The Effect of Inflation on Economic Development
Publication Date:
01 Jan 1963
eISBN:
9781451956023
Language:
English
Keywords:
SP; export; export norm; Japan; inflating economy; rate of inflation; economic system; aids development; excess demand; Exchange rates; Consumption; Foreign assets
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This is a revised version of a paper prepared for presentation to the Conference on Inflation and Growth in Rio de Janeiro, January 3–11, 1963.

Abstract

This is a revised version of a paper prepared for presentation to the Conference on Inflation and Growth in Rio de Janeiro, January 3–11, 1963.

Graeme S. Dorrance *

I. Introduction

The problem

IN MANY of the less highly developed countries, incomes are not rising as rapidly as the desires of the community. In these countries, personal savings are low, so that only limited resources are released for the expansion of the community’s capital. At the same time, the tax systems provide only enough revenue to meet part of the community’s desires for government services, with very small surpluses available to finance development. Under these circumstances, inflation may appear to be an easy method of providing finance to expand investment and hence to be an easy way of obtaining capital for a more rapid expansion of output. If a government can persuade the central bank to create money to finance a development program, or if the banking system freely makes loans to private investors for the finance of physical investment, the problem of expanding the community’s real assets may appear to be easily solvable. Consequently, it is sometimes argued that “a case could be made for making inflation an instrument of (development) policy, rather than the control of inflation an object of policy.”1

There is no doubt that, on occasion, a monetary expansion somewhat greater than the current increase in real output will introduce an element of flexibility in an economy, and lead to some “forced saving” releasing resources for development. However, there are strict limits to the amount of development which may be fostered in this way. Admittedly, the available simple evidence on the relation between inflation and growth is difficult to interpret. The difficulty is common in analyses of the effects of pervasive influences, like the degree of inflation, on phenomena which are also subject to other, complex, forces.

Table 1 presents summary data gathered from three sources. This evidence varies from the inconclusive simple comparison of average rates of growth for the years 1954–602 as derived from the UN national account statistics, to the rather more persuasive conclusions obtained from a recording of the data relating to specific periods of rather constant price change identified by U Tun Wai.3 The rates of growth in the simpler comparisons are based on one observation per country; hence each observation reflects not only the effect of inflation but also the effects of the available natural resources and their stage of exploitation, and the general political atmosphere and other influences, such as the general social attitudes, in each country. The separation of shorter periods for individual countries when different rates of price increase prevailed, based on Tun Wai’s observations, tends to strengthen the influence of the rate of inflation, as distinct from other forces, in the last three comparisons in Table 1. These latter data suggest that in the postwar years the less highly developed countries have, on the average, enjoyed annual increases in per capita output of approximately 4 per cent during those periods when they maintained monetary stability. During periods of mild inflation the increase in output in these countries was only half as great. During periods of strong inflation, the increases in output tended to be even smaller.4

Table 1.

Relationship of Rates of Inflation to Economic Growth in Recent Years1

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For description of stable, mild inflation, and strong inflation countries, and for statement of countries and periods covered, see Appendix, page 32.

For sources of data, see Tables 11, 12, and 13 (pp. 33–34).

It is true that individual units of investment financed by bank credit are likely to be created even in inflationary conditions. It is not the immediate products of monetary expansion which are in question; rather it is the over-all effect on progress which deserves consideration. An expansion of the monetary system’s assets involves an equal expansion of its liabilities. Unless members of the community are willing to increase the real value of their money balances by an amount equal to the increase in bank credit, and thereby indirectly to provide finance for the new investment, either prices will rise, or imports will be so encouraged and exports discouraged that there will be a fall in the community’s capital held in the form of exchange reserves, i.e., a disinvestment in reserves offsetting the newly financed domestic investment. If prices rise, the real value of any increase in money holdings will be eroded. This fall in the real value of money may be considered as a tax on money holders. Inflationary policies, or policies which lead a government to be weak in resisting inflationary pressures, may be assessed by criteria similar to those used in assessing alternative taxation proposals.

The efficiency of any tax is largely dependent on the degree to which it cannot be evaded. The degree to which a tax “cannot be evaded” is, in turn, largely a function of the degree to which it does not lead to incentives encouraging evasion. A mild inflation may well encourage little, or no, evasion of the “inflation tax.” On the other hand, a strong inflation, and frequently a mild one also, will lead to community reactions which have effects similar to those of widespread tax evasion.

A development policy may have wider aims than the encouragement of a high level of investment. It may be directed to the encouragement of types of investment different from those which would emerge in an economy in which all economic decisions are made by individual economic units acting without positive inducements by the government. If an attempt be made to foster development through an “inflation tax,” the types of economic incentive induced by inflation are also relevant to its effectiveness. A strong inflation creates distortions in the economy, which may be regarded as comparable to the undesirable incentives induced by unsatisfactory forms of taxation.

It must be recognized that rapid economic development, by evoking supply shortages in certain specific fields, frequently leads to increases in the prices of certain commodities. The number of these may be fairly large. Under these circumstances, some rise in the average level of prices may frequently be an unavoidable companion of economic progress. This observation does not, however, lead to the conclusion that inflation aids development, or that its control should not have a high priority among the targets for economic policy.

The significance of expected price increases

The monetary system operates on the assumption that money serves as a satisfactory medium of exchange, numéraire, standard for debt repayment, and store of value. If prices are stable or rising imperceptibly, money will be accepted by the community for all these purposes. If prices rise markedly, individuals and businesses will cease to hold money for the latter two of these four purposes. If prices are not expected to remain stable, the economic adjustments attempted by the community will be different from those which will be attempted when price stability is expected.5 In some respects, the problem facing the analyst is the comparison of these different adjustments.

The effect of inflation on the desire for liquidity6

Inflation has two effects on the desire for liquidity, which are related to the two basic reasons why individuals and businesses wish to hold liquid assets—the speculative and precautionary motives. Inflation increases the value of effective liquidity, thereby raising the community’s desire for it, but it makes the most generally accepted store of liquidity—money and financial assets denominated in money—unacceptable sources of protection. This strengthening of the community’s wish for liquidity and weakening of the usefulness of the traditional store of liquidity will exert their greatest influence on the types of investment undertaken during periods of inflation, but they will also work to reduce the total flow of resources available for investment.

If an inflation were expected to proceed at a uniform rate, it might have little effect on the community’s desire for liquidity. In practice, the rate of any inflation is unpredictable, and the variations in this rate are likely to become more pronounced as the average rate of inflation increases. In a stable economy, price movements are reasonably predictable. In an inflationary economy, if the current rate of price rise is 20 per cent a year, the rate next year may almost equally well be approximately 10 per cent or over 40 per cent.7 This uncertainty regarding the future course of prices creates an incentive for liquidity. With the future uncertain, the probability of unpredictable investment opportunities arising, or business difficulties occurring, is increased. Hence the desire to hold liquid assets for speculative and precautionary purposes is strengthened.

However, during an inflation money and financial assets denominated in money cannot be depended on as stores of liquidity, since they decline in real value as prices rise.8 They even fail to provide acceptable liquidity to bridge the gap between transactions, because the intervals between cash receipts and disbursements may be long enough for prices to rise appreciably. In these conditions, attempts will be made to acquire assets whose value is expected to rise in the interval before the investment opportunity or other occasion for disbursement arises. This flight into nonmonetary assets is the source of many of the distortions which accompany an inflation, and is a partial cause of the decrease in the flow of resources to investment.

Inflation is not the only problem of development

The control of inflation is only one of the problems facing a government wishing to encourage rapid economic development. The fight against illiteracy, the reform of bureaucratic practices, the building of basic sanitary facilities for the eradication of endemic diseases, the substitution of competitive for monopolistic trade practices, the encouragement of a widespread spirit of entrepreneurship, and the creation of an adequate amount of social capital, may be important prerequisites for rapid growth. However, attacks on these problems are likely to be more feasible in an atmosphere of financial stability: a rapid inflation will make the failure of such attacks much more likely.

II. The Flow of Resources for Development

Acceleration of development, or the maintainance of a high rate of economic progress, calls for encouragement of the flow of resources to development uses and their utilization in the most productive directions. These resources can come only from that part of total domestic output which is not consumed, or from foreign borrowing. Hence, a development policy may be judged by its influence on output, the rate of saving, the decisions of foreign lenders, and the uses to which the total flow of investment funds are put. The future level of output will be, in large part, determined by current and foreign borrowing, and by the productivity of the investments financed from these sources.

