Causes, Consequences and Extent of Inflation on an Economy

Published on September 30, 2006 By Paul Bourne In Blogging

By Paul Andrew Bourne, M.Sc.; B.Sc.; Dip. Edu.

Inflation is a monetary phenomenon (Mishkin 2003: 11), which is created when ‘more money is chasing too few goods’. In a situation where goods and services are scarce, an increase in money supply will only fuel a higher valuation of the same commodities without a corresponding change in the production function (i.e. capital formation- materials, stocks, work-in-progress, finished goods). With this reality, businesses and government are forced to pay higher prices for products; and so, this further amplifies cost increases throughout the general economy. Economists refer to this phenomenon as the multiplier effect of changes throughout the economy. This project seeks to examine price index in Jamaica between 1987 and 2004 in order to evaluate the inflation rates, changes and its effect on other macroeconomic indicators.

An increase in the cost of a certain product affects the cost structure of other related products and/or non-related commodities. Wilson (1982: 118) forwards a perspective that explains this economic force, which concurs with Mishkin’s position that government’s monetary policies directly influence general prices throughout the economy, and that this is not only related to government services and/or expenditures. Wilson summarizes this aptly in a relatively length quotation that best explains the interrelatedness of price increases and other macroeconomic variables. He writes that:

Inflation is a persistent rise in some general index of prices that, due to expectations, becomes self-supporting. Yet not all prices rise, or do they raise by the same extent. Inflation therefore results in a form of income and wealth redistribution totally unrelated to any desirable goal of either economic or social policy Wilson (1982: 118)

Governments in for many years have tried (and continue to attempt) to combat the scourge of inflation and its consequences on the populace, but this is to no avail. Mishkin (2003) in his book titled ‘The Economics of Money, Banking and Financial Markets’ asked the question, “What explains inflation?” and this forms the basis upon which this paper analyzes the issue of inflation on the Jamaican economy. He posits that one clue to this issue is money supply. Generally, it is because of changes in the price levels. He writes that, “[The] continuing increase in the money supply might be an important factor in causing the continuing increase in the price level that we call inflation” (p. 11). Hence, inflation is inextricable linked to the continuous increase in money supply. Mishkin (op cit) posits that, government’s concern about inflation is its monetary policy given the direct influence between money supply and price levels.

In order to grasp the complexities and consequences of the inflation phenomenon in Jamaica, it must be contextualized within the broad space of other societies compared to what exists in this society (Jamaica). With that been said, I will quote a number of instances from Hanke and Schuler’s monograph:

Loans in Jamaican dollars are a big gamble for lenders and borrowers because inflation is so unpredictable. For example, if the nominal interest rate on a loan is 5 percent a year and inflation is 1 percent, the borrower pays 4 percent real interest. But if inflation is 5 percent, the borrower pays zero real interest, and if inflation exceeds 5 percent, the borrower pays back less in real value than he borrowed (Hanke and Schuler, 1995, 3).

Nominal interest rates for Jamaican dollar loans to good borrowers are approximately 42 to 45 percent a year today, compared to approximately 11 to 14 percent for U.S. dollar loans in Jamaica. That is not the end of the story, of course; we need to adjust for inflation. Suppose that inflation will be 20 percent in Jamaica and 3 percent in the United States this year. Real interest rates are therefore 18 to 21 percent for Jamaican dollar loans and 8 to 11 percent for U.S. dollar loans.1 The gap of 10 percentage points in real interest rates mainly represents the difference in credibility between the Bank of Jamaica and the U.S. Federal Reserve System, which issues the U.S. dollar (Hanke and Schuler, 1995, 3).

Monetary policy in Jamaica today faces a dilemma that may last for quite some time. On the one hand, high real interest rates for Jamaican dollar loans are stifling business activity and economic growth. They also imply a future crisis for government finances, which would sow the seeds for further high inflation. Continuing the current monetary policy condemns Jamaica to low economic growth until the Bank of Jamaica has more credibility. On the other hand, reducing real interest rates by increasing inflation would destroy the credibility that the Bank of Jamaica gained in 1994. Economic activity might increase temporarily, but lenders of Jamaican dollars would demand even higher real interest rates in the future. To offset the higher interest rates the Bank of Jamaica would have to create even more inflation, leading to a vicious cycle (Hanke and Schuler, 1995, 4).

