Competitive Equilibrium Hyperinflation Under Rational Expectations

Cagan’s (1956) seminal work provided the first attempt to explain the hyperinflation phenomenon. That essay was so influential that small variations of Cagan’s model can be found in several textbooks, such as Blanchard and Fischer (1989), Obstfeld and Rogoff (1996) and Romer (2001).Cagan’s model is capable of generating hyperinflation under two types of expectation mechanisms: adaptive and rational. Both are unsatisfactory because adaptive expectations yield systematic forecasting errors, while rational expectations need to be combined with a partial adjustment mechanism in the monetary market. Moreover, both mechanisms require violation of the government intertemporal budget constraint to generate a hyperinflation. That is, in Cagan’s model hyperinflation is not a competitive equilibrium outcome.