Question

List the uses for the cagan equation?

Answer 1

The most important properties of the solution are governed by the coefficient β1. If −1 < β1 < 1,
(that is |β1| < 1), then the inflation dynamics of the system are said to be ‘dynamically stable,’
meaning that if the government stabilizes the money supply process mt, then the price dynamics will stabilize too. In this case, once a government gets control of the money supply process, inflation will eventually come under control too. But if β1 is too large, then even a stable monetary process
may lead to hyperinflations driven purely by ‘momentum’ — by individuals extrapolating from
past inflation behavior.
Cagan found that in the cases of the European hyperinflations of the 1920s, in most
episodes inflation dynamics were driven purely by fundamentals (|β1| < 1) and not by momentum effects. But in the case of Germany (1922-1923) and Russia (1921-1924), he found β1 = 3.17 and β1= 5.92, respectively, indicating that in these episodes inflation had a significant momentum component too.
One of the important messages that economists take away from Cagan’s paper is the need

(i) for discipline and/or an independent central bank, to prevent monetized deficits that canallow a hyperinflation to get started, and

(ii) the need for individuals’ inflation expectations to be ‘anchored’ — and thereby relatively unlikely to lead to a momentum-driven inflation break-out. Of course, part of the trick to anchoring inflation expectations is for government policy to be credibly anti inflation.