Hyperinflation in Chile and Brazil - Coursework Example

Hyperinflation in Chile and Brazil Introduction Several definitions for hyperinflation have been proposed, however, the most commonly used and adopted one is that proposed by Cagan (25) who defined hyperinflation as present in all cases in which monthly inflation has reached in at least one month fifty percent or more. Typically, inflation patterns involve an extreme rapid increase in level of inflation for a short period, which is often shorter than a few years (Sargent 41). Classical hyperinflation episodes have in common a fiscal cause in which for a variety of reasons, the government is unable to sufficiently tax, and can consequently not borrow, and turns to seignorage as the solution. Moreover, another reaction common with hyperinflation episodes is the resorting of economic agents to alternative currencies, which is in most cases the dollar. Brazil and Chile have undergone different episodes of hyperinflation since the early nineties, and both nations have undertaken various measures and adopted different policies to curb inflation. In the case of Brazil, the hyperinflation episodes experienced in the country reached levels that were above 1000% in 1989, and continued to remain high until stabilization through the Real Plan in July 1994 (Garcia 139). Hyperinflation in the country was a stretched out, extended process, with inflation levels gradually increasing over a period of years with occasional hammering from stabilization plans. The stabilization plans adopted over the periods of hyperinflation in Brazil have usually been intended to freeze wages and prices, however they failed to last long (Cati, Garcia and Perron 25). It is imperative to not here that the definition offered by Cagan can only be applied in the Brazilian case on one occasion between December 1989 and March 1991. This paper aims to document the hyperinflation episodes in Brazil and Chile, with a closer look at the policies and strategies adopted by economic agents, and their respective impacts. Before concluding, a further analysis of the general effects of hyperinflation is given, with specific focus on the long-term effects on economic policy and the consumer purchasing power. Hyperinflation in Brazil The early periods Brazil experience a very good economic phase in the early 1970s, with rapid GDP growth and inflation rates reaching their lowest point during this period until the Real Plan. This can be attributed to the financial reforms in the mid-sixties, which had provided the government with the remarkable tool of domestic debt. During this period, the fiscal deficits largely contributed to creating a market for government debt based in the institutionalization of monetary correction, or indexation, which defined the foundation of development of fiscal markets in the preceding years, in spite of the increasing annual inflation rates between 1973 and 1994 (Garcia 140). This strategy was successful for a period as the country’s GDP growth rate reached above 10 percent. Between 1970 to 1979 During this period, the stock of government bonds was increased five-fold (Bevilaqua, et al 10). The second half of the decade saw a sharp decline in GDP growth rates in comparison to the first half, with inflation doubling and increased difficulties in controlling the growth of public sector financial needs. The average maturity period of public debt fell from twenty to fourteen month starting from 1977 and 1979, but the share of fixed interest bonds continued to grow until the end of the period. The interest rate ceilings, which have existed until September 1976, were abandoned, and subsequently, the interest rates started rising in the same year. The period of high inflation between 1980 and 1994 The consistent rise of inflation from 1970 to 1985 is attributable to two major factors. The first reason that can be used to explain the consistent rise is the oil shock and the increased frequency of readjusting wage. Secondly, the country’s currency was highly devalued in 1983, and this could have contributed to the high inflation rates (Reisen and Trotsenberg 60). Although the country was experiencing increasing inflation during this period, the plans initiated in the eighties were aimed at reducing external imbalances rather than reducing inflation. The first step in the stabilization plan by aimed at reducing these external imbalances was the changing of currency from the cruzeiro to cruzado. The Cruzado plan sought to address freezing of prices, interest rate conversion and monetary and financial policies and during the first period of its adoption, this plan proved successful as the monthly inflation reduced, reaching an average of 0.9% from March to July 1986 (Garcia 141). In addition, the freezing of prices had a direct impact on the citizens since they felt that they had the power to audit prices, bringing about an increase in sales by 23% in the first six months of 1986 in comparison to the same period of the previous year. The overall result was overheating spreading in the economy due to low prices and scarcity of various products, and thus low inflation, jeopardizing trade and current account balances. The scarcity of products brought about higher levels of demand, and increased imports into the country while exports declined, thereby aggravating the external position. Faced with all these challenges, the government decision was a fiscal plan dubbed Cruzado II (Garcia 140), increasing the revenue by