Causes and Impacts of Inflation on Developing Countries

Causes and Impacts of inflation on gain CountriesIntroduction frugal development in low official countries is a contested argument amongst economists, all of which argon looking for the trump way to ordinate sparingal festering. The discussion surrounds whether stable monetary polity leave behind encourage stinting development by encouraging international direct coronation or leave gold depreciation and pretension create the right environment for exports growth and thereof economic growth? This essay go emerge discuss the becomes of lump and its repercussions for economic growth in develop nations. The argument for monetary stability and its repercussions for economic development provide also be discussed. The scenario surrounding the Asian monetary crisis w stroke be used at the conclusion of the essay to illust ramble the finer points in the argument for monetary stability as a means to economic development.The Causes of InflationKrugman and Obstfel d define pompousness as the increase of bells of goods1. There argon arguably numerous causes of inflation it is a complex combination of many macroeconomic variables that act as together to increase the bell of consumer goods in a ontogeny parsimoniousness. Shamsul, Shyam and Kamath discuss, there are two dominant hypotheses regarding the causes of inflation the monetarist guessing and the structuralist hypothesis. The monetarist hypothesis refers to an increase in the funds supply which in dig causes an increase in the price of goods and the structuralist hypothesis refers to structural characteristics of a develop economy creating inflation including the nature of the tax system, orthogonal switch over restraints, the budgetary process, the nature of the labour merchandise and administered prices. every consequence in a devaluation of domestic silver on a worldwide currentness securities industry2. The forces that return in an increase in the money supply or a devaluation of domestic currentness against foreign currency will discussed.Common economic theory states that liberalisation of pecuniary and capital markets in developing countries results in growth and stability in those countries. However Chakraborty discusses how unrestrained opening up of an economy put forward result in a foreign trade crisis. That an inflow of foreign currency with investment and fixed counterchange place will result in higher militia in the central base, which in turn results in more money actual in the economy which causes inflation. Inflation consequently prat be seen as a cause of the devaluation of a domestic currency on global money markets3. Developing countries will often use an export lie economic st valuategy to increase growth. Devaluations of a domestic currency will make exports look more captivateive on foreign markets w indeed governments will try and keep commuting range down. Chakraborty impacts that as prices continue to rise the demand for money similarly rises by domestic residents. It is commonality for residents to sell foreign bonds in run to buy local currency, which in turn puts pressure on the currency to appreciate. In order to disobey this scenario banks will sell local currency and buy foreign reserves to counteract the appreciation of the exchange rate stunned-of-pocket to the change magnitude demand. This scenario has a cyclical effect and will in turn increase the money supply and inflation4.The shoes surrounding a floating exchange rate washbowl be quite different. Chakraborty discusses how liberalising the capital market will attract capital inflows from foreign investors which will increase the money supply, still will so far appreciate the exchange rate. This type of form _or_ system of government will unremarkably be accompanied by a contractual monitory insurance that will increase demand for money and increase the interest rate. The increased interest rate will thr ow proscribed attract capital inflows and further appreciate the exchange rate. An appreciated currency will be slight attractive on foreign markets thus export demand will decrease and imports will increase, deteriorating the balance of trade deficit5. Large foreign debts result in a higher bump of pecuniary instability.Inflation and currency devaluations puzzle been a common problem in the history of developing nations. Instability in prices and foreign exchange rate discourages lenders in richer countries from spend in poorer markets due to the threat of losing money in a pecuniary crisis or currency devaluation. Krugman et al discuss how richer nations protect themselves against this risk by insisting that poorer countries repay their loans in the lenders currency. A transfer of wealth passel be directed towards foreign lenders in the stock-stillt of currency devaluation as it raises the local currency valuation of the debt. This scenario weed lead to developing countr ies softness to repay foreign debts and sometimes in default6.Inflation mint be a result of external incidentors in a global economy including contagion from other trading partners. Cheng and Tan discuss that although domestic factors are important determinants of inflation, they are often not as important as price volatility macrocosm transmitted from one country to another. In the brass of Malaysia, interactions in the form of trade resulted in a causality of inflation from other ASEAN nations to inflation in Malaysia7. This form of contagion