Chapter 5 Inflation and Disinflation

1. The World Bank Chapter 5Inflation and Disinflation © Pierre-Richard Agénor

2. Sources of Inflation • Nominal Anchors in Disinflation Money vs. the Exchange Rate • Disinflation Programs: The Role of Credibility • Two Recent Stabilization Experiments

3. Sources of Inflation • Hyperinflation and chronic Inflation • Fiscal Deficits, Seigniorage, and Inflation • Other sources of Chronic Inflation • Wage Inertia • Exchange Rates and the Terms of Trade • The Frequency of Price Adjustment • Food Prices • Time Inconsistency and the Inflationary Bias

4. Hyperinflation and Chronic Inflation • Cagan's criterion: Hyperinflation is defined as an inflation rate of at least 50% per month, or 12,975% per annum. Three main features of hyperinflation (Végh, 1992): • It typically has its origin in large fiscal imbalances. • Nominal inertia tends to disappear. • It brings about a chaotic social and economic environment.

5. Example of hyperinflation: Zaire. • A deep and worsening political crisis led to a drastic increase in government expenditure. • At the peak of the hyperinflation process, in December 1993, inflation rose to almost 240% a month. • During the whole period, domestic prices were increasingly set in foreign currency. • Figure 5.1: during the whole episode, the monthly rate of depreciation of the parallel exchange rate remained closely correlated with the inflation rate.

8. Features of chronic inflation: • Fiscal imbalances are often less acute in the short run than those observed during episodes of hyperinflation; in this case more difficult to mobilize political support for reform. • There is a high degree of inflation inertia resulting from widespread indexation of wages and financial assets. • The public is often skeptical of new attempts to stop inflation, particularly when there is a history of failed stabilization efforts. • Lack of credibility can be a source of inertia.

9. Fiscal Deficits, Seigniorage, and Inflation • In countries where the tax collection system, capital markets, and institutions are underdeveloped, fiscal imbalances are often at the root of hyperinflation and chronic inflation. • Governments often have no other option but to monetize their budget deficits. • Bruno and Fischer (1990): how monetary growth and fiscal deficits affect inflation. • Suppose: real money demand, md, is a function of the expected inflation rate, a.

10. Under perfect foresight expected and actual inflation rates are equal,  = a. • Money demand: md = m0exp(-). • At equilibrium, m = ms = md. This implies:  = - [ ln(m/m0)/ ]. • Along an equilibrium path, inflation and real money balances are negatively related. • Downward-sloping curve in the -m space, denoted MM in Figure 5.2.

13. .   M/M : rate of growth of the nominal money stock. • Real fiscal deficit: d = dA + ,  > 0, dA: autonomous component of the deficit; : measure Olivera-Tanzi effect (rise in the inflation rate lowers the real value of tax revenue as a result of the lag involved in collecting taxes). • Deficit must be financed by seigniorage revenue: d = m,

14. Rate of change of real money balances: m/m =  - . . . • After substitution, in steady state with m/m = 0,  = :  = [dA /(m - )], which implies that inflation and real money balances are negatively related in equilibrium (DD in figure 5.2).

15. Economy moves along MM in the short run; MM intersects DD only when the economy reaches its long-run equilibrium position (constant level of real money balances). • Depending on the size of dA, MM and DD may or may not intersect. Figure 5.2 illustrates three cases: • two equilibria, corresponding to curve DD; • one equilibrium, corresponding to curve D´D´; • no equilibrium, corresponding to curve D´´D´´.

16. Under what conditions is the long-run equilibrium unique? • Suppose  = 0. In steady state, m = dA. • As dA increases, steady-state seigniorage revenue (inflation tax) must increase as well. • But the relationship is nonlinear because as inflation rises, real money demand falls. • Exponential form of the money demand function: when inflation begins to rise, real money balances fall by relatively little, and revenue from the inflation tax increases at first. • As inflation continues to rise, real money balances begin to fall at a rate faster than the rate at which inflation rises.

17. Thus, after a phase during which m increases (at a decreasing rate), it starts falling (at an increasing rate) and eventually tends to zero as  goes to infinity. • These results define a concave relationship: seigniorage Laffer curve associating the steady-state , and m = dA. • Figure 5.2: for some level of dA, there are two corresponding rates of inflation, one low one high. • MM and DD curves in that case intersect twice. • Uniqueness occurs only at the optimal inflation rate, max: maximizes steady-state seigniorage.

18. Revenue-maximizing rate of inflation is reached: - [(dm/m)/(d/)] = m/ = 1. m/: elasticity of real money demand with respect to inflation. • Optimal inflation rate: max = 1/, : inflation elasticity of money demand.

19. Level of dA in this case: dA = (m0exp(-1) - )/. m m • When  < max, increases in  raise revenue from the inflation tax: ( d(m) / d > 0 and m/ < 1). • When  > max, increases in  decrease revenue from the inflation tax: ( d(m) / d < 0 and m/ > 1). • Is the solution stable? • Equilibrium with a lower inflation rate is unstable.

20. This means that any disturbance or exogenous shock will lead the economy away from low inflation equilibrium point. • But, high inflation equilibrium is stable. • Given the nature of the adjustment process under perfect foresight, a country can be stuck in a situation in which inflation is persistently high: inflation trap (Bruno and Fischer, 1990). • Any equilibrium characterized by  > max is inefficient: the same amount of revenue could be collected at a lower inflation rate. • What can governments do to move the economy away from an inefficient position?

21. Change either dA or , because both affect the position of the economy along the seigniorage Laffer curve. • For instance, a credible reduction in the money growth rate may shift MM and DD in such a way that the MM curve will intersect the DD curve only once. • Figure 5.3: positive relation between inflation and seigniorage. • Figure 5.4: positive relation between inflation and broad money growth. • De Haan and Zelhorst (1990) and Karras (1994b): link between monetary growth and budget deficits in developing countries.

24. Conclusion: only in a small number of cases does a close, positive relationship exist. • Explanation: role played by expectations about future policy changes (Kawai and Maccini, 1990). Criticism for public finance approach to inflation: • Since • taxation is an alternative to money creation; • marginal cost of taxation is moderate relative to the welfare costs of extreme inflation; high money growth (and therefore high inflation) is not optimal.

25. Other Sources of Chronic Inflation In addition to fiscal deficits and money growth, other factors that can affect the inflationary process in the short run: • Wage inertia • Exchange rates and the terms of trade • The frequency of price adjustment • Food prices • Time inconsistency and the inflation bias

26. Wage Inertia • Backward-looking wage formation mechanisms (e.g. wage indexation on past inflation rates) can play an important role in inflation persistence. • Model: economy produces home goods and tradable goods.

27. The inflation rate, , is given by a weighted average of changes in prices of both categories of goods:  = N + (1 - ) ( + T) 0 <  < 1, : share of home goods in the price index, N: rate of change in prices of home goods, T: rate of change in prices of tradables, : devaluation rate. * *

28. Changes in prices of home goods are set as a mark-up over nominal wage growth, w, and the level of excess demand for home goods, dN: N = w + dN. ^ ^ • Nominal wage growth is determined through indexation on past inflation as follows: w = -1 0 <   1, with  = 1 denoting full indexation. ^

29. Inflation:  = -1+ dN + (1 - )( + T), inflation inertia exists as long as  is positive. * • Agénor and Montiel (1999): experience of countries like Chile in the early 1980s and more recently Brazil has shown that backward-looking wage indexation can contribute to inflation inertia. • In some countries: frequency at which nominal wages are adjusted tends to increase with the inflationary pressures generated by exchange rate movements.

30. Exogenous shocks in the wage bargaining process could also exert independent impulse effects on inflation. • This could persist over time in the presence of an accommodative monetary policy.

31. Exchange rates and the terms of trade • Nominal exchange rate depreciation can exert direct effects on the fiscal deficit through two channels: • by affecting the domestic-currency value of foreign exchange receipts by the government and foreign exchange outlays; • by affecting the revenue derived from ad valorem taxes on imports. • Since depreciation raises the prices of import-competing goods and exportables, it may exert pressure on wages due to its effect on the cost of living.

32. This is likely to occur in a setting in which indexation mechanisms are pervasive. • Example: a country facing a sharp deterioration in competitiveness and a large current account deficit and policymakers decide to devalue the exchange rate. • Devaluation will increase both the domestic-currency price of imported final goods as well as imported inputs. Thisputs upward pressure on domestic prices. • Increase in prices can be large enough to outweigh the effect of the initial devaluation on competitiveness---thereby prompting policymakers to devalue again.

33. The process can therefore turn into a devaluation-inflation spiral. • If wages are indexed on the cost of living, they will increase also, putting further upward pressure on prices of domestic goods. • Evidence: Onis and Ozmucur (1990) for Turkey; Alba and Papell (1998) for Malaysia, the Philippines, and Singapore. • Similar process can be seen in countries where the official exchange rate is fixed but the parallel market for foreign exchange is large. • Deterioration in external accounts leads agents to expect a devaluation of the official exchange rate to restore competitiveness.