One might be tempting to argue that Hanke and Schuler may be biased in their presentation of the fact, hence a research done for the Inter-American Development Bank by Zahler and Desmond (2003) that a number of issues that concur with those perspective forwarded by Hanke and Schuler. They (Zahler and Thomas, 2003) say that:

Despite some successes in the second half of the 1980s, the Jamaican economy has shown enormous difficulties to achieve stable GDP growth and low inflation. In fact, average output growth over the last 25 years has been dismal and total measured output in real terms has been practically unchanged. The first half of the 1990s showed stagnant economic growth, which was followed by contractions in Jamaica’s economic activity during the second half of the 1990s. Only in 2000 and 2001 has economic growth resumed, at very low rates, averaging less than 1.5% per year. In 2002, GDP growth was less than 0.5%. On the other hand, inflation was reduced significantly during the 1990s and since 1997 has been maintained at one-digit levels, despite external price shocks and exchange rate adjustments (Zahler and Thomas, 2003, 3).

The maintenance of price stability is one of the main objectives of governments throughout the world, ever since the dawn of finance; this observable fact affects the lives of everyone. One economist, states “the absence of fiscal and monetary discipline breeds inflation, which in turn stifles growth” which is why this issue is of fundamental importance to all. As was previously stated by Wilson (1982), inflation is the general rise in prices and so any movement in this phenomenon influences social and economic policies, for example, incomes, wealth and peoples’ lives. As such, this issue cannot be left to the wind as is importance is positively related to man’s welfare and so must be adequately analyze in order that we will be able to effectively deal with its effects, influences and consequences (Mishkin, 2003).

According to Wilson (1982), in his article titled ‘Inflation: Causes, Consequences and Cures,’ inflation will not persist unless it is accommodated by sustained increase in money supply. Inflation, therefore, is fundamentally a monetary phenomenon (see for example Mishkin, 2003). Milton Freidman also forwarded this theorizing. Inflation is a major factor in the choice of monetary policies by governments. Ever since the early 1990s, when Jamaica experienced annual inflation rates as high as 80.2 percent (see Table 1), the issue of inflation has become everybody’s concern. This was severely felt by the average person.

Table 1: AVERAGE ANNUAL GROWTH RATE OF PRICES4
(By the Moving average – from December of one yr. to December of next yr.)

YEAR
% GROWTH

1987 8.4

1988 8.8

1989 17.2

1990 29.8

1991 80.

1992 40.2

1993 30.1

1994 26.8

1995 25.6

1996 15.8

1997 9.2

1998 7.9**

1999 6.8

2000 8.2

2001 7.0

2002 7.1

2003 10.3

2004 13.6

Source: Statistical Digest, 2000 and Economic and Social Survey Jamaica, 2004, p. 5.4
* The highest inflation figure ever recorded in Jamaica
** Revised figure in 2000, i.e. 7.9 accepted figure, and 7.2 was discarded

Jamaica gained independence in 1962 and was enjoying strong economic growth (i.e. increase in the production of goods and-or services of one year over another), so much so that economists and peoples worldwide thought it would become a first world country, as America and Europe. Imagine that! This, therefore, means that Jamaica’s economy was stronger than that of all the other developing countries in the Caribbean and Latin America (ECLAC). In the 1950s, the country had an income per capita that was higher than that of entire Latin America. According to one group of scholars “In the 1950s and 1960s it seemed that Jamaicans would slowly catch up to the standard of living that West Europeans or Americans enjoy” (Hanke and Schuler, 1995, 2). Statistics revealed that between 1952 and the 1962, GDP on an average grew by 6 percentage points. This sparkling revelation means that, the growth rate was the highest in the Western Hemisphere (World Facts Now – Data-Maps and World Bank Group, statistical data).

However, in the last 25 years, Jamaica has almost no economic growth per person, while developed countries (i.e. first world economies) have grown by 2 percent or more on an average (see for example Hanke and Schuler, 1995). Countries that were, economically (using macroeconomic variables such as National debt, GDP, NI, employment rate, inflation, standard of living and/or cost of living) far behind Jamaica in the 1960s, for example, Singapore, Barbados, and the Cayman Islands, presently have stronger economies. Those states are now removed from the plague of high unemployment, high inflation, and huge debts (both external and internal). The government of those countries has been able to bolster their economies, and maintain price stability, a target Jamaica has been unable to do.

