Infltion and case study of zimbabwe during 2008

CHAPTER I MONEY I What is Money? • Anything that is generally accepted in payment for goods and services or in the repayment of debts • Money is distinct from income and wealth II Functions of Money Medium of exchange Money's most important function is as a medium of exchange to facilitate transactions Without money, all transactions would have to be conducted by barter, which involves direct exchange of one good or service for another The difficulty with a barter system is that in order to obtain a particular good or service from a supplier, one has to possess a good or service of equal value, which the supplier also desires In other words, in a barter system, exchange can take place only if there is a double coincidence of wants between two transacting parties The likelihood of a double coincidence of wants, however, is small and makes the exchange of goods and services rather difficult Money effectively eliminates the double coincidence of wants problem by serving as a medium of exchange that is accepted in all transactions, by all parties, regardless of whether they desire each others' goods and services Store of value In order to be a medium of exchange, money must hold its value over time; that is, it must be a store of value If money could not be stored for some period of time and still remain valuable in exchange, it would not solve the double coincidence of wants problem and therefore would not be adopted as a medium of exchange As a store of value, money is not unique; many other stores of value exist, such as land, works of art, and even baseball cards and stamps Money may not even be the best store of value because it depreciates with inflation However, money is more liquid than most other stores of value because as a medium of exchange, it is readily accepted everywhere Furthermore, money is an easily transported store of value that is available in a number of convenient denominations Unit of account Money also functions as a unit of account, providing a common measure of the value of goods and services being exchanged Knowing the value or price of a good, in terms of money, enables both the supplier and the purchaser of the good to make decisions about how much of the good to supply and how much of the good to purchase CHAPTER II INFLATION I Definition • Inflation is a sustained increase in the price level of goods and services in an economy over a period of time • Inflation rate: inflation rate is a measurement of inflation, the rate of increase of a price index (e.g consumer price index) It is the percentage rate of change in prices level over time • Inflation affects economies in various positive and negative ways The negative effects of inflation include an increase in the opportunity cost of holding money, uncertainty over future inflation which may discourage investment and savings, and if inflation were rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future Positive effects include reducing unemployment due to nominal wage rigidity II Measure inflation In North America, there are two main price indexes that measure inflation: Consumer Price Index (CPI) A measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles The CPI measures price change from the perspective of the purchaser U.S CPI data can be found at the Bureau of Labor Statistics Producer Price Indexes (PPI) A family of indexes that measure the average change over time in selling prices by domestic producers of goods and services PPIs measure price change from the perspective of the seller U.S PPI data can be found at the Bureau of Labor Statistics In the long run, the various PPIs and the CPI show a similar rate of inflation This is not the case in the short run, as PPIs often increase before the CPI In general, investors follow the CPI more than the PPIs III Inflation and Interest Rate Inflation and interest rates are often linked, and frequently referenced in macroeconomics Inflation refers to the rate at which prices for goods and services rise In the United States, the interest rate, or the amount charged by lender to a borrower, is based on the federal funds rate that is determined by the Federal Reserve (sometimes called "the Fed") In general, as interest rates are reduced, more people are able to borrow more money The result is that consumers have more money to spend, causing the economy to grow and inflation to increase The opposite holds true for rising interest rates As interest rates are increased, consumers tend to save as returns from savings are higher With less disposable income being spent as a result of the increase in the interest rate, the economy slows and inflation decreases Under a system of fractional-reserve banking, interest rates and inflation tend to be inversely correlated This relationship forms one of the central tenets of contemporary monetary policy: central banks manipulate short-term interest rates to affect the rate of inflation in the economy CHAPTER III MONEY SUPPLY AND INFLATION Rapid increases in the money supply can be the result of poor management by the central bank or by a decision to print money to support government spending A frequent problem in developing nations is that governments without stable or consistent tax collections often resort to printing money to finance government spending Money becomes worthless if too much is printed If the Money Supply increases faster than real output then, ceteris paribus, inflation will occur If you print more money, the amount of goods doesn’t change However, if you print money, households will have more cash and more money to spend on goods If there is more money chasing the same amount of goods, firms will just put up