drive out be very influential for a developing country liberalizing its pecuniary and capital markets in a global economy.Instability and inflation can lead to supposition which in turn can lead to monetary crisis. Krugman et al discusses contagion as the vulnerability of developing economies to suffer a loss of confidence in their financial markets which can cripple even the healthiest economies. Speculation regarding the devalua tion of a local currency can result in investors pulling out of their investments (which now must be paid in the lenders currency), selling all the local currency (which has a further devaluing effect) and going the country with a large foreign debt. Speculation can be contagious as was seen in the Asian financial crisis where devaluation of the Thai baht was followed by similar speculation surrounding other Asian currencies including that of Indonesia and Malaysia and finally resulted in full financial crisis8.Controlling Inflation and Stabilising an providenceMethods used to counteract heavy speculation and financial instability includes selective information transparency. Ferreira de Mendonca and Filho discuss increasing information transparency as implying a downfall in inflation bias and inflation volatility. Anxiety regarding inflationary pressures can be controlled through forecasts world released by the central banks of developing nations making policy and macroeconom ic performance more predictable. There is evidence that economic transparency can reduce inflation and lower interest rates thus improving the conduction of monetary policy9.Wagner discusses inflation as being regarded as the signal of bad policy and political and economic instability. The variables are the relevant locational factors that determine the attractiveness of economies for investment. A loss in investors and planetary factors of production such as technology transfer and knowledge results in loss of potential production and potential output and hence growth. local residents suffer through an increase in unemployment and a decrease in productivity10. Local economies become more unstable as a consequence.It can now be deduced that managing exchange rates is paramount to haughty inflation in developing countries. Wagner discusses two methods of managing exchange rates in order to control inflation the labored peg option and the floating currency option. The term hard pe g refers to the currency maturates, where monetary policy impropriety is completely given up. Hard peg exchange rate regimes have gathered a lot of interests for developing economies over recent historic period as currency crises are not possible under the hard peg system. There are certain preconditions for an economy that need to be present in order for a hard peg to be possible. The recipient developing nation must have a developed, soundly supervised and regulated financial system the rule of law financial discipline and wage and price flexibility. Many emerging nations lack these preconditions and hence are unable to sustain a hard peg11.Boyd and Smith arouse that low inflation is the central objective of developing economies in their efforts to enact economic growth. Growth is seen as having an inverse relationship to inflation and thus must be kept as low as possible. Developing countries in the Caribbean such as the Bahamas have been successful in let down inflation a nd stabilising the exchange rate through using a currency board as part of their institutional structure. The currency board ties the monetary policy of the constituent countries and provides disciplinary controls on monetary and monetary policy which in turn provides stability in their output. All the countries in the currency union experienced persistence however low rates of inflation and low variability in inflation rates so could be considered stable and an acceptable monetary policy performance12.Wagner further postulates that a floating exchange rate is similarly effective in imperious high inflation. Despite anxiety that a floating exchange rate will result in an unstable currency, floating exchange rates can be used to attract foreign investment and thus appreciate the abide by of the currency. Interest rate and intervention policies can be used to influence the behaviour of the exchange rate and reduce the prohibit effects of speculation13. A floating exchange rate ca n be flexible enough to encourage investment through appreciation however encourage exports through devaluation provided controls are in place to ward false speculative attacks.Maskooki shows Mexcio as having successfully implemented a floating exchange rate in order to control inflation. It reduced the value of the peso by gradual and frequent currency adjustments in reaction to market conditions. The slow depreciation of the peso made exports more attractive foreign and was offset by the liberalization of the capital market which was attractive to foreign investors. The combination of the two had a balancing effect on inflation and exchange rates and thus encouraged stability of prices. This had made the external market little exposed to unexpected shocks14. Through economic stabilization Mexico is now less compromising to investment reversal and thus less vulnerable to financial crisis.Stable inflation rates and exchanges rates ravish positive signals to global financial m arkets of positive financial policy in developing countries. Good corporate founderment has the reflexive ability