Since independence, between 1962 and 1973, the strong economic growth that Jamaica enjoyed (Gross Domestic Product (GDP) growth) averaged 5 percent per annum, this has deteriorated to negative growth between 1996 and 1999 (see Table 2). From the years 1973 to 1980, the economy experienced a severe contraction due to negative external shocks and inappropriate domestic policies . This contraction reiterates the macroeconomic vulnerability of the economy, which is highly responsive to international price changes, external political decision, climatic changes, demand shifts and other socio-economic and political variables.

Between the years 1987 to 1980, Jamaica’s inflation rate averaged 17 percent2. Following the previously mentioned periods, despite that actuality, one of the main objectives of the governments was to lower this phenomenon. The macroeconomic policies of the then government do not seem to support price stability. Nevertheless, in 1991, the rate of inflation rose to an alarming 80.2 percent and as such, the government of the day had to implement numerous policies to reduce this reality. This is seen in 1992 as the level of inflation left to 40.2 percent, a reduction of approximately 100 percent compared to 1991. In 1997, the average annual growth in prices (rate of inflation) was 9.2 percent falling from 15.8 percent in 1996, and further reduce to 7.2 percent in 19983 (see Table 1). The lesson learnt in 1991 concerning monetary policies has meant a change in policies. This may account for the non-teen inflation valuation after 1996 and leading up to 2004. Since1991, the social realities have taught us a serious lesson in regards to better money management. Those inflation actualities created hardship for countless peoples. In that, the cost of purchasing goods and-or services became higher and so less was bought with the same original dollar.

According to Desmond Thomas (1998), the ‘maintenance’ of price stability is due to a combination of factors, including the tight monetary policy pursued and the ‘sluggish’ level of economic activity. At the same time that the government is pursuing policies to lower inflation, they are also engaging in other activities to increase it. In that, they have: the growth in the money supply of over 40 percent per year, the increase in public spending which includes large wage increases to government employees every two years, the accumulation of unprecedented levels of international reserves in 1992 and 1994, a policy of sterilization and the doubling of the stock of domestic debts.

The substitutability of short-term debt with money showed up in an increase in the money supply during the year 1991 and 1995. Wage awards in 1993 (demand pull inflation) and the latter part of 1995, and government intervention in 1995 in support of troubled financial institutions increased public expenditures5. All of the above arguments have contributed to
Jamaica’s inflationary problems, but the most expansionary and therefore inflationary method of financing a deficit is for the government to borrow money directly from the Central Bank.

According to Schuler (1998), throughout most of the Bank of Jamaica’s history, it has merely been “the printing press of the Ministry of Finance, with no ability to resist the ministries orders to finance government deficits by creating inflation”. Because of this constant inflation creation, Jamaica was ranked at number 90 out of 108 countries in average annual inflation from 1971 to 19916 (Hanke and Schuler, 1995).

The Jamaican government has had a complex time maintaining inflation at a relatively low percent; nevertheless, the economy is growing at a sluggish rate. Hanke and Schuler (1995) believe that the government’s policies are primarily responsible for this stagnation. They state that a good monetary policy is necessary, but not sufficient for sustained economic growth. Their reasoning is clear; that the government has tightened its monetary policy (contraction policy), lower inflation and still has not succeeded in stimulating production (i.e. capital formation). The economy experiences stagnant growth of GDP of 0.4 percent. This is evident in GDP rate of growth over the four-year period 1996 to 19998. Hanke and Schuler (1995) posits that an exceptionally good monetary policy cannot offset the growth-destroying effects of high taxes, insecure property rights, excessive regulation and fear of the future cause of economic policy. This affords an explanation for the stagnation within the economy despite the government’s efforts to curtail money supply.

