The common approach to the analysis of the causes of inflation is to relate it to monetary expansion only. However, empirical analysis shows that although inflation cannot be sustained in the medium to long term without monetary expansion, inflation is caused, affected, and transmitted by many other factors, both domestic and external, which can vary from country to country and from lime to time within a country. Because countries react in different ways to inflation, its effects on economic growth also vary. The very diversity of experience demonstrates that a broad framework is absolutely necessary to understand the process of inflation and its effects on growth and to identify successfully the policy instruments that can best deal with the underlying problems. A schematic diagram of the major transmission channels of inflation is presented in the chart.
The eight Latin American countries selected for the study were chosen to encompass a wide variety of patterns of inflation and growth (see Table 1). This variety helps not only to show significant differences in the inflation and growth factors affecting these countries but also to understand similar factors operating in the rest of the developing world. The study reviewed external factors—such as changes in import prices—and domestic factors—such as wage increases, price subsidies, public sector deficits—with evidence of transmission via expansionary credit policy and exchange rate depreciation.
|Rate of change of real GDP||2.6||3.7||4.5||6.0||6.8||–2.1||–3.2||4.9||–3.4||8.5|
|Rate of change of CPI1||13.5||34.8||58.4||61.5||23.5||182.8||443.6||173.6||175.5||159.5|
|Rate of change of M12||19.8||35.9||67.0||103.6||71.6||196.5||297.7||148.7||133.3||135.8|
|Rate of change of real GDP||5.3||3.8||5.1||7.0||6.1||5.5||6.0||4.6||3.0||2.8|
|Rate of change of CPI||3.9||3.6||6.5||31.6||62.7||8.0||4.5||8.1||10.4||20.6|
|Rate of change of M1||12.6||15.3||25.1||34.3||43.4||11.8||36.5||20.9||12.4||16.7|
|Rate of change of real GDP||8.6||7.5||0.0||–3.7||6.0||–11.2||4.1||8.3||7.2||8.5|
|Rate of change of CPI||33.3||19.0||77.3||354.5||504.5||374.7||211.9||92.0||40.1||30.3|
|Rate of change of M1||66.7||120.0||145.5||316.7||272.4||257.4||193.7||108.2||67.0||55.1|
|Rate of change of real GDP||6.7||5.8||7.8||7.1||6.0||3.8||4.6||4.8||8.0||6.0|
|Rate of change of CPI||6.8||9.0||14.3||22.8||24.4||25.7||17.4||30.0||17.4||25.1|
|Rate of change of M1||15.5||11.9||27.1||30.7||17.8||20.1||34.7||30.4||25.1||28.1|
|Rate of change of real GDP||5.5||6.8||8.2||7.7||5.6||2.1||5.5||7.8||5.9||3.5|
|Rate of change of CPI||4.6||3.1||4.6||15.2||30.1||17.4||3.5||4.2||6.0||10.0|
|Rate of change of M1||8.1||29.0||14.1||24.4||19.2||24.1||30.4||24.4||24.0||10.4|
|Rate of change of real GDP||6.9||3.4||7.3||7.6||5.9||4.2||1.5||3.2||6.6||8.0|
|Rate of change of CPI||5.2||5.4||5.0||12.0||23.7||15.0||15.8||29.1||17.4||18.0|
|Rate of change of M1||10.7||7.6||17.9||22.4||20.7||21.4||29.1||26.0||30.0||33.3|
|Rate of change of real GDP||9.7||5.1||5.8||6.2||6.9||3.3||3.1||–1.2||–1.8||4.0|
|Rate of change of CPI||5.0||6.8||7.4||9.5||16.9||23.6||33.5||38.0||57.9||57.0|
|Rate of change of M1||55.3||10.2||28.9||25.2||41.4||17.0||25.8||20.8||45.4||70.3|
|Rate of change of real GDP||4.4||4.5||3.0||6.7||5.8||5.2||7.8||6.4||5.8||4.0|
|Rate of change of CPI||2.6||3.2||2.9||4.1||8.2||10.2||7.7||7.8||7.2||10.0|
|Rate of change of M1||7.4||16.6||19.6||19.7||43.6||50.3||14.7||24.1||15.7||9.3|
Consumer price index.
M1 refers to narrow money (cash and demand deposits).
Consumer price index.
M1 refers to narrow money (cash and demand deposits).