to create the positive economic environment to control inflation and also the positive outcome of successful monetary policy. Arsoy and Crowther comment that mandatory corporate governance can be achieved through the creation of capital markets in which transparency, accountability, righteousness and fairness are understood by both investors and shareholders15. transparence being the proponent for fighting speculative attacks by reducing risks associated with investing in developing countries. Krugman et al discuss that governments of developing countries must create a stable environment through reducing the risk of inflation and protect property rights in order to encourage economic growth. In defend property rights they encourage private enterprise, investment, innovation and ultimately economic stability16. The conditions for economic stabilization feed off each o ther stabilization encourages investment which in turn encourages more stabilization.Nsouli, Rached and Funke discuss the control of inflation as paramount to the success of any domestic economy. Here again price can be seen as a signal of economic health as price liberalization is essential for the efficient allocation of resources at bottom andacross sectors of the economy. Without a rational price system, profit and losses only cannot signal what industries should expand and which ones should shrink. In both transition and developing economies, price liberalization led to a rapid increase in the approachability of products for consumer use17.The Asian Financial CrisisThe countries of the Asian economic boom in the mid(prenominal) 1990s are a perfect example of how unstable monetary policy can bring even the most impressively outgrowth economy down. Krugman et al tells us the Asian tigers were initially South Korea, Hong Kong, capital of Singapore and Taiwan and then Thailand , Malaysia and Indonesia later joined the group. They had achieved incredible rates of growth through high savings and investment rates, improving education levels amongst the work force and by liberalising trade or at least a high level of openness and integration with global markets. The Asian tigers were gaining popularity as an investment opportunity as restrictions on capital inflows were lifted. However all this investment was leading to large deficits and would eventually result in financial demise18.Krugman et al continues that starting with the depreciation of the Thai Baht, a chain reaction of events brought the Asian miracle into financial crisis. A sharp drop in the value of the Baht as it was left to float after being pegged to the American vaulting horse brought about speculative attacks on the currencies of its neighbours Malaysia and Indonesia and eventually South Korea. All countries had large foreign debts mostly in American dollars and as a result were facing inc reasing values on these debts due to the change magnitude exchange rate. Many debts in Asia had the power to push banks and viable companies into nonstarter as a result of exchange rates spirally out of control19. The Asian financial crisis was seen as a self perpetuating scenario based rough speculative attacks on currency valuations. Lee argues that as soon as a currency peg is seen as non-defensible market participants expect that the market will move in one direction and in fact it does. Once the expectation sets in collective action takes hold (in this slip-up investors pull out of their investments) and the result can inflict financial impair on whole economies20. The Asian miracle had come to an abrupt end.Krugman further discusses the cause of such violent economic collapse can be seen through bad government policy. In Thailand and Indonesia crony capitalism was the source of a lot of poor investment decisions. The sons and daughters of royalty or prominent politicians were the recipients of a lot of investment money regardless of the legitimacy of the project resulting in considerable moral hazard in lending. The regulatory system was ill equipped to deal with companies in danger of loser or to promote quality investments in the economy that would count towards real growth21. As a result the first sign of instability caused foreign investors to pull out of investments and leave the economy in crisis.The act of stabilising an economy is a complex process involving effectively monitoring the potentially volatile variables of an economy. Wagner discusses economic stability as being created through strengthening domestic banking and financial systems providing better information and policy transparency strengthening corporate finance, including unsuccessful person laws and their implementation taking precautions against potential capital flow reversals and last but not least, building packages of sound macroeconomic and exchange rate policies22. A lthough the situation in South East Asia has improved over the years since the financial crisis, Low tells us that many questions still remain in Asia regarding their economic stability for the future, for example, whether effective democratic checks-and-balances in the political system, legal, judicial and institutional processes can help reinforce the moral economy23. It is fare to say that controlling inflation is but the tip of the ice burg when stabilizing a developing nations growth.ConclusionInflation and economic instability are a common problem for low developed countries trying to establish themselves in global markets. Inflation