Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 4 Monetary Policy and Inflation

Inflation in Developing Countries

Inflation cycles in developing economies broadly resemble those in advanced economies. Inflation in the developing economies accelerated during the 1970s and the 1980s before moderating from the second half of the 1990s. The decline in the subsequent period has been dramatic. Inflation fell from 56 per cent in the first half of the 1990s to six per cent in 2000-03. The decline is widespread. In Latin America and the countries in transition, inflation has fallen from 230 per cent and 360 per cent, respectively, during 1990-94 to less than 10 per cent in 2003. Out of 184 members of the IMF, 44 countries had inflation greater than 40 per cent in 1992. In 2003, this number fell to three. At the same time, in terms of magnitude, the developing world is not a homogeneous group.

A key distinguishing feature of the developing world is their chronic fiscal deficits on account of low tax bases. Coupled with underdeveloped financial sector, high fiscal deficits increase the reliance of the governments in these economies on seigniorage revenues. The monetisation of government budget deficits fuels inflationary pressures, leading to a vicious nexus between fiscal deficits, money supply and inflation. More recent versions of the fiscal dominance theory suggest that high fiscal deficits can increase prices even without any increase in money supply - money supply adjusts to prices and not the other way around (Box V.3). The breakdown of the Bretton Woods system made it easier for the developing economies to explore seigniorage revenues in the 1970s and the 1980s until public apathy to inflation became an increasingly binding domestic constraint (IMF, 2002). Non-monetary factors - supply shocks due to the continued predominance of the agricultural sector - further complicate monetary management by blurring the role of demand side factors in the inflation process. Sharp devaluations in developing economies have often been fully transmitted to domestic prices which puts additional pressures on inflation. However, it may be noted that inflation hardly rose in Thailand, Indonesia and South Korea in the aftermath of the Asian crisis despite substantial devaluation of their currencies. In the case of transition economies, administered pricing as well as backward-looking wage indexation necessitated large adjustments in relative prices to catch up with free market prices at the demise of central planning.

An empirical analysis of 24 inflation episodes in 15 EMEs between 1980 and 2001 suggests that increases in output gap, agricultural shocks and expansionary fiscal policies raise the probability of inflation. A more democratic environment and an increase in capital flows (relative to GDP) reduce the probability of inflation starts. A reduction of one percentage point in fiscal deficit/ GDP ratio reduces inflation by 2-6 percentage points (Catao and Terrones, 2003). In order to reduce inflation, macroeconomic policies in developing economies during the 1980s and 1990s, therefore, focused on fiscal consolidation and structural reforms to provide monetary policy necessary flexibility in its operations. Indeed, fiscal deficits in EMEs are now less than half of their levels in 1970s and 1980s. Taken together with the earlier noted estimated impact of fiscal deficits on inflation, this suggests that inflation could have declined by 5-15 percentage points on account of the lower fiscal deficits (IMF, 2002).

Developing countries also benefited from lower import prices due to low inflation that had already been achieved in advanced economies. Openness to trade and liberalisation fostered competitive pressures which also contributed to lowering of inflation. Reduction or elimination of indexation of wage and financial contracts helped to reduce inflation inertia. Finally, as in advanced economies, improvements in the institutional design of monetary policy - increased central bank independence - with increased policy emphasis on price stability as an objective of monetary policy helped in lowering inflation in developing economies (IMF, op cit.).

Sharp swings in exchange rates have become quite common as has been the recent experience of movements in the US dollar vis-à-vis the euro since 2000. Such sharp movements in exchange rates have significant implications for inflation process. One reason as to why emerging economies do not adopt flexible exchange rates is the alleged "fear of floating". This fear of floating is, inter alia, on account of a high and immediate pass through from exchange rate to prices, i.e., sharp movements in the exchange rate can induce equivalent movements in domestic inflation. The degree of pass-through is important for the conduct of forward looking monetary policy.