readjusting some public prices and some indirect taxes, leading to a high inflationary shock. Consequently, indexation was reintroduced and with it came monetary correction, creating once again an environment of high inflation reaching seventeen percent per month in January 1987. The Bresser Plan, implemented between July 1987 to December 1987 (Bruno 178) was aimed at reducing inflation. However, it was unsuccessful given that the operational borrowing requirements was 5.5% which was way higher than the promised three and half percent. Due to the unpopularity of the plan, the government liberalized prices, a move that reduced the effectiveness of price freezing. A further attempt at reducing inflation was made in January 1988 with the introduction of the Feijao-com-Arroz Economic policy (Font 229). This policy did not freeze prices or conduct another heterodox shock but rather led to reduced deficit and inflation to fifteen percent per month, while the GDP was expected to rise to between seven and eight percent in 1988. The reduction of deficit was as a result of temporary freezing of public sector wages, however, the plan was unsustainable as adverse agricultural shock led to increase in prices, and the intended fifteen percent inflation per month was not attained in the second quarter of the year. The Summer Plan, just like the other plans, had components of price freezing, with the main objective being reduction of inflation through control of the public deficit and expenditure and increasing revenue through radical reforms such as privatizing public-owned assets. However, by 1989, inflation was back due to high interest rates increasing government deficit occasioned by the tight monetary policy. In March 1990 when President Fernando Collor came into power, he immediately launched a fiscal plan that aimed to reduce hyperinflation through introduction of taxation of financial intermediation, suspension of tax incentives and widespread privatizations. However, the threatening nature of the government in implementing the fiscal plan especially towards public employees deemed the plan unpopular, and in the end, the monetary policy component of the plan was not active. During the second phase of the economic plans, government expenditures were drastically reduced through retrenchment of civil servants, privatization of state owned enterprises and elimination of indexation. The second phase of the plan also intended to improve the quality of products by opening the economy to external competition. Beginning in 1994 with the creation of a new currency, the Real, the Real Plan was launched that intended to reduce deficits, modernize firms and reduce distortions arising from previous price freezing regimes. Following its launch two decades ago, inflation has experienced a new level of stability throughout the period; several institutional reforms have been accomplished, such as committee of monetary policy, inflation targeting and Law of Fiscal Responsibility, generally tasked with regulating municipal and state-level public institution expenditures. Although inflation was high during the currency regime switch in 1999 when controlled exchange rate was replaced with a floating exchange rate and inflation targeting, the highest level it reached of nine percent was nothing compared to the hyperinflationary period since the seventies. Chile: Hyperinflationary periods and policy impacts Chile has experienced three distinct economic transformations defined by different inflationary episodes since the early seventies. The periods can be grouped into the early seventies hyperinflation episodes during President Allende’s regime spanning 1971 to 1973, the BOP crisis of 1980s during Pinochet’s regime until 1987, and the democratic periods from 1990 onwards that brought about positive rates of growth and declining inflation. Hyperinflation during the early 1970s During the early seventies during President Allende’s reign over the country, the period was of nominal volatility and fiscal deficits. Before the explosion of inflation, Allende had hoped to buy popularity to win elections by increasing wages for the working. The government assumed that the money to pay for this could be obtained through expropriating unpopular large companies (Roxborough, Philip and Jackie 76), raising taxes for the classes that supported his opponent part, and freezing of prices. Although the plans were successful during the first year with increases in real income, the economy suffered the following year as inflation exploded. The public deficit sharply increased from 8.1% in 1971 to a whopping 23% in 1973. Persistent Inflation from 1974 In the early seventies, the country experienced hyperinflation episodes that reached a high of 700% in April 1974. The extremely high inflation was potentially caused by the removal of price controls in September 1973. The period from 1974 to 1978 experienced persistent inflation as inflation slowly began to decline despite the sharp reduction of the fiscal deficit which was near zero after 1974 (Fortin 140). In June 1979, the government adopted a fixed exchange regime although the inflation at the time was still high, and wages and some financial contracts were indexed to past inflation. This change in government policy led to a decline in inflation to single-digit levels, reaching 9.5% in 1981 since real appreciation induced trade balance deficits. Moreover, the cost of borrowing was greatly reduced because of appreciation. In June 1982, the