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When the functions of money break down: Hyperinflation

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To illustrate what the functions of money are, it can help to look at circumstances where those functions break down. Hyperinflation, in which prices of things increase really really fast, is one such example. Created by Grant Sanderson.

Video transcript

- [Voiceover] So in the last video, I was talking about various functions of money. 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 onto your money, it's value isn't just going to evaporate. Whereas if you hold onto a bunch of apples, as they rot and degrade away they're no longer valuable. And 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? That something that's 100 dollars is about twice as valuable as something that's 50 dollars 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 breakdown, 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 one dollar one day, it would be if it increases later on. So maybe it's $1.20, and if the prices of all goods as a whole in the economy tend to be increasing, it's not just milk is getting rarer or something like that, it's called inflation, and hyperinflation is basically a case where this is just happening really, really quickly. So Sal has 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. And 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 1980's and early 1990's, so 1980's and a little bit into the 1990's, was undergoing very fast inflation, and to give a feel for the kind of rates we're talking about at it's peak it was around 80% per month. And what this means is that every month the prices of general goods, a carton of milk, or a chair, 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 1,000. So that would mean if you have something that costs 100 dollars one day, it's gonna cost after a year, if inflation increases at this rate, 100,000 dollars. 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. And just to get our minds around what it might feel like to be in en 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 let's name these guys, 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 dollars a month for all of his things. And B in response gives A things. And then B, she buys all of her things from C, and she pays that same amount. She takes the full 50 dollars that she earned and she gets various things that she needs in life from C, and 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 over simplified as an economy, but I do think it gives a good feel for 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 80% increase per month. Something that costs 100 dollars one day, a month later is gonna cost 180 dollars. If you were person A and you knew that prices of things are gonna 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 gonna charge you 51 dollars because things are getting more expensive so I want to earn more. And then D in response says geez now I have to pay more so I'm gonna have to charge my customer C a little bit more as well. I'm gonna charge him 51. And then C says I'm gonna have to charge my customer more as well in order to make ends meet. And everybody has to increase their prices to keep up. And when the next day rolls around, 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 gonna make sure that I'm not the last one so I'm gonna increase my prices. I'm gonna increase them maybe she says 53 just to be sure. And then A, noticing the prices have increased has to keep up as well so he needs to do this. And of course the cycle continues. Everyone in order to make ends meet has to increase their prices. So this circumstance where you're changing your prices in anticipation of future change is what distinguishes hyperinflation in a qualitative sense from regular inflation. I think there's a quote that I really like. I think it's by Napoleon. It's "Quantity sometimes has a quality all of it's own." And that's definitely the case with hyperinflation because ordinary inflation, 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 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. And 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? This is about functions of money. Why am I talking about hyperinflation? Well let's take a look at these functions of money and 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 value however, this one clearly breaks down, because if you're holding on, let's say you have 100 dollars in savings today and then you know that things are increasing by 100,000% per year it's gonna be 1,000 times less valuable after a year. So most certainly it is no longer a store of value. And 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 a dollar that you hold on to, 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 dollars of value, and then after a year it's 50,000 dollars, you're not thinking of the value of that thing in terms of the national currency. And often throughout history, people started 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. So if you want to know how much should a carton of milk cost? Rather than thinking in your own nation's currency maybe so oh it's analogous to 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. And 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 U.S. dollar. This still serves as our unit of value. So that's one of the core distinctions. I think that's actually very important for 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. And basically because there was a really interesting way that they went about solving it. Any solution has to address the underlying causes of inflation and this video isn't necessarily about those. So there's gonna be things associated with making sure that the government is still fiscally responsible and balancing budgets and things like that but a different component that needs to be addresses is that money is no longer serving as a unit of value. So one really interesting thing that Brazil did in the early 1990's is they introduced a fake currency that they called the URV, for unit of real value, or really it was in the, really it's the Portuguese words for these, I think Unidade Real Valor, I don't really know Portuguese but the initials are the same, URV. And what they started doing is saying okay everybody continue paying in the national currency which at the time was the crucero I'm probably pronouncing that wrong but crucero. So they're still paying for everything in terms of their crucero. 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 crucero. In this case I've written dollars, so let's pretend this says 53 crucero, 51 crucero, things like that. 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, because everything started off being 50. And they loosely pegged this fake currency, this made up number, to the U.S. dollar. So over time even though the price in terms of cruceros was increasing, it might be 53 cruceros, and then 55, and then everyone's paying more and more in terms of cruceros, 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. So at this time the crucero was still serving the function as a medium of exchange. Nothing was really serving the store of value except for hard goods like land. And then this made up number was serving the function as a unit of value. And over time, as people started getting used to the idea that you go out to buy milk and you know that it's gonna be let's say one unit of real value, and then you just have to look up, okay how many cruceros 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. And 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 and printing money in terms of these URVs and abandoning the crucero, and telling people they could trade in their crucero for these URVs and that was gonna be the new currency. And 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! And the number would stay stable and instead of having prices increase 80% a month it decreased drastically to something that's much closer to a healthy economy's level of inflation. And 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 and invent something new that addresses that same function. Sure it's a made up currency, it's just a number you're assigning 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. And with that I will see you next video.