This article is based on a longer paper by the author, “Effects Which Alternate Monetary Policies Have Had on Inflation and Growth in Latin American Countries,” presented at the Fourth Development Banking Round Table of the Inter-American Development Bank, March 2–4, 1981; copies are obtainable from the author.
A major finding was, for instance, that in the mid-1970s imported inflation was an important first cause of the inflationary bout suffered by many small, traditionally noninflationary countries (such as Costa Rica). In other countries with a long history of high inflation, the origin was mainly domestic—and in most cases either caused or transmitted by large public sector deficits. In both cases monetary policy was passively accommodating. The study also examined the extent to which inflation impinged on growth in all these countries as a result of its effects on some key macro-economic relative prices, such as the terms of trade, real interest rates, and real wage costs. The importance of the coordination of different stabilization and reform measures is illustrated by contrasting Argentina’s experiences with those of Chile.
The study was based on a general equilibrium model of an open economy that distinguished between real and nominal magnitudes. The model specified the expenditure sector, the production and wage sector, and the monetary, fiscal, and balance of payments sector. Using this model as a frame of reference, the study reported and reviewed major developments of crucial variables that affect inflation and its effect on growth, and examined certain interactions among these variables. The data were compiled on an annual basis, annual statistics being the only available data for some series, especially for public sector deficits and wages.
Diverse inflationary experience
The relative importance of foreign and domestic factors in explaining the substantially different inflation rates of Latin American countries varied widely. As a first approximation, relative effects were gauged from the relationship between domestic prices and the prices of domestically produced and foreign goods—a relationship that provides an estimate of the minimum effect of foreign price increases on domestic prices (see Table 2).
|Argentina— total CPI change||13.5||34.8||58.4||61.5||23.5||182.8||443.6||173.6||175.5||159.5|
|Direct effect of foreign prices||…||…||…||…||6.0||1.2||0.3||1.0||1.3||1.8|
|Exchange rate effect||1.3||2.3||—||—||—||131.9||32.6||13.7||8.0||6.6|
|Residual (domestic price) effect||…||…||…||…||17.5||49.7||410.7||158.9||166.2||151.1|
|Bolivia—total CPI change||3.9||3.6||6.5||31.6||62.7||8.0||4.5||8.1||10.4||20.6|
|Direct effect of foreign prices||…||…||…||…||9.6||3.3||1.0||3.8||8.3||5.8|
|Exchange rate effect||—||—||25.3||—||—||—||—||—||—||6.0|
|Residual (domestic price) effect||…||…||…||…||53.1||4.7||3.5||4.3||2.1||8.8|
|Chile—total CPI change||33.3||19.0||77.3||354.5||504.5||374.7||211.9||92.0||40.1||30.3|
|Direct effect of foreign prices||…||…||…||…||9.1||2.0||0.2||2.9||1.4||5.7|
|Exchange rate effect||3.0||4.5||7.8||219.8||88.9||62.0||17.7||12.8||4.8||4.6|
|Residual (domestic price) effect||…||…||…||…||406.5||310.7||194.0||76.3||33.9||20.0|
|Colombia—total CPI change||6.8||9.0||14.3||22.8||24.4||25.7||17.4||30.0||17.4||25.1|
|Direct effect of foreign prices||…||…||…||…||4.8||1.8||0.8||1.3||1.6||2.0|
|Exchange rate effect||1.3||1.8||1.5||1.4||3.0||2.7||1.9||0.9||1.6||0.9|
|Residual (domestic price) effect||…||…||…||…||16.6||21.2||14.7||27.8||14.2||22.2|
|Costa Rica—total CPI change||4.6||3.1||4.6||15.2||30.1||17.4||3.5||4.2||6.0||10.0|
|Direct effect of foreign prices||…||…||…||…||21.3||4.3||–1.9||2.1||2.6||5.2|
|Exchange rate effect||—||—||—||0.1||14.7||—||—||—||—||—|
|Residual (domestic price) effect||…||…||…||…||–5.9||13.1||1.6||2.1||3.4||4.8|
|Mexico—total CPI change||5.2||5.4||5.0||12.0||23.7||15.0||15.8||29.1||17.4||18.0|
|Direct effect of foreign prices||…||…||…||…||4.8||2.1||0.4||0.9||1.5||2.0|
|Exchange rate effect||—||—||—||—||—||—||9.7||2.0||—||—|
|Residual (domestic price) effect||…||…||…||…||18.9||12.9||5.7||26.2||15.9||16.0|
|Peru—total CPI change||5.0||6.8||7.4||9.5||16.9||23.6||33.5||38.0||57.9||57.0|
|Direct effect of foreign prices||…||…||…||…||7.0||3.1||0.4||3.4||2.8||3.4|
|Exchange rate effect||—||—||—||—||—||4.8||13.3||21.4||9.9||7.2|
|Residual (domestic price) effect||…||…||…||…||9.9||15.7||19.8||13.2||45.2||46.4|
|Venezuela—total CPI change||2.6||3.2||2.9||4.1||8.2||10.2||7.7||7.8||7.2||10.0|
|Direct effect of foreign prices||0.8||1.4||1.1||1.5||4.0||3.6||1.9||2.9||2.8||2.5|
|Exchange rate effect||—||–0.6||—||–0.4||—||—||–0.1||—||—||—|
|Residual (domestic price) effect||1.8||2.4||1.8||3.0||4.2||6.6||5.9||4.9||4.4||7.5|
Indicates no exchange rate change.
