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Students define inflation and hyperinflation and identify likely causes of each.
Overview
The following lesson integrates principles of macroeconomics in the teaching of world history. The lesson develops an analysis of historical events based on a monetarist view of macroeconomic management. The topics selected for analysis include causes of the rise and fall of great powers and the role of macroeconomic management in establishing hegemonic power during the evolution of the modern world system of international relations. These topics are related to central themes of global education.
Teaching Activity
Inflation, Deflation, and Hyperinflation
Introduce the concept of inflation by citing a list of prices from an old Statistical Abstract of the United States. For example, you might use the following list of 1940 prices — potatoes: 2 cents/lb., flour: 4 cents/lb., milk (delivered fresh!): 25 cents/half a gallon, chuck roast: 22 cents/lb., the median cost of a house: $2,900, the median monthly rent: $24.
Define inflation as a sustained rise in the average level of prices. Enhance the definition by blowing up a balloon and explaining that it represents the level of prices. Once the balloon is inflated, let it go and ask the students what happened. (Deflation.)
Inflate the balloon again until it bursts and ask the students what happened. (Hyperinflation led to an economic breakdown.)
Ask the students to consider briefly whether all inflation is undesirable. In discussing their answers, establish the following points:
- High inflation is undesirable; it distorts price signals and leads to a misallocation of resources. When inflation is high, producers find it hard to tell if a rise in the price of a product reflects general inflation or an increase in demand for that product. High rates of inflation are therefore bad for economic growth and jobs.
- Low inflation is desirable for the opposite reasons.
For a lucid discussion of the desirability of low inflation, direct the students to “How Low Can You Go?” The Economist, November 9, 2000.
State that you are about to demonstrate one of the causes of inflation.
Building the Model of the Quantity Theory of Money
Give each student a small amount of token money (for example counters or beans), and announce that in this activity each token will be worth $5. Keep track on the board of the total amount of money you have handed out by writing, “Money Supply: $100.”
Auction off a candy bar, a bag of candy, or an apple. Only token money can be used during this and subsequent auctions.
Keep track on the board of the final sale price of the candy bar in this auction by writing, for example:
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Allow the students to keep the money they have not spent; increase the money supply by handing out additional token money to them — a few more counters per student. Keep track of the new amount of money supply on the board. Auction off a second bar of candy (or similar item) and repeat the prior steps.
Expand the money supply further by handing out additional token money. Then run a third and final auction, repeating prior steps. Your board may look like this:
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Ask the students to describe and explain what happened during this activity. In discussing their answers note that the price of the auctioned item increased as a result of an increase in the money supply because the students spent the additional money.
Ask the students to consider whether the final sale price of the candy bar in the third auction would have been different had 1,000 candy bars been offered for sale instead of only one. They will probably answer that the price would have been much lower. Emphasize the underlying point: increasing the money supply is apparently inflationary when the rise in the money supply exceeds the increase in the number of goods.
Ask: “If you were to assemble data which may provide you with evidence that changes in the money supply are linked to changes in the level of prices, what data would you gather?” When discussing answers suggest, for example, inflation rates and money supply growth rates or inflation rates and value of the money supply over a period of time. You may choose a time series as in the table below.
| 1986 | 1987 | 1988 | 1989 | 1990 | 1991 | 1992 | 1993 | 1994 | 1995 | 1996 | |
|---|---|---|---|---|---|---|---|---|---|---|---|
| M1 billion $ | $724.4 | 749.9 | 787.0 | 794.2 | 825.8 | 897.3 | 1,025.0 | 1,129.8 | 1,150.7 | 1,129.0 | 1,081.1 |
| Inflation rate | 1.9 | 3.6 | 4.1 | 4.8 | 5.4 | 4.2 | 3.0 | 3.0 | 2.6 | 2.8 | 3.0 |
| Information obtained from www.whitehouse.gov/fsbr/esbr.html. | |||||||||||
M1 is a measure of the money supply. It includes currency (coins and paper money) held by the public and deposits at the banks such as checking accounts.
You may also choose to share with the students diagrams based on such statistics. All current textbooks for introductory macroeconomic courses contain an array of such diagrams. See for example, Mankiw, N.G., Principles of Macroeconomics, New York: Harcourt College Publishers, 2001. Particularly relevant is Mankiw’s chapter on money growth and inflation.
Tell the students that one theoretical model formally expresses the relationship between money supply and inflation. This model is called the equation of exchange. Write the equation on the board as follows: M x V = P x Q.
Explain the symbols. M is the money supply, the total quantity of currency (coins and paper money) held by the public and deposits at banks. V is velocity, the average number of times a unit of money is spent during a time period. P x Q is the total value of spending required to purchase the economy’s output; P represents the average price, and Q represents the units of total output.
Show the students how the equation works by discussing the following problem: “Yahooland, a hypothetical economy, produces one product only, bread. Each month 100 loaves are produced. By the end of each month, Yahooland’s consumers purchase all the bread produced. Throughout last year, the average price of the loaf of bread remained stable at $1.”
Ask: “What was the value of the total spending required to purchase last year’s output of this economy?” Answer: 100 loaves x 1 dollar x 12 months = 1,200 dollars.
Ask: “Given that Yahooland’s money supply (M) equals $100, how many times on average, must each dollar have changed hands (V) in Yahooland last year?” Answer: 12 times, since 1,200 = 12 x 100.
Ask: “Suppose that the people of Yahooland learned of an imminent attack to be launched against them by a warring neighbor state. In response, the consumers of Yahooland hide away — remove from circulation — half of the nation’s money supply. Assuming that prices and the economy’s total output remain the same, how would the velocity of circulation (V) have to change so that consumers could purchase Yahooland’s total annual output?” Answer: Since M = 50, V will have to double in value (V = 24) to enable consumers to spend $1,200, the value of the total annual output.
Hyperinflation in Germany (1923)
Distribute Handout 1, Hyperinflation in Germany in 1923. Discuss possible reasons for hyperinflation in Germany in 1923. During the discussion, note that Gutman’s diary documents an increase in the velocity of circulation, which followed an expansion of the money supply when the German government attempted to pay its bills by printing money. (Note: Here, M and V both rise; at other times, they might move in opposite directions. Teachers should not infer from this text any “normal” or causal relationship between V and M.)
Tell the students that you want them to consider some additional examples of the management of the money supply and the consequences of different policy decisions. You will provide examples of historical events and ask the students to predict what consequences might follow from different policy decisions related to those events. You also will invite the students to speculate about similarities among great empires in history.
Distribute Handout 2, The Decline of the Roman Empire, and discuss the question it poses. Note that the emperor mentioned here is Caracalla (211-217 A.D.). Ill advised by his economic advisors, he did debase the empire’s gold and silver coins, thus undermining the stability of the value of the currency. The result was that good money was driven out by bad money (Gresham’s law), while the velocity of circulation of bad money increased — bringing about rapid inflation and further reducing real wages. The political effect was further dissatisfaction among the mercenary troops. The end of the Roman Empire is partly attributed to bad management of the money supply.
Distribute Handout 3, The Decline of the Spanish Empire. Discuss the question it poses. Enrich likely answers by providing the following information, which you may choose to deliver as a mini lecture. The treasure of the Americas provided Spain with purchasing power, which ultimately stimulated the development of England, France, Holland and other parts of Europe. Spain’s gains were only temporary because it spent the bullion of the Americas to buy consumption goods, which these other nations exported. Further, Spain’s windfall gains led the government to pursue a war-mongering policy, which drained the Spanish treasury. By the beginning of the 18th century, as stocks of bullion were depleted in the mines of Mexico and Peru, the momentum of the Spanish economy evaporated. The artisans and entrepreneurs Spain needed to sustain its economic growth were insufficient to generate wealth to counterbalance the government’s debt and the expenditure needed to sustain a plethora of priests, lawyers and bureaucrats. Spain’s economy therefore declined absolutely and relative to the other leading nation states of Europe. For further discussion of the impact of American bullion on Europe’s economic growth, see Ferdinand Braudel, The Mediterranean and the Mediterranean World in the Age of Philip II, Los Angeles: University of California Press, 1996.
