1. PARMESHWAR RAMLOGAN IMF RESIDENT REPRESENTATIVE 17 TH MAY 2010 1 Inflation: Causes, Dynamics, and Consequences

2. Organization of the Presentation 2 The “Evils” of Inflation  Inflation harms economic growth  Inflation increases poverty and income inequality  Inflation generates financial instability Causes and Dynamics of Inflation  International price shocks  Autonomous wage increases  Domestic supply shocks  Excess demand  Inflationary Expectations The International Shift To Inflation Targeting

3. Inflation Harms Economic Growth 3 International Experience  Low and stable inflation promotes economic growth.  There is a threshold rate above which inflation reduces economic growth.  The threshold inflation rate is low: single digits, even low single digits.  The negative effect on growth is highest just after the threshold is crossed, and tapers off as the inflation rate increases.

4. Inflation Harms Economic Growth 4 Experience of Mongolia  In light of international experience, the inflation outlook for Mongolia is disturbing. Inflation could reach – percent in 2010.  Such a high inflation rate would seriously damage Mongolia’s economic growth prospects.

5. Why Does Inflation Harm Economic Growth? 5 Reduces consumption. Reduces investment.  Negative real interest rates lower saving.  Uncertainty about future inflation increases the riskiness of long-term financial contracts and investment plans. Reduces external competitiveness through real exchange rate appreciatio n. Generates financial instability.

6. Inflation Increases Poverty and Income Inequality 6 International Experience  Inflation increases poverty levels and rates.  Inflation can cancel out the positive effect of economic growth on poverty. That is, higher economic growth does not reduce poverty if it is accompanied by higher inflation. Countries may be better off with low growth and low inflation than with high growth and high inflation.  Clear policy implication: Any policy measure to reduce poverty may be self-defeating if it raises the inflation rate.

7. Why Does Inflation Increase Poverty and Inequality? 7 Inflation affects households unequally. Inflation has the biggest impact on the real income and consumption of the poor. Why?  The income of the poor is not indexed, or not fully indexed, to inflation.  Savings of the poor are more likely to be in cash or unhedged instruments.

8. 8 Inflation may provoke currency and banking crises. How?  Inflation leads to dollarization, capital flight, and deterioration of the trade balance  These lead to pressures on the currency to depreciate.  Expectations of depreciation may result in a speculative attack on the currency.  The currency crisis may lead to a banking crisis because of:  Currency mismatches on banks’ balance sheets  Rising non-performing loans of firms due to increased debt service costs  Capital flight may lead to run on bank deposits Inflation Generates Financial Instability

9. Causes and Dynamics of Inflation 9 International Price Shocks  Example: International fuel and food price increases in 2008  Impacts directly on consumer price index or indirectly via production costs.  Impact may be magnified by subsequent currency depreciation.

10. Causes and Dynamics of Inflation 10 Autonomous wage increases  Wage increases not stemming from, or in excess of, prior inflation  Wage increases in excess of productivity increases, usually stemming from demonstration effects  Leads to a wage-price spiral

11. Causes and Dynamics of Inflation 11 Domestic supply shocks  Example: Current meat price increase in Mongolia due to the dzud.  Inflationary impact depends on the policy response.

12. Causes and Dynamics of Inflation 12 Excess demand  Domestic demand too high relative to the production capacity of the economy  Acts directly on prices of locally-produced goods or indirectly on prices of imports through currency depreciation  Major source is excessive government spending financed by money creation  Sources of inflationary financing: (1) revenue shock in the mineral sector in Mongolia, (2) the central bank, or (3) external borrowing  Assumption: no central bank sterilization

13. Causes and Dynamics of Inflation 13 Inflationary Expectations  Public expectations of inflation generate behaviour that feeds back onto the inflationary process. Inflation becomes a self- generating process.  Examples: indexation of wage contracts, capital flight.  Sources of inflationary expectations:  Past history of inflation. History of high inflation can lead to inflation inertia.  Inflationary fiscal and monetary policies.  Lack of credibility of the central bank

14. The International Shift Toward Inflation Targeting 14 More and more countries are using inflation targeting to anchor inflationary expectations. Core elements of inflation targeting:  Set a target inflation or inflation range  Communicate that target clearly to the public  Do everything possible to achieve that target or target range Currently 26 countries have formally adopted inflation targeting. Including major copper producers such as Chile, Peru, Australia, Indonesia, and Canada (Table). Inflation targeters appear to have achieved better macroeconomic performance than non-targeters (Charts).

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