Unit 7 Macroeconomic policy in the global economy

7.10 Why do some countries still end up with high and volatile inflation?

The FlexIT and Fix regimes provide alternative ways of ‘tying the policymaker’s hands’ to address the problem of high inflation. In a FlexNIT economy, there are no such constraints. The result can be a combination of high inflation and sustained exchange rate depreciation, reinforcing fluctuations in output and exacerbating inflationary pressures. In turn, expected depreciation will push up nominal interest rates.

With such obvious disadvantages, why would a government choose a FlexNIT regime? Why are FlexNIT countries with high inflation still so common? To answer this question, we need to think more carefully about the role of governments in the economy.

Economic policy analysis often focuses mainly on what government policymakers should do, if they want to improve outcomes for citizens in their jurisdiction. But to understand the differing economic outcomes we observe in countries across the world, we need to examine what governments actually do.

Actual governments may use their power to pursue their own objectives rather than those of their citizens. For example, they may use tax revenue for the consumption of members of the government themselves, or for spending that is simply designed to reinforce their power (such as populist welfare expenditure or payments to members of the elite, who the government relies on to keep it in power).

Or, they may not have the power to take the steps to improve their citizens’ lives. Remember from Figure 7.2 that most of the ten countries with the highest inflation rates in 2022 were in some kind of crisis. In at least some of these cases, the crisis can be traced to the failures of current or previous governments.

Why might the behaviour of less-than-ideal governments have the particular consequence of leading to high and volatile inflation? The answer usually lies in the way they pay for government expenditure.

Government deficits and debt

An important difference between the government and other economic actors is its ability to extract taxes from citizens—if necessary, with the threat of force. But in many countries around the world, current taxes do not provide sufficient resources to pay for all government expenditure. In that case, the government can choose to borrow.

To be clear, governments may borrow for good reasons, to benefit the economy now or in future. And borrowing need not lead to inflation. Most governments around the world have at least on occasion run large fiscal deficits—meaning that they have spent more than they raised in taxes. In recent years some countries, including both FlexIT and Fix economies such as the United States, Japan, and Germany, have done so on a sustained basis, without any clear impact on inflation.

sovereign debt crisis

If a government is unable to repay its debt as required, and cannot negotiate a change in terms with the lender, it may default on some or all of the debt. A situation in which the government either defaults, or is expected to default, is described as a sovereign debt crisis.

But borrowing on a sustainable basis, while keeping inflation under control, frequently proves difficult in FlexNIT countries. If domestic savings are not high enough to finance the deficit, the government would need to borrow from abroad. When it issues bonds (discussed in Section 6.7) it will need to pay interest on them at a sufficiently attractive rate for foreign lenders to be willing to lend. Foreign investors are often only prepared to lend in foreign currency, usually dollars. This means, the interest rate will typically be higher because of the risk of default. Note also that the value of foreign debt in domestic currency goes up if the exchange rate depreciates, increasing the burden of the debt on the home country and the likelihood that it will be unable to pay the interest and will default. The CORE Insight ‘Public debt: Threat or opportunity?’ shows that in some economies—particularly in lower-income countries—this process can lead to debts that spiral upwards. The burden of interest payments on debt may lead to a sovereign debt crisis, when governments default on some or all of their debts.

In the aftermath of such crises, governments in these countries may find themselves unable to borrow in global financial markets. Even if they can borrow, governments may not wish to accept the discipline of repaying the debt in foreign currency that foreign borrowing imposes.

However, as long as it has its own currency, there is an alternative—a government can finance its deficits; but only in a way that almost invariably leads to high inflation.

Monetary finance and inflation

base money, monetary base, high-powered money

Base money (also called the monetary base and sometimes high-powered money) consists of the cash held by households, firms, and banks, together with the balances held by commercial banks in their reserve accounts at the central bank.

Base money (also known as the monetary base) consists of both notes and coins and the reserve deposits held by commercial banks, which are all liabilities of the central bank. And, since central banks belong to the government, money is just a particular, if rather special, form of government debt.

So even if a government cannot borrow by issuing bonds in global financial markets, it can still borrow by issuing money.

A key feature of the traditional form of money, currency (notes and coins), is that the nominal interest rate on money is precisely zero. It is therefore a cheap—sometimes very cheap—way for the government to borrow.

Since the nominal interest rate is zero and inflation, \(π\), is usually positive, the real rate of return to those who hold currency is negative: the real interest rate on currency is equal to −\(π\). Recall the situation where the government’s spending plans mean that unemployment is below equilibrium and that inflation will be rising period by period. Assume that the government is funding its spending with newly issued money. Then, the higher the inflation rate rises, the lower is the effective return to those holding the debt, and therefore the lower is the real cost of borrowing. So the government can continue to spend and borrow at this level.

The FlexNIT regime is the only one in which a government can implement its spending plans by taking advantage of its access to monetary financing via inflation. The government in a FlexIT regime cannot do this because of the inflation target and a government in a Fix regime cannot do this without ceasing to have a fixed exchange rate. But in a FlexNIT regime, with unimpeded government control over monetary policy, then to the extent that the government borrows by issuing more currency, the higher is the inflation rate, the lower is the effective cost of this borrowing.

