The Monetary Dynamics of Hyperinflation - Dissertation Example

The Monetary Dynamics of Hyperinflation Abstract Inflation and deflation forms one of the important indicators of a country’s economic scenario and of the world economy in general. This paper intends to define and understand inflation, disinflation, deflation and its variants in the current market state of affairs. The various causes of inflation, disinflation and deflation, its impact on the economy also forms a topic of discussion in this paper. A comparison of the phenomenon of inflation with its reserve process, deflation is undertaken in order to provide clarity on the subject. In the fast paced , ever changing of our modern times it is absolutely difficult to suggest hard and fast rules to control these market indicators. However, as a conclusion of the paper some suggestive measures to bring the inflation and deflation rates to desirable levels and to steer the economy in the direction of growth, are also put forward. Inflation, Disinflation and Deflation Keeping an economy running smoothly without stalling or over accelerating is a very difficult task to achieve in the fast changing current economic scenario. Governments and economists all around the world closely observe the various range of market indicators to understand the changes in the economy, and try hard to bring about policies to sustain the growth or a positive change at the same time cautioning the people against a wave of adversities Like Doctors and experts from field of medicine take clues about the health status of a patient from indicators like body temperature, blood pressure etc., governments and economists keep a tight watch on the economic indicators to understand the economic wellbeing of a nation and determine cure all its ailments through sound monetary reforms. Inflation and deflation are recurring phases of a continuous economic cycle (Morris 22) . It is a complex task to forecast its occurrence and to manage its impact on the economy. However most countries try to control the money supply to regulate inflation and deflation and bring it to a desirable rate in order to achieve a steady growth rate for the country. 1. Inflation In general terms inflation is the increase in the price of the goods and services which is calculated over a fixed duration of time. Even though inflation is simply stated as rise in the price of commodities, in actual scenario it is a much complex phenomenon, having great impact in the economy of a nation. Due to inflation, the purchasing power of the currency decreases; that is with the same unit of currency, as inflation increases lesser units of goods and services could be purchased. When inflation continues unchecked the value of money gets destroyed. The value of a currency is measured in terms of the purchasing power, that explains the amount or units of tangible goods that money can purchase. For example if there exists a inflation of 3% in a country, then a packet of chocolate which cost 1$ today will cost 1.03$ in a year. Inflation thus erodes the value of money over a period of time. A reliable measure to understand inflation is the inflation rate. It is calculated as the annualized percentage change in the Consumer Price Index (CPI) over a period of time. Consumer Price Index gives a direct clue regarding the impact of economic changes on the citizens of a country and how much people have to pay for the goods and services in comparison with the previous years. It measures the average price change of a basket of goods (representative lot of goods and services) which includes petrol, housing goods and food. The Retail Price Index (RPI), Whole ale Price Index (WPI) are other indices used to measure inflation. One of the variants of inflation is Hyperinflation. Hyperinflation is the rapid, accelerating and unmanageable increase in the rate of inflation. It can lead to complete collapse of a nation’s monetary and economic system. Philip Cagan in his The Monetary Dynamics of Hyperinflation defined a hyperinflationary episode as starting in the month that the monthly inflation rate exceeds 50%, and it ending when the monthly inflation rate drops below 50% and stays that way for at least a year.( Cagan 73) Thus it is considered that when the monthly inflation rate exceeds 50%, economists consider it to be hyper inflation. Hyperinflation occurs after a war, or a natural disaster or some social and political anarchy where the government find it impossible to handle the economic system of the country. For example, in Germany, in 1923, because of the economic trmoil after the First World War, inflation rose close to 2500% in one month that you had to pay close to 726,000,000 marks to buy what you had been able to get for one mark in 1918 .( Morris 7) Another variant of inflation is Stagflation. A typical example of the case of stagflation occurred in industrialized countries during 1970s, when they faced an economic stagnation due to high oil prices combined with increased unemployment. Stagflation is increased inflation combined with high rate of unemployment (Taylor).These two conditions impair the economic growth of the country and put government and economists in dilemma regarding the appropriate policy changes to be brought out to alleviate the problem. Milton Friedman famously described this situation as "too much money chasing too few goods". In industrialized countries during the 1970’s the productive capacity was worsened due to limited supply stock caused by the increased oil price. This made production process less profitable and more costly. These factors increased inflation, created unemployment and hindered growth of the country (Wikipedia.org). Causes of inflation Inflation is caused due to many reasons. It is difficult to pin point any specific reason for inflation. However, increased money supply and accelerated demand for goods and services are attributed as the causes of inflation. When money supply increases beyond a limit, the value of money gets eroded. This in turn increases the prices of commodities and services. Economists suggest several theories to understand the causes of inflation. According to Robert J. Gordon inflation can be caused due to three reasons: Demand- pull inflation: This type of inflation occurs in growing economies where increased demand of the goods and services results in increase of the price of the commodities. This is considered beneficial for the growth of economy to some extend as the increased spending by people will eventually enhance the investment and thus will strengthen the economy. Cost- Push Inflation: Sometimes prices of commodities increase tremendously when the cost of production of those commodities increase. Increase in the cost of production may be due to rise in the costs of raw materials or taxes. It can also be due to damages incurred to a natural calamity. In order to maintain the profit margin companies increase the price of the finished products leading to inflation. Built- in Inflation: When the workers of a company try to increase their wages in accordance with the increase in the prices of the goods and services prevailing in the market; the company management raises the commodity prices to maintain the same level of profit. This will contribute to the increase in the inflation rate. Impacts of Inflation Anticipated inflation at a controlled or anticipated level is a positive aspect as far as the development of a country is concerned. It indicates the growth of an economy. A moderate level of inflation helps to alleviate the problem of unemployment to some extent. This is because when demand increases and people have money to spend, then production increases automatically. This will in turn increased work and employment opportunities for the people of the nation. When inflation increases at a steady rate, the Gross Domestic Product (GDP) of a country also increases. This denotes a growing economy which will encourage more and more investments to the nation. If the banks hike their interest rates and these monetary changes can be anticipated by the people and they can plan their investment prospects accordingly. Employees can enter into contracts with management where their wages will increase in accordance with the increase in price level of goods and services. Inflation promotes investments in the fields like art, real estate etc where there is a scope of reselling the products at a much higher price in future. Debtors also would love to make deals during inflation. Investments in all sectors of market like production, infrastructure and service sectors will find the business profitable as the spendable money increases with inflation. Even though a moderate inflation in tune of two- three percentage acts as a boost to the economy, a rapid, accelerated and unanticipated increase in inflation rate is always unwarranted. This type of high inflation can only lead to economic turmoil. In such cases of unantipated inflation, creditors incur huge losses if the money is given without considering the rise in the inflation rate. For debtors, this will be like getting interest- free loans. (Difference between inflation and deflation). A sense of uncertainty prevails in the market in case of rapid inflation. In this kind of ambiguous market condition, corporations and investors show reluctance to take any strong investment decisions which will eventually lead to decreased output. Increase in the inflation rate will be a great cause of concern for people living off a fixed income like retirees. When the purchasing power of the money decreases they find it hard to maintain their standard of living. The same unit of money will buy lesser and lesser products over a period of time. When the inflation rate of a country is higher than other countries, export becomes less profitable as the domestic products will not be able to compete in the international market, and eventually it leads to the loss of global market for those commodities. Some enterprises may require their documents rate menus and data bases to be updated, which can be expensive. Due to increase in inflation, tax rates also increases. This will lead to increased spending by people as they realize that more holding of currency will lead to enhancement in the amount of tax paid and also due to the reason that people will tend to buy and stock up before the prices increase tremendously. This phenomenon will result in rapid increase of the limited products, which in turn reinforces the inflation. Savings decreases and hoarding increases creating an artificial dearth of commodities which again contribute to the vicious cycle of inflation. Control of Inflation Inflation can be brought under control through stringent monetary policies. It is a very difficult task to identify is the reasons of inflation and to implement economic policies to bring down the inflation under desirable limits. The Central Banks of all the nations are entrusted with the daunting task of implementing the monetary policy by regulating the interest rates of all the other banks of the country. The Central banks undertake measures to control inflation. For example in United States of America, the U.S Federal Reserve controls the interest rate and supply of money so as to achieve a desirable level of inflation Monetary