azils Experience with Hyperinflation

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Growth and Industrialization were the main goals ofazils policy makers until the 180s. In the early 80s to mid 10sazil experienced a high rate of inflation. This extraordinarily high rate of inflation is what is known as hyperinflation.azils policy makers now had to divert their attention to curbing this new enemy. What was the performance of the nations economy before, during, and after the crisis? What were the political and economic events that contributed to the crisis and how did the government react to correct these problems?

azil has a history of economic growth even amidst inflation. Political instability and economic stagnation led to the overthrow of the government in 164 and a period of military rule that would last until 185. The new government implemented a stabilization and adjustment program that accelerated growth between 167 and 17. The government was instrumental in economic development amidst the oil shock of 17 by undertaking infrastructure projects, stimulating private business through credit and fiscal incentives, and enlarging the realm of state-owned enterprises. Government overspending and the ability of many of the rich to avoid paying taxes helped lead toazils problems.azil was able to maintain high growth rates in the late 70s even amidst unfavorable international conditions that negatively affected many growth rates in developed countries.azil had an average growth rate of 6.% from 174 to 180. The government ofazil was able to achieve this by increasing the availability of credit, which permitted continued inflow of resources to finance investment. This in turn helped to push inflation up and severely increased foreign debt.azils deficit rose from US$1.7 billion in 17 to US$1.8 billion in 180. This large deficit forcedazil to borrow heavily in the international financial market.azil was left very vulnerable to external conditions. When the second oil shock hit inflation rates rose andazil was forced to borrow just to meet its debt obligations. The intense borrowing pushed the foreign debt from US$6.4 billion in 17 to US$54 billion in 180. Then in 18 the Mexican foreign debt moratorium perpetuated the closure of the international credit market to Latin American countries. This causedazils government to accept that the debt crisis was a major concern. The country tried to combat this by reducing growth and thereby reducing imports and by expanding exports. As a result real GDP declined by 4.4%. As the economy declined, inflation increased. Then by the mid 80s domestic debt nearly displaced foreign debt asazils main economic problem.

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With an inadequate government, it became very clear that major fiscal reform was needed to fight inflation and restore the public sectors ability to invest. Total investment had dropped to under 18% of GDP. In 185 government control was handed over to civilian rule.

Tancredo Neves had negotiated the transition to a full democracy and had been elected president, but he died before taking office. Jose Sarney, vice president at the time was then sworn in as president. Sarney tried implementing various strategies to combat the economic problems of his country. The first plan was the Cruzado Plan in 186.The key measures of the Crazado plan were to implement a price freeze, a wage readjustment freeze, readjustment and freezes of rent and mortgage, a freeze of the exchange rate, and a ban on idexation. It had wonderful results, and the monthly rate of inflation lowered to almost zero, and growth increased. By the end of 186 the plan was beginning to show signs of failing. Wage adjustments were too large which led to increased aggregate demand, which pushed inflation upward. Also the price freeze was maintained too long which led to shortages in supply. If the government would have acted quickly, this plan might have been saved. This led to increased inflation and a return of indexation.

The next two plans, theesser Plan and the Sumner plan were aimed at controlling inflation. These plans failed due to public skepticism and a lack of political support in implementing policies. These failed plans and the lack of fiscal reform led to the gradual decline of credibility with the public. Lack of credibility would further push the effects of inflation. This lack of credibility also permeated into doubt about whether the government could service its debt and eventually repay the principal. The loss of credibility resulted in the shortening of terms and raising real interest rates. This cycle caused the government to go even further into debt. The effect of the debt also led to problems with monetary control. Included with short terms and high rates, the government forced the central banks to purchase bonds that could not find a home in the public market. This caused automatic increases in the money supply, which pushed inflation even higher. The poor in the country really paid the price. The cash they received was rendered almost worthless overnight. The middle class was able to escape this hyperinflation somewhat as they were able to place their money in indexed bank accounts that kept up with inflation somewhat. The indexing of the economy also played a role in the increased inflation by raising inflationary expectations.

With the government and the economy in shambles Sarney gave way to a new President. Fernando Collor de Mello was elected in 18. When Collor took office, the economy was in shambles, average GDP was 1.6% annually. A sizeable amount of the countrys growing public deficit was financed through the expansion of the money supply. Collor initiated taxation and a freeze on financial assets to reduce the liquidity and generate resources. Collor then attacked inflation through economic and public sector reform. Collor was able to decrease the deficit, he reduced internal debt, and he increased international reserves. His attempt to lower inflation failed, but he did make one important change. Collor slashed trade barriers and openedazils economy to the rest of the world. Collor then stepped down in 1 due to accusations of corruption.

