Economics management study help on: Inflation rate in Zimbabwe

Q1. Describe the money growth rate and the inflation rate in Zimbabwe since 2000. How do we know that Zimbabwe’s reported inflation between 2003 and 2007 is almost certainly below the true inflation rate?Ans1. Money growth and inflation paths started to diverge from late 2003. Inflation soared from about 20 percent in December 1997 to a peak of 623 percent in January 2004, but decelerated sharply from March to around 130 percent at end-2004. Broad money growth, however, started decelerating only in July 2004 from over 400 percent at end-2003 to some 130 percent by end December 2004.

This is contrary to the experience under recent stabilization efforts in most countries, where inflation inertia has been evident. That is, inflation lags—rather than leads— the decline in money growth because price and wage expectations are likely to be based, at least partly, on the past behavior of inflation and because expectations of the future stance of monetary policy are likely to react slowly to shifts in the observed rates of money growth.

Accordingly, changes in the rate of monetary expansion would be slow to translate into changes in the rate of inflation. Further, a significant monetary tightening might not be perceived as credible until well into the stabilization program. By contrast, prices in Zimbabwe appear to have responded to factors other than just changes in monetary policy.Despite a depreciation of the parallel market exchange rate in 2004, the demand for real

balances increased. The parallel exchange rate appreciated in early 2004 as a result of the introduction of a managed foreign exchange tender system and a clamp down on the parallel market, where the bulk of foreign exchange transactions was taking place in 2003. However, the tender rate depreciated only moderately for the rest of the year, despite a growing gap between demand and supply in the tender. As a result, the parallel market resurfaced with a rapidly depreciating exchange rate. Real money balances, however, continued to increase despite the continuous depreciation of the parallel exchange rate

Q2. What features of the Zimbabwe’s economy provides a view of the cost of hyper-inflation?Ans2. Hyperinflation in Zimbabwe began shortly after destruction of productive capacity in Zimbabwe’s civil war and confiscation of white-owned farmland. Food output capacity fell 45%, manufacturing output 29% in 2005, 26% in 2006 and 28% in 2007, and unemployment rose to 80%. During the height of inflation from 2008–09, it was difficult to accurately account and monitor for Zimbabwe’s hyperinflation because the government of Zimbabwe stopped filing official inflation statistics. This cessation in filing made it difficult to accurately observe how severe inflation was in the country. In 2009 Zimbabwe abandoned its currency; at present in 2012 a new currency has yet to be introduced, so currencies from other countries are used.

Impacts on Neighboring Countries

Zimbabwe’s neighbors have swung between patience and intolerance, as well as delight and dismay, at the antics of their once-prosperous trading partner. During periods of severe exchange rate distortions, price controls, or heavy subsidies, Zimbabwe became the cheapest supply source for food, fuel, and consumer goods, attracting shoppers by the thousand. But after the government’s policies closed down many Zimbabwean producers, the busloads of shoppers all moved in the opposite direction and many border towns in neighboring countries began to thrive on the trade.However, the downside for all of Zimbabwe’s neighbors has been the loss of jobs to better-trained Zimbabwean competitors. Estimates place the number of Zimbabweans now working abroad in the region at several million, with perhaps one million more working overseas. While these skills have undoubtedly improved the economic growth rates of all Zimbabwe’s neighbors, their presence is still resented in their host countries, even by those who have jobs but who feel that their promotion prospects have been damaged by the arrivals of skilled workers. People in this category include hundreds of doctors, nurses, engineers, accountants, and thousands of teachers and factory workers with experience in textile mills, clothing and shoe factories, food processing, and light engineering. Zimbabwe has also lost skilled people from the power stations, the railways, airways, and telephone and municipal services.

Abandoning the Zimbabwe Dollar

As soon as the government decided that it could print its way out of its difficulties, the Zimbabwe dollar was placed on a self-destructive course. The more the government printed, the less the money was worth, resulting in twenty-five zeros having to be removed from the notes between August 2006 and February 2009. By then, nobody wanted the money, so it had to be abandoned.

This happened over the course of a few months, and started with people illegally offering or asking for US dollars in exchange for goods. Ultimately, the government legalized the transactions, since even its officials could not buy what they wanted using Zimbabwe dollars. The civil servants and the military were refusing to accept Zimbabwe dollars for payment of salaries.The government has struggled to find US dollars with which to pay its employees. External loans have been reluctantly provided after lengthy debates, but each new month has presented new challenges. The government’s former practice of taking a percentage of foreign earnings in exchange for Zimbabwe dollars has had to be abandoned since the collapse of the Zimbabwe dollar and the use of Statutory Reserves taken from the banks has come to an end. The government is still waiting for companies to become profitable so that it may start collecting profits taxes, while the Pay-As-You-Earn personal taxes, import duties, and value-added taxes are building up so slowly that the amounts collected are still falling very short of the government’s wage bill.

Q3. What policy changes would address Zimbabwe’s inflation problem? Explain. 

Ans3. Some of the policy changes which would address inflation problem in Zimbabwe have been discussed as under:

Þ    Monetary Policy

Monetary policy refers to a tool which would help to control the rising inflation in Zimbabwe. With the help of the monetary policy, the central bank at Zimbabwe would keep their lending rates a bit low as compared to the normal lending rate practiced by the same. The low inflation rate would be termed as one of the most dangerous aspects for the economy. The lending rate would be approximately 2%-3% as compared to the normal rate i.e. 2%-6%.

There are a number of methods that have been suggested to control inflation. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.

Monetarists emphasize keeping the growth rate of money steady, and using monetary policy to control inflation (increasing interest rates, slowing the rise in the money supply). Keynesians emphasize reducing aggregate demand during economic expansions and increasing demand during recessions to keep inflation stable. Control of aggregate demand can be achieved using both monetary policy and fiscal policy (increased taxation or reduced government spending to reduce demand).

Redistribution: Inflation will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and profits which may keep pace with inflation — any senior pensioner still receiving a couple of thousand Zimbabwe dollars being a clear example. Similarly, it will redistribute wealth from those who lend a fixed amount of money to those who borrow. For example, where the government is a net debtor, as is usually the case, inflation will reduce this debt by redistributing money towards the government. Thus inflation is sometimes viewed as similar to a hidden tax. This discourages savings and investment, the actual tax regime becomes impossible to calculate.

Fixed exchange rates:

Under a fixed exchange rate currency regime, a country’s currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.

Under the Bretton Woods agreement, most countries around the world had currencies that were fixed to the US dollar. This limited inflation in those countries, but also exposed them to the danger of speculative attacks. After the Bretton Woods agreement broke down in the early 1970s, countries gradually turned to floating exchange rates. However, in the later part of the 20th century, some countries reverted to a fixed exchange rate as part of an attempt to control inflation. This policy of using a fixed exchange rate to control inflation was used in many countries in South America in the later part of the 20th century (e.g. Argentina (1991-2002), Bolivia, Brazil, and Chile).

International trade: If the rate of inflation is higher than that abroad, a fixed exchange rate will be undermined through a weakening balance of trade, and forex shortage will set in.

Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank or hours spend trying to access cash). Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.