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Monetary Policy: Hyperinflation to Dollarization

Explore the rise and fall of Zimbabwe's economy under Mugabe's leadership, from success to crisis, covering hyperinflation, unemployment, and the transition to dollarization.

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Monetary Policy: Hyperinflation to Dollarization

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  1. UCT Summerschool 2015 Monetary Policy:Hyperinflation to Dollarization

  2. This is a story about a country led by an African freedom-fighter, who: • Had a history within the South African ANC • Opposed the white colonial rulers of his country • Jailed for his "terrorist" activities • Convincingly elected to lead his country and advocated reconciliation between blacks and whites • "If yesterday I fought you as an enemy, today you have become a friend (...) If yesterday you hated me, today you cannot avoid the love that binds you to me and me to you." • Was overloaded with international honours (honorary doctorates, Hunger Project Prize, Knighthood by ERII, short-listed for Nobel Peace Prize)

  3. Which One?

  4. Zimbabwe success story from 1980-1990 • High growth rates • High school enrolment rates increased from 2% to 70% • Literacy rate nearly doubled from 45% to 80% • NY Times in 1986: "Zimbabwe under Mr. Mugabe’s leadership remains one of Africa’s success stories. His sensible economic policies have kept the country’s key agricultural sector healthy. His responsible treatment of the white remnants of colonial Rhodesia has checked the flight of a skilled minority. Even the debilitating relations between black tribes seem to be less tense."

  5. … And Now … • Inflation surpassed 1 billion percent in 2008; • About 90% of all Zimbabweans are unemployed and at least 4,160 companies have closed; • more than 25% of citizens have left the country; • Male life expectancy was 58 years in 1991 vs. 45 years in 2006; Female life expectancy was 61 years in 1991 vs 34 years in 2006; • Country is no longer food self-sufficient and imports most goods from South Africa (and China)

  6. Zimbabwe presently • unemployment estimated at close to 90%; since 2011, • “And worst of all we can't even grow our own food anymore; in the first six months of 2014 we imported over US$400 million worth of groceries, most from South Africa.”

  7. Zimbabwe Monetary Policy:From Hyperinflation to Dollarization UCT Summerschool 2015

  8. What is Hyperinflation? • Generally: Over 100% annual rate of inflation • Cagan’s definition: month-on-month price increases exceeding 50% • Hanke& Krus (2012) identify 29 episodes of hyperinflation

  9. Nature of Inflation • Increase in price for the same goods or services, adjusted for quality. • Both a socio-political & economic issue • Battle for income shares • The depreciation – inflation spiral

  10. Zimbabwe CPI Inflation (12 month inflation in percent change)

  11. Zimbabwe Inflation in Context Source: Hanke, S and Krus, N (2012), World Hyperinflations, Cato Working Paper No 8.

  12. Other Past Hyperinflations • Post-war • World War I (Germany) • Post world war II (Hungary, Greece, China) • Latin America – as a result of 1980’s financial liberalization(Peru, Bolivia, Chile, Argentina, Brazil) • Former USSR,transition into democracy • African cases (Congo Brazzaville & DRC)

  13. Zimbabwe’s Hyperinflation: (Lecture I) • Costs and benefits of inflation • How did it happen? • How is money created? • How was the exchange rate set? • Hyperinflation and Purchasing Power Parity • Hyperinflation and the Quantity of Money Theory

  14. Hyperinflation and Policy(Lecture I) • Was government leadership ignorant of consequences of policy? • Was government pursuing an alternative strategy that went wrong? • Was policy calculated to benefit only a few?

  15. Hyperinflation Exit Strategy(Lecture II) • Multi-currency dollarization exit strategy • Pros and Cons of Dollarization • Optimal Currency Area implications • Current policy issues

  16. Costs and Benefits of Inflation

  17. Costs of High Inflation • Hurts purchasing power of those on fixed incomes • Raises real rate of taxation (personal and business) • Distorts relative prices leading to incorrect decisions by economic agents • May reduce short-run output and raise output volatility

  18. Inflation andthe Interest Rate • Inflation (or expected inflation) raises the nominal interest rate Nominal interest rate (R) = expected inflation (ie) + constant (r) • What really counts is the real interest rate r= R -ie Or how much above the inflation rate you have have to pay to borrow money. r= real interest rate

  19. Inflation Affects theNominal and Real Interest Rates • For rising or volatile Expected inflation, the real interest rate premium ( r ) becomes larger. • R = r + ie • High (real) interest rates reduce investment, and • Undermine the real value of debt (good for debtors)

  20. Costs of High Inflation • Inflation can create real distortions in economy and affects the real interest rate.

  21. Benefits of Inflation • Seigniorage– the difference in the value of money created by the government/central bank and the cost of creating that money. Often estimated as the change in central bank base money, or simply the change in the value of notes and coins. Governments like seigniorage.