Indicates data not available in two sources used.
Indicates no exchange rate change.
Indicates data not available in two sources used.
In Argentina and Chile, two traditionally high inflation countries, inflation originated almost exclusively from domestic factors, a pattern that is typical of all highly inflationary countries. Again, in Bolivia, Colombia, and Peru inflation was mainly of domestic origin, a pattern typical of many countries with a medium level of inflation over the long term. In Mexico, a traditionally noninflationary country, domestic factors, too, were much more important than imported inflation in explaining its surge of inflation.
By contrast, in Costa Rica, inflation was caused to a significant extent by increases in import prices. This suggests that in the majority of developing countries with traditionally low inflation and with a large ratio of imports to gross domestic product (GDP)—such as other Central American and Caribbean countries and most other small countries throughout the world—the surge of inflation that simultaneously occurred in the mid-1970s mainly originated abroad. Again, in Venezuela, one of the few developing countries to escape serious inflation in the 1970s, inflation was also imported to a significant extent.
In virtually all the countries that suffered from domestically generated inflation, large public sector deficits in relation to GDP were a major disruptive factor. However, the underlying causes differed significantly from one country to another and between periods. Complications of a sociopolitical nature were prominent in Argentina and Chile during the early 1970s. In these countries, large public sector deficits were partly caused by large public sector wage increases, which tended to parallel similar increases in the private sector. In turn, wages grew much faster than prices partly because of the stated government policy of redistributing income in favor of the working class. Thus, wages were propelling prices and vice versa, and credit expansion was passively adjusting. This is the reverse of the causation generally assumed in the literature, which identifies credit expansion as leading to wage and price increases; inflation, generated by domestic factors can—like imported inflation—lead from rising prices to an increasing money supply to maintain the real demand for money.
Major transmission channels of inflation in developing countries
In all of the countries where substantial inflation was generated domestically, the necessary adjustment in the balance of payments (BOP) sooner or later required exchange rate depreciation, regardless of the official exchange rate policy. Depreciation then became the most important secondary channel of transmission of domestically generated inflation. (The effects of depreciation on consumer prices are formally similar to those of increases in import prices in foreign currency but are of domestic origin because they can be attributed largely to domestic policies and conditions.) This is another instance of reverse causation—one that is particularly important for small open economies and has sometimes been seen as causing the vicious circle of inflation and depreciation.
Colombia’s inflationary experience—in contrast to that of other countries that suffered mainly from domestically generated inflation—did not derive from the financing of its public sector deficit. From the last quarter of 1972 through the end of 1973, it emanated largely from the need to support, with central bank funds, the banking system and the financieras (in Colombia, finance companies). The liquidity of these institutions had dwindled in the face of an experiment of partial indexation that allowed the newly created savings and loan associations to offer attractive indexed deposits while the interest rates for other financial institutions were subject to relatively low ceilings. After 1974, Colombia’s steady medium-level rate of inflation was sustained by various factors, among them the abundance of funds derived from the high prices of its oil, coffee, and other exports together with relatively protectionist policies, including a downward crawling peg.
Effects on growth
Inflation can affect growth in many ways but the most important and detectable ones are manifested through changes in the terms of trade (the ratio of export to import prices), real interest rates (interest rates deflated by an appropriate domestic price deflator), and real wage costs (wage rates deflated by the GDP deflator).
There were noticeable differences in the variations in the terms of trade—a variable generally outside the control of the domestic authorities in relatively small developing countries—in different countries and during different years within a country. However, throughout the 1973–79 period, cumulative gains were recorded in all but two of the eight countries analyzed, Chile and Peru. These gains, especially large in the oil and mineral producing countries, help explain the relatively favorable growth performance of their economies in a period in which, by contrast, world production was growing very slowly. Interestingly, the substantial recovery of the Chilean rate of growth after 1975 took place despite its unfavorable terms of trade largely caused by the decline in the price of copper on international markets.
The study’s findings supported once again the hypothesis that positive real rates of interest help the real growth of the financial sector and thus encourage economic efficiency as resources are transferred from lower yielding to higher yielding investments and from consumption to investment. In Chile, for instance, where all interest rates were freed in 1975, the financial markets established highly positive real rates for the first time in many years; the rate of economic growth recovered strongly after the depression caused by earlier stabilization measures and continued at unprecedentedly high levels throughout the remaining years of the decade, despite Chile’s unfavorable terms of trade. By contrast, in Mexico and Peru the real rate of growth of monetary aggregates fell far short of the historical growth as inflation accelerated and regulations failed to provide for a sufficient adjustment of interest rates. In both countries, the financial constraint dampened the rates of economic growth. Mexico’s growth slowed down, despite a favorable turn in the terms of trade.
A negative correlation was found between real wage costs, which suffered pronounced variations in some countries, and growth. In Argentina and Chile, the increase in real wage costs in the early 1970s resulted in an unfavorable effect on growth. Correction of this adverse factor by subsequent policy adjustments created the condition for more rapid growth. In Bolivia, Colombia, Costa Rica, and Venezuela, real wage costs declined, on average, until 1977, helping to maintain the incentives to invest throughout this difficult period of accelerating inflation, but this tendency was reversed as wage costs increased in the remaining years of the decade. By contrast, in Mexico and Peru, real wage costs were allowed to increase rapidly until well into the second half of the 1970s, encouraged partly by official policies. This resulted in a negative impact on investment and growth at a time when other adverse factors, including rising inflation and external debt problems, also were operating. However, wage costs began to decline in the remaining years when the official policies were reversed in connection with these countries’ stabilization programs.
Because of the diverse origins of inflation and its transmission channels, the success of anti-inflationary policies in curtailing inflation and in setting the stage for the resumption of economic growth depended crucially on the ability of the authorities to choose appropriately and to coordinate macroeconomic policies. In small open economies, which had suffered largely from imported inflation in the mid-1970s, it sufficed for the authorities to maintain existing macroeconomic policies for the inflationary pressures to abate significantly with the disappearance of the underlying external effects. On the other hand, in the countries of the Southern Cone, as well as in a few others, such as Mexico, which had suffered rather severe inflation largely arising from domestic sources, subsequent adjustments in fiscal, exchange rate, trade, monetary, credit, and financial sector policies significantly affected the course and consequences of inflation.
The importance of coordinating and timing policy measures may be illustrated by the different anti-inflationary and economic reform experiences of Chile and Argentina. In both countries the strategy of development, initiated in 1973 and 1976 respectively, was based on opening the economy to the outside world, on the free working of the markets, and on a subsidiary role for the state, but the intensity and timing of the measures undertaken in these two countries differed noticeably. Two major lessons may be drawn from their experience. First, fiscal reform and the liberalization of trade should precede, or at least accompany, financial sector reform and, in particular, the liberalization of foreign capital inflows. Second, the exchange rate should not be fixed prematurely, that is, before the underlying causes of the continuing high inflation—such as wage increases and fiscal and credit expansion—have been brought under control.
Reform was initiated in Chile in October 1973 when the new Government decided to decontrol all administratively fixed prices. This was followed by a comprehensive package of far-reaching fiscal, trade, and financial sector measures. The size of the public sector was reduced, partly through the divestiture of public enterprises, and the state’s financial position changed from a substantial deficit to a moderate surplus in 1976, which continued in all subsequent years. International trade restrictions were rapidly eliminated and tariffs were reduced from levels of up to 1,000 per cent prior to 1973 to 10 per cent on all items except automobiles. Simultaneously, financial reform aimed at denationalizing the banking system, freeing all interest rates, and opening up the financial system to foreign competition. Also, the authorities managed the exchange rate so as to progressively reduce its downward slide, until they fixed it with respect to the U.S. dollar in July 1979.
Eventually, this combination of measures—intended in time to let international goods price arbitrage be a principal mechanism in keeping the domestic rate of inflation at the world rate—enabled the authorities to regain control over domestic credit through the use of monetary policy instruments. During the period of adjustment, the authorities had retained certain controls in order to discourage excessive capital inflows. These were progressively dismantled only after the price and tariff systems had been liberalized. The result was a rapid reduction in inflation from over 500 per cent in 1975 to 39 per cent in 1979 (and to 9 per cent in 1981). The rate of economic growth recovered vigorously after 1975, following a decline of output by around 20 per cent between 1973 and 1975, attributable to both the initial stabilization measures and the unfavorable turn in Chile’s terms of trade. The unemployment rate suffered an initial jump to around 20 per cent and then declined progressively to around 12 per cent by the end of the decade, with a tendency toward further decline.
In Argentina, reform of the financial system was more rapid and decisive than that of the public sector and trade. Interest rates were freed between 1976 and 1977; the deposits and loans of the banking system were decentralized in June 1977; and controls on foreign capital inflows were virtually eliminated between 1977 and early 1979. The authorities also moved quickly to moderate the depreciation of the exchange rate, opting for a system of preannounced minidevaluations which eventually became insignificant despite the continuing high rate of inflation. Meanwhile, however, the Central Bank was unable to produce a rapid deceleration in the rate of increase in total domestic credit and money because of both the need to finance the continuing public sector deficits and substantial capital inflows. The delay in the trade reform impeded the creation of profitable investment opportunities capable of absorbing the new financial resources. Because of this, the results of the reform were somewhat mixed. By the end of the 1970s, inflation had abated to below 100 per cent; the unemployment rate had remained at a moderate level throughout; and the rate of economic growth had stayed within an acceptable range in relation to the overall Argentinian postwar record. However, eventually many enterprises were unable to repay their loans, forcing the liquidation of a number of banks and financieras in 1980 and 1981, a situation that threatened to undermine the long-term gains from the reform.
The findings of this study have important implications for policies dealing with problems of inflation and growth. If inflation has diverse origins, the remedies used to combat it must be diverse. Inappropriate measures pose the risk of failing to reduce inflation, and worse, of exacerbating real distortions that also threaten to reduce the rate of economic growth. For instance, to attempt to reduce the rate of increase of monetary aggregates in order to stabilize prices would be inappropriate in a situation where irresistible social pressures, possibly the result of pressing basic needs, are leading to large increases in wage payments. The result would be a rising unemployment rate without assurance of a reduction in inflation. Again, imported inflation would need to be offset by deflationary policies, such as exchange rate appreciation, yet such policies would largely be inapplicable because of the adverse effects that they can have on both output and on the BOP. It is often counterproductive, too, to impose credit limitations in the face of a social revolution that imposes heavy demands for public sector outlays when a relatively weak government is unable to raise enough taxes to pay for them. The result can be to crowd the private sector out of the credit market and produce adverse effects on growth.
These truths have only recently begun to be recognized, partly as a result of the unsettled state of the world economy in which all sorts of diverse inflationary situations have arisen in individual countries. The general equilibrium approach is useful for several reasons. It can help identify the original sources of inflation; the multiple interaction in the process of transmission of inflation; the influence of relevant structural factors, such as the size and the degree of openness of an economy, in the generation and transmission of inflation; the influence of the overall policy orientation of the country on monetary expansion and inflation; and also the channels—fiscal, credit, exchange rate, wage, and other measures—through which policy is manifested. Similarly, this approach can help examine the different effects on economic growth of different inflationary processes and different anti-inflationary policies, inasmuch as they affect the relative prices and nominal magnitudes differently. In particular, the general equilibrium approach helps to examine explicitly the interactions through the external sector that are of particular importance in the analysis of the process of the international transmission of inflation and growth cycles. Increasing recognition of this new approach has motivated international organizations and their member countries to search for new enlightened solutions to the serious problems of inflation and international adjustment now faced by the entire world.