Domestic saving

Amount

General observations. In all countries, a considerable part of the community’s saving takes the form of the accumulation of financial assets. In most poor countries, money forms the major part of the community’s financial assets. Even in wealthy countries, financial assets denominated in money (money itself, savings deposits, insurance policies, bonds, etc.) absorb a large part of the community’s saving. The willingness of individuals and businesses to hold an expanded quantity of money, or financial claims denominated in money terms, is influenced by their expectations regarding the future price levels. If prices are expected to rise markedly, holders of money will try to limit any increase in the money value of their holdings, or may even attempt to dispose of them. Evidence of community reaction to inflation is provided in Table 2. Historically, the ratio of money to income in all but the wealthiest countries has tended to rise, but in recent years this ratio, on the whole, has declined in countries where inflation has prevailed. The simpler comparison of the value, in terms of constant prices, of the increases in money leads to similar conclusions. In countries which have gone through fairly extended periods of strong inflation, the volume of savings accumulated in the form of money and quasi-money has been quite small, whereas in the more stable countries these accumulations have been substantial. In Argentina and Bolivia the real value of money holdings has even declined. It should be remembered that this latter comparison is limited to changes in the value of these holdings. It does not take account of any changes in the real value of transactions which these holdings are required to finance.

Table 2.

Comparison of Rates of Inflation and of Increases in Monet and Quasi-Money1

(In per cent)

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See Tables 16 and 17 (pp. 36 and 37).

Saving in the form of money accumulation is only one part of saving through the acquisition of financial claims. A large part of money accumulation is involuntary. Other holdings of financial assets are voluntary. These latter holdings are likely to rise less (or fall more) than those of money if prices are expected to rise. The experience of Argentina and Brazil, outlined in Table 26, may be taken as typical. Between 1950 and 1961 the money holdings of Argentine residents rose almost tenfold. However, the increase in quasi-money was only sevenfold and holdings of government debt remained constant over the period. While Argentine residents increased their money holdings by more than 800 per cent (which in fact represented a decline of 25 per cent in the real value of these assets), the wider group of financial assets rose by only 685 per cent, representing a decline of more than 40 per cent in their real value.9 In Brazil, where money holdings have, until recently, tended to increase slightly in real value, all financial assets, taken together, have, until the last few months, been remarkably stable in real value. The decline in the value of financial assets other than money has offset any saving forced by monetary action.

It is true that this argument says nothing more than that one element of saving will be reduced. Yet, it is the element of saving most widely accessible to nonproperty owners in less highly developed countries. Individuals who forego money savings will undoubtedly divert some of their saving to other forms. However, consumption is also a rival for expenditure, if saving in the form of accumulation of assets denominated in terms of money is unattractive. Consequently, a communal shift away from holdings of financial assets is almost certain to be associated with a decline in total saving.

Personal saving. In part, the decline in saving may be explained by the changes in income distribution which are likely to accompany a strong inflation. In the early stages of a mild inflation, the belief that prices will not rise markedly may well lead wage earners to accept nearly constant money payments, and pension plans which promise fixed money payments. Consequently, in the early stages of a mild inflation, there may be a shift in income distribution from the relatively low-income wage earning and pension groups, who have a low propensity to save, to the relatively wealthy profit recipients, who are likely to have a higher propensity to save.

Once wage earners realize that the real value of fixed money earnings is likely to decline, they will press for higher wages or for sliding scale adjustments which will ensure, at least, the maintenance of the real value of their earnings. At the same time, employers, with rising money profits, will be willing to compete for workers by agreeing to higher wage payments. Similarly, prospective pensioners will not be satisfied with retirement programs which relate benefits to past money incomes. Pressures will be exerted for the adoption of plans with escalator clauses. Governments, acting on the basis of humanitarian motives, will accede to these pressures. As a result, pension programs will be developed which, in effect, relate pension payments to the cost of living, the level of minimum wages, or some similar escalating provision. This process will result in a shift in income distribution from the wealthy back to the less wealthy, with a consequent decline in saving.

Whether these forces will be sufficient to make the final distribution of income more or less favorable to the relatively poor is probably impossible to determine. Table 27 suggests that, if reasonably long periods are taken, the degree of inflation has relatively little influence on real wage rates. Similarly, the data in Table 28 suggest that the shift in the distribution of income may be quite small, with perhaps a slight increase in the share going to wage earners in periods of inflation.

At the same time, inflation will be associated with a qualitative redistribution of profits. Every rapid inflation provides an opportunity for fortunate speculators, and their ostentatious consumption gives an impression of a radical shift in the community’s income distribution. However, these groups are not likely to be large savers relative to their incomes. The nouveaux riches are likely to be more typical of this group than the frugal entrepreneurs who reinvest profits to build industrial empires.

Business saving. The pressures which depress personal savings will have a similar influence on business saving. In addition, strong inflation will bring forth two specific pressures encouraging businesses to distribute, rather than to reinvest, current earnings.

The strengthening of the desire for liquidity which results from inflation will discourage long-term investment. As a result, shareholders will press company managers to distribute profits.

Moreover, as shown below, in their search for liquidity and profitable investment, residents of countries where there is inflation are likely to shift from domestic to foreign investment. Shareholders in companies, being among the wealthy and more sophisticated members of the community, are persons who have the knowledge of, and effective access to, foreign investment. For this reason also, they are likely to put pressure on company managers to pay dividends rather than to retain earnings, so that the proceeds of these payments may be transferred abroad.

Comparative statistics on company practices are very scanty, to say the least. One, admittedly unsatisfactory, comparison is given in Table 19. Statistics on the activities of corporations controlled by U.S. residents, but operating in other countries, identify the data, by country, for only a relatively few countries. In the years 1957–60, the records relating to those less industrialized countries where prices were stable indicate that companies operating in these areas tended to reinvest half their disposable earnings. Similar companies operating in countries where prices were rising tended to reinvest only half as much.10

Government saving. If saving by the private sector is inhibited by inflation, it is possible that the shortfall might be made up by government saving. The data in Table 3 indicate the reverse. However, this relationship reflects primarily the attempts of some governments to finance investment by budget deficits. That is, in effect some countries have made inflation an instrument of development policy rather than making the control of inflation an object of policy.

Table 3.

Relationship of Rates of Inflation to Budget Deficits, Selected Years1

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See Table 18 (P. 37).

There is one important factor which will tend to increase government expenditure and lead to budget deficits. Even though a worker realizes that his wages are increased, he strongly resents a rise in his rent or in the prices of bread or beans, and particularly resents any increase in public utility prices. In an attempt to forestall some of the undesirable effects of inflation, the government may attempt to restrain the rise in prices of consumer goods. Farmers and other producers will expect, and will provide supplies only if they receive the benefits of, rising prices. If the price of one commodity is controlled while other prices are rising, the demand for the price-controlled commodity will increase. If the supply of a commodity is to be encouraged, its price must rise relative to other prices. Hence, government restraint of price increases will only be possible if the production of the price-controlled goods is subsidized. The cost of these subsidies may well absorb substantial amounts of government expenditure. For example, the persistent deficits of government-owned public utilities, resulting from rising costs and opposition to rate and fare increases, are a common characteristic of government accounts in countries experiencing a strong inflation.

This is exemplified by the fiscal problems of the Government of Ceylon. In the past few years, factors which might lead to rapidly rising prices have been present in that country. The Government has striven to restrain these pressures, largely by using subsidies to suppress the effects of inflation, and has met with considerable success. Because of the country’s high propensity to import (even though subject to controls, imports are equal to approximately 40 per cent of gross national product and imported goods account for over 40 per cent of consumer expenditure), the domestic price level is determined predominantly by foreign prices. The evidence of inflation has appeared primarily in a 60 per cent reduction in the country’s foreign exchange reserves in the five years ending in 1962. Government revenue rose (Table 4), partly as a result of increased tax rates and new taxes, but government expenditure increased more rapidly in the six years ending in 1960 (the latest period for which data are available). Consequently, the Government’s cash accounts changed from a position of near balance to a deficit equal to approximately 7 per cent of gross national product. If the Government had been able to avoid the expenditures made to restrain the inflation, its excess of current revenue over current expenditure would have provided surpluses to finance its investment expenditure in the fiscal years 1955–58, and the 1959 and 1960 deficits would have been small. The decision to provide food subsidies and to cover the operating losses of the railways and electricity departments induced inflationary deficits in the years 1956 to 1960. Even with the investment program, there would have been inflation-repressing surpluses in the early years.

Table 4.

Ceylon: Prices and Government Finance, 1955–60

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Source: Central Bank of Ceylon, Annual Report for the Year 1961.

Food subsidies as per cent of personal consumption.

Revenue plus grants under Colombo Plan and from other sources.

Food subsidies and losses of railway and electricity departments.

