Inflation

Inflationary pressures persistently dog every type of economy across the world. However, the pressures are typically much higher amongst many developing counties. In many cases, aside from the lack of necessary economic tools required to combat inflation, a major component in the constraints faced by these countries is the issue of credibility. In this essay I will focus on the role that credibility plays within various stabilisation programs, and more specifically the effect that it has on inflationary inertia and on the real exchange rate.

This will be done by looking at the different types of stabilisation programs that have been used, the causes of a lack of credibility of these programs, the steps that governments can take to increase the credibility of its schemes, and finally a conclusion will be drawn regarding the links between credibility and both inflationary inertia and exchange rate overvaluation. Firstly though, it is worth looking at the scope of the effects that inflation has across the world.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!


order now

While the western hemisphere is in no way immune to the threat of inflation, it is true that high levels of inflation are much more widespread amongst developing countries where, as Agenor and Montiel (1996) show sustained inflation rates of over 25% have routinely appeared in no less than 54 countries across the world since 1965. They also identify a small group of 14 (mainly Latin American) countries, which have persistently dogged by “chronic inflation” from 1965-89. More recent examples include Argentina and Brazil in the 1990’s.

The effects of high levels can be devastating, with in almost all cases, huge corresponding falls in output, rises in unemployment and rises in government deficits as well as the obvious psychological harm and distress that it will cause the unfortunate members of the afflicted country. Stabilisation programs: Programs aimed to reduce these inflationary pressures are known as stabilisation programs and will typically take 3 main forms: * Populist approach: Aims to address a range of macroeconomic issues such as production failures, income distribution and external crisis as well as inflation.

This is done through a stimulation of aggregate demand as well as the implementation of wage and price controls. Examples of this approach are Chile under Allende (1970-73) and Peru under Garcia (1986-89). Outcomes of both were high levels of inflation (exceeding 6000% in Peru in 1988) as well as extreme exchange rate overvaluation. * Orthodox approach: Uses a nominal anchor (either monetary growth or exchange rate targets) in order to implement the necessary fiscal adjustments needed to reduce demand.

Examples of using monetary growth as a target are Chile (1973) and Bolivia (1985). It is also worth noting here that, as the central bank is not the sole source of base money (the others being the balance of payments and the private sector), fiscal contraction will not automatically imply a reduction in money growth. The so-called “Southern cone” exchange rate based approaches encompass attempts by Chile, Argentina and Uruguay in 1978. Results do vary but typically result in a gradual fall in inflation as well as a loss of output and corresponding high levels of unemployment.

Exchange rate overvaluation is an additional danger of this approach. * Heterodox approach: These are based on the premise of a strong inertial component in inflation and combine features of the other two approaches in the form of price controls, fiscal adjustment and a nominal anchor in the form of the exchange rate. The presence of inflationary inertia is normally brought about by the existence of backward-looking indexation mechanisms (such as monetary aggregates or the exchange rate), and will prolong the recovery period that the economy faces.

As Agenor and Montiel (1996) note, when inertia is absent (the case under hyperinflation) “quick inflation convergence with minimal output costs is possible”. Furthermore, Edwards () showed the speed of inertia to be vital element that governs a countries recovery process. Examples of heterodox approaches are in implementation of the Cruzado Plan in Brazil (1986), “El Pacto” in Mexico (1987), the Austral plan in Argentina (1985) and in Israel in 1985. Interestingly, while both Argentina and Israel were suffering from very similar economic conditions, the outcomes of the approaches were very different.

Whilst the Austral plan in Argentina only succeeded in reducing inflation to a still very high quarterly rate of 110% in 1986 (leading to the overvaluation and eventual devaluation of the Austral and subsequent ill-fated attempts to control inflation), the Israeli plan was successful, reducing inflation from a quarterly rate of 42% in Q1 1984 to 4. 5% Q1 1987. One of the main reasons for this contrast of fortunes was the role that credibility plays in reducing inflation (or more specifically, inflationary inertia).

Causes of credibility: Internal inconsistency: This arises when the public views the stabilisation approach as inconsistent with other policies that are being pursued. An example of this is the Brazilian Cruzado plan, which sought to combat inflation at the same time implementing an expansionary fiscal strategy. As private investors could see the inflationary nature of the fiscal expansion, the plan quickly lost credibility. Furthermore, the fixing of the exchange rate must be a credible and sustainable measure in itself.

To take an example, Blanchard (2003) states “Fixing the exchange rate while continuing to run a large budget deficit will only convince financial markets that money growth will start again, and that devaluation is soon to come”. This has been the case with many fixed exchange rate programs, with the resulting overvaluation if the domestic currency. Argentina under Menems convertibility plan (implemented in 1989) probably the most recent example of this. Time inconsistency: This arises when the ex post and ex ante goals of policy makers conflict.

Once expectations are formed as a result of a policy announcement, there is a strong temptation on the governments to renege on the policy in order to peruse additional objectives. An example of this would be the incentive to devalue a currency in order to promote output after announcing a fixed exchange rate, the policy that the public’s initial expectations were formed around. Governments often have to balance economically sound policies with politically popular ones.