The Jamaican economy shwinked in 1996 and 1997 (-1.3 and –2.0 respectively see Table 2). The reductions in GDP meant that companies’ profits were less. This meant that businesses had to reduce their productive capacity; many companies collapsed under their debts and went into receivership or were closed down9. For some companies in garment manufacturing it became too expensive to export and returns (i.e. profits) were minute. Many banks had to close for example, the Century National Bank (CNB), and the Union Bank now owns by Royal Bank of Trinidad and Tobago (RBTT) either because of the economic climate or because of poor management. All of this led to many Jamaicans being without jobs and many more lose their jobs by the end of the year. Those redundancies coupled with the high inflationary climate contribute to the continually increased unemployment and change in many governmental social policies.

The high interest rates in both nominal and real terms that were experienced by the economy placed a damper on economic activity. Meaning, high interest rates continue to be persistently higher than the rate of growth of government taxes, which means that the government has to use more and more of its revenue to repay its debts and less and less to other activities. The debts cannot be financed by taxes alone, because it is too small, so the government has three options available to them: (1) to further reduce spending on everything except repaying debts. (2) Default, and (3) to create inflation10.

According Hanke and Schuler (1995), default is unnecessary because the government can make the Bank of Jamaica print all the money it needs to repay its bills. Consequently, inflation has been the usual result in the past, and the chance of it happening in Jamaica's future is close to 99.9 percent. It is 99.9 percent likely because, both intentional and domestic debts continue to increase yearly, to the point where Jamaica probably will not be able to repay all of its debts in the near future. The question arises then, how will Jamaica be able to lower inflation with the government's implementation of tight monetary policies, without having to create more inflation to finance its debts? Where is the solution?

If the government continues current monetary policies, Jamaica will be condemned to low economic growth until the Bank of Jamaica has more credibility, on the other the hand, reducing real interest rates by increasing inflation would destroy the credibility that the Bank of Jamaica gained in1994. Hanke and Schuler (1995) believe that the only way out of Jamaica's dilemma of 'high interest rate verses high inflation’ is to reform current arrangements for monetary policy in Jamaica. They believe that the best options for return are most far-reaching. In the case of Jamaica, it means 'stripping' the Bank of Jamaica of its power to issue the Jamaican dollar. Jamaica will then have to change its monetary policy to have a strong economy.

The main reason for Jamaica's dilemma is the type of monetary policy it uses. There are two types. 1) A market led monetary regime - which relies on market forces to determine the supply of money and credit and the effects of the exchange rate and 2) A managed monetary regime. This regime is a system of rules governing who issues money and credit, and how domestic currency is to be treated in foreign exchange, while a managed monetary regime relies heavily o regulations to determine those things (Hanke and Schuler, 1995). The type of monetary regime that Jamaica's monetary authority have been practicing is the managed monetary regime, while, some countries such as America uses the market led monetary regime. The regime has caused more harm than good as is shown in the poor performance of the Jamaican economy over the years.

Table 2: Annual Growth Rate of Gross Domestic Product at Constant Prices7
YEARS VALUE

1988 2.9

1989 6.8

1990 5.6

1991 0 .9

1992 1.6

1993 1.7

1994 1.1

1995 0.7

1996 -1.3

1997 -2.0

1998 -0.5

1999 -0.4

2000 0.8

2001 1.5

2002 1.1

2003 2.3

2004 1.2

Source: Balance of Payment of Jamaica, 1999 and PIOJ (2004) - ESSJ

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ABOUT THE AUTHOR

The author, Paul Andrew Bourne, holds a Masters of Science degree in Demography, a Bachelor of Science degree in Economics and Demography from the University of the West Indies, Mona, Kingston, Jamaica, West Indies. He belong an elongated career in teaching (formerly taught mathematics at- Kingston College, Vauxhall, St. Mary’s College, Oberlin High school; an educator who work in business education – Gaynstead High, Wolmer’s Boys, Pentab Evening Institute, and ACRM). On completion of his B.Sc. degree (in 2004) Bourne resigned from Vauxhall High (2004) where he was the Head of the Mathematics department and began working in the department of Sociology as a Tutor in statistics, and a research assistant (RA). His duties as a tutor was short lived as he was transferred to the position of a graduate assistant (GA) in the same department, only after four months. Mr. Bourne occupied the position of GA for approximately two-year, after which he was employed by the department (Sept. 1, 2006) as a Teaching Assistant (TA) in Research Methodology and Methods. Despite the demands of this position, he still is able to tutor statistics and Introduction to Population Studies in the department of Sociology, Psychology and Social Work.

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