Purchase of foreign assets

In an inflationary economy, foreign financial assets serve to protect liquidity. Insofar as they are claims denominated in money terms, they provide the same quality of protection that domestic financial assets provide in a stable environment. Insofar as the expectation of price increases has, as a concomitant, an expectation of exchange depreciation, domestic claims will be expected to decline in real value, whereas foreign claims will not. Consequently, it may be expected that inflation will lead to an increase in the community’s desires to hold foreign assets, and that savings will be diverted from the purchase of domestic assets to the purchase of foreign assets. Any expectation that the exchange rate will depreciate to a greater degree than domestic prices rise will strengthen the desire for foreign assets.11

Comprehensive statistics on the acquisition of foreign assets by residents of countries experiencing inflation are not available. A number of estimates of the total amounts involved have been made, but they can be no more than guesses. The few available statistics are depressing. In the five years ending in 1961, private residents of Latin America, other than banks, increased their investments in the United States by approximately one billion dollars.12 The summary in Table 5 of data on the acquisition of short-term foreign assets by residents of Mexico provides an example of the relation between these capital movements and the rate of inflation. Indeed, “a particularly unfortunate feature of the international financial scene in the last decade has been the large flow of private capital from those less developed countries which have tolerated inflation to countries, frequently wealthy, which have maintained monetary stability.”13

Table 5.

Mexico: Average Net Purchases of Short-Term Foreign Assets by Residents, 1951–601

(In millions of U.S. dollars)

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Based on data in Table 20 (p. 38).

Purchase of financial assets

Even if inflation did no more than lead to a shift in the flow of saving from the accumulation of financial assets to the purchase of other types of assets, this would involve a decline in the “quality” of saving. It may be argued that, if all domestic capital markets were perfectly linked, if the different availabilities of capital in each market were reflected solely in the different rates of interest prevailing, and if these rates reflected only the liquidity and risk elements in the capital transactions, financial transactions might be considered to reflect purely economic forces. If these conditions prevailed, each economic unit desiring to invest would have to compete with all the others desiring to invest, and this competition would be based on the relative returns to be earned in different activities and the relative costs of borrowing from different sources. Under these conditions, investment should be channeled to the most productive uses. It must be admitted that these perfect conditions do not prevail in any market, and that the capital markets of all the less highly developed countries tend to be more inflexible than the markets of the more highly developed countries. Yet, anything which encourages the flow of savings to the financial markets may be expected to increase the economic desirability of the resulting investment which the community’s saving makes possible. Anything which limits the flow of savings to financial markets, or reduces the opportunity for self-investors to acquire financial assets, may be expected to limit the influence of economic criteria on investment decisions.

Foreign capital

Amount

In addition to the release of domestic resources through saving, just discussed, resources for development may be obtained by borrowing abroad. But just as an outward flow of capital is encouraged by an inflation (above, p. 11), so an inflow in the form of portfolio investment is discouraged by inflation.

A major part of private international capital transfers arises from equity investment by nonresidents. This flow is largely in the form of direct investment by experienced entrepreneurs interested in establishing types of production not previously undertaken in the developing economies. This is frequently one of the major sources of capital for the productive diversification of staple-exporting economies. The volume of this investment is largely a function of its expected return. Inflation may be expected to raise the money return on investment. If the exchange rate could be expected to depreciate at the same rate that prices increased, inflation would tend to have a neutral effect on prospective nonresident purchasers of domestic equity investments. However, as will be indicated below, the exchange depreciation is likely to be more severe than the increase in prices induced by inflation. Hence, the net return to nonresident equity investors in inflating economies may be expected to deteriorate. Therefore, the flow of equity capital to inflating economies will probably be lessened.

There is one very positive impediment to nonresident investment induced by inflation. It will be indicated that one of the effects of inflation is a deterioration of the foreign balance and that this induces the government to take protective action. One of these acts may be the restriction of payments to nonresidents. Payments on capital account to nonresidents are prime candidates for such restrictions. At the first sign of inflation in a country, nonresidents will fear that restrictions of this kind will be imposed and will refrain from investing there. They may even attempt to repatriate previous investments in anticipation of such restrictions. This type of reaction probably accounts for the disparate movements of international capital indicated in Table 6. This shows that net private direct investment in less highly developed countries by residents of the country with the largest capital exports increased at a rate 20 per cent faster than the comparable increase in investment in a group of mild inflation countries during the eleven years ending in 1961. The comparable increase in a group of countries where prices were rising rapidly was equivalent to only a little more than the reinvestment of earnings at a rate equivalent to 4 per cent of the capital invested.

Table 6.

Average Increases in Value of U.S. Private Direct Investment in Less Highly Developed Countries, 1950–611

(In per cent)

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See Table 21 (p. 39).

Protection of foreign investors

It was suggested earlier that development policies are designed to make the flow of resources for investment greater than they would be in the absence of such policies. Since in the absence of government intervention, inflation is likely to have a depressing effect on the flow of foreign capital to a developing economy, it is likely to make a government more willing to protect foreign lenders. If this protection is to be effective, it is almost inevitable that it must err, if it errs at all, on the side of being excessive. That is, inflation may lead to the adoption of policies which give better terms to foreign lenders than they could command under stable conditions.14

The degree of uncertainty created by inflation may be greater in the opinion of foreign than of domestic investors. Not only is the uncertainty regarding the real domestic value of future earnings increased by inflation, but uncertainty regarding the future course of exchange rates is created and there is also the fear of exchange restrictions. To allay these fears, the government of an inflation-ridden economy may be pushed to borrow directly from abroad or to guarantee the repatriation of private loans raised abroad. However, development must, almost inevitably, include risky investment. No matter how astute investors may be, some investments will be unprofitable. If such investments have been financed through private channels, the process of bankruptcy will lead to a sharing of the cost of any unsuccessful investment between borrowers and lenders. If they have been financed by government borrowing, or with a government guarantee, the full cost of investment, which in retrospect will be seen to have been unwise, will be borne by residents of the borrowing country.15

Changes in relative prices

The distortion of the price structure created by inflation is likely indirectly to discourage saving and encourage consumption. In most nonindustrial countries, investment has a high import component. The excessive exchange depreciation induced by inflation, and the protective import substitution policies likely to be adopted by the authorities, frequently lead to relatively large increases in the prices of investment goods. The experience in nine Latin American countries, summarized in Table 7, suggests that one unit of consumption expenditure foregone in a stable country would permit the use of 15 per cent more investment, in real terms, than in the mild inflation countries, and almost 40 per cent more than the average for the strong inflation countries. This rise in the relative price of investment goods decreases the money rate of return on investment, and consequently on saving, with a resultant discouragement of investment and encouragement of consumption.16

Table 7.

Relative Prices of Investment Goods, Selected Latin American Countries, 19601

(Average for all countries = 100)

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See Table 22 (p. 39).

Conclusion

This analysis, which appears to be supported by the available statistics, suggests that inflation is likely to evoke forces which both diminish the resources available for development and reduce the true effectiveness of those funds which continue to flow to investment. Saving is likely to be lower than under stable monetary conditions, and to take forms which lead to a lessening of the adaptability of the economy and to a lessening of the force of economic criteria in the choice of final investment. The inflow of foreign capital is likely to be reduced, and the terms on which it comes to the country are likely to become more stringent with regard to its eventual repayment.

III. The Direction of Investment

Inventory investment

The effect of inflation on the desire for liquidity has already been discussed. If money, and financial assets denominated in money, cease to provide satisfactorily protected liquidity, other sources of this protection will be sought. The accumulation of salable inventories is one means of obtaining realizable assets whose real value is likely to be maintained in the face of rising prices. Consequently, inflation may be expected to encourage investors to forego the purchase of financial assets which could have financed long-term physical investment and to accumulate inventories directly. As a result, the available resources will be devoted to inventory stockpiling rather than to long-term investment.

Moreover, in addition to the disadvantages of illiquidity attached to long-term fixed investment, there is an element of uncertainty. In an environment of unstable prices and rising costs, the long gestation period involved in fixed investment means that its eventual cost is indeterminate, and hence the possibility of financing the total outlay may be questionable. As a result, it may prove impossible to complete projects.

There are strict limits to the changes which may be made in the structure of a given stock of physical assets. Most of these changes must result from the channeling of currently accruing resources into the most desired form of asset. As the changes desired may well be large in relation to total annual investment, it may be expected that a large part of this total may be devoted to inventory investment, until the structure of the community’s stock of physical assets is changed. Subsequently, the flow of investment resources will be divided between inventory accumulation and fixed asset formation, in the ratio which the community wishes to maintain between these components of its stock of physical assets. Hence, in a brief period of inflation, or in the early stages of a longer inflation, a marked diversion of investment resources toward the accumulation of inventones may be expected. In the later stages of a prolonged inflation, the ratio of inventory investment to fixed investment may be expected to be somewhat higher than it was prior to the inflation, but it should be less than in the early stages of inflation.