It is perhaps no surprise that, over the course of economic history, many governments throughout the world have tried this. But unfortunately, the result has almost always been disastrous: high inflation or sometimes hyperinflation, frequently accompanied by massive disruption to the real economy. In our comparison of inflation rates in Figure 7.2, the list of countries with very high inflation in 2022 was also largely a list of countries in crisis, in some form or other.

What happens when governments resort to monetary finance?

In many historical episodes, such as the hyperinflations in Germany and Austria in the 1920s, the primary mechanism was funding additional spending by increasing the monetary base (literally printing new banknotes). In more recent inflationary episodes, the expansion in the monetary base may also arise from the central bank borrowing, on the government’s behalf, from commercial banks, which increases commercial bank reserves. Banks will typically be paid an interest rate on this borrowing, but the rate will be set by the central bank, and hence effectively by the government. Figures 7.2 and 7.18 showed, for example, that in 2022 the Turkish central bank was paying a nominal interest rate of just 7%, with inflation at over 70%—hence a massively negative real interest rate. As long as it lasts, this lowers the cost of funding the deficit.

However, inflation will continue to rise due to a vicious cycle: as the value of money declines, the government must print more to keep up with its desired spending in real terms, leading to even higher inflation and eventually, if the process is sustained, hyperinflation. Furthermore, households are aware that their money will be worth more if they spend it now rather than keep it for later, so they spend more (and may even follow the example of Noira in Argentina in Section 7.1 by hoarding goods to protect against future inflation), which pushes up inflation even further.

As wages and pensions typically fail to keep up with the rate at which prices are rising, the economic hardship people face in such a situation is extreme.

Eventually, as inflation rises higher and higher, people will not only refuse to buy government bonds but they may also increasingly refuse to hold bank notes, which are becoming more and more worthless. In a situation like this, they may follow the same strategy as Jorge in Argentina in 2023 (also in Section 7.1) of switching to the use of another currency such as the US dollar. Inevitably, this will drive up the price of dollars in domestic currency—the nominal exchange rate will depreciate rapidly. This, in turn, will further boost inflationary pressures—via import prices.

We will study the impact of this process in our final visit to Argentina.

Example: Deficits, monetary finance, and inflation in Argentina (1960–2017)

In the 30 years from 1960 to 1990, Argentina always had a ‘primary deficit’: meaning that government expenditure excluding interest payments was always more than government revenue from taxation. The primary deficit, shown in the upper panel of Figure 7.21, was typically around 3 to 4% of GDP. This was followed by more than a decade when there were primary surpluses.

Argentina frequently resorted to monetary finance.

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https://www.core-econ.org/macroeconomics/07-macroeconomic-policy-global-economy-10-why-some-countries-high-inflation.html#figure-7-21

Figure 7.21 Monetary finance and inflation in Argentina (1960–2017).

Timothy J. Kehoe, Juan Pablo Nicolini, Thomas J. Sargent, ‘A Framework for Studying the Monetary and Fiscal History of Latin America’, 1960–2017, Federal Reserve Bank of Minneapolis.

You might think that borrowing via new base money equivalent to 2% to 3% of GDP does not sound like a lot. But the stock of base money in any economy is typically quite small. In Argentina during the whole period covered by the chart, the average ratio of the monetary base to GDP was just under 7% (and at points fell as low as 2%) so relatively small fractions of GDP implied sometimes massively high rates of growth of money. For example, if money is as low as 2% of GDP, then a change in the stock of money equal to 2% of GDP implies a doubling of the stock of money in that year.

At the point in Argentina when the ratio of money to GDP reached its low point of around 2%, the annual inflation rate was close to its peak of 5,000%—meaning that money became worthless extremely rapidly. This is shown in the bottom panel of the chart. A key element in this process was, as shown in Figure 7.1, rapid depreciation of the peso, which reinforced inflationary pressure.

The period 1990–2000, when the exchange rate was held fixed against the dollar, was a distinct exception to this pattern. During this period, monetary finance was simply impossible because it would have led to a depreciating exchange rate. Since the Argentine government had only limited capacity to borrow from overseas, it was compelled to bring its deficit down. In the early part of the period, the primary deficit fell to zero, but then actually went negative—that is, a surplus—so that expenditure before interest payments was actually below revenues.

In 2001, the fixed exchange rate was abandoned and monetary finance via growth of the monetary base resumed. Initially, this growth was at a relatively slower rate than in the earlier period, because, as the top panel shows, for a while the government actually ran an even larger surplus. But in due course, as it reverted to deficits, growth of the monetary base resumed—accompanied by ever more rapid inflation. By the time Javier Milei came to power, Argentina was again on the verge of hyperinflation.

Exchange rates and monetary regimes: A summary

We summarize the story in this unit by extending the table from Figure 7.13: