9 Inflation and Stabilization

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INFLATION AND STABILIZATION IN LATIN

AMERICA

Leonardo Vera

JANUARY 2003

Latin American CentreTopics in Latin American Economics

University of Oxford

Directed by Rodrigo Cubero-Brealey


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WHY LATIN AMERICAN INFLATIONARY

EXPERIENCES HAVE CAUGHT WORLD ATTENTION?

Latin American countries have been plagued with inflation over several

decades without parallelism

There have been several episodes of extreme inflation with. Bolivian Inflation,

for instance, between May and August of 1985 reached an annualized rate of

60,000 percent, the seventh worst case of hyperinflation in history.

During the second half of the 20th century the region presented many

interesting events of low and high inflation, hyperinflation as well as

stabilization experiences.

A rich debate focusing not only on the theoretical causes of inflation but on its

appropriate solutions emerged


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SOME PRELIMARY REMARKS

Inflation is the change in purchasing power of a unit of domestic currency

during a period of time. More money is needed than before to achieve the

same amount of purchasing power

Occasionally it gets out of control: After World War I, for instance, in

Germany money as so little value that a weeks wages had to be transportedin a wheelbarrow. In Mxico, in periods of high inflation people bought new

cars a put them on blocks because they retained their value reasonable well.

The Consumer Price Index is calculated from a market basket of consumer

goods and services

The rate of Inflation is calculated as the rate of change of the consumer price

index (CPI)


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THE COSTS OF INFLATION

The economy start to emphasize finance at the expense of production

(hedging, hoarding and speculation displace real production)

Re-distributional Costs: Income generated by long-term nominal contracts

shrinks in real terms. Typical redistribution from lenders to borrowers.

Capital flight may rise as people loose confidence in the local currency

causing balance of payments problems

Inflation may undermine institutions and conventions (past practices) such as

rules of thumbs and contracts

Menu Costs in the sense that firms have to spend time and money posting

new prices in catalogues, and on ticketed merchandise

Informational costs: inflation may distort information used to make

comparisons between goods, generating problems of allocation and

diminishing welfare.


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INFLATION, HIGH INFLATION AND

HYPERINFLATION

Latin American countries have registered all types of inflations

In general low inflation countries have average inflation rates below 10

percent. These rates do not raise major costs to the economy. It is the typical

range found in developed economies. You may play a fine tuning game.

As inflation rises, volatility in the inflation rises as well and people start to

develop protective behaviour. That kind of inflation becomes chronic but does

not turn easily into hyperinflation.

In extreme cases hyperinflation develops.In this case the increase in prices is always greater than increase the

money supply

People do not want to hold domestic currency

Long-term contracts disappear of the economy


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FAMOUS INFLATIONARY EPISODES

During the Roman Empire: Emperor Gordian in the third century reduced

the silver content of the coins (silver denarius). Edict of Diocletian (301 A.D.)

Spain in the sixteenth century, following the discovery of precious metals in

America

US War of Independence, 1779-1780. Inflation reached 1,000%.

French Revolution. Introduction of theassignats (paper currency). Inflation

reached 3,000% in 1795

US Civil War. Inflation reached 40% per month in the confederacy


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THE THREE HYPERINFLATIONARY PHASES

IN THE TWENTIETH CENTURY

The aftermath of World War I

Between 1921 and 1924 hyperinflation developed in:

Austria, Germany, Hungary

Poland and the Soviet Union

In the wake of WW IIHungary

China and Taiwan

Greece

In the 1980s after the Debt Crisis

Argentina, Bolivia, Brazil, Nicaragua, Per, Polandand Yugoslavia


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German Hyperinflation: 192123


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figure 2. Selected Latin American Countries: Inflation Performance

(Annual percent change in consumer price index)

Source: IMF, World Economic Outlook.