government abandoned the exchange rate regime due to adverse international conditions comprising of higher foreign interest rates and reversal of capital inflows. There were severe domestic trade imbalances as expenditure boom induced public deficits which stood at an unsustainable 14% of the GDP in 1981. In 1982, the economy was collapsing as the peso depreciated sharply, there were no international funds, and most commercial banks became insolvent since they were not able to service their debts, The Central Bank began implementation of wide-ranging rescue programs such as liquidation of banks, purchasing portfolios of private banks, and providing foreign currency to suffering banks at subsidized prices. Following these developments, the foreign debt of the central bank increased significantly, and the rescue plans led to severe operational losses by the central bank. Fiscal Discipline: 1990 onwards Following the collapse of the economy during Pinochet’s regime, newly elected democratic government launched economic reforms that were intended to instill fiscal discipline into the country financial system. Chile has always had an explicit policy of avoiding default since early 1980s, and this was renewed in the early 1990s. Treasury and the Central Bank assumed the cost of the Balance of Payment (BOP) crisis and the debt position of the government increased substantially. In attempts at avoiding monetization, public debt was indexed and/or in foreign currency and the maturity of debt period was lengthened to thirty years in cases of internal debts. In 2001, the government launched implementation of a fiscal rule based on annual structural surplus of one percent which significantly improved the net asset position of the governments, and enabled payment of both internal and external debts. This has further contributed in enabling the government in its pursuit of an independent monetary policy. General Impacts of hyperinflation Hyperinflation in a country are usually as a result of public budget deficits which are largely financed by money creation which increase as inflation increases, and can bring about severe effects especially to the general economy, policies and the citizens way of life. the Currency substitution as observed in the case of Brazil leads to strong diminishing of the real stock of the inflating money, and in cases where inflation persistently remains at a substantial high such as the case of Chile, the bad inflating money can be driven out of circulation. Citizens and organizations wish to get rid of the inflating money before it loses much of the purchasing power, however, since the economy is swamped with increasing amounts of the money coupled with foreigners’ preference not to be paid in that currency, there is a sharp increase in price of commodities at a rate faster than the money supply. This situation therefore leads to reduction in the real stock of money (Peter Bernholz, 2003, pp. 76), as was evident in the case of Chile. During hyperinflationary periods, the scope of capital markets reduces, especially the duration of contacts, which implies that the intertemporal coordination of saving and investment, consumption and production suffer due to higher inflations. It has been found that hyperinflation has a great impact on the saving and investment behavior of individuals, and in the case of Brazil, those who have a memory of the period are less likely to invest in the stock market (Alesina and Fuchs-Schündeln 1520 ). Hyperinflations are a hindrance to growth of the GDP, and do not enhance lowering of unemployment rates in a country. Conclusion Brazil and Chile experienced periods of hyperinflation in the early eighties, and this have had some lasting effects on the economy, monetary policy and consumer purchasing power of the citizens of these countries. Brazil experienced hyperinflation, which reached over 1000% in 1989, and embarked on a series of economic plans aimed at recovering the economy. Some of the most notable policy reforms in Brazil in response to the inflationary periods include freezing of prices, indexation, tax incentives and privatization of state-owned enterprises. In 1994, the government launched the Real Plan that comprises of policies that have significantly contributed to stabilization of inflation by reducing deficits, modernizing firms in order to increase productivity. The government has also put in place policies and institutional reforms to regulate public expenditures, replaced the controlled exchange rate by a floating exchange rate, and introduced inflation targeting. In summary, the highlights of Chile’s fiscal and monetary policy are the economic experiences and transformations from early seventies to date including hyperinflation of the early seventies, which were mainly associated to fiscal deficits, and the efforts made at stabilizing the economy in the early eighties through a fixed exchange rate policy. However, the severe BOP crisis in the eighties led to the government abandoning the exchange rate regime. Beginning the early nineties, the government embarked on implementing fiscal discipline by first assuming the costs of the BOP crisis by the central bank and Treasury, and systematic policy of fiscal surplus that was launched in 1970 and is still operational to date. The fiscal policy has led to reduced fiscal debt, and the potential implementation of Inflation Targeting policy to reduce inflation in the country. 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