Table 8 indicates that, in two relatively stable countries, the inventory component of gross domestic investment has been relatively stable. There is some indication that in one of these, Ecuador, the ratio of inventory accumulation to total investment has been slightly correlated with the rate of inflation. In two mild inflation countries where the rate of inflation has varied (Colombia and Mexico), there is clear evidence of correlation between the rate of inflation and shifts in the stocking of inventories. In two strong inflation countries (Brazil and Chile), the rate of inventory investment has varied markedly. In Brazil, when the rate of inflation rose, inventories were increased sharply. Thereafter, even though inflation might be rapid, the rate of inventory investment reverted to a more normal level; when the rate of inflation was reduced, there was a temporary decline in the rate of inventory investment. In Chile, similar effects appear to have followed after a lag.17

Table 8.

Relationship of Inflation to Variability of Inventory Investment, Selected Countries, Selected Years1

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See Table 23 (p. 40).

Housing

The implication of the above analysis is that inflation encourages excessive investment in inventories, which is a form of short-term investment, and at least temporarily discourages long-term investment in fixed assets. Nevertheless, it is frequently suggested that an inflationary economy is characterized by excessive investment in luxury housing—a form of long-term investment. However, this paradox is apparent rather than real. Encouraged to acquire physical rather than fixed-money assets, savers must find some asset which satisfies their demand. One of the physical assets most easily acquired by individuals is residential property. Hence, inflation may be expected to encourage the demand for houses, either for occupation or for rent. In many of the inflation-ridden economies, governments are prone to control money rents. Hence, the return on rental housing is prevented from rising in step with the increase in the level of prices. The outcome is that savers are encouraged to buy houses for self-occupancy and discouraged from investing in rental property.

Data on the distribution of expenditure between housing and other forms of investment are scarce, and data on investment in houses for owner-occupancy are practically nonexistent. The indirect indication of the effect of inflation on the demand for building materials, presented in Table 29, is consistent with an argument that inflation leads to a rise in the relative demand for buildings, as distinct from other forms of investment. While these data are consistent with the arguments presented here, they should be used with caution because the demand for building materials is more subject to the distorting effects of inflation than is the demand for most other products. The prices of all investment goods tend to rise more during inflation than the general level of prices. Stocks of building materials (other than cement) are prime targets for inventory investment, as they tend to be durable (bricks, pipe, tile, etc.), their cost of storage (on the sites of incomplete buildings) is relatively low, and they may be financed from a variety of sources (e.g., both by bank loans for working capital and by construction mortgages).

Business fixed assets

The pressures exerted by inflation on the allocation of investment funds to the purchase of different types of fixed asset may be separated into those which may be termed “fundamental forces,” and those which reflect the adjustment of individual economic units to the “inflation restraining” actions of the government.

Requirements for investment in fixed assets differ markedly between industries. Some activities (e.g., railroad transport) require long-lived equipment, whereas others (e.g., highway transport) require much shorter-lived equipment. It may be taken that the most appropriate combination of investment in different activities will result from the interplay of competing demands by investors looking for the most profitable investments (adjusted to take advantage of subsidies and taxes where these are considered desirable for social reasons). However, some of these investments involve long-term commitments and hence will be influenced by the community’s expectations. If investors believe that the prospective economic parameters will be similar to those presently existing, or if they can reasonably expect that changes in these parameters will be orderly, they can have a firm basis for their decisions. Technological factors will then be the primary determinants for the distribution of investment. If investors expect rapid change in basic economic relations, they will be hesitant to commit themselves for long periods. If capital investments may be amortized quickly, an investor has more frequent opportunities to review his decisions. The expectation of rising prices will therefore be likely to bias investment decisions toward the purchase of fixed assets with relatively short lives. For these reasons, an inflationary economy may be expected to evolve along lines where long-term industrial and social investment is discouraged, and where resources flow more readily to those fields in which returns may be achieved most quickly. Such an economy may be expected to become one where railway transport deteriorates, while trucks have their useful lives curtailed bouncing roughly on pot-holed roads.

As suggested earlier, inflation brings forth two reactions by governments:

  • (1) The impetus to imports calls for protection of reserves, which may involve active encouragement of import-substituting activity and exchange restrictions.

  • (2) The reactions of the community to increases in the cost of living are likely to force the government to institute price controls over “the basic necessities of life.”

An active policy of encouraging import substitution may involve protection of domestic production from foreign competition. This protection may be given by administrative restrictions, tariffs, or excessive currency depreciation. It is possible that the rapid development of import-substituting production may entail nothing more than an acceleration of part of the over-all development process. It is also possible that it will lead to the encouragement of activity which, in the absence of protection, would remain unproductive almost permanently in the face of foreign competition.

Some indication of the extent of desirable diversification which has been achieved in recent years may be obtained by comparing the export data for individual countries. If a country is able to diversify its export sales, there are grounds for believing that it has been able to expand the production of goods other than its staple exports, and that this expansion has been in the fields where it enjoys some degree of comparative advantage. If it does not achieve diversification of export sales, there are grounds for believing that it has lost some of its comparative advantages, and that any diversification of production which has been achieved has involved the expansion of output in those fields where its costs are high by international standards. Table 9 summarizes the changes in the volume of exports between 1953–54 and 1958–59 in two groups of countries. In both groups, the volume of staple exports (major exports) expanded. However, in the stable countries the volume of other exports (minor exports) expanded more rapidly than exports generally, providing some evidence that these countries achieved some economically desirable diversification of production. In the strong inflation countries the volume of minor exports was unchanged during these years. Whereas the minor exports accounted for approximately one tenth more of the total in the stable countries, this proportion fell by approximately one sixth in the strong inflation countries.

Table 9.

Percentage Increases, 1953–54 to 1958–59, in Volume of Major and Minor Exports, Selected Countries1

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See Table 24 (p. 41).

To protect exchange reserves from the erosion induced by inflation, many countries have resorted to exchange restrictions. Many restrictive systems have been based on multiple exchange rates, which have the adverse qualities to which attention has frequently been drawn.18 They frequently provide minimum exchange depreciation for certain basic export products. This preferential treatment adds to the structural distortions of the economy, discussed earlier. The favorable rates provided for the import of essential commodities serve to discourage domestic production and encourage activities (usually the production of nonessential goods) which are given the greatest degree of protection. Often these are not the most appropriate uses for the country’s resources. For example, the exchange rate system of Indonesia at the end of 196119 could be described as a government production plan, designed to penalize the production of rice and to divert domestic resources from investment to personal consumption, particularly of luxury items.

Investment decisions made by private entrepreneurs are primarily influenced by the expected profitability of investment. The relative profitability of investment in any activity is a function of the prices of final output rendered possible by the investment compared with the prices of final outputs which could be achieved by alternative investment. Governments frequently attempt to restrain inflation by imposing controls on the prices of the basic necessities of life, or of community services. Under these circumstances, the general rise in other prices is equivalent to a relative fall in the prices of the basic necessities or services. If price controls are not accompanied by subsidies to the producers of the price-controlled goods and services, investment in the production of basic necessities and community services will become relatively unprofitable and will be discouraged. Consequently, if the consumer is protected, as he frequently is, from the evils of inflation, the result may well be to divert investment, so that he is deprived of access to potential supplies of basic necessities and community services.

This aspect of inflation is seen most frequently in the public utility field. Many public utilities are natural monopolies. Hence, their prices are frequently subject to control by regulatory bodies. This control, with the almost inevitable legalism involved in its administration, is likely to create a lag in the rise of public utility prices behind other prices. Moreover, the regulatory process makes this field a prime candidate for price control to restrain increases in cost of living indices. Hence, inflation will almost inevitably lead to a diversion of investment from public utilities. As a result, the recurrent power shortages, which are one of the aspects of life in an inflationary economy, are easily comprehensible.

Conclusion

These arguments, which are supported by observation, suggest that inflation is likely to evoke forces which divert the resources available for domestic investment to an excessive accumulation of inventories and the building of houses for occupancy by the relatively wealthy, rather than to the construction of productive facilities or the provision of housing for the major part of the community. Of the productive facilities actually built, a bias develops toward investment in relatively short-lived projects, and the attraction of truly low-cost production tends to be weakened, while resources are diverted from the production of basic necessities and investment goods to the production of consumption goods, particularly luxury commodities.

IV. The Balance of Payments

The frequency with which inflating countries have had to resort to the International Monetary Fund for assistance, together with the relatively small volume of continuing drawings by non-inflating countries, provides clear evidence of the relation between strong inflation and balance of payments difficulties. These difficulties arise because strong inflations encourage capital flight, strengthen import demands, and reduce export supplies. They make large exchange rate depreciations necessary. The attempts to limit exchange pressures often lead to the imposition of restrictions which have distorting effects on the structure of investment and production.

Imports

When there is a generalized excess demand for goods it will quickly become evident as a demand for purchases from the most readily available elastic source, i.e., from foreigners. Hence, one of the first effects of inflation will be a rise in imports. In the early stages, the effect of expanding demand on the price level may be dampened by the ability of the community to import. With a small rise in domestic prices, foreign supplies become relatively cheaper and the pressing demand from the domestic economy will be diverted to the larger world economy. This diversion will limit the demands impinging directly on the domestic economy and will restrict the immediate effects of inflationary pressures on domestic prices.20

In many countries, the impact of inflation on imports is repressed by trade controls, so that the level of imports is determined, not by relative prices, but by administrative decision. However, the trade controls and the exchange depreciation in inflating countries provide clear evidence of the payments difficulties of these countries.