The role of pass-through in explaining inflation received little attention in the traditional open-economy macroeconomic models because the assumptions of Purchasing Power Parity (PPP) implied complete and immediate pass-through. More recent research has approached this issue from the industrial organisation perspective and has stressed upon industry- or market-specific factors to explain the pricing behaviour of producers. Under imperfect competition, "pricing to market" may take place when markets are segmented and firms with some monopoly power price discriminate across countries. Incomplete pass-through results from third-degree price discrimination which allows destination prices to be stable in the face of exchange rate fluctuations due to nominal rigidity and local currency pricing, market segmentation and presence of local distribution costs and adjustment in mark-ups for maintaining market share. The incomplete pass-through - 'exchange rate disconnect' - has important implications for monetary policy as it affects both the forecasts of inflation and also the effects of monetary policy on inflation.

Analysis across the distribution chain shows that pass-through is highest for imported goods at the dock and the lowest for consumer prices. Pass-through is largest and fastest for non-oil import price shocks followed by exchange rate shocks and oil price shocks. Pass-through to import prices is relatively quick and, in the long-run, more or less complete. Illustratively, for a sample of 25 OECD countries over the period 1975-99, Campa and Goldberg (2002) find that short-run pass-through coefficient to import prices is 0.61 while the long-run coefficient is 0.77; similarly, for a sample of 11 industrialised countries over the sample period 1977-2001, Bailliu and Fujii (2004) estimates these coefficients at 0.75 and 0.91, respectively. In contrast, pass-through to producer prices and consumer prices is much lower at 0.20 and 0.08, respectively, in the short-run; the corresponding long-run coefficients are 0.16 and 0.30. Lower pass-through to consumer prices reflects the fact that local distribution costs are a large part of retail prices. Distribution costs are estimated to be 45-65 per cent of the final goods price in the case of the USA, 55-65 per cent in the euro area and even higher at 65-70 per cent in Japan.

Moreover, there is evidence that exchange rate pass-through to domestic inflation has tended to decline during the 1990s across a number of countries. Illustratively, the 1992 depreciation and the 1996 appreciation in the UK, the 1992 depreciation in Sweden, and the 1999 depreciation in Brazil showed a significantly small pass-through of exchange rate fluctuations to retail prices. For a sample of 11 industrial countries, Gagnon and Ihrig (2001) find that the pass-through to consumer price inflation almost halved in the 1990s compared to the pre-1990s period (from 0.12 to 0.06). Similar results are reported by McCarthy (2000) for nine OECD countries; his results show that pass-through more than halved in the US, UK, Japan and France and to a lesser extent in other countries during the period 1983-96 compared to the earlier period 1976-82. There is evidence that pass-through has declined in developing countries also during the 1990s and the extent of decline in these countries is estimated to be larger than that in advanced economies.

Interestingly, the decline in the pass-through during the 1990s has taken place in an environment characterised by a greater openness to external trade. A key explanation for the decline in the pass-through is the increased commitment of monetary policy towards maintaining price stability. When a central bank is committed to price stability, the pass-through is lower because inflation expectations do not rise proportionally with the movement in the exchange rate. This occurs as the central bank applies countervailing measures to contain aggregate demand contemporaneously and firms believe that the central bank will be successful in its objective. As the decade of the 1990s was one of low and stable inflation, the decline in pass-through may be correlated with this low inflation environment.

Financial innovations such as availability of hedging products can also lower pass-through by permitting importers to ignore temporary shocks. Another view suggests that the decline in the pass-through could be due to a change in the composition of imports towards sectors with low pass-through rather than a decline across all. Available evidence for industrialised economies, at least, confirms that their import composition has shifted in favour of sectors with low pass-through such as the manufacturing sector. According to Burstein, Eichenbaum and Rebelo (2003), the low observed pass-through might be due to disappearance of newly expensive goods from consumption and their replacement by inferior local substitutes.