Factors Leading to Hyperinflations - Essay Example

What factors lead to hyperinflations and what can be done to eliminate them Introduction: The general price level captured by inflation rate is an important macroeconomic variable which presents the degree of economic resilience in a country. Hyperinflation is the extreme form of inflation with rapid increase in the general level of prices. Episode of hyperinflation has pervasive implications for any economy as it jeopardizes the macroeconomic fundamentals in a substantive way. The basic enquiry is, therefore, into the factors that are responsible for the occurrence of hyperinflation, and map out the strategies to counter their destructive role on the economy. Hence, this essay begins by defining hyperinflation in section 2, and proceeds to present the economic theories behind causes of hyperinflation in section 3. To provide an empirical verification of hyperinflation phenomenon, a more focused study on the ravaging hyperinflation and its impacts on Zimbabwe are attempted in section 4. Some of the course correction that a country such as Zimbabwe requires to embark on to arrest its hyperinflation is presented in section 5, before section 6 concludes this essay. 2. Definition of Hyperinflation: A number of economists have attempted to define inflation, in their own terminology. For professor Crowther, inflation is marked by declining value of money, and conversely the rising level of prices (197). Pigou observed that inflation occurs when money income expands more than proportionately to income earning activity (439). In general, inflation is associated with a state of abnormal increase in the quantity of money. Inflation is linked to the issue of too much currency in the economy (Hawtrey 60). For Coulborn, inflation is a monetary phenomenon where "too much money chases too few goods" (356). According to Keynes, inflation is caused by an excess of effective demand over supply (296). For Friedman, inflation is a process of steady and sustained increase in prices. Inflation, thus, is a monetary phenomenon characterized by high prices, and conversely falling values of money (17). Hyperinflation is a typical case of an extremely rapid growth in the general level of prices, lasting for a number of years. Although a rise in the general prices of more than 50 per cent is treated as hyperinflation, there is no well-defined threshold. All these definitions point to one basic point: When the quantity of money in circulation exceeds the total amount of goods and services in the economy, it results in extraordinary increase in prices which we define as hyperinflation. It may be noted that hyperinflation is also called a "runaway" or "galloping" inflation, where the quantum of money increases to an extent that its value declines to an incomprehensible level. Historically, hyperinflation has occurred in China, Greece, Taiwan, Austria, Germany, Hungary, Poland and Russia. In recent years, countries such as Chile, Argentina and Bolivia experienced hyperinflation. At present, hyperinflation in Zimbabwe is a great cause of concern for the economists as it continues to threaten the livelihood of its people. 3. Causes of Hyperinflation: 1According to Prof. Fisher, other things remaining constant, as the quantity of money in circulation increases, the price level also increases in the same proportion and the value of money decreases, correspondingly (45). 1In its rigid form, the quantity theory of money defends a strict proportionality between changes in the stock of money and the general level of prices. If M = stock of money in circulation, V = velocity, P = general price level, the theory states that the level of P depends on MV. Since V is assumed to be constant in the short-run, P and M are proportional to each other. Thus, if P represents the general price level, then 1/P captures the purchasing power of money. The implication is that when the stock of money increases, the value of money decreases, which reflects proportionately on the increase in general level of prices. Hyperinflation is, therefore, caused by excessive increase in money supply in the country. Theoretically, depreciation of money significantly increases the cost of holding it, during hyperinflation. Although the general public does not abandon the depreciating currencies completely, they undertake costly efforts to reduce the cash-holdings and opt for barter arrangements and the use of more stable substitutes such as foreign currencies (Barro 1970). These efforts result in a large reduction in money balances in real terms and a large rise in monetary velocity. 1In general, economists agree that hyperinflation is caused by excessive supply of money which leads to excessive aggregate demand over the aggregate supply of goods and services. Excessive aggregate demand may result on account of a number of factors, such as the following: (a) Excessive supply of money, which is more than proportionate to increase in production of goods and services. (b) Increased public expenditure which includes government spending on infrastructure and social expenditure, (c) Credit expansion by the monetary authorities by reducing bank rate, cash reserve ratio or through buying bonds through open market operations. (D) Financing the country's budget deficits by printing money or through borrowing programs. Similarly, there are a number of factors which contract the aggregate supply which include the following: (a) Shortage of factors of production such as skilled labourers, raw materials, modern technology which pushes up the cost of production. (b) Profit orientation of businessmen which pushes up their profit. (c) Man-made and natural calamities such as wars, drought, floods, earthquakes. (D) Powerful labour unions which pushes up the wage rates without any linkage to labour productivity. (E) Artificial scarcities created by hoarders and speculators. (F) Contagion effect whereby hyperinflation in one country is transmitted to another country through its trade and financial linkages. 4. Hyperinflation in Zimbabwe: Hyperinflation in Zimbabwe coincides with its independence. On account of steep devaluation and the deteriorating value of Zimbabwean Dollar (ZD), there is a general preference for American dollar. Zimbabwe's hyperinflation reached 624 percent in early 2004 and further increased to touch1730 percent by March 2007. Furthermore, by June, inflation increased manifold, and stood at a stunning figure of 7638 percent. The IMF estimated inflation rate to touch an all time high of 115000 percent by December 2007, and further at 150000 percent by January 2008 (Wines). This phenomenal growth on hyperinflation in Zimbabwe makes an important case study on the factors responsible for such a high growth rate. Keeping in mind the classical theory, one can verify that Zimbabwe's output (GDP) growth rate is far less desirable to match its growth rate in money supply. As figure 1, indicates, while GDP growth rate shows a negative and declining growth trend since 1998, money supply has been increasing at a phenomenal rate. This is a typical case of too much money chasing too few goods. Figure 1: Trend in Zimbabwe's GDP and Money Supply Annual Growth Rates Data Source: World Development Indicators, World Bank, Washington DC, 2006. This takes us to next task of analyzing the linkage between money supply and price index. Although the growth rate of money supply fluctuated before 1998, it has been rising at a significant rate since then. The monetary authorities in Zimbabwe seemed to have paid too little attention to curb the credit expansion. As we can observe from figure 2, there is no distinction between the growth rate of food price and consumer price index since 1995. This indicates the food crisis in Zimbabwe which has deepened over the years, at an increasing rate. It is striking to note that the growth in money supply and the consequent depreciation in the value of Zimbabwe's dollar seemed to have forced its citizen to store its cash-holdings in terms of food grains. In an effort to present the declining value of Zimbabwean dollar, Makochekanwa observes, "Zimbabweans are getting stronger. Thirty years ago it took five people to carry fifty Zimbabwean dollars (Z$50)'s worth of groceries. Today a child can even carry five hundred thousand dollars (Z$50 x 104)'s worth of groceries" (2). Zimbabwe's monetary authorities opted to print excess currency notes to finance the 300 percent rise in salaries of its soldiers and policemen, and 200 percent increase in that of civil servants. This unplanned credit expansion resulted in a significant depreciation in the value of its currency. Even though, new currency was issued in August 2006 by the government, and civilians exchanged their old notes for the new, this effort failed to contain the growing hyperinflation. Other punitive legal measures undertaken by the government included arrest of some executives of the companies of Zimbabwe and legal condemnation of inflation (Reference). Figure 2: The close link between Growth in Money Supply and Price Index Data Source: World Development Indicators, World Bank, Washington DC, 2006. The fast growing money supply and the consequent increase in general price level have their adverse impact on savings and investment. Although the deposit rates offered by banks may increase, the prevalent hyperinflation does not motivate the people in Zimbabwe to save their hard earned income. With spiraling rise in prices of goods and services, it does not make any economic sense to save and pay more to get the same goods and services at a future date. Real rate of interest presents the realistic reward for saving. However, the prevailing negative real rate of interest does not provide any incentive for saving. In addition, as figure 3 portrays, the gap between deposit rate and real rate has been widening since 1999. This indicates the economic rationale to spend more, at the earliest, to mitigate the falling value of Zimbabwean dollar. The other option would be to convert the local currency into a stable foreign currency such as US dollar or Euros. Under