Next came Itamar Franco. Under Franco inflation continued to rise at a rate of ,500% annually. With no end in site, Mr. Franco appointed Fernando Henrique Cardoso as his finance minister. Cardosa was not considered an economist, but he assembled a group of advisors who devised what is known as the "Real Plan". Unlike earlier plans, it did not depend on price and wage freezes to stop inflation.

The first phase of the Real Plan was the Immediate Action Program. This program focused largely on the underlying causes of inflation inazil.azil determined that their economy was fairly healthy in late 1 as there was an increase in exports, an increase in industrial productivity, and a positive change in GDP. Average GDP growth rates in the previous 10 years had been %. In 1 GDP increased by 4.% and unemployment decreased slightly to 5.%. It was deduced that the inflationary illness was caused by the financial and administrative disorder in the public sector. The effects of this disorder were a lack of money to pay for basic services and government investment, financial resources were lost due to waste, inefficiency, corruption, fraud, and payment defaults, and state bank indebtedness was out of control. This fiscal disorder made it impossible for the government to decide what the priorities were concerning expenditures. This chaos also made it impossible for the government to create a fiscal policy with the future in mind and thus made it impossible for the Central Bank to exercise an active monetary policy. This first plan dealt with these issues in order to achieve economic growth and pay down debt, although the country can only achieve growth if they defeat hyperinflation. This hyperinflation paralyzes investment, which negatively affects growth. Along with the budget cuts, revenue recovery, banking reform, privatization was also introduced. The government concentrated on the social programs and let go of the steel industry, petro-chemical and fertilizer companies. The government drove growth by funding these industries in the pre-hyperinflation era.

Once the Immediate Action Plan was implemented the next phase of the" Real plan "could go into effect. The plan was primarily focused on replacing the old currency with something known as a "Unit of Real Value". The "Real" as it was soon to be called was pegged to the dollar, which therefore restricted price rises for imported and tradable goods. This action resulted in the de-indexation of theazilian economy. The real actually appreciated against the dollar in the first year. Short-term stability and expectations of an eventual depreciation of the real led to greater mobility of financial capital with world markets. This led to a strong appreciation of the real and high domestic interest rates. Savers required high interest rates to help protect them against depreciation. This led to large inflows of foreign capital. This helped to finance the large inflows of imports spurned by the resurgence of economic growth. With a stable government, a stable monetary system, foreign capital, and renewed positive expectations,azils inflation began to decline. The" Real plan" worked, and by 16 the federal budget was significantly smaller and inflation declined. GDP rose to 6%, unemployment leveled to 5.1%, and inflation decreased to a manageable 1%.

Now that we have somewhat of an understanding of the crisis we can further concentrate on the macroeconomic variables and apply the data. From 165 to 17 inflation averaged 0 percent and the economy grew at an average rate of 5. percent. The unemployment rate remained stable at a natural rate of 4.7 percent. Stagflation and inflation started to incur in 181. GDP declined in 181,8,and 18. From 185 to 10 inflation averaged 856 percent and the economy grew at an average of 4.5 percent. Unemployment rose in the early 80s but returned to a more natural rate as fairly strong growth still persisted from 184 to 18. Then in 10 until the first installment of the "Real Plan", GDP fell, inflation skyrocketed and unemployment remained fairly high in accordance with the natural rate of around 5%. The economic data supports the fact that GDP and the rate of growth of GDP help push unemployment down.azil helped push GDP by investing in industry and through government spending. This helped keep employment up which fueled consumption.

The data also helps support the theory of Okuns law which states that a change in unemployment rate caused by growth of Real GDP can be predicted by taking the real GDP growth rate, subtracting and dividing that difference by . An example of this is proven by looking at the real GDP growth rate from 1 to 14. In 1 growth increased from 4.% to 6% in 14. Unemployment declined from 5.% in 1 to 5.1% in 14. This would imply that unemployment decreased as real GDP increases and that economic forecasts can be made in terms of the rates.

