Resolving High Inflation

I have observed that the government is implementing monetary and fiscal decisions in an effort to reduce high inflation. However, despite these measures being applied for several years, there has been no significant change in the inflation rate. It is important to understand that inflation is influenced by various factors, and each factor requires a specific remedy. Therefore, I have compiled a list of several factors contributing to high inflation and their corresponding remedies:

1. Increase in Money Supply: 

• When there is an excessive increase in the money supply in an economy, it can lead to high inflation. This can happen through various means such as central bank policies, government deficit spending, or excessive credit creation by commercial banks.
• Remedy for high inflation due to increase in money supply:
• Implement tight monetary policy by the central bank, such as raising interest rates or reducing the availability of credit.
• Strengthen banking regulations to control excessive credit creation.
• Improve transparency and accountability in monetary policy decisions.

2. Demand-Pull Inflation: 

• High inflation can occur when there is a significant increase in aggregate demand for goods and services in an economy, surpassing the available supply. This can happen due to factors like increased consumer spending, investment, or government expenditure.
• Remedy for demand-pull inflation:
• Implement contractionary fiscal policies, such as reducing government spending or increasing taxes, to reduce aggregate demand.
• Use monetary policy tools, like increasing interest rates, to curb excessive borrowing and spending.
• Encourage savings and investment to divert funds from consumption.

3. Cost-Push Inflation: 

• When there is a rise in production costs, such as labor, raw materials, or energy prices, it can lead to cost-push inflation. Businesses may pass on these increased costs to consumers through higher prices, resulting in inflationary pressures.
• Remedy for cost-push inflation:
• Address underlying factors contributing to cost increases, such as labor market reforms or reducing trade barriers for essential inputs.
• Promote competition to keep prices in check and prevent businesses from passing on all cost increases to consumers.
• Provide targeted subsidies or tax breaks to industries facing significant cost pressures.

4. Imported Inflation: 

• If a country heavily relies on imports and the value of its currency depreciates, the cost of imported goods and raw materials can rise. This increase in import prices can contribute to inflation.
• Remedy for imported inflation:
• Focus on stabilizing the exchange rate through appropriate monetary and fiscal policies.
• Promote domestic production and reduce reliance on imports through industrial development initiatives.
• Diversify import sources to mitigate the impact of currency fluctuations.

5. Exchange Rate Fluctuations: 

• When a country's currency depreciates in relation to other currencies, it can lead to higher inflation. This is because it becomes more expensive to import goods and services, and prices of imported goods tend to rise.
• Remedy for high inflation due to exchange rate fluctuations:
• Use appropriate monetary policy measures to stabilize the currency.
• Build foreign exchange reserves to intervene in the market when necessary.
• Implement structural reforms to enhance competitiveness and reduce reliance on imports.

6. Inflation Expectations: 

• If people expect prices to rise in the future, they may adjust their behavior by demanding higher wages or increasing prices for goods and services. These expectations can become self-fulfilling, driving up inflation.
• Remedy for high inflation due to inflation expectations:
• Communicate clear and credible monetary policy objectives and strategies to manage inflation expectations effectively.
• Maintain price stability as a primary goal of monetary policy.
• Use forward guidance to signal future policy actions and manage inflation expectations.
• Strengthen central bank independence to maintain confidence in monetary policy decisions.
• Monitor and manage inflation expectations through surveys and public outreach programs.

7. Supply Chain Disruptions: 

• Disruptions in the supply chain, such as natural disasters, conflicts, or trade restrictions, can lead to shortages of goods and services. When supply falls short of demand, prices tend to rise, causing inflationary pressures.
• Remedy for high inflation due to supply chain disruptions:
• Enhance disaster preparedness and risk management strategies.
• Diversify supply sources and develop local production capabilities.
• Improve infrastructure and logistics to ensure smooth supply chain operations.

8. Government Policies and Regulations: 

• Government policies, such as excessive taxation or regulations that hinder competition, can increase production costs and limit supply, leading to inflationary pressures.
• Remedy for high inflation due government policy and regulations:
• Evaluate and streamline regulations that hinder competition and increase production costs.
• Implement pro-growth policies, such as tax reforms and investment incentives, to stimulate supply and increase productivity.
• Enhance transparency and efficiency in government spending to reduce fiscal deficits.

9. Speculative Activities: 

• Speculative bubbles in asset markets, such as real estate or stocks, can lead to an increase in prices beyond their fundamental value. When these bubbles burst, it can cause significant economic disruptions and inflationary effects.
• Remedy for high inflation due to speculative activities:
• Implement effective financial regulations and supervision to detect and prevent asset bubbles.
• Enhance market transparency and improve investor education to discourage excessive speculation.
• Use macroprudential measures, such as higher margin requirements or loan-to-value ratios, to curb speculative activities in asset markets.

Identifying the exact cause of the current high inflation requires a thorough analysis of the specific economic conditions. Once the root cause is determined, the appropriate remedy can be applied to achieve lower inflation. It is essential for policymakers to carefully assess the situation and implement targeted measures accordingly.

