Category Archives: Inflation

AS Revision – Functions of Money and Venezuela

Covering this topic last week at a revision course and there was some confusion between the functions of money and characteristics. It is important to remember that the characteristics fall within the medium of exchange. Below are some notes and a video about how hyperinflation impacts people in Venezuela and the functions of money.

1. Medium of exchange. This is very important in a specialised economy as barter would be very inefficient. It also makes possible a great extension of the principle of specialisation.

The desirable qualities of money are as follows:-

  • Acceptable: Must be sure somebody will accept your money for goods & services
  • Scarce: Should be, if there’s too much, then no one would value it, hence gold was always good money.
  • Portable: Convenient to carry around
  • Divisible: Can be divide up into different denominations
  • Durable: Money (physical) that can last

2. Unit of Account. A unit of account is a way of placing a specific value on economic goods and services. Thus, as a unit of account, the monetary unit is used to measure the value of goods and services relative to other goods and services. It thus enables individuals to compare, easily, the relative value of goods and services.  A firm uses money prices to calculate profits and losses: and a typical household budgets its regular expenses daily using money prices as its unit of account.

3. Store of Value. Once a commodity becomes universally acceptable in exchange for goods and services, it is possible to store wealth by holding a stock of this commodity. It is a great convenience to hold wealth in the form of  money. Consider the problems holding wealth in the form of wheat. It may deteriorate, it is costly to store, must be insured, and there will be significant  handling costs in accumulating and distributing it.

4. Standard of Value/Standard of Deferred Payment. An important function of money in the modern world, where so much business is conducted on the basis of credit, is to serve as a means of deferred payment. When goods are supplied on credit, the buyer has immediate use of them but does not have to make an immediate payment. The goods can be paid for three, or perhaps six, months after delivery.

How does hyperinflation affect the functions of money?

Medium of exchange – consumers may lose confidence in this function of money and therefore resort to barter.
Store of value – inflation erodes the value of money so does not keep its value. Better for consumers to spend their money rather than see it decline in value. Also they can’t afford to save.
Unit of account – prices change with inflation making comparisons difficult. Also notes need to be printed in higher denominations.
Means of deferred payment – with inflation decreasing the value of money the amount of money that you pay back to the lender decreases in real terms. However the lender is most likely to increase the cost of borrowing so they are protecting the value of money owed to them.

Argentina – will capital controls work?

Last week Argentina imposed currency controls on business to prevent money leaving the economy after the Argentinian Peso lost over 25% of its value since elections last month – see graphic. The central bank now require that:

  • exporters to repatriate earnings within 5 to 15 days
  • businesses will need permission to repatriate profits abroad or buy US dollars
  • residents are restricted to foreign exchange purchase of US$10,000 and non-residents US$1,000

With a track record of hyperinflation and financial crises, Argentinians are quick to sell their Pesos for US$ to maintain store value – with inflation and turmoil in an economy the local currency has less purchasing power. It is important for the Argentina government to restrict the demand for US$ and improve its ability to pay its significant debt – US$101bn. Capital controls have the aim of protecting the stability of the Peso and savers.

Will it work?

Although capital controls do stabilise the currency in a panic situation, they will only work in the long-term if they are used to confront the underlying macroeconomic problems in the economy itself. However, with Argentina’s inflationary issues coupled with fiscal deficits, capital controls are a band aid solution to the macroeconomic problems. Below is a very good video from the FT giving a background to the problems in Argentina.

50 basis points cut by RBNZ – are they going negative?

The 50 basis points of the OCR (Official Cash Rate) by the RBNZ took everyone by surprise. Cuts of this magnitude generally only occur when significant events happen – 9/11, the GFC, the Christchurch earthquake etc. However the US China trade dispute have significant implications for global trade and ultimately the NZ economy. The idea behind such a cut is to be proactive and get ahead of the curve – why wait and be reactionary.

The Bank has forecast the OCR to trough at 0.9 percent, indicating a possible further interest rate cut in the near future. The RBNZ believe that lower interest rates will drive economic growth by encouraging more investment but you would have thought that such low rates wold have been stimulatory by now. I don’t recall the corporate sector complaining too much about interest rates and according to the NZIER (New Zealand Institute of Economic Research) latest survey of business opinion only 4% of firms cited finance as the factor most limiting their ability to increase turnover. The problem seems to be an increase in input costs for firms which is hard to pass on to consumers.

Lower interest rates have a downside in the reduction in spending by savers and this could also impact on consumer confidence. Any hint of further easing seems to encourage financial risk-taking more than real investment. Central bankers have thus become prisoners of the atmosphere they helped to create. There is still a belief amongst politicians that central bankers have the power by to solve these issues in an economy and politicians keep asking why those powers aren’t being used.

Are negative Interest rates an option?

The idea behind this is that if trading banks are charged interest for holding money at the central bank they are more likely to make additional loans to people. Although this sounds good negative interest rates on those that hold deposits at the bank could lead to customers storing their money elsewhere.