Latin America

0

100

200

300

400

500

600

1981 1984 1987 1990 1993 1996 1999 2002

485 percent

Argentina

0

5001000

1500

2000

2500

3000

3500

1981 1984 1987 1990 1993 1996 1999 2002

3,080 percent

Bolivia

0

2000

4000

6000

8000

10000

12000

14000

1981 1984 1987 1990 1993 1996 1999 2002

11,750 percent

Brazil

0

500

1000

1500

2000

2500

3000

3500

1981 1984 1987 1990 1993 1996 1999 2002

2,948

Chile

05

10

1520253035404550

1981 1984 1987 1990 1993 1996 1999 2002

31 percent

Colombia

05

10

1520253035404550

1981 1984 1987 1990 1993 1996 1999 2002

32 percent

Mexico

0

20

40

60

80

100

120

140

1981 1984 1987 1990 1993 1996 1999 2002

132 percent Peru

0

1000

2000

3000

4000

5000

6000

7000

8000

1981 1984 1987 1990 1993 1996 1999 2002

7,486

Selected

Latin

American

countries

Recent

Inflation

Performance


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COMMON ELEMENTS OF THE INFLATIONARY

EXPERIENCES IN LATIN AMERICA

High Budget

Deficits

Rapid Increases

in

the Money Supply

Exchange rate

Depreciation

or Strong Devaluations

Based on the inflationary experiences in the southern cone, a strong debate

started in the 1950s between two school of thought, the so-called monetarists

and thestructuralists. The debate was enriched over the years by the New

Monetarists (Rational Expectations School) and the Inertialists (or New

Structuralists). The debate have focused on the theoretical causes of inflation

and its appropriate solution


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INFLATION ( AND MONEY GROWTH IN LATIN

AMERICA


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MAIN TENETS OF MONETARISM

Inflation: Too much money chasing too few goods

Most Known Exponents: Bresciani-Turroni, Phillip Cagan, Milton Friedman,

Tom Sargent, and the IMF

Interpretation

Budget Deficit(weak governments, populism,

expansionary keynesian policies,

subsides, industrialization

policies)

Increase in the Money Supply(by printing money)

Inflation(as a result of the excess of

money)

Capital Flight, Currency

Substitution, and Severe

External Problems

Loss of InternationalReserves (if a fixed ER regime

operates) or Exchange Rate

Adjustment (in a flexible ERsystem)

Expectationsof Fiscal

Disarray


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MORE ON BUDGET DEFICITS AND

Government Budget ConstraintDEF = GT= MB + B

1. Deficit financed by bonds, no effect onMB andMs

2. Deficit not financed by bonds,MB andMs

Financing persistent budget deficit by money creation leads tosustained

1. Deficit financed byMs leads toAD shifts out

2. If deficit persists,Ms continually and getP continually,

i.e., as

Conclusion:Deficit , only if it is

1. Persistent

2. Financed by money creation rather than by bonds


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MAIN TENETS OF STRUCTURALISM

Inflation: The structure of LDCs give rise to imbalances and rigidities

accommodated by passive money

Most Known Exponents: Osvaldo Sunkel, Julio Olivera, Dudley Seers, Lance

Taylor, Edmar Bacha.

Interpretation

External SectorVulnerability: Fall in the

Terms of Trade, The Need of

Key Imports, Increase in the

Debt Service, Sudden Stops of

Capital Flows

ER Depreciation or

Devaluation

Price and Wage

Increases

Monetary Policy

Accommodates

Reduction in

Tax CollectionEconomic

Contraction

Increase in the

Budget DeficitIncreases the DebtService in Domestic

Currency


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POLICY RECOMMENDATIONS

Monetarists

(a) Fiscal Adjustment

(b) Limits to Money

Creation(c) Liberalization or a

freeing of markets

from Government

Intervention

Structuralists

(a) Government

Investment in

Key Sectors

(b) Industrial Policy

(c) Income Policies


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INERTIA

During the 1980s and 1990s New Structuralists have emphasized the role of

Inertia in the propagation and chronic behaviour of Inflation

In LA countries sometimes contracts are written to include an adjustment for

inflation (indexation)

Formal indexation is usually backward looking. Wages, prices and contracts

are adjusted for past inflation

Also the shortening of the interval for adjustment of wages, prices, public

sector prices and the exchange rate appears as inflation increases.

Inertialists claim that these two factors (indexation and the shortening of the

intervals of price adjustments) will not allow drastic fiscal adjustment or

fixed exchange rates to stop inflation rapidly. There is some inertia and the

costs in terms of output can be severe.


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FOUR RECENT EPISODES OF STABILISATION IN

LA: Bolivia (1984-1985)

FACTS

Between 1971-1978 (during Hugo Banzer

regime) Bolivia experienced favourable

terms of trade and heavy borrowing (pro-

cyclical financial markets)

By the late 1970s and early 1980s fallingcommodity prices (TIN) and tight

international credit put an end to easy

economic times

By 1982 inflation was running at almost

300 % per year. Siles-Suazo, the head of aleftist coalition was put under pressure

by strikes and lockouts and demands

were attended increasing the fiscal deficit

and money creation

Bolivia faced a combination of debt

overhang, huge fiscal problems,dolarization and social conflicts.

