Thomas Sargent, Noah Williams, and Tao Zha
Working Paper 2006-20
November 2006

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We infer determinants of Latin American hyperinflations and stabilizations by using the method of maximum likelihood to estimate a hidden Markov model that potentially assigns roles both to fundamentals in the form of government deficits that are financed by money creation and to destabilizing expectations dynamics that can occasionally divorce inflation from fundamentals. Our maximum likelihood estimates allow us to interpret observed inflation rates in terms of variations in the deficits, sequences of shocks that trigger temporary episodes of expectations driven hyperinflations, and occasional superficial reforms that cut inflation without reforming deficits. Our estimates also allow us to infer the deficit adjustments that seem to have permanently stabilized inflation processes. Our results show how the available inflation, deficit, and other macroeconomic data had left informed economists like Rudiger Dornbusch and Stanley Fischer undecided about the ultimate sources of inflation dynamics.

JEL classification: C5, E5, H3

Key words: self-conirming equilibria, rational expectations, adaptation, inflation, seigniorage, deficits, escape dynamics

The authors thank Eduardo Ganapolsky, Karsten Jeske, Albert Marcet, David Romer, and especially Christopher Sims, Dan Waggoner, and Michael Woodford for helpful discussions. Sagiri Kitao, Tomasz Piskorski, and Demian Pouzo provided outstanding research assistance. Namgeun Jeong and Eric Wang provided indispensable assistance on clustering and parallel computing in the Linux operating system. The authors acknowledge the technical support of the Computing College of the Georgia Institute of Technology on grid computation techniques. They also thank Mike Chriszt, Jose Ricardo, Diego Vilan, and Elena Whisler for their help with both collecting the data and understanding institutional details. Sargent thanks the National Science Foundation for research support. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Thomas Sargent, Professor of Economics, Department of Economics, New York University, 269 Mercer Street, New York, NY 10003, 212-998-3548,; Noah Williams, Assistant Professor, Department of Economics, Princeton University, 001 Fisher Hall, Princeton, NJ 08544-1021, 609-258-4019,; or Tao Zha, Research Economist and Senior Policy Adviser, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470, 404-498-8353,

For further information, contact the Public Affairs Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8020.