prices The Quantity Theory of Money The Quantity theory of money seeks to establish this connection with the formula: MV = PY Where: M = Money supply V = Velocity of circulation (how many times money changes hands) P = Price level Y = National Income (T = number of transactions) If we assume V and Y are constant in short-term, then increasing money supply will lead to increase in price level Example: Simple example to explain why printing money causes inflation: Suppose the economy produces 1,000 units of output Suppose the money supply (number of notes and coins) = $10,000 This means that the average price of the output produced will be $10 (10,000/1000) Suppose then that the government print an extra $5,000 notes creating a total money supply of $15,000; but, the output of the economy stays at 1,000 units Effectively, people have more cash, but, the number of goods is the same Because people have more cash, they are willing to spend more to buy the goods in the economy Ceteris paribus, the price of the 1,000 units will increase to $15 (15,000/1000) The price has increased, but, the quantity of output stays the same People are not better off, and the value of money has decreased; e.g A $10 note buys fewer goods than previously Therefore, if the money supply is increased, but, the output stays the same, everything will just become more expensive The increase in national income will be purely monetary (nominal) If output increased by 5% and the money supply increases by 7% Then inflation will be roughly 2% Assumptions in the above example [In the real world, it is possible, if the government printed money, people would just decide to save the extra money and therefore, prices wouldn’t automatically rise However, to simplify the link between the money supply and inflation, let us assume that consumers are willing to spend the extra money Also, if you expect inflation to rise, you have an incentive to spend it – rather than see the value of your money fall.] CHAPTER IV INFLATION: HARMS AND BENEFITS I HARMS Discourage investment Inflation tends to discourage investment and long-term economic growth This is because of the uncertainty and confusion that is more likely to occur during periods of high inflation Low inflation is said to encourage greater stability and encourage firms to take risks and invest Menu costs Menu costs refer to an economic term used to describe the cost incurred by firms in order to change their prices For example, it may be necessary to reprint menus, update price lists or re-tag merchandise on the shelf Even when there are few apparent costs to changing prices, changing prices may make customers apprehensive about buying at a given price, resulting in a menu cost of lost sales Inflation causes more inflation Inflation urges people to spend and invest, which in turn tends to boost inflation, creating a potentially catastrophic feedback loop As people and businesses spend more quickly in an effort to reduce the time they hold their depreciating currency, the economy finds itself awash in cash no one particularly wants In other words, the supply of money outstrips the demand, and the price of money – the purchasing power of currency – falls at an ever-faster rate The result is hyperinflation Hyperinflation can destroy an economy It can wipe out the savings of the middle-classes, and redistribute wealth and income towards those with debt and assets and property Some infamous examples: Germans papering their walls with the Weimar Republic's worthless marks (1920s), Peruvian cafes raising their prices multiple times a day (1980s), Zimbabwean consumers hauling around wheelbarrow-loads of million- and billion-Zim dollar notes (2000s) and Venezuelan thieves refusing even to steal bolívares (2010s) Cost of reducing inflation To restore price stability, Governments/Central Banks need to pursue deflationary fiscal/monetary policy However, this leads to lower aggregate demand and often a recession The cost of reducing inflation – is unemployment, at least in the short-term II BENEFITS Increase economic productivity When the economy is not running at capacity, meaning there is unused labor or resources, inflation theoretically helps increase production More dollars translates to more spending, which equates to more aggregated demand More demand, in turn, triggers more production to meet that demand Famous British economist John Maynard Keynes believed that some inflation was necessary to prevent the "Paradox of Thrift." If consumer prices are allowed to fall consistently because the country is becoming too productive, consumers learn to hold off their purchases to wait for a better deal The net effect of this paradox is to reduce aggregate demand, leading to less production, layoffs and a faltering economy Reduce unemployment The increased production stated above may lead to the need for more workers, thus leads to more jobs vacancies An other explanation is based on wage’s stickiness As wages tend to be sticky, which means they change slowly in response to economic shifts, once inflation hits a certain rate, employers' real payroll costs fall, and firms are able to hire more workers Increase economic growth Inflation discourages saving, since the purchasing power of deposits erodes over time That prospect gives consumers and businesses an incentive to spend or invest At least in the short term, the boost to spending and investment leads to economic growth Speaking above, inflation's negative correlation with unemployment implies a tendency to put more people to work, spurring growth Encourage borrowing and lending Inflation also makes it easier on debtors, who repay their loans with money that is less valuable than the money they