THE STABILISATIONAPPROACH

In 1985 the elected government of Victor

Paz Estensoro implemented a

stabilization plan (in September inflation

had reached 56% per month)

The government declared a moratorium

of Debt Service (accepted by the IFI)

The exchange rate was fixed

The government implemented a deepfiscal reform (sharp increase in public

sector prices, reduction of subsidies to the

mining industry and public sector wage

freeze)

By 1986 inflation reached 66% (from

8.178% in 1985


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LA: Mxico (1987-1989)

FACTS

Mexico suffer chronic and moderate

inflation since the 1970s

Severe external crisis in 1982, debtoverhang and exchange rate adjustment

Rounds of new devaluations and fiscal

austerity programmes in 1986 and 1987

accelerated inflation

Failure of Orthodox Programmes ledMiguel de la Madrid to look for

alternatives with less output and

employments costs

THE STABILISATIONAPPROACH

In 1987 the government announces the

Economic Solidarity Pact, which was

followed by the Pact for Economic

Stability in 1989.

Strong adjustment of the peso followed

by smalls and decreasing over time

adjustments in the exchange rate

Guidelines for wage and price

adjustments (voluntary agreementsmonitored by the three parties: business,

labour and the government)

Tariff reduction and trade liberalization

Inflation diminished slowly and the costs

in terms of output were low


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LA: Argentina (1990-1991)

FACTS

In June 1985 the annualised inflation rate

reached almost 6,000 %.

Austral plan I and II; which consisted of

wage-price controls and fixed ER wererelatively successful in the short-run.

When the price freeze was lifted, prices

took off.

At the time of presidential elections in

1989, the government of Alfonsin was

weak, isolated and unable to collect taxes.

In May interest rates hit 150% per

month. Rumours spreadthe

government had run out of paper and ink

to print money.

The situation led Alfonsin to step downearly after the elections.

THE STABILISATION APPROACH

In 1991, after huge chaos, the convertibility plan

was launched by the government and approved by

the congress.

Convertibility of the peso at 1-to-1 rate with the US

dollar and obligations of the monetary authority tomaintain full backing of the monetary base in

foreign reserves were mandatory.

The law also banned any kind of automatic price

adjustment linked to domestic prices and contracts

in foreign currency were allowed.

The programme was complemented with a massive

privatisation of public utilities (which solved

partially the fiscal problem). The government

implemented deep trade and financial

liberalization.

Successful results at curbing inflation.


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LA: Brazil (1984-1985)

FACTS

Until the mid 1980s inflation in Brazil

was relatively stable because of

dissemination of backward looking

indexation.

The relatively stability collapsed n 1986with the Cruzado Plan. Inflation

subsequently presented a upward trend.

About 11 economic plans followed after

the Cruzado plan with no success at

curbing inflation. Fears emerged in terms

of the survival of the fragile newdemocratic system.

At the end of June 1994 inflation was

running at the astonishing rate of 7,000%

per year. Severe problems in the fiscal

front and the external sector.

THE STABILISATION APPROACH

Advocated by then finance minister Fernando

Henrique Cardoso, the Real Plan was launch in

June 1994. It had three phases.

Phase one of the plan was an attempt to securefiscal stability through tax increases, expenditure

cuts and the reduction of compulsory transfers to

local administrations.

Phase two, contemplated the creation of the Unit

of Real Value (URV), a stable unit of account

whose nominal value increase daily according tothe rate of inflation (of cruzeiros reais).

Phase Three, was the transformation of URV into

the Real . In took place in June after relative

prices were aligned.

Inflation declined drastically


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Evolution of the Rate of Inflation Before and After Stabilization

Year Bolivia Mexico Argentina Brazil

1980 24

1981 25 28

1982 296 59

1983 329 102

1984 2177 66 211

1985 8170 64 385 228

1986 66 106 82 58

1987 11 159 175 366

1988 52 388 993

1989 20 4924 1765

1990 30 1833 23601991 19 84 421

1992 12 18 989

1993 8 7 2086

1994 4 2312

1995 1,6 75

1996 0,1 11

1997 8

FOUR CASES OF STABILISATION IN LA

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9 Inflation and Stabilization