CFA 1

The Macroeconomic Environment Inflation and Monetary Policy

- Inflation
o The increase of the general price level over a period of time
 Leading to a decrease in purchasing power
o CPI – Fixed basket of goods
 Weighted average cost of a market basket of consumer goods and
services
o Keynesian theory
 In the long run we are all dead
 The market can stay irrational longer than you can stay solvent
 True inflation begins when the elasticity of supply of output in
response to increase in money supply has fallen to zero or when
output is unresponsive to changes in money supply
 In a state of full employment, conditions will be inflationary, if there is
an increase in money supply
 Coulbom: too much money chasing too few goods
 Over the long haul, prices generally increase
o States of the economy
 Deflation
 A period of decreasing general level of prices, where the
purchasing power increased
 Price stability
 When an economy experiences no inflation (0%)
 Hyperinflation
 Extreme inflation where there is a 3-digit percentage point
increases in price annually
 Stagflation
 Where a high level of unemployment and inflation occurs
simultaneously
o Types of inflation
 Low inflation
 Rises slowly and predictability
o i.e. single-digit annual inflation rates
 When prices are stable, people trust money
o Willing to hold onto money because it will be almost as
valuable in a money or a year as it is today
 Most industrial countries have experienced low inflation over
the last year
 Galloping inflation
 In the double or triple digit range of 20, 100 or 200 percent a
year
 From time to time advanced industrial countries suffer from
this
 Contracts are indexed to a price index or to a foreign currency,
like the dollar
 o Money loses it value quickly, so people hold onto the
bare minimum amount needed for daily transactions.
o Financial markets wither away, as capital flees abroad
 Hyperinflation
 Nothing good about it
 Prices rise a million or trillion percent per year
 Common features of hyperinflation
o Real demand for money falls drastically
o Relative prices become highly unstable
o Huge variation in relative price and real wage
 Five bad cases
o Greece (1944)
 Post WW2 was 18% every day
o Germany (1923)
 Post WW1
 Every 3. Days prices doubled @ 29500%
o Yugoslavia (1994)
 Inflation was 313m%
 Every 34 hours prices doubled
o Zimbabwe (2008)
 Prices doubled everyday
 79 Billion %
o Hungary (1946)
 13.7 quadrillion % per month
 Prices doubled every 15 hours
o Sources of inflation
 Demand-pull inflation (over demand)
 Increase in demand for resources
o From government/entrepreneurs/households
 That cannot be met by the available supply
o Too much money chasing too few goods
 Cost-push inflation (no output)
 No increase in aggregate output
o But prices still rise because wages/salaries rise
 Inflation that is created from high prices imposed by produces
o By raising costs, prices are pushed up
 Increase demand due to
 Increase in money supply
 Increase in disposable income
 Increase in community’s aggregate spending
 Excessive speculative and tendency to hoarding and
profiteering on the part of producers and traders
 Increase in foreign demand and hence exports
 Increase in wages/salaries
 Increase in population
 No corresponding increase in output, due to
  Deficiency of capital equipment
 Scarcity of other complementary factors of production
 Speculative hoarding by the producers, traders, middlemen in
anticipation of a further rise in price
 Drought/famine or other natural disasters adversely affecting
agricultural production and prolonged industrial unrest
resulting in reduction of industrial production
 Impact of inflation on income and wealth
 If you owe money, a rise in prices is a windfall again
o You borrow 1m to buy a house
o Interest rate is fixed and is 100k pa
o Extreme inflation doubles all income/earnings
o Nominal mortgage is still 100l per year, but the real
cost is halved
o Need to work only half as long as before to make your
mortgage payment
 Alternatively
o Lender who gave a loan of 1m
o Inflation raises the price leaving you in a poorer
position
o Money repaid to you is worth less than the money you
lent out
 Therefore
o People tend to anticipate inflation and market adapt
o Allowances for inflation are therefore built into the
market interest rate
 The cost of stopping inflation
 Increase interest rates
 Increase taxes
 Minimum salary increases
 How to calculate inflation
 CPI
o A measure of inflation by the weighted average prices
of a cluster of industries related to an urban household
 PPI – producer price index
o A measure of price change from an index of domestic
products, not important to economies that rely on
industries other than manufacturing
 ((B-A)/A)x100
o ((CPI y2 – CPI y2)/CPI y1) x100
 Is inflation good or bad
 Anticipated inflation
o Effects are not too bad
o Workers can negotiate wage increases as prices rise
o Banks can charge interest rates to better fit the state of
the economy
  Unanticipated inflation
o Creditors do worse and debtors do better
o Consumers and companies not as willing to spend as it
hurts the economy and GDP
o Those relying on fixed-income
 Such as pensions
 Like retirees, lose buying power and
experience lower living standards
o Domestic products may become less competitive
- Compound Interest
o The most powerful force in the universe
 1% - 72 years
- Interest Rates
o Neoclassical interest rate theory
 Determined by the supply of and demand of loanable funds
 The function of money is to serve as medium of exchange
 If money supply grows faster than the economy, prices will increase
 i.e. inflation
o Post Keynesian Theory
 Determined by central banks as a key policy variable in pursuit of its
monetary policy objectives
- Short term interest rates
o Short term financial instruments
o Interbank market and operations of the SARB
o Established a desired money market shortage or level of borrowed reserves
o Cost of borrowed reserves provided by Banks accommodation rate
 i.e. the repo rate
o over draft rate
 linked to repo rate
o SARB creates money market shortage as it forces higher cost of capital on
banking system and banks are coerced (not forced) to adjust their prime
overdraft rates in proportion to increase in the repo rate to maintain
profitability
- Who determines the interest rate
o The SARB is the monopoly supplier of reserves to the banking system
o Therefore, in high inflation, SARB will likely raise interest rates
o The SARB can’t control the economy, but rather, responds to the state of the
economy
o And, the SARB cant control the rate of interest on all credit instruments
- Monetary Policy
o SARB aims to keep inflation within a target range of 3-6%
- Exchange Rates
o Widely accepted fundamental theory
 If an economy raises its interest rates, its currency will strengthen,
because the higher interest rates attracts more foreign investor flows
to take advantage of this higher return
 So when SARB increases interest rates (or US decreases
interest rates), the ZAR should strengthen against the US$
o But what really happens