Introduction

Historical studies of periods of rapid and sustained inflation as well as empirical studies of the demand for and supply of money have convinced monetarists that a strong link exists between money and prices. Indeed, Friedman (1968) has argued that movements in the money supply dominate movements in the price level.

One study that monetarists have often cited as strong evidence for this link between money and prices is Phillip Cagan's [1956] study of hyperinflations. With data on the money supplies and price levels of six countries in the throes of hyperinflation, Cagan finds that the hyperinflations were apparently caused by the pressure of a rapidly growing and exogenous money supply against a stable demand for real money balances. Unfortunately, the statistical procedures available to Cagan did not enable him to test the specification of his model adequately. In particular, he tested neither his specification of the mechanism generating expected inflation rates nor his specification of an exogenous money supply. Indeed, he failed even to test for serial correlation of the error terms. The Monte Carlo experiments of Granger and Newbold (1974) amply demonstrate that the goodness of fit of a regression is often greatly over-stated when serial correlation is present in the error term. It is therefore desirable to reassess Cagan's study.

In this chapter, I apply the technique advocated by Zellner and Palm (1974, 1975) to test three specifications of the dynamics of the German hyperinflation:

• Model C, Cagan's original model;

• Model MC, a modification of Cagan's original model in which expectations of inflation are rational in the sense of Muth (1961); and

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