Expansion of the money supply does not guarantee prosperity in the long run. The economy’s output in the long run is determined by supplies of capital and labor and the available production technology for turning capital and labor into output. This is a fundamental assumption of the “quantity theory of money.”
State that the quantity theory of money shows how changes in the money supply (M) are related to changes in the economy’s output (Q) in the short run, and to changes in the level of prices (P) in the short run and in the long run. Note that Q represents the “real output,” as opposed to the “nominal output” (P x Q). The real output is expressed in constant dollars.
Pose the following question: “The equation of exchange, M x V = P x Q, is a representation of the quantity theory of money. If V fluctuates whenever M changes, will changes in M have an impact on the nominal output?” Answer: If V increases as M increases it will magnify M’s impact. If V falls while M increases, it will reduce or even cancel out M’s impact. The teacher is reminded once again that there is no “normal” relationship inferred between M and V.
Ask: “Apart from the assumption that the economy’s output in the long run is determined by real factors and not money, what other assumptions must hold for this theory to hold?” Answer: For changes in M to cause changes in P and Q, the velocity (V) has to remain stable and must not be affected by changes in the money supply (M). And evidence indicates that velocity is usually resistant to change.
Quantity Theory of Money and Imperial Power
State that you are about to demonstrate how the quantity theory of money helps us understand some aspects of the concept of global interdependence. This concept lies at the heart of globalization, a historical process (or set of processes) of gradual transformation of the modern world into the contemporary system of international economic, political and social relations. The challenge of global interdependence is that it affects state power of nation-states directly and unevenly. The quantity theory of money helps us understand some aspects of globalization as a process of historical transformation of state power. For a detailed analysis of this topic the students may visit the following Web sites:
Distribute Handout 4, The Decline of the Chinese Empire and the Expansion of the British Empire, and discuss the question it poses. Use the following information to direct a class discussion.
When gold and silver are the only forms of international payment, a trade deficit reduces the money supply of any nation whose imports are greater than its exports. England found itself in this position. Its trade deficit had to be financed with an outflow of bullion since the Chinese were not interested in purchasing English goods and did not want to buy England’s financial assets — capital that could have been used for payments in lieu of money.
Ask: “Since bullion made up England’s money supply, what must have been the effect of its outflow on the level of prices? Why?” Answer: In accordance with the quantity theory of money, a reduction in the money supply must have reduced spending and consequently the price level (deflation).
Ask: “What were the likely effects of these changes on sales revenues and business profits?” Answer: It is likely that both revenues and profits fell. Note: some perceptive students might note that profits might have remained steady if input prices fell along with goods prices.
Ask: “Under these circumstances what is likely to have happened to the output of the English economy?” Answer: It must have been reduced; businesses must have reacted to the fall in revenues and profits by cutting down production and laying off workers.
The British government gave in to the entreaties of opium traders (such as the firm of Jardine Matheson) and vigorously defended the opium trade to the point of declaring war against China. By now, it should be obvious why. Revenues from exports of opium paid for imports of silk and tea. Britain was defending its balance of payments, its monetary stability, and the prosperity of its national economy.
If you have covered in your lessons the market for loanable funds, you may add the following points to your discussion. Otherwise introduce directly the question in the next paragraph. You may point out that lower spending could lead to a decrease in savings and therefore in loanable funds, resulting in higher interest rates and a tightening of credit. Advocates of the quantity theory of money (monetarist tradition) would add that an unanticipated fall in prices increases real wages (the purchasing power of wages) and provides an incentive to reduce costs by laying off workers. For these reasons a fall in the economy’s output — in the short run — would be expected.