34. Such expectations will be translated immediately into a depreciation of the parallel exchange rate. • Because the parallel rate measures the marginal cost of foreign exchange, domestic prices will tend to increase. • This increase in prices will further erode competitiveness, leading agents to expect an even larger devaluation of the official exchange rate. • Figure 5.5: although parallel exchange rates display a higher degree of variability than prices, the correlation is positive in the case of Morocco and Nigeria during the 1980s and early 1990s. • When the government is directly involved in controlling exports of commodity, there may be:

38. direct effect of changes in the terms of trade on the budget; • indirect effect through taxes on corporate profits and domestic sales. • Reduction in government revenue due to negative shock causes pressure for monetizing the fiscal deficit. • Improvement in the terms of trade may lead to higher inflation in the future: • if government spending has increased sharply in response to temporary commodity price booms and; • if such increases are difficult to reverse when commodity prices fall.

39. The frequency of price adjustment • When high inflation is associated with highly variable inflation and uncertainty over the pricing horizon of price setters, the frequency of price adjustment becomes endogenous and tends to accelerate. • Shortening of the adjustment interval raises inflation, leading to a further shortening of the adjustment interval. • So price setters will be more and more opting to denominate their prices in a foreign currency.

40. Dornbusch, Sturzenegger, and Wolf (1990): increased synchronization between domestic prices and the nominal exchange rate as inflation rises in Bolivia, Israel, Argentina, and Brazil.

41. Food prices • In many developing countries food items comprise the bulk of the goods included in consumer price indices. • Consumer price index in Nigeria: food items representing 69% of the total basket. • So supply-side factors affecting food prices have an important effect on the behavior of prices. • Moser (1995): rainfall had a significant effect on the rate of price increases, in addition to money growth and exchange rate changes in Nigeria. • Figure 5.6: close correlation between inflation in food prices and inflation in consumer prices.

43. Time inconsistency and the inflation bias • Lack of credibility may impart an inflation bias to monetary policy. • This lack of credibility may result from the time inconsistency problem faced by policy announcements: a policy that is optimal ex ante may no longer be optimal ex post. • Reason: policymakers are concern about inflation as a policy goal and with the fact that inflation may carry benefits.

44. Barro and Gordon (1983): policymakers are concerned about both inflation and unemployment, with a loss function: L = (1/2)(y - y)2 + (/2)( - )2,  > 0, y: current output, y: its desired level, : actual inflation, : desired inflation rate, : relative importance of deviations of inflation from its target value in the loss function. ~ ~ (13) ~ ~

45. Expectations-augmented Phillips curve: y = yL + ( - a) + u,  > 0, yL < y yL: long-term level of output, a: expected inflation, u: disturbance term with zero mean and constant variance, yL < y: ensures that the policymakers have an incentive to raise output above its long-run value. ~ (14) ~

46. Policymakers want private agents to expect low inflation, in order to exploit a favorable trade-off between inflation and output. • But the mere announcement of a policy of low inflation is not credible, because policymakers have an incentive to renege to increase output and reduce unemployment and private agents understand this renege. Result: • inflation will in equilibrium be higher than it would be otherwise; • monetary policy suffers from an inflation bias.

47. Substitute (14) in (13): L=(1/2) {yL + ( - a) - y + u}2 + (/2)( - )2 ~ (15) ~ • With a binding commitment to low inflation,  = a; the loss function becomes: L = (1/2)(yL - y + u)2 + (/2)( - )2. ~ ~

48. ~ ~  (y - yL) 2 (a - ) ~ +  =  +  + 2  + 2 • Under discretion, policymakers take expected inflation as given; the first-order condition for minimizing the expected value of (15) with respect to  is: • In equilibrium,  = a (Phillips curve):  =  + (y - yL)/. ~ ~

49. In equilibrium output can deviate from its capacity level only as a result of random shocks: y = yL + u. • Under discretion, the equilibrium inflation rate will be higher than desired inflation. ~ • The higher (y - yL), the higher the slope of the Phillips curve, and the lower the relative importance of inflation in the loss function, the higher inflation will be.

50. Credible commitment to a policy rule is welfare enhancing compared with a discretionary policy. • If policymakers can credibly commit themselves to low inflation, the economy will be better off; output will be the same as in the discretionary policy case but inflation will be lower.