The Nature of the Effect of the Removal of Price Controls

The nature of the hyperinflation in Russia in the 1990's is widely misunderstood. It was not due to any shock therapy; it was due to the expansion of the money supply by the central bank of Russia. The removal of price controls would have resulted only in a one-time ostensible price increase, but even this is dependent upon an erroneous notion of what constitutes a price. When price controls hold prices down below their market equilibrium rate they create a shortage at the control level of prices and a black market. People cannot buy as much as they would like at the control prices and often it is only a lucky few with inside connections who get to buy at the control prices. Those without those connections and those who want more than they get at the control price must go to the black market and pay the higher price. The real market and the real market price is the black market price. Suppose gasoline is rationed and the ration price set at $2 per gallon but the black market price is $5 per gallon. Someone who buys gasoline at $2 per gallon decides whether to use that gallon or sell it on the black market based upon the black market price of $5 per gallon not the purchase price of $2 per gallon. The real price therefore even for those who buy at the control price is the black market price.

The black market price is not only higher than the control price, it is higher than the equilibrium price. Therefore when price controls are removed the real price goes down not up. The real price goes from the black market price down to the market equilibrium price. The control price is irrelevant but it is the price that would be used in price indices for measuring inflation. So the effect of the removal of price controls is not real inflation but the change from a bogus price to a real market price. However, without the continual expansion of the money supply there would be no further price increase.

Monetary Policy in the Ukraine in the 1990's