The European Central Bank sees that negative interest rates have an expansionary effect which outweighs the contractionary effect. An example of this is Jyske Bank, Denmark’s third-largest bank, offered a 10-year fixed-rate mortgage with an interest rate of -0.5%. for a ten-year mortgage – in other words the bank pay you to take out a mortgage.

However negative interest rates is seen as a short-run fix for the economy. Getting people to pay interest for deposit holdings may mean that banks have less deposits to lend out in the long-run and this may choke off lending and ultimately growth in the EU.

Modern Monetary Theory vs Mainstream Monetary Theory

Although not in the A2 syllabus we have had some great discussions in my A2 class on Modern Monetary Theory – MMT. It has its roots in the theory of John Maynard Keynes who during the Great Depression created the field of macroeconomics. He stated that the fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. When you get this situation it is the government that can get the economy moving again by putting money in people’s pockets.

MMT states that a government that can create its own money therefore:

1. Cannot default on debt denominated in its own currency;
2. Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
3. Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
4. Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
5. Does not need to compete with the private sector for scarce savings by issuing bonds.

Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

How does it differ from more mainstream monetary policy – see table below.

Those against MMT are dubious of the idea that the treasury and central bank should work together and also concerned about the jobs guarantee. They argue that if the government’s wage for guaranteed jobs is too low it won’t do much to help unemployed workers or the economy, while if it’s too high it will undermine private employment. They also say that trying to use fiscal policy to steer the economy is a proven failure because politicians rarely act quickly enough to respond to a downturn. They can’t be relied upon to impose pain on the public through higher taxes or lower spending to quell rising inflation.

Below is a video from Stephanie Kelton, an MMTer who was the economic adviser on Vermont Independent Senator Bernie Sanders’s presidential campaign in 2016.

Sources:

The Economist – Free Exchange – March 16th 2019

Wikipedia – Modern Monetary Theory

A2 Economics – Quantity Theory of Money

Just covered MV = PT with my A2 class and produced some notes followed by a video from Marginal Revolution which I got from the Economics Teacher group.

Quantity Theory of Money

The Monetarist explanation of inflation operates through the Fisher equation.

M x V = P x T

M = Stock of money

V = Income Velocity of Circulation

P = Average Price level

T = Volume of Transactions or Output

For example if M=100 V=5 P=2 T=250.   Therefore MV=PT – 100×5 = 2×250

Both M x V and P x T are equivalent to TOTAL EXPENDITURE or NOMINAL INCOME in a given time period. The Quantity Theory is the familiar monetarist interpretation of the Equation and is based on the following assumptions:

  1. T is broadly equivalent to total output and is fixed in the short run
  2. V is broadly stable (i.e. the demand to hold money is relatively uninfluenced by the change in interest rates that arises from changes in the money stock).
  3. Causality runs from the left hand side to the right hand side of the equation

On these assumptions, increases in the money supply (after a suitable time lag) cause equivalent increases in the price level.

Critics argue that:

  1. V is not stable and responsive to interest rate changes.
  2. T is not fixed and is responsive to increases in the money supply below full employment.
  3. Change is P tend to cause changes in M (and not v.v.). In other words, changes in the money supply accommodate inflation and do not cause it.

Calculation using MV = PT

Since MV=PT (by definition), if M=$60, V=4 and T=12, then P can be found.

P =   MV /T  =  (60 x 4)/12  =  $20 

Hyperinflation – can be controlled with a different government.

Venezuela has been in the news for sometime with its economy spiralling out of control with the inflation rate last year at 100,000% – doubling roughly once a month. The occurrence of hyperinflation in economies has become more common with governments now printing money rather than that money being backed by the amount of gold that they held – gold standard. Because the gold supply is quite inelastic, being on the gold standard would theoretically stop government overspending and keep inflation under control. The country effectively abandoned the gold standard in 1933, and completely severed the link between the dollar and gold in 1971 – this was around the time of the Vietnam War.

The more recent hyperinflation in Zimbabwe, Bolivia, Argentina etc have come about through government’s not been able to control the printing presses and succumbing to the desire to stay in power at the expense of crippling the economy. Huge fiscal deficits and excessive borrowing are the common denominator here – see flow chart below:

Hyperinflation usually happens amongst chaotic domestic conditions, whether social unrest or that country being involved in conflict – e.g. post war Germany. However as reported by The Economist hyperinflation can occur under more mundane circumstances. For instance in Bolivia’s inflation reached 60,000% which was started by a commodity boom which allowed them to borrow heavily from overseas but once resource prices tumbled there was a significant reduction in government revenue. The  government under Hugo Banzer increased spending to satisfy the voters who supported them in the election and this created further inflationary pressure. In a way this is similar to the Venezuela experience with high oil prices generating significant revenue for the government but once the oil prices fell the printing presses started to work overtime. And once inflation starts to accelerate Inflationary expectations kick in and then it becomes very difficult to control. However these inflationary expectations could reflect the lack of seriousness of government policy to rectify the problem as a change of government which is focused on prices can end hyperinflation in weeks. This reflects the trust in the incoming regime and was true of Bolivia (see video below).  Here the incoming government under Gonzalo (Goni) Sánchez de Lozada were serious about the ravages of inflation and to deal with it  didn’t use highly sophisticated economic theory.  See below:

  • Government spending was slashed
  • Price controls were scrapped
  • Import tariffs were cut
  • Government budgets were balanced.
  • No borrowing from the Central Bank

As Jeff Sachs – advisor to the Bolivian government –  said:

“All this gradualist stuff just doesn’t work. When it really gets out of control you’ve got to stop it, like in medicine. You’ve got to take some radical steps; otherwise your patient is going to die.”