and currency depreciation are thoroughgoing signals to wealthier nations that a local market is too big a risk to invest in thus leaving development and growth dead(a) in those countries. Price stability on the other hand can signal to potential investors that a local financial market has fast monetary policy, that exchange rates can be control led and that the local personal credit line environment is encouraging to growth. Countries with unstable monetary policy are vulnerable to speculative attacks from market participants as can be seen in the case of the Asian Financial crisis. Pegging local currencies to stronger currencies such as the United States dollar can result in devastation if markets forecast a currency will be overvalued. Contagion can result in a chain reaction of events that brings trading partners into similar financial crisis. Although devaluing a currency can make exports more attractive on foreign markets it can also discourage foreign direct investment from investing due to the high incidence of default on foreign debt.Mechanisms have been knowing to control factors such as inflation and encourage foreign investment by richer nations. A floating currency or a currency board can be used effectively to stabilise exchange rates and thus control the flow of funds in and out of a local market. Good corp orate governance including transparency of monetary policy can be used to reduce the risk of speculation and forecast inflationary activity. Political stability also needs to be created through effective regulatory systems on financial and capital markets including bankruptcy laws and laws preventing capital flight in the face of financial crisis.Reference incliningArsoy, A.P, Crowther, D (2008) Corporate Governance in Turkey Reform and Convergence, complaisant Responsibility ledger, vol.4, iss.3 pp.407-422Boyd, D Smith, R (2006) pecuniary Regimes and Inflation in 12 Caribbean Countries, Journal of Economic Studies, vol.33, iss.2, pp.96-108Chakraborty, D (1999) Macroeconomic conditions and Opening Up Argentina, chili pepper and India A Comparative Study, planetary Journal of neighborly Economics, vol.26, iss.1/2/3, pp.298 -311Cheng, M.U. Tan, H.B. (2002) Inflation In Malaysia, International Journal of Social Economics, vol.29, iss.5, pp.411-426Ferreira, H Filho, J.S (2007) Economic Transparency and Effectiveness of Monetary Policy Journal of Economic Studies, vol.34, iss.6, pp.497-515Krugman, P.R. Obstfeld, M. (2005). International political economy Theory and policy (7th ed.). Boston Addison-Wesley LongmanLee, J.Y. (2007) Foreign Portfolio Investors and Financial Sector stability in Asia, Asian Survey, vol.47, iss.6 pp.850-871Low, L (2006) A Putative East Asian Business Model, International Journal of Social Economics, vol. 33, no.7 pp. 512-528Maskooki, K (2002) Mexicos 1994 peso Crisis and its Aftermath, European Business Review, vol.14, no.3, pp.161-169Nsouli, S.M Rached, M Funke, N (2005) The Speed of Adjustment and the Sequencing of Economic Reforms Issues and Guidelines for Policy Makers, International Journal of Social Economics, vol.32, no.9, pp.740 766Shamsul, A Shyam, A Kamath, J (1986) Models and Forecasts of Inflation in a Developing Economy, Journal of Economic Studies, vol.13, iss.4, pp.3-30Wagner, H (2005) Globalisation and Financia l Instability Challenges for Exchange set out and Monetary Policy, International Journal of Social Economics, vol. 32, iss.7, pp.616-639.1Footnotes1 Krugman, P.R. Obstfeld, M. (2005). International economics Theory and policy (7th ed.). Boston Addison-Wesley Longman.2 Shamsul, A Shyam, A Kamath, J (1986) Models and Forecasts of Inflation in a Developing Economy, Journal of Economic Studies, vol.13, iss.4, pp.3-303 Chakraborty, D (1999) Macroeconomic conditions and Opening Up Argentina, Chile and India A Comparative Study, International Journal of Social Economics, vol.26, iss.1/2/3, pp.298 -3114 Chakraborty (pp.298 311)5 Chakraborty (pp.298 311)6 Krugman et al (pg.615)7 Cheng, M.U. Tan, H.B. (2002) Inflation In Malaysia, International Journal of Social Economics, vol.29, iss.5, pp.411-4268 Krugman et al (pg.623)9 Ferreira, H Filho, J.S (2007) Economic Transparency and Effectiveness of Monetary Policy Journal of Economic Studies, vol.34, iss.6, pp.497-51510 Wagner, H (2005) Gl obalisation and Financial Instability Challenges for Exchange Rate and Monetary Policy, International Journal of Social Economics, vol. 32, iss.7, pp.616-639.11 Wagner (pp.616-639)12 Boyd, D Smith, R (2006) Monetary Regimes and Inflation in 12 Caribbean Countries, Journal of Economic Studies, vol.33, iss.2, pp.96-10813 Wagner (pp.616-639)14 Maskooki, K (2002) Mexicos 1994 Peso Crisis and its Aftermath, European Business Review, vol.14, no.3, pp.161-16915 Arsoy, A.P, Crowther, D (2008) Corporate Governance in Turkey Reform and Convergence, Social Responsibility Journal, vol.4, iss.3 pp.407-42216 Krugman et al (pg. 634)17 Nsouli, S.M Rached, M Funke, N (2005) The Speed of Adjustment and the Sequencing of Economic Reforms Issues and Guidelines for Policy Makers, International Journal of Social Economics, vol.32, no.9, pp.740 76618 Krugman et al (pg.620)19 Krugman et al (pg. 623)20 Lee, J.Y. (2007) Foreign Portfolio Investors and Financial Sector Stability in Asia, Asian Survey, vol. 47, iss.6 pp.850-87121 Krugman et al (pg.622)22 Wagner (pp.616-639)23 Low, L (2006) A Putative East Asian Business Model, International Journal of Social Economics, vol. 33, no.7 pp. 512-528