the present circumstances, there is no incentive to save and postpone the consumption for the future. Figure 3: Trend in Real interest rate and Deposit Rates Data Source: World Development Indicators, World Bank, Washington DC, 2006. This declining trend in saving and investment is captured in figure 4. This downward trend in savings and investment places the country on the path of a deteriorating economic future. Figure 4: Trend in Savings and Investment in Zimbabwe: Data Source: World Development Indicators, World Bank, Washington DC, 2006. As can be observed in figure 4, the falling trend in saving has been consistent since 1999. Moreover, the wild fluctuations in gross savings reflect the prevalent insecurity among its people to undertake any meaningful long-term investment program. It is not strange that gross capital formation exhibits a significant decline over the years. Although the situation seems to have reversed since 2002, long term sustainability of Zimbabwean economy remains a major concern. 5. Measures to Counter Hyperinflation: In order to deal with hyperinflation, a country requires a multi-pronged strategy by utilizing its monetary, fiscal and direct control measures in a war footing manner. Monetary measures aim at reducing the available credit in the economy, while the fiscal measures work as complementary efforts in containing the rapid increase in general price level. Monetary measures include raising the bank rates and cash reserve ratios, selling of government bonds and securities in the open market, and adopting a number of selective credit control measures, such as raising margin requirements, regulating consumer credit, etc. These policy tools can be very effective to deal with demand pull factors. In addition, exchange rate mechanism needs to be regulated to avoid the preference for foreign currency and the potential capital flight. At the same time, in order to deal with cost push factors, the government needs to utilize the fiscal measures to curb unnecessary and wasteful government expenditures, and personal consumption expenditures, supplemented by increased level of taxes. However, caution must be exercised in imposing additional taxes as it would result in lesser saving, restricted investment and the consequent reduced levels of production. In addition, the government will have to reduce import duties on essential goods to ease the price spiral. Any incentive provided to increase the level of savings can be a productive solution in dealing with hyperinflation. While prudent spending is expected on the part of the government, it also requires that government opts for a surplus budget, rather than taking recourse to deficit financing. 6. Conclusion: From a theoretical as well as empirical perspective, we have observed that hyperinflation is caused by excessive supply of money in the economy, which leads to a decline in the value of money and increase in the general level of prices. To the extent the government turns to printing of money to pay for its spending, it sets the inflationary spiral on the fast track. Since the rate of change in prices are so rapid and rampant, people prefer to hold goods and services rather than holding cash money, or they rush and convert their local currency into foreign currency which is more stable. Consequently, consumption increases leading to further rise in prices of goods and services. Alternatively, they save less and invest less which results in lesser production, lesser income, wages, rent and profits. This trend continues for a long period of time. The hyperinflation ends when the government institutes fiscal reforms such as cuts in government spending that eliminate the need for inflation tax. Hence it requires a multi-pronged policy strategy, which includes monetary, fiscal and direct control measures to curb the fast growth in rising general level of prices, which is termed as hyperinflation. References: Barro, R.J. "Inflation, the payments period and the demand for Money", Journal of Political Economy, 1970. pp.1228-63. Coulborn, W.A.L., A Discussion of Money, London: Longmans, Green and Co., 1950. Crowther, Geoffrey. An Outline of Money, London: Thomas Nelson and sons, 1941. Fisher, Irving. The Purchasing Power of Money, New York: Macmillan, 1922. Freidman, Milton. Inflation - Causes and Consequences, Bombay: Asia Publishing House, 1963. Hawtrey, G. Ralph. Currency and Credit, Third Edition, London: Longmans, Green and Co., 1928. Keynes, J.M. The General Theory of Employment, Interest and Money, London: Macmillan, 1936, (reprinted in 2007). Makochekanwa, Albert, "A Dynamic Enquiry into the Causes of Hyperinflation in Zimbabwe", University of Pretoria, Department of Economics Working Paper Series, July 2007. Retrieved on March 20, 2008 from: http://web.up.ac.za/UserFiles/WP_2007_10.pdf Pigou, A.C. "Types of War Inflation", Economic Journal, Vol. 51, No. 204, 1941. Wines, Michael, Caps on Prices Only Deepen Zimbabweans' Misery, New York Times. 2007. World Bank, World Development Indicators, CD-ROM, Washington DC, 2006. Read More