Sources:

The Economist – February 2nd 2019

Commanding Heights – PBS Video

Turkey’s economy – stuffed

Inflation at 25%, Central Bank interest rates at 24%, Lira down 30% in value since the start of the year. What hope is there for the Turkish economy?

Wages and salaries haven’t kept pace with inflation and the reduction in demand has led to higher unemployment. There is pressure on the central bank to keep interest rates to avoid the lira collapsing. However this makes it expensive for businesses to borrow money and thereby reducing investment and ultimately growth.

No pain no gain – there is no alternative for Turkey other than undertaking painful and unpopular economic reforms. Remember what Reagan said in the 1980’s “If not now, when? If not us, who?”  He was referring to the stagflation conditions in the US economy at the time and how spending your way out of a recession, which had been the previous administration’s policy, didn’t work.

In order to the economy back on track things will need to get worse but President Erdogan has the time on his hands as there is neither parliamentary nor presidential elections in the next five years. This longer period should allow him the time to make painful adjustments without the pressure of elections which usually mean more short-term policies for political gain. Beyond stabilising the lira, which helped to ease the dollar-debt burden weighing on the country’s banks and corporate sectors, the 24 per cent interest rate level the central bank imposed also brought about a long-overdue economic adjustment. A cut in interest rates discourage net inflows of investment from foreigners and the resulting depreciation would accelerate the concerns about financial stability and deteriorating business and consumer confidence. Below is a mind map as to why a rise in the exchange rate maybe useful in reducing inflation.

A2 Economics – Wage Price Spiral and the Long Run Phillips Curve

Phillips CurvePart of the CIE A2 macro syllabus focuses on the wage price spiral which relates to the Phillips Curve. Here are some excellent notes that I picked up from Russell Tillson in my early days teaching at Epsom College. As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve.

During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

AS Economics – Hyperinflation causes and ends

Starting with a definition. In 1956 Phillip Cagan, an economist working at America’s National Bureau of Economic Research, published a seminal study of hyperinflation, which he defined as a period in which prices rise by more than 50% a month.

There seems to be common patterns when hyperinflation occurs in an economy. These include:

  1. Fiscal pressure – cost of funding a war, increased social welfare payments, corrupt officials taking money from the budget.
  2. Dependence of a particular resource – the resource curse. Some economies rely on exports of oil, iron ore or other resources to fund its spending. This has the effect of increasing the value of the currency and although this will make imports cheaper once the resource runs out or global prices start to drop the overvalued currency falls causing a large increase in imported prices. Furthermore governments come to depend on revenue from oil and a sudden drop in prices saw a massive drop in tax revenue – 90% of Venezuela’s revenue came from oil.
  3. Printing money – like Bolivia in the 1980’s, Venezuela overcame their shortfall in income by printing more money. The increase in the supply of money pushes up inflation. But what makes it worse is, as the inflation rate impacts the real value of government revenue, they continue to print money to finance the budget deficit which in turn exacerbates the problem – bigger budget deficit and further inflation.
  4. Exchange rate – at some stage the exchange rate will collapse as people lose confidence in the currency. Imports become ever increasingly expensive and feed into the inflation calculation.
  5. Inflationary expectations – In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue. This is evident in Venezuela as people become accustomed to higher prices and expect them to continue which makes inflation likely to continue.Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves.

Hyperinflation tends to end in two ways.

  1. The paper currency becomes so utterly worthless that it is supplanted by a hard currency. This is what happened in Zimbabwe at the end of 2008, when the American dollar took over, in effect. Prices will stabilise, but other problems emerge. The country loses control of its banking system and its industry may lose competitiveness.
  2. The second, hyperinflation ends through a reform programme. This was very much the case in Bolivia in the 1980’s – Government spending was slashed. Price controls were scrapped. Import tariffs were cut. Government budgets were balanced. Therefore this typically involves a commitment to control the budget, a new issue of banknotes and a stabilisation of the exchange rate—ideally all backed with confidence-inspiring foreign loans. Without such reform, Venezuela’s leaders, though scornful of America, may find that its people are forced eventually to adopt its dollar anyway.

Sources:

  • The Economist “The half-life of a currency” September 15th 2018
  • The Economist “The roots of hyperinflation” February 12th 2018