MACROECONOMIC POLICY, INFLATION AND STABILIZATION

1. MACROECONOMIC POLICY, INFLATION AND STABILIZATION http://www.youtube.com/watch?v=TfkZlbax0Lw&feature=related http://www.youtube.com/watch?v=ScXCBJkp3s4&feature=related

2. Why was Latin America so inflation prone? • What caused inflationary pressures in the region? • Why was inflation so intractable? • What mechanisms were used to bring inflation under control in the region? What worked? • Is inflation in Latin America now gone for good? Will the collapse of the exchange rate-based stabilization plans in Argentina and Brazil result in renewed inflation in the region?

3. What causes Inflation? Two Schools of Though: Monetarists VS Structuralists. 1. Monetarists: Too much money chasing too few goods. “Quantity theory of money” The equation of exchange with multiplied terms on both sides: Where • M is the total amount of money in circulation on average in an economy during the period, say a year. • V is the velocity of money, that is, how often each unit of money is spent during the year. This reflects availability of financial institutions, economic variables, and choices made as to how fast people turn over their money. • P•Q is the money value of expenditures • P is the price level for the economy during the year. • Q is an index of the real value of expenditures

4. If the rate of growth of output and velocity are assumed to be constant in the short run, prices are determined by the quantity of money in circulation. According to monetarists inflation occurs because monetary authorities increase the growth rate of money supply despite of the rising in prices. • Monetarist explanations for such excess in Latin America include: a. Irresponsible deficit financing, b. Erosion of the tax base, c. Mismanagement of the debt crisis.

5. A. DEFICIT FINANCING • If G-T > 0 Government budget deficit; G-T = 0 Govt’ budget balanced; G – T < 0 budget surplus • If government spends more than it collects, then it must finance its deficit thru either (i) printing money (seignorage); (ii) issuing domestic debt or (iii) borrowing from abroad. • LATAM governments were precluded from borrowing abroad due to the recent debt crisis and from issuing domestic debt because of the underdeveloped domestic financial markets. They financed their deficits by increasing the money supply (printing money) this spurted inflation. Interest rates sky rocked causing a large contraction of investment and consequently a halt on economic growth. High inflation with recession (Stagflation) • Whereas deficit spending in most industrial countries is countercyclical, in Latin America it has largelybeen procyclical. That is, instead of spending to stimulate the economy during a recession, Latin American governments tend to contract during recession. This is tied to access to funds. As recession erodes the government’s ability to raise money in international markets, it must reign in spending. Unfortunately, such procyclical policies, by their very nature, exacerbate macroeconomic volatility.

6. B. TAXATION • The level of taxation in Latin America is very low compared to other regions. This exacerbates the necessity of monetize the deficit C. Effects of the Debt Crisis • No access to international financial markets for new loans and the necessity of service the debt pushed governments to print more money. Devaluations increased the value of external debt in terms of domestic currency

7. 2. STRUCTURALISTS: CAUSES OF INFLATION ARE DUE TO THE INCOMPLETENESS OF MARKETS IN DEVELOPING COUNTRIES. • Structuralist or heterodox explanations focus on the structure of the underdeveloped economy as the propagating mechanism for inflation. • Economies in Latin America can best be understood as incomplete markets that do not automatically tend toward full employment equilibrium. • Bottlenecks in both the agricultural and the industrial sectors create price pressures. If input markets cannot quickly adjust to price signals to meet supply requirements, inflation will result. • External price shocks from the international economy can also introduce or exacerbate instability in the domestic market. • Cost-push elements represented by internal and external shocks interact with the structure of industry and labor organization to fuel an inflationary struggle. • Inflation then reflects the distributive conflict between capital and labor. • If all agents assume inflation, each side wants to build predicted price increases into its share of the pie.

8. INDEXATION, INFLATIONARY EXPECTATIONS, AND VELOCITY • Measures introduced to minimize the costs of inflation: • wages were indexed to indicators that accommodate periodically to inflation. Indexing made easier to live with inflation. • Inflationary expectations • Velocity of money changed in response to economic agents learning to live with inflation. • V= GDP/M. If V is increasing or equivalently M is decreasing without changing GDP.

9. TIMING AND ADJUSTMENT • Three policy choices that are often considered desirable are: (1) Fixed exchange rates (less uncertainty), (2) Free movement of capital, (3). Independent monetary policy. • The macroeconomic policy trilemma is that only two of these three objectives can be attained simultaneously. • The trilemma provides a convenient way to categorize the choices that different countries make. The United States runs an independent monetary policy (the Taylor rule), allows free capital mobility, and has a flexible exchange rate. • Facing this “trilemma,” monetarists largely counseled abandoning domestic monetary policy and linking to a “hard” international currency; structuralists suggested exchange controls to preserve domestic autonomy.