Exports21

Just as inflation may be expected to encourage imports, it may be expected to discourage exports. Rising domestic demand will impinge on those export goods which are suitable for domestic consumption, and will divert them from export to domestic sales or stockpiles.22 Of course, in many cases, this diversion will be limited. An economy with only a few basic export products is not likely to increase its consumption of these products sufficiently to affect markedly the supply available for sale to foreigners. Even a doubling of domestic consumption of Brazilian coffee or Malayan rubber would lead to relatively small percentage declines in the supplies of these goods on world markets. However, it is easy to overstate this argument. All export production involves the use of some generalized resources. In any economy, excessive demand will impinge on these generalized resources, and bid them away from the production of export goods. This may be a somewhat longer-run effect, and is likely to be an influence leading to a structural distortion of the economy rather than to immediate short-term balance of payments difficulties. However, it is not merely coincidental that the volume of exports made available by Argentina, Bolivia, Brazil, Chile, and Haiti declined during the half-century between 1913 and 1958, and that these countries have experienced almost continuous inflationary pressures since World War I.

In the period 1953 to 1959, the export experience of the three groups of raw material exporting countries differed markedly, as indicated in Table 10. These differences do not reflect varying market conditions, as the grouping bears no relation to the export products of these countries. Exporters of coffee, cotton, nonferrous metals, and rubber are in all three groups; of cereals, meat, and wool in the stable and strong inflation groups, and of fish and sugar in the stable and mild inflation groups. Consequently, it is not surprising that the average change in the world market prices (i.e., export price indices in terms of U.S. dollars) have moved in the same direction and by approximately the same amount for each group of countries. While the volume of exports of the stable countries rose by one quarter, and of the mild inflation countries by one fifth, the increase for the strong inflation countries was less than one sixteenth. The pressures of inflation led to a domestic absorption of resources in those countries where domestic prices were rising, preventing them from participating in the expansion of world demand for their products.23

Table 10.

Average Changes, 1953 to 1959, in Domestic Prices, Export Prices and Volume, and Exchange Rates, Selected Countries1

(In per cent)

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See Table 25 (p. 42).

The exchange rate

The incentives to capital exports and the discouragement of capital imports, caused by inflation, have been discussed above. These influences augment the balance of payments difficulties on current account so that, unless action is taken, an inflating economy’s international reserves are soon dissipated. The action which is needed may take the form of restrictions on imports or on capital payments, or it may include exchange depreciation. If inflation is continued, it is practically inevitable that the exchange rate must depreciate.

Moreover, if imports are not restricted, the eventual exchange depreciation is likely to be greater than the rise in domestic prices. The excess demand caused by inflation will meet supply inelasticities. The spillover of demand into the foreign market and the reduction of exports, consequent on inflation, can only be offset by a greater rise in the domestic equivalent of foreign prices than of purely domestic prices. As shown by the comparison in Table 10, the depreciation of the exchange rate in mild inflation countries exceeded the rise in domestic prices in the period 1953–59 by almost 15 per cent on the average. In the strong inflation countries this excess averaged 75 per cent.24

While there is ample evidence to support the view that the exchange rate will depreciate by more than the increase in domestic prices, it does not follow that this is a smooth progress. Most governments attempt, either consciously or unconsciously, to maintain confidence in the value of money. One of the quickest ways to destroy this confidence is to allow the exchange rate to depreciate. Therefore, it may be expected that the government will attempt to maintain the rate, for a period at least. Six examples of the pegging of exchange rates, at one time or another, are provided in Chart 1. Periods when the rate was pegged despite pressures toward depreciation are indicated by stability of the exchange rate (light) lines coinciding with decline in the price (heavy) lines. Such pegging action has two repercussions. First, as the domestic currency prices of exports and imports are maintained, the pressures of inflation are given full play; if the rate were allowed to depreciate, the depreciation would mitigate or even offset the balance of payments effects of inflation. Second, with exchange depreciation clearly forecast by the rise in prices, the inducements to capital flight, discussed above, are strengthened.

Chart 1.
Chart 1.

Selected Countries: Exchange Rates and Purchasing Power of Monet, First Quarter 1951–Second Quarter 1962

(As percentages of 1951 averages)

Citation: IMF Staff Papers 1963, 001; 10.5089/9781451956023.024.A001

1 For Argentina and Indonesia, implicit export rate; Brazil, implicit export rate excluding coffee; Peru, principal exchange rate, which does not differ markedly from the implicit export rate and the implicit import rate; Uruguay, principal export rate.2 For Argentina, Brazil, and Chile, implicit import rate; Indonesia, “other” import rate; Uruguay, free rate.

V. Stabilization Problems

The difficulty of stabilization

It is often alleged that, even though inflation may be undesirable, a cure by means of a stabilization program may be worse than the disease of inflation. Those who favor monetary reform are accused of placing a higher value on price stability than on economic growth. If the analysis presented in this paper is valid, an economy experiencing inflation must be one where development is proceeding less rapidly than it would if the economy were stable, all other conditions being similar. It does not follow, however, that a change in the climate will immediately ease an inflating economy’s difficulties. In particular, it does not follow that a stabilization program will bring an immediate increase in output.

The desirable reshuffling of the economy, resulting from stabilization, may lead directly to a temporary decline in the demand for physical investment. There is an inevitable lag between the decision to create physical capital and the actual consumption of resources in capital production. On the other hand, investment already in progress may be abandoned rather quickly. One of the effects of inflation is the encouragement of industries which would be uneconomic in a noninflationary world. Stabilization may bring a quick cutoff in the development of these industries, leading to a decline in the demand for investment resources. While a stable environment will make alternative industries appear to be profitable fields for investment, it takes some time for entrepreneurs to convert their investment desires into consumption of resources. Hence, the period immediately after the start of a stabilization program may well be marked by a lag in the consumption of investment resources, with a consequent decline in the production of capital goods.

It might be thought that, as inflation is a situation of generalized excess demand for goods and services, a reduction in demand might do no more than eliminate the excess. But the situation which develops in an inflation is that the supply of goods and services, which necessarily cannot be less than effective expenditure, includes types of commodities and services for which demand will exist only so long as inflation continues. The reduction of this demand caused by the cessation of inflation, and its replacement by expenditure appropriate to stable conditions, involves a corresponding readjustment of supply. It would be Utopian to expect that all phases of this readjustment process would be closely synchronized. There are particular difficulties in the smooth adjustment of investment expenditures, which follow from the effects of inflation discussed above. In the first place, inflation induces an accumulation of inventories in excess of those which would have been built up in stable conditions. Necessarily, therefore, the cessation of inflation will lead to disinvestment in inventories, reversing this part of the flow of demand. Secondly, investment in industries during the inflation is likely to have been directed to those enjoying a high degree of protection. Insofar as the exchange rate is unified or changed to a more realistic one, or insofar as stabilization by strengthening the balance of payments (e.g., by reducing purchases of imports for addition to inventories), enables exchange restrictions to be eased, the protection afforded these industries will be diminished, and their attractiveness for investment will decline. Thirdly, the increasing attractiveness of physical assets during an inflation may be expected to lead also to a rise in the demand for owner-occupied housing. Once stabilization is under way, the existing supply of this type of house, together with the rising demand for financial assets, can be expected to lead to a reduction of investment of this kind. And even if stabilization and the easing of rent control make rental housing a desirable form of investment, it takes time to convert desires to invest into orders for bricks and mortar.

Thus the flow of resources evoked by an inflation will be not only in excess of, but also partially inappropriate to, the flow of demand in stabilized conditions. The severity of the consequential adjustment problems, and the time required to solve them, will depend, in part at least, on the degree to which the economic system has been distorted. This degree of distortion will in turn depend largely on the duration and rate of the inflation which is being brought to an end. When the inflation has not been too severe, and in its current bout has lasted no more than about two years, as in Peru at the time of the adoption of its 1959 stabilization program, the problem is not too serious. When inflation has been rampant for decades, as in Argentina by 1958, the problem will have become very serious.