Ask: “Would the gold standard have had any merits?” If the class does not see any merits, ask: “If gold served as the international medium of exchange and a government allowed prices to rise relative to prices in other nations, what would you expect to be the effect on its imports? Why?” Answer: Its imports would rise relative to its exports since foreign goods would be cheaper. The nation would experience a “deficit in its balance of payments.”
Ask: “What would be the effect of the balance of payments deficit on this nation’s money supply and the level of prices?” Answer: Both would fall.
Ask: “Do you see any merit in maintaining a gold standard?” Answer: One merit is that the gold standard promoted long-term price level stability within countries and internationally. Downside: countries on the gold standard did experience short-term price instability.
Announce that finally you would like the class to consider how monetary management and the international monetary system may combine to vest one country with hegemonic power. Define “hegemony” as dominance of leadership, especially by one nation over others.
Distribute Handout 5, Hegemony through the Balance of Payments? Ask the class to read it. Discuss the answer to the question posed on the handout as follows.
Ask: “When nations operate under the gold standard their balance of payments deficits result in a fall of their money supply. Would this also happen when nations operate under a gold-exchange standard?” Answer: Yes, except in one case: the country that issues the reserve currency would not experience a reduction in its money supply.
Ask: “Some economic historians have called this an ‘extraordinary privilege’ for the reserve currency-issuing nation. In what sense do you think this would be a privilege?” Answer: The reserve currency-issuing nation would be the only one that could pay its international bills by printing money and running balance of payments deficits.
Ask: “Would the reserve currency-issuing nation be likely to abuse this privilege?” Answer: Yes. It would be tempted to increase its prosperity and to finance the expansion of its economy simply by printing money.
Ask: “If the reserve currency-issuing nation abused this privilege, how would other nations respond?” Answer: They would seek guarantees — for example, high interest rates for holding funds denominated in the reserve currency. Alternatively, they could demand to be paid in gold.
Ask: “Do you see any problems arising from such circumstances?” Answer: The system would work only if the reserve currency-issuing nation pursued and was able to implement a policy of economic stabilization, for itself and the world economy. This would be a difficult task, especially given the likelihood that it would abuse the privilege to which we referred earlier.
Allow the students to speculate on the likely problems that may befall an international monetary system based on a gold-exchange standard. Conclude by suggesting that the students research the reasons for the collapse of the Bretton Woods system in 1971. The reasons are clearly stated in a number of studies including Benjamin J. Cohen’s well-known paper available at the following Web site: www.polsci.ucsb.edu/faculty/cohen/inpress/bretton.html.
Conclusion
Write the following proposition on the board: “Economic theory is a necessary tool of historical understanding.” Allow students to reflect on the usefulness of economic theory in promoting historical understanding and ask the class to write an argument in favor of the proposition, referring to evidence from the various examples you used during this lesson.
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Equation of Exchange A mathematical identity equating the quantity of money in existence times the average number of times it is spent during a period to total spending: M x V = P x Q. Gold-Exchange Standard Unlike the gold standard, this is a system based on fixed rates against a principal currency. For example, in 1944 the Bretton Woods agreement called for fixed exchange rates against the U.S. dollar at an unvarying price of $35. Member countries held their official international reserves largely in the form of gold or dollar assets and had the right to sell dollars to the Federal Reserve for gold at the official price. Gold Standard During much of the 18th, 19th, and early 20th centuries, the developed economies of Europe and America were on the gold standard. Gold served as the international medium of exchange, and a nation’s gold stock limited its ability to purchase foreign products. Gresham’s Law This proclaims that “bad” money drives “good” money out of circulation. Inflation A sustained rise in the average level of prices. Money Supply One measure of this is the total quantity of currency (coins and paper money) held by the public and deposits at banks. Quantity Theory of Money A theory which links changes in the money supply (M) to changes in the economy’s output (Q) in the short run and to changes in the level of prices (P) in the short run and in the long run. Note that Q represents the “real output,” as opposed to the “nominal output” (P x Q). The real output is expressed in constant dollars. Velocity of Circulation The average number of times a unit of money is spent during a time period. |