people. So we'll have four different people here, and let's say, I don’t know, let's name these guys like person A, person B, person C, and person D.

I guess I should give person D some eyes. And let's say it's the case that the way that this economy works is that A buys all of his things from B. So A will give B, maybe, let's say it was $50 a month for all of his things, and B, in response, gives A things. Then B, she buys all of her things from C, and she pays that same amount. She takes the full $50 that she earned and she gets various things that she needs in life from C.

Then similarly, C buys all of his things from D, and let's say just for simplicity that it's the same amount. And then D buys all of her things from A, and this is obviously way oversimplified as an economy. But I do think it gives a good feel for kind of the cyclic nature of things, that one person's income is another person's expenses.

Now let's say that you're in a hyperinflationary circumstance where you have this, you know, 80% increase per month. Something that costs $100 one day a month later is going to cost $180. If you were, say, person A, and you knew that prices of things are going to increase, you might, in anticipation, raise your prices as you're selling things to D. You might raise your prices and say, “Well actually, today I think I'm going to charge you $51, because things are getting more expensive. So I want to earn more.”

Then D, in response, says, “Geez! Now I have to pay more, so I'm going to have to charge my customer C a little bit more as well.” And I'm going to charge him $51. Then C says, “I'm going to have to charge my customer more as well in order to make ends meet.” And everybody kind of has to increase their prices to keep up.

When the next day rolls around, you know, no one wants to be the last one to increase their prices. So maybe this time B says, “Oh, yesterday I had prices increase on me, and I was earning less, but then I had to spend more. So today, I'm going to make sure that I'm not the last one, so I'm going to increase my prices.”

Maybe she says $53 just to be sure. Then A, noticing the prices have increased, has to keep up as well, so he needs to do this. Of course, the cycle continues; everyone, in order to make ends meet, has to increase their prices.

This circumstance where you're changing your prices in anticipation of future change is what distinguishes hyperinflation in kind of a qualitative sense from regular inflation. You know, I think there's a quote that I really like; I think it's by Napoleon, that “a quantity sometimes has a quality all of its own.” And that's definitely the case with hyperinflation, because ordinary inflation, like let's say that which the United States dollar is undergoing around these days, typically ends up being around 1 to 3%. It depends, but 1 to 3% per year.

So obviously, this is dramatically less than, you know, 100,000% per year. But the idea is that hyperinflation isn't just that it's a much bigger number; it's that there's a psychological difference in the society where people are starting to anticipate changes and change their prices accordingly. This is how things spiral out of control. This is how you get insane numbers like 80% per month.

Now, why am I talking about this, right? This is about functions of money. Why am I talking about hyperinflation? Well, let's take a look at these functions of money and kind of analyze whether or not they still apply in a hyperinflationary economy.

Now, medium of exchange, money is still being used as a medium of exchange; people are still buying things using the national currency. So that one stays intact. Store of value, however, this one clearly breaks down. Because if you're holding on, let's say you have $100 in savings today, and then you know that things are increasing by 100,000% per year, it's going to be 1,000 times less valuable after a year. So most certainly, it is no longer a store of value.

You could argue, by the way, that even in an ordinary inflation circumstance, money doesn't quite serve this function as a store of value. Because even if prices are increasing only very slowly every year, it's still the case that, you know, a dollar that you hold onto, you know, you're not investing it or collecting interest rate slowly degrades over time.

So you could argue that even in an ordinary circumstance, store of value doesn't quite apply due to inflation. But let's consider this third function of money: unit of value. If you're living in this hyperinflationary circumstance, the numbers that you're seeing no longer really correspond to value.

Right? If you had something that originally was $50 of value, and then after a year it's $50,000, you're not thinking of the value of that thing in terms of the national currency. Often throughout history, people start thinking of the value of various items in terms of another nation's currency.

So if your own currency, all of the numbers are fluctuating very rapidly and they're increasing very rapidly, you look for a more stable number. Just so, if you want to know, “Hey, how much should a carton of milk cost?” Rather than thinking in your own nation's currency, you maybe say, “Oh, it's analogous to, you know, 1.5 British pounds or something,” that seems a little bit more stable.

So this unit of value property no longer applies in the case of hyperinflation. Notice that that's distinct; that is something different between hyperinflation and regular inflation. Because even in, let's say, the United States these days, even though prices slowly increase, we still think about the value of things in terms of the US dollar. This still serves as our unit of value.

So that's one of the core distinctions, and I think that's actually very important for, you know, what distinguishes hyperinflation from inflation in a qualitative sense. Now, why did I choose to think about Brazil's hyperinflation as opposed to a lot of other ones, like post-World War I Germany or Zimbabwe, or places where you've had even faster rates of hyperinflation?

Basically, because there was a really interesting way that they went about solving it. Now, any solution has to address the underlying causes of inflation, and this video isn't necessarily about those. So there are going to be things associated with making sure that the government is still fiscally responsible, balancing budgets, and things like that.

But a different component that needs to be addressed is that money is no longer serving as a unit of value. One really interesting thing that Brazil did in the early 1990s is they introduced a fake currency that they called the URV for Unit of Real Value. Or really, it was in the, um, really it's the Portuguese words for these. I think, unid Valor; I don't really know Portuguese, but the initials are the same: URV.

What they started doing is saying, “Okay, everybody continue paying in the national currency,” which at the time was the, the cruzeiro; I'm probably pronouncing that wrong, but cruzeiro. So they're still paying for everything in terms of their cruzeiro; that's serving as the medium of exchange. But what they did is they said, “Every time that you're pricing something, please list your prices not only in terms of the cruzeiro,” so I guess in this case I've written dollars, but let's say—let's pretend this says 53 cruzeiro, 51 cruzeiro, things like that—and in addition to listing it there, please also list the price in terms of units of real value, which in this case might have been like 50.

'Cause everything started off being 50, and they loosely pegged this fake currency that's just a made-up number to the US dollar. So over time, even though the price in terms of cruzeiros was increasing, it might be 53 cruzeiros and then 55, and everyone's paying more and more in terms of cruzeiros, the unit of real value would stay the same because it had no reason to increase. It's just a made-up number that you're pegging on things just to keep straight how valuable things actually are.

So what they're basically doing is they said, “Currency, our current money is not serving this function as a unit of value, so let's just make up a new thing that does.” At this time, the cruzeiro was still serving the function as a medium of exchange, you know, nothing was really storing the function of store value, except for hard goods like land.

Then this made-up number was serving the function as a unit of value. Over time, as people started getting used to the idea that you go out to buy milk and you know that it's going to be, let's say, one unit of real value, and then you just have to look up, “Okay, how many cruzeiros corresponds to a unit of real value today?”

People start actually thinking in terms of this number, even though they're paying in terms of another. After this had kind of set into the psychology of the society, and of course, while certain fiscal responsibility on the side of the government was being addressed, they made the switch to make units of real value an actual currency, printing money in terms of these URVs and abandoning the cruzeiro and telling people they could trade in their cruzeiros for these URVs, and that was going to be the new currency.

Because people were used to the idea that this was a stable number, and they were thinking of prices in terms of this stable number, and because the underlying causes of inflation had started to be addressed, it actually worked. The number would stay stable, and instead of having prices increase 80% a month, it decreased drastically to something that's much closer to, you know, a healthy economy's level of inflation.

I think that's really powerful, actually, that you can recognize that one of the functions of money has broken down and then address it specifically, you know, invent something new that addresses that same function. Sure, it's a made-up currency; it's just a number you're assigning to things, but it's serving this function, and then apply that in a very real setting on the scale of an entire nation and solve an economic problem.

So hopefully, this sheds a little bit of light on why it might be useful to break down the functions of money in terms of these three different categories. With that, I will see you next video.