It should be emphasized that the depressive influences discussed above are temporary, rather than fundamental. After a relatively short period, they should evaporate. If the stabilization program is effective, the period of uncertainty must pass, and a new set of expectations should enable investors to make plans for future capital creation, with a consequent rise in their demands for resources. The decline in investment arising from the lag between the end of development of protected industries and the expansion of more economic (from a long-range view) alternative investment, is by definition a temporary cutback in investment. Likewise, by definition, disinvestment in inventories must also be temporary. The general adjustment which should accompany stabilization (including the elimination of controls, such as ceilings on rents) may be expected to revive the demand for investment in rental housing to replace the decline in the demand for owner-occupied residences. The general flight from real assets to financial assets, which is one of the healthy signs of stabilization even though it may exert depressing effects on investment, should also be temporary. After a short period of adjustment, individual economic units may be expected to desire additions to their stocks of both physical and financial assets. At the same time, the capital flight resulting from inflation should stop. The switch in the flow of saving from foreign to domestic investment, and the repatriation of earlier accumulations of foreign assets, will lead to an increase in the demand for domestic resources.25

A government which decides to eliminate the distortions created by inflation will be faced with a host of problems while the economy is readjusting to a condition of monetary equilibrium. There is no doubt that the difficulties facing the community will be dependent on the imagination exercised by the government. A stabilization program which relies on monetary instruments alone will involve more stresses in the economy than one which includes fiscal and broader economic improvement measures as well. If a stabilization program can be quickly associated with measures for the development of previously neglected facilities (e.g., the rehabilitation of obsolescent railway systems and the development of public utilities), the stresses will be eased. Foreign assistance (e.g., drawings on the International Monetary Fund to make more rapid elimination of exchange restrictions possible, and loans from the International Bank for Reconstruction and Development to facilitate the redeployment of resources for development) will make the elimination of distortions in production easier. However, no cleaning-up process is pleasant. Stabilizing an inflating economy is one of the least pleasant of the operations facing a responsible government.

The case fob firm action

If an abrupt ending of an inflation is likely to bring a temporary decline in output, is not some alternative possible? Might not a tapering-off policy be adopted? Might not the rate of inflation be brought to an end slowly? The answer to these questions is that a gradual approach is fraught with more danger than sudden stabilization.

Among the real damages done by inflation is the distortion created in the economy. There is need to reorient the system. Drastic changes must be made in the community’s expectations. These changes are not likely to occur if the community believes that the government may be lukewarm in its attack on inflation. If individuals see little change in the economic climate, they will be under very few effective pressures to change their views. The fundamental changes which are required will not take place.26

The persistence of expectations as to the movements of prices is a particular problem to be faced in introducing a stabilization program. In the early stages of an inflation, individuals may continue to believe that prices will soon stop increasing. But once inflation is established, they will expect prices to go on rising; and even if they believe that the inflation has been halted, and that prices will be stabilized, they will not expect stabilization to take place immediately. Moreover, they will always be conscious of the possibility that the program may fail. Even, therefore, when money and financial assets begin once more to appear attractive, the acquisition of such assets may be deterred by a lingering fear that they may again decline in real value. By contrast, the continued holding of inventories offers protection, even if the program succeeds, against any loss except that of the potential income from financial investments; and the holder of foreign financial assets risks the loss only of the possibly excessive returns on domestic financial assets over the return on foreign ones. If the program fails, such holders stand to gain much more. Thus, to enable a stabilization program to succeed, it is above all necessary for the government to convince the community that the value of money will henceforth be maintained.

In short, an attempt to slow down an inflation will take a long time to be effective and its final result will be uncertain. The restrictions on credit necessary to bring some stabilization will deter borrowers from investing, but the inflation-induced distortions of the economy are likely to persist. The continued rise in prices (even though it be slower than before) will deter the accumulation of financial assets and continue to act as a brake on the flow of resources to investment. Unless the authorities are firm in their attack, the atmosphere of financial stability necessary to induce a revival of output to levels higher than those which would have prevailed under inflation will not emerge.

VI. Conclusion

This review of the relation between inflation and economic development leads to the conclusion that the control of inflation should be one of the major objects of economic policy in a developing economy. It is true that, per se, rapid economic development is likely to provoke inflationary pressures. Therefore, one of the problems calling for high priority on the part of the authorities in a rapidly developing economy is the restraint of inflation.

Inflation diminishes the volume of resources available for domestic investment. Community saving is reduced, and a considerable part of this saving is channeled to foreign rather than domestic investment, while the flow of capital from abroad is discouraged. A substantial part of the reduced flow of resources for domestic investment is diverted to uses which are not of the highest social priority. The accumulation of large inventories is encouraged. The diversion of savings from the capital markets, where investment decisions are more subject to longer-term economic criteria, is exemplified by the diversion of investment from productive uses for the entire community to the building of owner-occupied housing for the relatively wealthy few. The apparent profitability of certain short-lived investments leads to distortions in the productive structure which make the economy less adaptable. Balance of payments difficulties are symptoms of the underlying stresses. To reduce the foreign deficits, the authorities are almost forced to resort to controls, which in most cases protect uneconomic production. Political pressures lead to further restrictions which, in the last analysis, create further distortions. Economic activity becomes steadily more distorted.

However, if the economic system has been allowed to get out of hand, the authorities must decide to stabilize, or not to stabilize. There is no doubt that the process of stabilization is difficult, but difficult or not, it is a prerequisite to rapid economic growth.

APPENDIX

“Selected Countries”

The term, “Selected Countries,” in the tables presented in this Appendix refers to all the less highly developed countries for which the relevant data are available in the sources. South Africa is not included, however, because its dual social structure makes statistical averages difficult to interpret, nor are the countries of the Eastern bloc. In several tables, Finland and Greece are included. The tables do not include other countries in Western Europe nor, of course, the United States and Canada.

“Selected Years”

In the tables compiled for this study, an attempt has been made to use series extending from 1948 to 1961. Many of the data, however, are not available for the full period. In these cases all the available data have been used, and the tables are stated to refer to “selected years.” In many of the tables where annual averages are used, the time periods are not the same for all countries. Where tables are derived from other sources, no attempt has been made to alter the time periods covered by the original authors.

Classification of countries

Countries are classified as stable, if the percentage increase in the cost of living index is less than 5 per cent a year for the period covered. If the rate of increase is 10 per cent or more, they are classified as being subject to strong inflation. The intermediate countries are considered to be subject to mild inflation. These boundary criteria should not be considered as separating clearly definable situations. Eather, they are arbitrary limits intended to identify rather different situations. They may be considered to be on the high side; in part they have been adopted because some price increases have been almost universal in the postwar period.

Ordering of countries

Within each group, countries are arranged by the degree of inflation experienced, with the country experiencing the lowest rate of inflation placed at the top of the table, and the country with the highest rate at the bottom.

Weighting of averages

Where averages are given for groups of countries they are unweighted averages, unless it is stated otherwise (e.g., when the value of exports is relevant to a comparison of changes in exports).

Table 11.

Inflation and Economic Development, Selected Countries, Selected Years1

(In per cent)

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Sources: Based on data in United Nations, Yearbook of National Accounts Statistics, 1961, and International Monetary Fund, International Financial Statistics, hereafter referred to as IFS.

Generally 1954–60; see page 32 for description of “Selected Years.”

Average annual increase in cost of living index.

Average annual increase in real gross domestic product per capita.

See page 32 for the basis of these classifications.

Table 12.

Inflation and Economic Development, Selected Latin American Countries, 1955–59

(In per cent)

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Sources: Based on data in Economic Commission for Latin America, Economic Survey of Latin America, 1959 (E/CN.12/541), p. 57, and IFS.

Average annual increase in cost of living index.

Change from 1955 to 1959 in index of gross domestic product per capita.

Table 13.

Inflation and Economic Develoment1

(In per cent per annum, compounded)

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Source: U Tun Wai, “The Relation Between Inflation and Economic Development,”Staff Papers, Vol. VII (1959–60), Table 1, pp. 303–304.

This covers all the cases in Tun Wai’s table for the years after the end of World War II hostilities, except for those affected by rebellions or immediate postwar reconstruction.

Average annual increase in cost of living index.

Average annual increase in per capita national income deflated by cost of living index.

Between 4.5 and 5.0.

Weighted by number of observations for each country.

Table 14.

Inflation and Economic Development

(In per cent per annum, compounded)

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Source: U Tun Wai, op. cit., p. 305.

Average annual increase in cost of living index.

Average annual increas for changes in the terms of per in per capita national income, deflated by cost of living Index and adjusted trade.

Table 15.

Inflation and Economic Development

(In per cent per annum, compounded)

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Source: U Tun Wai, op. cit., p. 306.

Average annual increase in weighted averages of sector prices.

Average annual increase in social product, deflated by the sector price index and adjusted for changes in the terms of trade. 8 Figure in source is 4.9.

Table 16.

Average Annual Rates of Change in Ratio of Money to Income, Selected Countries, Selected Years1

(In per cent)

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Sources: Based on data in IFS and United Nations, Monthly Bulletin of Statistics.

See page 32 for description of “Selected Years.”