Aligning Exchange Rates to Economic Fundamentals

In this blog post(AI generated), I will discuss how to align the exchange rate to economic fundamentals without devaluation or adopting a flexible exchange rate regime. This is a challenging task for many countries that face external imbalances, inflationary pressures, or financial instability.

The exchange rate is the price of one currency in terms of another. It reflects the relative demand and supply of different currencies in the global market. Economic fundamentals are the underlying factors that determine the equilibrium exchange rate, such as productivity, trade balance, fiscal policy, inflation, and interest rates.

One approach to align the exchange rate to economic fundamentals is to use the Fundamental Equilibrium Exchange Rate (FEER) method. This method involves calculating the real exchange rate that equates the current account at full employment with sustainable net capital flows. The FEER is the exchange rate that would prevail if the economy were operating at its potential output and external balance. If the actual exchange rate deviates from the FEER, it implies that the currency is overvalued or undervalued.

To explain the FEER method more, let me use an example. Suppose a country has a current account deficit of 5% of GDP and a potential output growth of 3%. The FEER method would estimate the real exchange rate that would reduce the current account deficit to a sustainable level, say 2% of GDP, given the potential output growth. This would require a depreciation of the real exchange rate to make the country's exports more competitive and imports more expensive. The FEER method would also take into account the net capital flows that are consistent with the desired current account balance and the intertemporal budget constraint of the country.

Another approach to align the exchange rate to economic fundamentals is to use the Behavioral Equilibrium Exchange Rate (BEER) method. This method involves estimating a reduced-form equation that relates the real exchange rate to a set of explanatory variables that capture the economic fundamentals. The BEER is the exchange rate that is consistent with the observed behavior of agents in the economy. If the actual exchange rate deviates from the BEER, it implies that there are temporary shocks or market imperfections that distort the exchange rate.

To explain the BEER method more, let me use an example. Suppose a country has a real exchange rate of 1.2 and a set of economic fundamentals such as productivity, trade balance, fiscal policy, inflation, and interest rates. The BEER method would estimate a regression equation that relates the real exchange rate to these variables using historical data. The equation would have a constant term and coefficients for each variable that measure their impact on the real exchange rate. The BEER method would then plug in the current values of these variables into the equation and obtain a predicted value for the real exchange rate, say 1.1. This would indicate that the actual exchange rate is overvalued by 0.1 compared to the BEER.

Both methods have advantages and disadvantages. The FEER method is normative and prescriptive, as it reflects what the exchange rate should be rather than what it is. The BEER method is positive and descriptive, as it reflects what the exchange rate is rather than what it should be. The FEER method requires more assumptions and judgments about the potential output and sustainable net capital flows. The BEER method requires more data and econometric techniques to estimate the equation.

To align the exchange rate to economic fundamentals without devaluation or adopting a flexible exchange rate regime, a country needs to adjust its macroeconomic policies and structural reforms to influence the demand and supply of its currency. For example, a country with an overvalued currency can reduce its fiscal deficit, increase its domestic savings, promote its exports, diversify its production structure, and liberalize its capital account to increase the demand for its currency and reduce its supply. A country with an undervalued currency can increase its fiscal spending, reduce its domestic savings, stimulate its imports, upgrade its technology level, and regulate its capital account to reduce the demand for its currency and increase its supply.

Aligning the exchange rate to economic fundamentals without devaluation or adopting a flexible exchange rate regime is not easy or quick. It requires coordination and consistency among different policy instruments and objectives. It also depends on the external environment and the reactions of other countries. However, it can help a country achieve a more stable and sustainable macroeconomic performance in the long run.

On Forex Mismatch

I want to share my thoughts on the article “Forex mismatch widens year after devaluation” published on the Nation website on 30th May 2023.

The article reports that there is a huge gap of K514 between the official exchange rate of the kwacha and the bank rate, especially the cash rate. I would like to suggest that this gap cannot be solved by devaluation because it is not caused by demand but by the costs and profits for the banks and parallel market forex traders. This is what one of them told me when I asked about the reason for the gap. Our policymakers need to understand this, otherwise, they will keep devaluing the kwacha but never achieve a narrow gap.

When economists see that demand is high, they usually increase the commodity's price. In the case of currencies, increasing the price means devaluing the currency.

But let's compare this to goods in a wholesale and retail setting. When the wholesale price goes up, the retail price also goes up because the retailer wants to keep his profit margin and cover his costs.

In the case of forex trade, the Reserve Bank rate is like the wholesale price and the bank rate is like the retail price. The gap, which is due to costs and profits, cannot be reduced by devaluing the currency more. If the Reserve Bank wants to reduce this gap, it has to limit the profit margin that the banks and parallel market can make from forex trade.

So, in my opinion, the gap of K514 mentioned in the article can be reduced not by further devaluation, but by regulating the profit margin of the banks and parallel market.