1

PARMESHWAR RAMLOGANIMF RESIDENT REPRESENTATIVE

17 T H MAY 2010

Inflation: Causes, Dynamics, and Consequences

2

Organization of the Presentation

The “Evils” of Inflation Inflation harms economic growth Inflation increases poverty and income inequality Inflation generates financial instability

Causes and Dynamics of Inflation International price shocks Autonomous wage increases Domestic supply shocks Excess demand Inflationary Expectations

The International Shift To Inflation Targeting

3

Inflation Harms Economic Growth

International Experience Low and stable inflation promotes

economic growth. There is a threshold rate above which

inflation reduces economic growth. The threshold inflation rate is low: single

digits, even low single digits. The negative effect on growth is highest

just after the threshold is crossed, and tapers off as the inflation rate increases.

4

Inflation Harms Economic Growth

Experience of Mongolia In light of international experience,

the inflation outlook for Mongolia is disturbing. Inflation could reach – percent in 2010.

Such a high inflation rate would seriously damage Mongolia’s economic growth prospects.

5

Why Does Inflation Harm Economic Growth?

Reduces consumption. Reduces investment.

Negative real interest rates lower saving. Uncertainty about future inflation increases

the riskiness of long-term financial contracts and investment plans.

Reduces external competitiveness through real exchange rate appreciation.

Generates financial instability.

6

Inflation Increases Poverty and Income Inequality

International Experience Inflation increases poverty levels and rates. Inflation can cancel out the positive effect of

economic growth on poverty. That is, higher economic growth does not reduce poverty if it is accompanied by higher inflation. Countries may be better off with low growth and low inflation than with high growth and high inflation.

Clear policy implication: Any policy measure to reduce poverty may be self-defeating if it raises the inflation rate.

7

Why Does Inflation Increase Poverty and Inequality?

Inflation affects households unequally. Inflation has the biggest impact on

the real income and consumption of the poor.

Why? The income of the poor is not indexed, or

not fully indexed, to inflation. Savings of the poor are more likely to be in

cash or unhedged instruments.

8

Inflation may provoke currency and banking crises. How?

Inflation leads to dollarization, capital flight, and deterioration of the trade balance

These lead to pressures on the currency to depreciate. Expectations of depreciation may result in a speculative

attack on the currency. The currency crisis may lead to a banking crisis because of:

Currency mismatches on banks’ balance sheets Rising non-performing loans of firms due to increased debt

service costs Capital flight may lead to run on bank deposits

Inflation Generates Financial Instability

9

Causes and Dynamics of Inflation

International Price Shocks Example: International fuel and food price increases

in 2008 Impacts directly on consumer price index or indirectly

via production costs. Impact may be magnified by subsequent currency

depreciation.

10

Causes and Dynamics of Inflation

Autonomous wage increases Wage increases not stemming from, or in excess of,

prior inflation Wage increases in excess of productivity increases,

usually stemming from demonstration effects Leads to a wage-price spiral

11

Causes and Dynamics of Inflation

Domestic supply shocks Example: Current meat price increase in Mongolia

due to the dzud. Inflationary impact depends on the policy response.

12

Causes and Dynamics of Inflation

Excess demand Domestic demand too high relative to the production

capacity of the economy Acts directly on prices of locally-produced goods or

indirectly on prices of imports through currency depreciation

Major source is excessive government spending financed by money creation

Sources of inflationary financing: (1) revenue shock in the mineral sector in Mongolia, (2) the central bank, or (3) external borrowing

Assumption: no central bank sterilization

13

Causes and Dynamics of Inflation

Inflationary Expectations Public expectations of inflation generate behaviour

that feeds back onto the inflationary process. Inflation becomes a self-generating process. Examples: indexation of wage contracts, capital flight.

Sources of inflationary expectations: Past history of inflation. History of high inflation can lead

to inflation inertia. Inflationary fiscal and monetary policies. Lack of credibility of the central bank

14

The International Shift Toward Inflation Targeting

More and more countries are using inflation targeting to anchor inflationary expectations.

Core elements of inflation targeting: Set a target inflation or inflation range Communicate that target clearly to the public Do everything possible to achieve that target or target range

Currently 26 countries have formally adopted inflation targeting. Including major copper producers such as Chile, Peru, Australia, Indonesia, and Canada (Table).

Inflation targeters appear to have achieved better macroeconomic performance than non-targeters (Charts).

15

The International Shift Toward Inflation Targeting

16

The International Shift Toward Inflation Targeting

17

The International Shift Toward Inflation Targeting

18

The International Shift Toward Inflation Targeting