Because the ratio of money to income tends to be declining in the very wealthy and wealthy coun–tries, and rising in the poor and very poor countries, this table incorporates a dual classification, by wealth and by rates of inflation. The classification by wealth is based on United Nations, Per Capita National Income in Fifty-Five Countries, 1952–1954. Countries estimated to have had, at that time, average per capita incomes equivalent to more than US$1,000 are classified as very wealthy countries; those with per capita incomes in the $750–1,000 range, as wealthy; in the $500–750 range, as average: in the $250–500 range, as poor; and below $250, as very poor. Countries within each group are arranged by descending order of per capita income.

Table 17.

Relation Between Changes in Real Value of Monet Holdings and Changes in Cost of Living, Selected Countries, 1948–61

(In per cent)

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Source: Based on data in IFS.

Given by ML−100, where M is the 1961 index (base, 1948 = 100) of money (or money plu8 quasi-money) and L is the 1961 index (base, 1948 = 100) of cost of living.

Table 18.

Central Government Average Annual Surpluses or Deficits (—) as Percentages of Gross National Product, Selected Countries, Selected Years1

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Source: Based on data in IFS.

See page 32 for description of “Selected Years.”

Table 19.

Foreign Companies Controlled by U.S. Residents: Per Cent of Earnings Retained, Selected Countries, 1957–60

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Source: Based on data in Survey of Current Business.

Weighted by value of direct investments at end of 1957.

Table 20.

Mexico: Price Changes and Net Purchases of Short-Term Foreign Assets, 1951–60

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Sources: Based on data in IFS and International Monetary Fund, Balance of Payments Yearbooks.

Year-end comparisons.

Table 21.

Changes in Value of U.S. Private Direct Investment in Selected Countries, 1950–61

(In per cent)

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Source: Based on data in Survey of Current Business, August 1962, p. 22.

Averages for groups are changes in total value of investments in the countries in the group.

Excluding Panama: 197. Excluding Panama and Venezuela: 188.

Excluding Peru: 110.

Excluding Indonesia: 54.

Table 22.

Comparison of Price Relatives of Investment and Consumption Goods, Selected Latin American Countries, 19601

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Source: Economic Commission for Latin America, Comparative Prices and the Purchasing Power of Currencies in Selected Latin American Countries (E/CN.12/589), pp. 43, 47.

The figures for each country represent the cost of an assortment of investment goods expressed as a percentage of the cost of an assortment of consumption goods. The respective assortments are the same for each country; and, on the average for the nine countries, the cost of the assortment of investment goods is equal to that of the assortment of consumption goods.

As computed in source.

Table 23.

Rate of Inflation and Inventory Investment, 1950–60

(Based on data in current prices)

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Sources: Based on data in United Nations, Yearbook of National Accounts Statistics and Statistics of National Income and Expenditure; IFS.

Rate of inflation, i.e., percentage change in annual average of cost of living index.

Inventory investment as percentage of gross domestic investment.

Excluding stockpiling of coffee and cotton by the Government.

Table 24.

Volume of Major and Minor Exports, Selected Countries, 1958–59

(1953–54 = 100)

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Source: Based on data in Gertrud Lovasy, “Inflation and Exports in Primary Producing Countries,” Staff Papers, Vol. IX (1962), pp. 65, 66.

The major exports for each country are identified in the source.

Averages are weighted by 1959 export values.

Costa Rica, El Salvador, Guatemala, and Nicaragua.

Table 25.

Domestic Prices, Export Prices and Volumes, and Exchange Rates, Selected Countries

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Based on data in IFS.

Based on U.S. dollar price indices in IFS.

Based on data in G. Lovasy, op. cit.

For countries with multiple currency systems, the degree of exchange depreciation was computed by dividing the change in the domestic currency value of imports, recorded in IFS, by the recorded change in the U.S. dollar value of imports.

Averages are weighted by 1959 export values.

Changes in fluctuating rates within the limits of the Articles of Agreement of the International Monetary Fund have been ignored.

Estimate.

Table 26.

Holdings of Some Financial Assets by Private Sector, 1950–62

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Sources: Brazil—from IFS. Argentina—money and quasi-money, from IFS; government debt prior to 1957, estimates by the author; subsequently, from Banco Central de la República Argentina, Boletín Estadístico.

Total assets of life insurance companies.

Current value divided by cost of living index (base, 1951 = 100).

Estimate.

September.

Table 27.

Average Annual Changes in Real Wages,1 Selected Countries, Selected Years2

(In per cent)

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Source: Based on data in IFS.

Average annual change in money wage rates divided by average annual change in cost of living index.

See page 32 for description of “Selected Years.”

Table 28.

Changes in Cost of Living and in Share of Wages and Salaries1 in net Domestic Product

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Including income of unincorporated enterprises (e.g., farmers) as part of wages and salaries.

Calculated from IFS.

From E. H. Phelps Brown and M. H. Browne, “Distribution and Productivity Under Inflation, 1947-57,” Economic Journal, December 1960, p. 732.

Table 29.

Comparison of Indices of General Wholesale Prices and of Prices of Building Materials, Selected Countries, 1959

(1953 = 100)

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Source: Columns 1 and 2 are from A. S. Shaalan, “Impact of Inflation on the Composition of Private Domestic Investment,” Staff Paper, Vol. IX (1962), Table 5, p. 259,

Les conséquences de l’inflation sur la croissance économique

Résumé

Dans de nombreux pays peu développés, le revenu ne croît pas au rythme rapide qui caractérise les aspirations de la collectivité. L’épargne privée y est faible et ne permet pas de dégager des ressources suffisantes pour assurer l’accroissement du capital national. D’autre part, les recettes fiscales ne couvrent qu’une partie des dépenses afférentes aux Services publics demandes par la collectivité, et ne laisse qu’un tres faible excédent pour financer le développement. Dans ces conditions, l’inflation peut paraître un moyen facile de financer l’expansion des investissements et par suite d’obtenir les capitaux pour accélérer le taux de production.

Il ne fait aucun doute que dans certains cas une expansion monétaire légèrement supérieure à l’augmentation courante du produit réel peut introduire un élément de souplesse dans l’économie et avoir pour effet que “l’épargne forcée” libère certaines ressources à des fins de développement. Toutefois, le niveau de développement que l’on peut attendre de telles pratiques est strictement limité.

L’inflation réduit le volume des ressources disponibles pour l’investissement intérieur. L’épargne de la collectivité diminue, et une fraction importante de celleci est attirée vers l’étranger plutôt que vers les investissements intérieurs, alors que l’entrée des capitaux étrangers est découragée. Une part substantielle des faibles ressources destinées à l’investissement intérieur s’oriente vers des utilisations qui, du point de vue social, ne sont pas d’une priorité absolue. Par conséquent, l’accumulation de stocks importants est encouragée. L’épargne est détournée des marchés de capitaux où les décisions d’investissement sont davantage fonction de facteurs économiques à long terme; par exemple, l’investissement est détourné des utilisations qui seraient profitables à la collectivité toute entière et il favorise la construction de logements en propriété dont l’accès est réservé à quelques privilégiés relativement fortunés. La rentabilité apparente de certains investissements à court terme provoque dans la structure de production, des distorsions qui nuisent à la souplesse de l’économie. Les difficultés de la balance des paiements sont les symptômes de ces tensions profondes. Pour réduire les déficits extérieurs, les autorités sont pratiquement contraintes de recourir à des mesures de controle qui, dans la plupart des cas, protègent une production non rentable. Des pressions politiques viennent encore aggraver ces restrictions qui à leur tour provoquent de nouvelles distorsions. Il en résulte unesérie de déformations successives dans I’évolution de l’activité économique.

Il est exact qu’un rapide développement économique est susceptible de provoquer des pressions inflationnistes. C’est pourquoi, lorsqu’une économie est en voie de développement, l’un des problèmes sur lesquels les autorités doivent se pencher en premier lieu est de con-tenir l’inflation. Toutefois, si le système économique a réussi à échap-per à tout controle, il appartient aux autorités de décider s’il con-vient ou non de stabiliser la situation. II ne fait aucun doute que l’opération de stabilisation est ardue, mais quelles que soient les difficultés, elle est la condition préalable de l’accélération de la crois-sance économique.

Los efectos de la inflación sobre el desarrollo económico

Resumen

En muchos de los países de menor desarrollo económico los ingresos no aumentan con tanta rapidez como las aspiraciones de la comunidad. En tales países los ahorros personales son limitados, de suerte que los recursos de que se dispone para la expansión del capital de la comunidad no son sino pocos. Al mismo tiempo, el sistema tributario rinde solamente lo suficiente para hacer frente a parte de los servicios gubernamentales que la comunidad desea obtener, y los fondos que quedan disponibles para el financiamiento del desarrollo son muy pequeños. Ante tales circunstancias la inflación puede aparecer como un método fácil de financiar la expansión de las inversiones y, por tanto, como la forma más sencilla de obtener capital para incrementar más rápidamente la producción.