10. Heterodox Approaches to Inflation Stabilization in the 1980s: Brazil • The Cruzado plan inJanuary 1986 (President Jose Sarney) • A general price freeze and a partial freeze on wages following an 8-percent readjustment was implemented. • If the consumer price index increased more than 20 percent, wage increases would be permitted. • Indexation of contracts with less than one year’s duration was prohibited. • A new currency was created called the cruzado, set equal to 1,000 cruzeiros. • The exchange rate was fixed at 13.84 cruzados to the dollar. • In less than four months inflation fell from 459.1 % in January to 4.5% in April. • Brazilian’s consumer demand surged and credibility on the government commitment to combat inflation eroded. • A year and a half after the introduction of the plan, inflation topped 1,000 percent. • Brazil continued its heterodox experiment with the Bresser plan included another revaluation of the currency, lopping off three zeros once again and calling it the novocruzado.

11. THE REAL PLAN (FERNANDO HENRIQUE CARDOSO) • The real plan was a pragmatic mix of orthodox and heterodox elements. • Eliminate the inertial elements of inflation to break out of a cycle of indexed price increases that adjusted for past inflation by identifying disequilibria, eliminating price distortions, and introducing emergency fiscal adjustments. • All wages, prices, and taxes, and the exchange rate, were redenominated in a new accounting unit called the urv, or the real unit of value, roughly set at par to the U.S. dollar. • Indexation to other rates was prohibited, and the money supply was tightened, indicating a monetarist bent. • A new currency, the real, was introduced; it was tied initially one to one to the urv accounting unit. • The policy changes implemented in association with the Real plan were credible to the public. • The gradual, preannounced nature of each step served to calm expectations. • After more than two decades of unsuccessfully battling inflation, the public was simply ready to bite the bullet. Expectations of inflation were changed.

12. LESSONS: • (1) Heterodox policy alone is not enough. Simply focusing on expectations and taming the inertial component does not eliminate the imbalances creating the expectations. Fiscal and monetary fundamentals also need to be adjusted. Without reshaping the fundamentals, it is not possible to generate confidence that the imbalance in the domestic economy has been corrected. • (2) A pure orthodox approach was not dramatic enough to generate confidence and support. Simply restraining the money supply had perverse effects. When the money supply was cut and interest rates rose as a result, economic agents perceived this as a rise in the nominal interest rate. Without a change in expectations of inflation, without a clear sense of a change in the rules of the game, inertial aspects of inflation will plague the orthodox strategy.

13. The Case of Argentina: From the Austral Plan to the Convertibility Plan The Austral plan (Raul Alfonsin) • A heterodox plan, froze wages and prices (including the exchange rate), and introduced a new currency with a promise not to print money. • Fiscal adjustment was the third element of the plan. • Initially the plan succeeded as inflation decreased from 350 percent in the first half of 1985 to 20 percent in the second. • The Austral plan collapsed because its credibility was undermined. The exchange rate became overvalued and external accounts deteriorated. The convertibility plan (an orthodox plan, President Menem) • The convertibility plan locked the Argentine peso to the U.S. dollar. • Through a currency board independent of the Treasury, by law the money supply could be increased only if the U.S. dollars held in reserve were to rise. • Liberalization of the economy promoted exports and the inflow of foreign investment to increase the stock of dollars in Argentina.

14. THE CONVERTIBILITY PLAN (CONT’) • Fiscal adjustment was dramatic (but incomplete). • The government embarked on a large-scale privatization program, putting fifty one firms on the auction block between 1989 and 1992 • Tax reform increased revenues to balance government books. • Inflation tumbled in Argentina from the peak of more than 3,000 percent to an astoundingly low rate of 0.1 percent in 1996. • Domestic and international capital believed in the long-run commitment of the plan. International capital flowed to Argentina. • Social costs were high reflecting a 17-percent unemployment rate. • When its trading partner, Brazil, let the real float in 1999, fragilities in the Argentine model were exacerbated. • At the same time the strengthening dollar compounded the overvaluation of the peso. • External accounts deteriorated, unemployment remained stuck at socially unacceptable levels in the range of 18 percent, and fiscal deficits were not brought under control. • In January 2002, and Argentina tumbled into economic chaos.