Learning ObjectivesBy the end of this section, you will be able to do the following:
- Identify the causes and effects of inflation in various economic markets
- Explain the significance of a converging economy
Policymakers of the high-income economies appear to have learned some lessons about fighting inflation. First, whatever happens with aggregate supply and aggregate demand in the short run, monetary policy can be used to prevent inflation from becoming entrenched in the economy in the medium and long term. Second, there is no long-run gain to letting inflation become established. In fact, allowing inflation to become lasting and persistent poses undesirable risks and tradeoffs. When inflation is high, businesses and individuals need to spend time and effort worrying about protecting themselves against inflation, rather than seeking out better ways to serve customers. In short, the high-income economies appear to have both a political consensus to hold inflation low and the economic tools to do so.
In a number of middle- and low-income economies around the world, inflation is far from a solved problem. In the early 2000s, Turkey experienced inflation of more than 50 percent per year for several years. Belarus had inflation of about 100 percent per year from 2000 to 2001. From 2008 to 2010, Venezuela and Myanmar had inflation rates of 20 percent to 30 percent per year. Indonesia, Iran, Nigeria, the Russian Federation, and Ukraine all had double-digit inflation for most of the years from 2000 to 2010. Zimbabwe had hyperinflation, with inflation rates that went from more than 100 percent per year in the mid-2000s to a rate of several million percent in 2008.
In these countries, the problem of very high inflation generally arises from huge budget deficits, which are financed by the government printing its domestic currency. This is a case of too much money chasing too few goods. In the case of Zimbabwe, the government covered its widening deficits by printing ever higher currency notes, including a $100 trillion bill. By late 2008, the money was nearly worthless, which led Zimbabwe to adopt the U.S. dollar, immediately halting its hyperinflation. In some countries, the central bank makes loans to politically favored firms, essentially printing money to do so, and this too leads to higher inflation.
A number of countries have managed to sustain solid levels of economic growth for sustained periods of time with levels of inflation that would sound high by recent U.S. standards, like 10 percent to 30 percent per year. In such economies, most contracts, wage levels, and interest rates are indexed to inflation. Indexing wage contracts and interest rates means that they will increase when inflation increases to retain purchasing power. When wages do not rise as price levels rise, this leads to a decline in the real wage rate and a decrease in the standard of living. Likewise, interest rates that are not indexed mean that the lenders of money will be paid back in devalued currency and will also lose purchasing power on monies that were lent. It is clearly possible—and perhaps sometimes necessary—for a converging economy—the economy of a country that demonstrates the ability to catch up to the technology leaders—to live with a degree of uncertainty over inflation that would be politically unacceptable in the high-income economies.