  22. Benefits of Inflation • May create money illusion and help real wages adjust downward. %∆W - i = growth in real wages

  23. Benefits of Inflation • Inflation allows the possibility of a negative real interest rate (if nominal interest rate is set below the rate of inflation),which can be useful to stimulate the economy. Nominal interest rate (R) = expected inflation (ie ) + constant (r)

  24. Inflation and Money • “All inflation is a monetary phenomena” • Must have increased money supply to have inflation • “All inflation is a government phenomena” • Government must sanction the increased money supply.

  25. How is Money Created?

  26. All Money Is Created by Banks • Central bank creates new money when it makes a loan (to government or a State Owned Enterprise) • The Central bank reduces the money supply when it sells foreign exchange (reduces its foreign reserves) • Commercial banks have a money multiplier for the loans they make (to private sector and government)

  27. Central Bank’s Balance Sheet • Total Central Bank Liabilities = Reserve Money or Base Money or High Powered Money CIC In banks

  28. Commercial Banks’ Balance Sheet

  29. Money Creation

  30. Central Banks can Control Broad Money through the Money Multiplier mm = Broad money(M3)/Reserve Money • Increasing Reserve Money raises the money supply by a multiplier effect, which depends on reserve ratio (r) and cash/deposit ratio (c).

  31. Zimbabwe: Growth of Reserve Money

  32. Background to Zimbabwe’s Inflation Why the government would want to print money

  33. Background to Zimbabwe’s Inflation • The Congo War (1998) - Unbudgeted • Land Reform-Old problem, shifted approach • Farm mechanization • Political Challenge – rise of MDC in 1999 • Incentive for government to print money

  34. Structure of Zimbabwe’s Foreign Exchange Markets (>2000) Multiple Exchange Rates: • Official RZB rate (overvalued) • Parallel market rate (supply-demand) • UN Rate (PPP) • Rate for notes differed to rate for deposits • “Old Mutual Rate”

  35. Official versus Parallel Market

  36. Parallel Market Premium Log of Parallel Market Exchange Rate Premium ( >1 means more depreciated parallel rate)

  37. Hyperinflation and Economic Behaviour • How do economic agents behave in the face of hyperinflation? • Do they invest? • Do they save? • Do they speculate? • Do they spend money rapidly?

  38. Exchange Rate Arbitrage • Buying dollars in the official market and selling them in the parallel market • Buying dollars for Z$ cash and selling them for Z$ deposits • Barter may be better than cash

  39. Exchange Rate Arbitrage Winners and Losers • What is the impact of large profits on exchange rate arbitrage if GDP is static? • Would you consider these “rents”?

  40. What Is Money? Money serves as: • Means of payment • Measure of value • Store of wealth What happens to country’s money during hyperinflation?

  41. Economic theory behind money, prices and the exchange rate

  42. Inflation – Depreciation Spiral • The level of inflation is affected by the exchange-rate-pass-through into prices • The value of the exchange rate is determined (affected) by purchasing power parity (PPP)

  43. Purchasing Power Parity • The purchasing power parity relationship – that prices are equalized across countries – is based on: • The “Law of one price” P = NER Pf (for a single good) • Then for a basket of goods: NERppp = K P/Pf (aggregate price level) • NERppp is the equilibrium exchange rate e = local/foreign currency; increase=depreciation

  44. Does PPP Hold? • Tends to be a long-run phenomena after taking account of transportation costs and tax/tariff differentials. • Tends to be true for traded goods as opposed to non-traded goods

  45. Dynamic PPP If PPP holds in terms of levels,NER = K P/Pf Then it holds in terms of changes: Δ%NER = Δ%K + Δ%P -Δ%Pf Δ%NER = 0 + idom - ifor i.e. The %change in the exchange rate can be predicted by the inflation differential

  46. The Real Exchange Rate and Relative Prices The real exchange rate is equivalent to the relative prices between countries adjusted to one currency RER = (Rand/$*CPI_US)/CPI_SA = (CPI_US in Rand)/(CPI_SA) = Pus in lc/Psa • RER = (NER*Pf)/P = NER*(Pf/P)

  47. PPP and the RER NERPPP=K*(P/Pf) RER = NER*(Pf/P) • If PPP always holds, then the RER is constant (=K) • PPP only tends to hold over the long run, not in the short run

  48. PPP in Zimbabwe Did Purchasing Power Parity hold? • If PPP holds: • then: is constant • If the RER is Constant, then PPP holds • Test RER for stationarity

  49. Official versus Parallel real XR Official Rate: no unit root, Stationary Parallel rate: no unit root, trend Stationary (real depreciation)

  50. PPP and the Z$ Exchange Rate • Official exchange rate is stationary Did government price at PPP? • Parallel market RER is not stationary Hyperinflation caused real depreciation

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