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Friday, March 29, 2024

Inflation is toxic to your economic health

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There is no mystery about the cause of inflation. Like other commodities, the value of money is determined by supply and demand. When the supply of money is constant or increases at a slow, steady rate, the purchasing power of money will be relatively stable. In contrast, when the supply of money expands rapidly compared to the supply of goods and services, the value of money declines and prices rise. This is inflation. It occurs when the government prints money or borrows from the central bank in order to pay its bills.

Politicians often blame inflation on such scapegoats as greedy businesses, the tax reform law, infrastructure spending, oil prices, or foreigners. But this is a diversionary tactic. Persistent inflation has a single source: rapid growth in the supply of money. The nation’s money supply is its currency, checking accounts, and savings accounts held by individuals and businesses. When that supply increases faster than the growth of the economy, the prices of goods and services will rise.

The Philippines’ money supply grew 25,600 percent from P14.6 billion in 1978 to P3.8 trillion in 2018—a compound annual growth rate of 15 percent and faster than the growth of the economy. The inflation rate during the same period averaged 8.8 percent, including the 6.4 percent inflation rate recorded last month.

Countries that increase their money supply at a slow annual rate (5 percent or less) experience low rates of inflation. This is true for large high-income countries like the United States and Canada, as well as for smaller ones like Singapore and Sweden, and poor ones like the Central African Republic.

When the growth rate of the money supply of a country expands more rapidly, however, the inflation rate accelerates. The money supply in Nigeria, Uruguay, Malawi, Ghana, the Russian Federation, Romania, and Turkey grew at an annual rate between 20 percent and 50 percent. These countries experienced annual inflation rates similar to their rates of monetary growth.

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Extremely high rates of monetary growth (100 percent and above) led to hyperinflation in Ukraine, Zimbabwe, and Venezuela. As the growth of the money supply in these countries soared, so too did their rate of inflation.

There is a close relationship between rapid monetary expansion and high rates of inflation when measured over lengthy time periods. Historically, this linkage has been one of the most consistent relationships in all of economics.

Countries with high rates of inflation nearly always have wide fluctuations in the inflation rate. High and variable rates of inflation undermine prosperity. When prices increase 20 percent one year, 50 percent the next year, 15 percent the year after that, and so on, individuals and businesses are unable to develop sensible long term plans. The uncertainty makes the planning and implementation of capital investment projects risky and less attractive. Unexpected changes in the inflation rate can quickly turn an otherwise profitable project into a personal economic disaster. Rather than dealing with these uncertainties, many decision makers will simply forgo capital investments and other transactions involving long term commitments. Some will even move their business and investment activities to countries with a more stable environment. As a result, potential gains from trade, business activities, and capital formation will be lost.

Moreover, when the government pursues inflationary policies, people will spend less time producing and more time trying to protect their wealth. Because failure to accurately anticipate the rate of inflation can devastate one’s wealth, individuals will shift scarce resources away from the production of goods and services and toward actions designed to hedge against inflation. The ability of business decision makers to forecast changes in prices becomes more valuable than their ability to manage and organize production. When the inflation rate is uncertain, businesses will shy away from entering into long term contracts, place many investment projects on hold, and divert resources and time into less productive activities. Funds will flow into the purchase of gold, silver, and art, in the hope that their prices will rise with inflation, rather than into more productive investments such as buildings, machines, and technological research. As resources move from more productive to less productive activities, economic progress slows.

Economic progress will also be undermined when monetary policy makers are shifting between monetary expansion and contraction. When the monetary authorities expand the money supply rapidly, the more expansionary monetary policy will initially and generally push interest rates downward, stimulating current investment and creating an artificial boom. However, the boom will not be sustainable. If the expansionary monetary policy continues, it will generate inflation, which will cause policy makers to shift toward a more restrictive policy. As they do so, interest rates will rise, which will impede private investment and throw the economy into a recession. Thus, monetary shifts from expansion to restriction will generate economic instability, jerking the economy back and forth between booms and busts. This pattern of monetary policy will also create uncertainty, slow private investment, and reduce the rate of economic growth.

Monetary stability is an essential ingredient of the environment for economic progress. Without monetary stability, potential gains from capital investment and other exchanges involving time commitments will be eroded and the country’s people will fail to realize their full potential.

eric.jurado@gmail.com

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