No cabe duda de que a veces una expansión monetaria un tanto más grande que el aumento corriente de la producción real, imprime cierta flexibilidad a la economía y conduce a que algunos de los recursos que los “ahorros forzosos” dejen libres, se utilicen para el desarrollo. Sin embargo, existen límites estrictos en cuanto al grado de desarrollo que puede así fomentarse.

La inflación disminuye el volumen de los recursos que quedan disponibles para inversiones internas. Los ahorros de la comunidad se reducen, y una parte importante de los mismos se canaliza hacia las inversiones en el extranjero en vez de las inversiones internas, desalentándose, mientras tanto, la afluencia al país de capital extranjero. Una parte substancial de la menguada corriente de recursos para inversiones internas se desplaza hacia usos que no son precisamente los que se necesitan más urgentemente desde el punto de vista social. Se fomenta la acumulación de grandes existencias. El desplazamiento del ahorro de los mercados de capital, donde las decisiones de los inversionistas están en mayor grado sujetas a un criterio económico a más largo plazo, se ejemplifica en la canalización de las inversiones hacia la construcción de residencias privadas de un número relativamente pequeño de acaudalados y no hacia los usos que resultan productivos para la comunidad entera. La aparente rentabilidad de ciertas inversiones de corta duración conduce a distorsiones en la estructura productiva que restan adaptabilidad a la economía. Las dificultades de balanza de pagos son síntomas de las tensiones básicas. Con el fin de reducir los déficit externos, las autoridades se ven casi forzadas a valerse de controles, que en la mayoría de los casos sirven para proteger la producción antieconómica. Las presiones políticas dan origen a nuevas restricciones que a la postre traen consigo otras distorsiones. El desajuste de la actividad económica se vuelve entonces cada vez más acentuado.

Es innegable que un desarrollo económico rápido puede muy bien dar lugar a presiones inflacionarias y, por lo tanto, uno de los problemas que ameritan la mayor atención de parte de las autoridades en una economía en vías de rápido desarrollo, es el de contrarrestar la inflación. No obstante, cuando se ha dejado que la situación del sistema económico se vuelva casi incontrolable, las autoridades tienen que tomar la decisión de estabilizar o de no estabilizar. No cabe duda de que el proceso de estabilización es arduo, pero por difícil que sea, es un requisito previo para alcanzar un desarrollo económico más rápido.
*

Mr. Dorrance, Chief of the Finance Division, has been a lecturer at the London School of Economics and a member of the staff of the Bank of Canada.

1

H. J. Bruton, Inflation in a Growing Economy (Annual Lectures by Visiting Professor of Monetary Economics, 1960–1961, University of Bombay, Bombay), p. 57; parentheses added.

2

To be more precise: 1954–60 in most cases, in some cases shorter periods within that time span.

3

“The Relation Between Inflation and Economic Development: A Statistical Inductive Study,” Staff Papers, Vol. VII (1959–60), pp. 302–17.

4

It should be recognized that these conclusions are more positive than the conclusions in some other studies. The difference between the conclusions in Table 1 and those of other studies may be explained by the fact that the data in Table 1 cover a fairly large number of countries where the rate of inflation is high, whereas the data used by most other authors are dominated by relatively low rates of inflation. For example, of the more than 100 annual rates of price change analyzed by Bhatia (”Inflation, Deflation, and Economic Development,” Staff Papers, Vol. VIII, 1960–61, pp. 101–14), only 14 were larger than 5 per cent, and only 3 of these were in excess of 10 per cent.

5

It must be recognized that the degree of price change required to influence expectations is not only rather indeterminate in any particular case, but will depend to a considerable extent on the degree of price stability in earlier years; even so, it will differ from country to country, and between countries with similar monetary experiences.

6

This section, and Part III below, are based largely on A. S. Shaalan, “The Impact of Inflation on the Composition of Private Domestic Investment,” Staff Papers, Vol. IX (1962), pp. 243–63.

7

See, for examples, the data in Table 23, page 40. (The Appendix, pp. 32–44, contains Tables 11–29.) For a discussion of the effect of uncertainty regarding the rate of inflation on the structure of interest rates, leading to higher rates for long-term deposits than for short-term ones, and higher rates for short than for long loans, see C. D. Campbell and C. S. Ahn, “Kyes and Mujins—Financial Intermediaries in South Korea,” Economic Development and Cultural Change (Chicago), October 1962, pp. 64–65.

8

Presumably, this is what Keynes had in mind when he stated that “money itself loses the attribute of liquidity if its future supply is expected to undergo sharp changes.” (The General Theory of Employment, Interest and Money, New York, [1956], p. 241, n. 1.)

9

An examination of some unpublished data on insurance in Argentina indicates that the increase in all financial assets was less than 650 per cent.

10

A similar conclusion is obtained if the data relating to Venezuela (where investment in crude oil production is of a technological form which is not amenable to expansion through reinvestment of earnings) and to Brazil and Indonesia (where restrictions on capital repatriation led to forced reinvestment of earnings by foreign companies) are excluded from the comparison.

11

See Part IV for a discussion of this point.

12

Derived from Survey of Current Business and International Financial Statistics.

13

International Monetary Fund, Annual Report, 1962, p. 44.

14

This statement is not contradicted by the policies of certain governments restricting foreign investment in certain fields (e.g., exploration for petroleum). These policies may be adopted for specific national purposes, and the inflationary or noninflationary climate is irrelevant. Within the constraints set by such policies, inflation is likely to increase the pressures on these same governments to take positive steps to increase the inflow of nonresident capital.

15

These comments should not be taken as a generalized condemnation of government borrowing, or of intergovernment capital transactions. Under many circumstances, they serve highly useful purposes. Many forms of investment, which are appropriate for foreign financing (e.g., a part of social investment in roads, water, and sanitation works), can only be handled by the government or its agencies. Many of the sources of capital in the modern world are governments or intergovernment agencies (International Bank for Reconstruction and Development, Inter-American Development Bank, etc.) which may be expected to make only loans with government guarantees.

16

For a more complete discussion of this point, as related to one country, see R. Hayn, “Capital Formation and Argentina’s Price-Cost Structure,” Review of Economics and Statistics, August 1962.

17

See Table 23, as well as Table 8, for the basis for these observations.

18

E.g., International Monetary Fund, “Decision on Multiple Currency Practices,” Annual Report, 1967, pp. 161–62.

19

See International Monetary Fund, Thirteenth Annual Report on Exchange Restrictions, 1962, pp. 174–75.

20

See, for example, the discussion of Ceylon, pages 10–11 above.

21

This section is based largely on Gertrud Lovasy, “Inflation and Exports in Primary Producing Countries,” Staff Papers, Vol. IX (1962), pp. 37–69.

22

One aspect of this problem is exemplified by the following quotation from a report on the decline in the marketable supply of sisal: “Brazilian growers are simply retaining their stocks as a hedge against inflation” (The Statist, November 2, 1962, p. 328).

23

Given the decline in average export prices, there was a rise in the volume of demand, but not necessarily a rise in the demand schedules for the products of these countries.

24

If allowance is made for the fact that world prices rose by approximately 10 per cent during this period, and that hence a 10 per cent rise in domestic prices would have been consistent with exchange stability, these percentages become 25 and 80, respectively.

25

For a discussion of one example of the change in direction of international capital movements, see the reference to this aspect of the changes in Spain following the adoption of a stabilization program in 1959, in International Monetary Fund, Annual Report, 1962, p. 49.

26

The following is an assessment of the effect of these fundamental changes in one case:

“Now that the initial steps to stabilize the Spanish economy have been so successful the key to further progress seems to lie in the lowering of the import tariff and the abolition of the remaining import quotas. Spanish industry may be said to have grown up in the past 25 years in a hot-house atmosphere of complete freedom from foreign competition, and until imports began to be freed three years ago there had been no incentive or necessity to produce better goods at lower prices.

“But the limited measure of foreign competition to which it has already been subjected, together with free access to raw materials, has worked wonders. (In all fairness it should be said that during all that period Spanish manufacturers had to make do with substitute or makeshift materials in erratic supply, often smuggled in and sold at exorbitant prices.) Competition among manufacturers has made its appearance and quality has improved out of recognition.” (The Times, London, November 23, 1962, p. 19.)

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Cover IMF Staff Papers
IMF Staff Papers: Volume 10, No. 1
Author:
International Monetary Fund. Research Dept.
Volume/Issue:
Volume 1963: Issue 001
Publisher:
International Monetary Fund
ISBN:
9781451956023
ISSN:
1020-7635
Pages:
230
DOI:
https://doi.org/10.5089/9781451956023.024
  • Chart 1.
    View in gallery
    Chart 1.

    Selected Countries: Exchange Rates and Purchasing Power of Monet, First Quarter 1951–Second Quarter 1962

    (As percentages of 1951 averages)

Chart 1.

Selected Countries: Exchange Rates and Purchasing Power of Monet, First Quarter 1951–Second Quarter 1962

(As percentages of 1951 averages)