policies such as setting up high interest rates and tremendously decreasing the money supply are considered to the most effective and conventional methods by which inflation rates can be brought down. Fiscal Policy measures like increased taxation or reduced government spending are also implemented by the governments to bring down the aggregate demand and to stabilize inflation of a country. Income policies such as implementing price and wage control measures is also undertaken in some cases to regulate inflation; even though in the long run it is not beneficial to the economy. Price control measures may reduce product quality and discourage investments in that particular field. Some countries also resort to fixed exchange rate currency and establishing gold standards as measures to a steady inflation rate. 2. Disinflation When an economy is suffering from recession, there will be a slowdown in the rate of increase of inflation in the country. This is called Disinflation. It is the opposite of reflation and occurs when the rate of increase of essential commodities and services depreciate over a period of time. For example if the inflation is 2% in the month of January and it decrease to -1% in the month of February, we can say that prices are disinflated by 3% and they are decreasing at an annual rate of 1%. A decrease in the growth rate of money supply, imposed by the government and also recession are attributed as the major causes of disinflation. When apex monetary agency implements contractionary monetary policies, the demands of products decrease while the supply remaining the same. This condition can result in price decrease over a period of time leading to disinflation. Japan’s economy illustrates a typical example of disinflated economy where the inflation rate went on decreasing. The difference from deflation is that, the disinflation is lowering of inflation; but not negative inflation. 3. Deflation It is the general decrease in the price of goods and services over a period of time. Here the inflation rate becomes negative and economy plunges into a state of recession. When the deflation continues unchecked economies comes to a virtual halt as business collapse. An example of such a debacle is the recession that occurred in U.S in 1929 due to the crash of stock markets. During deflation the money value increases; that is purchasing power of the currency increases. A unit of currency fetches more amount of goods and services over time. Economists generally opinion that deflation is a negative sign of growth of an economy. This is because deflation is closely associated with decrease in the money supply, decrease in the employment rate and a general lowering of spending by the people. Citizens postpone their purchases in the anticipation that prices will fall further. This causes a decrease in the demand of the product, which in turn will decrease the gross output of the country. A deflationary spiral sets in due to the lowered production ultimately leading to unemployment problems (Hummel). Deflation has a cumulative effect where it gathers momentum with passage of time and will deepen the economic crisis. During deflation the money supply is reduced compared to the growth in population and economic growth. Thus the demand for money increases and economy starts to shrink. To alleviate the problem of deflation, governments amend the monetary and fiscal policies in such a way that the money supply is stimulated and the market growth is boosted in all possible ways. To avert the slow –down of economy central banks decreases the interest rate and encourage borrowing. This will eventually lead to increase in the investment and increase in the production output which will generate employment opportunities in the long run. Conclusion As a conclusion it can be seen that both inflation and deflation are recurring phases of an economy where multitude of factors contributing to the occurrence of each. To avert the tribulations of both high inflation and recession due to deflation stringent monetary and fiscal policies are required. However a moderate range of inflation, desirably below 5% can be viewed as a positive signal of economic growth and a stimulus for investment in the production cycle of business. A general price increase coupled with increased employment prospects as seen in inflated economies; always present a better opportunity than a deflated economy. It can be observed that inflation is a lesser evil compared to deflation, where the unemployment problem together with grim business scenario exists. However phenomenon like hyperinflation should be averted with appropriate monetary and fiscal measures. As a single agency handling the money supply of a country, Governments should always be watchful of the prevailing economic situations of a country and should take immediate and appropriate monetary regulations, to prevent a country from high rates of inflation or deflation. Money supply should be regulated by the Central Bank in such a way that a moderate, desirable level of inflation is maintained throughout. Works Cited Cagan, Phillip. The Monetary Dynamics of Hyperinflation. Chicago: University of Press, 1956. Print. “Difference between inflation and deflation”. Hyd- Masti. 2011. Web.23 Nov.2012 Hummel, Jeffrey Rogers. "Death and Taxes, Including Inflation: the Public versus Economists".Jan.2007.Web.24 Nov.2012 Morris, Kenneth M, Alan Siegel, Beverly Larson. Guide to understanding Money and investing in Asia. New York: Light bulb Press, n.d. Print. “Stagflation.” Wikipedia. 2010. Web. 24 Nov. 2012. Taylor, Timothy. Principles of Economics. Freeload Press, 2008.Print Read More