Another observation could be deduced by looking at inflation and unemployment. These two properties inversely affect each other in the short run. As inflation increases, the tradeoff is a decrease in unemployment. Inazil, inflation was out of control, yet unemployment was considered fairly under control. Inflation reached an annual rate of 500% in 1 and unemployment was 5.%. With hyperinflation so high, one would deduce that unemployment would be zero if these two conditions were proportionate. These variables do seem to move in opposite directions, but it is important to point out that the unemployment rate tends to move toward its natural rate in the long run and is cyclical around its natural rate in the short run, as accurately depicted by Milton Friedman and Edmund Phelps. Friedman and Phelps discounted the Phillips curve in determining the tradeoff between inflation and unemployment in the long run. This would accurately explain the conditions that persisted inazil in terms of the unemployment rate and inflation and prove that the long run Phillips curve is vertical.

azils political instability in the 80s also led to the increase in inflation and economic instability.azil was under military control until 185 in which a democratic government was established. Under military control,azil ran up the national debt and the new democratic government was ill equipped to deal with the problems arising in the economy. As mentioned earlier, the government was poorly run and lost credibility with its citizens and the rest of the world. The government had difficulties collecting tax revenue from its citizens and corporations. Capital flight didnt present as much of a problem as it would in other economies, asazil wasnt a true open economy. The instability of a sound democratic system, wasteful spending, and an overall fiscal nightmare played a big role inazils inflation crisis.

How can we explain the effects of indexation and increasing the money supply in terms of its effects on inflation and interest rates?azil tried to combat inflation through indexation, which caused the government to inject large amounts of money. The quantity theory of money asserts that the quantity of money available determines the price level and that the growth rate of money available determines the inflation rate.azil tried to stop this effect by implementing price freezes. This obviously did not work and inflation expectations prevailed and inflation spun out of control. The impact of the increased money supply pushed aggregate demand and fueled inflation. The increased inflation also pushed inflation expectations. The increased inflation expectations also had an effect on the economy in what is known as shoeleather costs. Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings. The time and effort wasted converting money into goods or another more stable unit of value. This resulted in lower productivity inazil. People packed banks and grocery stores in hopes of protecting their hard earned money. The increased inflation also affected the nominal interest rate. This can be explained by the Fisher effect.

The Fisher effect states that there is a one for one adjustment of the nominal interest rate to the inflation rate. The increased interest rate discourages investment by increasing the cost of borrowing, which decreases growth. The increased interest rate not only affects the market for loanable funds, but it also affects net foreign investment and the real exchange rate. They felt that increasing exports and limiting imports would help their economy. This can be reasoned by understanding that saving= investment + net foreign investment, and net exports = net foreign investment. This idea can be taken one step further and one would realize that net exports wouldnt increase because The Market for Loanable funds, NFI, and The Market for Foreign Currency are intertwined. Decreasing imports would increase the demand forazils currency, which in turn causes the real exchange rate to increase but net exports to remain the same. Domestic prices would increase relative to foreign goods and both imports and exports would decrease. Once the economy was completely opened up and tariffs were lightened, the Market for Foreign currency exchange shifted to an equiliium, which encouraged the flow of goods and services that benefitedazil and the rest of the world. The opening of the economy and the decentralization of many industries also led to an increase of direct foreign investment, which helped spark the economy.

The question is canazil continue to keep the economy on the right path? The honest answer is " nobody knows". The government believed that the future relied on defending the real against inflation and also in keeping it tied to the dollar. This is hard to defend becauseazil relies heavily on foreign capital. In order to protect the real in a bad economic run, interest rates would increase and a fiscal adjustment would have to be made in order to continue the inflow of foreign and domestic capital and prevent inflation and capital flight. The downside to this strategy is the unworldly high interest rates that would have to be implemented in order to keep the real tied to the dollar and fight off inflation in a bad economic run. The high interest rates would slow growth and move the economy towards recession. Eventually this plan would be scrapped and the real was allowed to float. The floating of the real leaves the prospect for future inflation, but it also leaves the ability for future prosperity and growth.

It is plain to see that inflation has many causes and symptoms that are intertwined in a web of illusion and chaos. It is important to remember that these conditions cannot be correctly dealt with by adjusting one variable in the economy. Inazils case a governmental and fiscal restructuring was needed before a solid inflation fighting strategy could be implemented. A solid foundation is needed in order to maintain long-term economic growth and stability. With a foundation in place the government can pinpoint and correct the variables that are leading the economy astray.azil has proven that they are a contender in the world economy.azil has won many victories in its fight against inflation. They have opened the economy to world trade, increased GDP, increased productivity, increased technology by privatizing many industries, and they have developed and administered a stable currency and an active monetary policy. The future definitely looksight forazil.

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