Unemployment levels are extremely politically sensitive, with a large rise in unemployment almost certain to cause civil unrest. As decreasing unemployment and disinflation are, by and large, the incentive in this case to renege is high – something that the public and private investors are only too aware. The sequencing of micro and macroeconomic policies is also very important, and the implementation of necessary microeconomic policies such as wage and price controls, or tax reforms, before the macroeconomic measures is essential.

If the government fails to do this (as in Argentina in 1985 where wage-price controls were implemented after the announcement of a fixed exchange rate), the stabilisation process will lack credibility and inflationary inertia will still be persistent. Imperfect information: If, as in many developing countries over the years, there is a rapid change of policy makers it is very hard for the public to gauge how credible a government’s commitment to disinflation is.

This can work either for or against the new policy maker with the publics initial reaction varying from one of suspicion to one of general trust and the “honeymoon period” enjoyed by many new governments. Once this period wears off however, distrust may well grow and the short-term gains are offset by longer-term losses and often the economy finds itself in a worse state than when the policy make took over. This is definitely been the case in, amongst others, Argentina and Brazil in recent years, with the initial euphoria leading to expansionary policies and the eventual overvaluation of the domestic currency.

Policy uncertainty: A fixed exchange rate will often entail severe monetary restrictions on government policy. Whilst this may be desirable in certain situations, it also severely restricts the freedom the government has in reacting to external shocks to the economy. An example of this would be Menems pegging of the Argentinean peso to the dollar in 1989. Whilst this effectively turned the central bank into a currency board (and in doing so ensured that the government debt could not be moneterized) it also removed any monetary power that the administration had.

The Argentinean economy was therefore extremely susceptible to any external shocks. When these shocks duly happened, such as the Mexican “Tequila” shock, the Brazilian-Russian crisis and the SE Asian crisis, private agents knew that the only viable course for Argentina to take was to devalue in order to remain competitive. Whilst the administration staunchly defended the peso-dollar exchange rate, it was clear that the peso was overvalued. Credibility of the scheme fell lower and lower leading to the inevitable devaluation of the peso (and removal of the Menem government) in 2002.

Political instability: The track record of a government (or indeed preceding ones) in successfully reducing inflation also plays a large part in the perceived credibility of a program. It is very likely that, as the recent stabilisation programs in Argentina and Brazil were the 5th and 6th attempts respectively made by recent governments to reduce inflation, there was already a lack of credibility of the plans in the public’s eye before they were even announced. Building Credibility: Of course, there are steps that governments can take to enhance the credibility of a stabilisation program.

It may signal its intent with an over-drastic policy in order to convince the public that its goal is genuine. This was successfully the case in Mexico in 1994, however there are drawbacks. The “over-drastic” policy may not be a credible one and, even if it is, it will take time to implement and for the public to gauge its success. The policy maker may also implement price controls such as price freezes or ceilings in order to buy time to convince the public of the credibility of the scheme.

However, the jury is still out as to its effectiveness in raising credibility. The success of this will depend on the percentage of prices that are actually controlled (100% control may not be viable or desirable for the government) and the initial credibility of the measure. Agenor and Montiel (1996) show the level of inflationary inertia to be inversely related the two aforementioned factors. Finally the presence of external aid will have a large effect on whether a program is deemed credible or not.

A big factor in the Israeli success as opposed to the Argentine failure in reducing inflationary inertia in 1987 was the presence of $1. 5 bn of US aid. More recently, the Menem govt sought credibility for the peso-dollar exchange rate through extensive IMF funding and approval. As we now know, this was not enough, and the vastly overvalued peso eventually devalued. Conclusion: One of the main problems in assessing the link between credibility and both inertia and exchange rate overvaluation is the difficulty in measuring these variables.

Gottschalk (2003) suggested that there are two types of chronic inflation (high and constant but subject to shocks, and constantly increasing) and that breaks in inflationary inertia can be shown by breaks in the time trend of respective non-linear and trend stationary series. Edwards (1998) conducted regressions on both the Mexican crisis of 1994 and the Chilean crisis of 1982. Although he found an initial decline in inertia in the Mexican case, this decline was shown to be short-lived. The Chilean stabilisation program showed no effect at all.

In both cases the models suggested that the sluggishness in inflationary inertia was due to a lack of credibility of the schemes. To conclude, we have seen that many stabilisation programs, and in particular, those which entail a fixed-exchange rate as a nominal anchor often lack a high degree of credibility. In the case of, amongst others, Chile (1978), Uruguay (1978) and the continuing attempts in Brazil and Argentina these have resulted in an overvaluation of the domestic exchange rate and eventual devaluation.

We have also seen that the degree of inflationary inertia faced by an economy will prolong the recovery period from high or chronic inflation. Due to the aforementioned causes of credibility, it makes intuitive sense that such inflationary episodes involving a high level of inertia such as Chile (1965-70, 1972-80 & 1982-86), Bolivia (1973-74, 1982-86) and Zaire (1976-89) as well as the above examples and many others suffered a high level of inertia as a result of the lack of credibility of the stabilisation programs.

Edwards, in his study of Chile and Mexico reinforces this view and finds a direct link between the level of inertia and perceived credibility. While it is accepted that the level of credibility that a program holds is by no means the sole factor of inertia or exchange rate overvaluation, it does have a significant influence on them and should be treated with the appropriate regard by any government implementing a stabilisation program.