borrowed This encourages borrowing and lending, which again increases spending on all levels CHAPTER V INFLATION: EXAMPLE AND ANALYZE I Case Study Studied case: Hyperinflation in Zimbabwe during 2008 II Analysis Overview On 18 April 1980 Zimbabwe gained official independence from the United Kingdom under the leadership of Robert Mygabe At that time, Zimbabwe had strong colonial infrastructure, a high level of cohesion and an abundance of government promises of reform People in Zimbabwe had every right to believe that Zimbabwe could become one of the strongest independent African state However, due to the 2008 hyperinflation, Zimbabwe is now one of the poorest countries in the world as life expectancy is low and malnutrition is becoming a serious problem in this country Causes The reasons behind Zimbabwe’s crisis are complex and interrelated, here may be the major causes: • Zimbabwe introduced its new currency - Zimbabwe dollar to replace the Rhodesian dollar, which has been introduced in 1970, at the rate of 1:1 At that time, a Zimbabwe dollar was actually worth more than the US dollar in the exchange market (1ZWD = 1.47 USD), however on the open and goods market, this did not reflect accurately its purchasing power and as a result, the currency had already started to erode over the years • The government decided to adopt Economic Structural Adjustment Programme (ESAP) as a fix to some problems in the economy such as inhibited investment and employment, constricted credit and foreign exchange and this brought negative effect to the Zimbabwean economy The ESAP involved decreasing in the government expenditure by a combination of rationalization cuts of in public public enterprise sector deficits employment, and trade liberalization, removal of subsidies, devaluation of the local currency, privatization and enforcement of cost recovery in the health and education sectors with the hope to create a new era of modernized competitive and export led industrialization and economic efficiency • The government further implemented land reforms that aimed at chasing white landowners and giving their pieces of lands to black people • The increase in money supply did not equate to an increase in productivity in the Zimbabwean economy, and there was little new investment to create new goods Consequences • A dramatic increase in unemployment rates as people can no longer afford for education, medical care resulting in doctors, nurses among other professionals joining the steady outward migration to neighbouring countries which offered better employment prospects Veterans of Zimbabwe's liberation war also began to feel the pinch of a declining economy and to agitate government for greater monetary assistance for their efforts in the liberation struggle The collapse was triggered by the government's decision in 1997 to ignore fiscal constraints by making large payments to veterans of the independence struggle, as a way of buying their loyalty and political support in the upcoming elections • Food output capacity fell 45%, manufacturing output 29% in 2005, 26% in 2006 and 28% in 2007, and unemployment rate rose to 80% , life expectancy dropped Solution to Zimbabwe’s inflation The government of Zimbabwe made the decision to print more money in order to buy as much goods as before The result was the faster the price increased, the more money they need to print and as the newly - printed money began to enter the market, the price increased, creating a feedback loop From 2000, the inflation rate increased drastically By 2001 prices were rising at a rate of 110% per year, followed by 200% in 2002, 600% in 2003 Overtime, the government had to redenominate the Zimbabwe dollar three times with denomination up to a $100 trillion banknote issued, making Zimbabwe dollar one of the lowest valued currency in the world In 2006, Zimbabwean people have to pay several thousands of dollars to buy food per day It all came down to 2008 when hyperinflation (7.6 billion percent per month) and economic troubles wiped out the wealth of citizens and set the country back more than a half century The Zimbabwean dollar was basically worthless so Zimbabweans refused to use it Robert Mugabe, the president of Zimbabwe had no choice but to abandon its currency, legalized transaction in foreign currency such as U.S dollar, Australian dollar, British pound, Euro, Chinese Yuan and Government accounts became denominated in United States dollars in 2009 As a result of this dollarization and the installation of a national unity government in 2009, the economy rebounded and had slow growth, the Zimbabwe hyperinflation was officially over The problems have yet to over for the people in Zimbabwe As Zimbabwe is a trade deficit country (Zimbabwe imports more than it exports so the total amount of dollars in the country is constantly decreasing), there will be a chronic shortage of physical US dollar in the country As a result, in 2016, the government introduced “bond notes” and officially announced that it was supposedly backed by a $200 million loan from the African Export Import Bank and would be traded 1:1 with the US dollar However, the public was not buying it as they were afraid that the government was making the same mistake and this would cause another hyperinflation like in 2008 The result was that the bond notes began to lose value as soon as they were introduced In the early 2019, the central bank tried again: this time, the pseudo-currency was called the Real Time Gross Settlement (RTGS) dollar — effectively a digital currency — and the bank abandoned the pretence that it would be equivalent to the US dollar, instead suggesting that 2.5 RTGS dollars to US$1 would be an acceptable exchange