By: Renzo Forastiero

We’ve all seen alarming pictures of recent events in Venezuela but most still wonder what really went wrong. The Venezuelan government tampered with one of the key features of a modern economy, the independence of its central bank, and inflation spiralled out of control, reaching 56 percent by 2014. Here’s why. According to the Quantity of Money theory, the following equation must hold true always:

M.V = P.Q

That is, Money x Velocity of Money equals the Price level x Output. Given that in the short run, prices are sticky (they do not change) and the velocity of money is assumed to be constant, Venezuelan policymakers decided to print money to finance government expenditures. As the theory suggests, this led to higher output. Later on, people began to realise what had been happening and the price level begun to shift. In order to keep output growing, the government was forced to print ever-larger quantities of money, leading to higher and higher inflation.

Faced with this situation, most Venezuelan savers ditched the local currency, the Bolivar, in favour of the US dollar. The government was then forced to impose restrictions on the purchase of foreign currency, which led to a black market exchange rate about 10 times higher than the official rate. Today, controls are so tight that anyone quoting the unofficial exchange rate can be sent to prison. Venezuela would seem to be yet another clear example of how governments cannot create wealth by printing money. Economists generally agree that Venezuela’s runaway inflation rate and shortages call for harsh economic medicine: currency devaluation, an end to state subsidies, and a lifting of exchange and price controls.

Jose Guerra, a respected Venezuelan economist and former research manager for the Central Bank of Venezuela, notes that a more economically rational faction within the United Socialist Party of Venezuela (USPV) does in fact appear to be gaining ground. Nevertheless, common sense economic measures will be politically difficult to implement in light of the 40 percent of Venezuela’s population who are poor, and continue to believe strongly in former leader Hugo Chavez’s promise of redistribution and equality. Only time will tell how this situation will unfold.