rate Again, the RTGS dollar is beginning to lose value immediately CHAPTER VI SOLUTIONS Inflation can be solved in a variety of ways one solution of inflation is the involvement of each section of the government when making all the important decision such as printing of the country currency The president will receive information from the economic experts on the importance of printing money thus making him more aware of the effects The other way of reducing inflation is to reduce wars that are commonly being experienced in the world today (Shah, par 4) These reduced cases of political instability will result to easy flow of raw materials thus reducing inflation Another way of reducing the cases of inflation in the developing countries, is when the developing countries stop or reduce the cases of international debts and start to depend on their own resources This will subsequently make the countries to keep the interests for themselves and thus use it to develop there country and economy Summary of policies to reduce inflation Monetary policy: Higher interest rates This increases the cost of borrowing and discourages spending This leads to lower economic growth and lower inflation Tight fiscal policy Higher income tax and/or lower government spending, will reduce aggregate demand, leading to lower growth and less demand pull inflation Supply side policies These aim to increase long-term competitiveness, e.g privatisation and deregulation may help reduce costs of business, leading to lower inflation Policies to reduce inflation in more details Monetary Policy In the UK and US, monetary policy is the most important tool for maintaining low inflation In the UK, monetary policy is set by the MPC of the Bank of England They are given an inflation target by the government This inflation target is 2%+/-1, and the MPC use interest rates to try and achieve this target The first step is for the MPC to try and predict future inflation They look at various economic statistics and try to decide whether the economy is overheating If inflation is forecast to increase above the target, the MPC are likely to increase interest rates • Increased interest rates will help reduce the growth of aggregate demand in the economy The slower growth will then lead to lower inflation Higher interest rates reduce consumer spending because: • Increased interest rates increase the cost of borrowing, discouraging consumers from borrowing and spending • Increased interest rates make it more attractive to save money • Increased interest rates reduce the disposable income of those with mortgages • Higher interest rates increased the value of the exchange rate leading to lower exports and more imports Diagram showing fall in AD to reduce inflation Supply Side Policies Supply side policies aim to increase long term competitiveness and productivity For example, it was hoped that privatization and deregulation would make firms more productive and competitive Therefore, in the long run, supply side policies can help reduce inflationary pressures However, supply side policies work very much in the long term; they cannot be used to reduce sudden increases in the inflation rate Also, there is no guarantee government supply side policies will be successful in reducing inflation Fiscal Policy This is another demand side policy, similar in effect to monetary policy Fiscal policy involves the government changing tax and spending levels in order to influence the level of Aggregate Demand To reduce inflationary pressures the government can increase tax and reduce government spending This will reduce AD Exchange rate policy Sterling exchange rate index, which shows value of Sterling against basket of currencies In the late 1980s, the UK joined the ERM, as a means to control inflation It was felt that by keeping the value of the pound high, it would help reduce inflationary pressures A stronger Pound makes imports cheaper (lower cost-push inflation) Stronger Pound reduces domestic demand, leading to less demandpull inflation A stronger Pound creates incentives for firms to cut costs in order to remain competitive The policy did reduce inflation but at the cost of a recession To maintain the value of the £ against the DM, the government had to increase interest rates to 15%, and this contributed to the recession The UK no longer uses this as an anti-inflationary policy Wage Control Wage growth is a key factor in determining inflation If wages increase quickly, it will cause high inflation In the 1970s, there was a brief attempt at wage controls which tried to limit wage growth However, it was effectively dropped because it was difficult to enforce widely Targeting Money Supply (Monetarism) In the early 1980s, the UK adopted a form of monetarism, where the government sought to control inflation through controlling the money supply To control the money supply, the government adopted higher interest rates and reduced budget deficit It did bring inflation down but at expense of deep recession Monetarism was effectively abandoned because the link between money supply and inflation was weaker than expected ... problem and therefore would not be adopted as a medium of exchange As a store of value, money is not unique; many other stores of value exist, such as land, works of art, and even baseball cards and. .. encourages borrowing and lending, which again increases spending on all levels CHAPTER V INFLATION: EXAMPLE AND ANALYZE I Case Study Studied case: Hyperinflation in Zimbabwe during 2008 II Analysis... the value or price of a good, in terms of money, enables both the supplier and the purchaser of the good to make decisions about how much of the good to supply and how much of the good to purchase