UNIVERSITY OF ILLINOIS UBRARV AT URBANA-CHAMPAIGN BOOKSTACKS ILLJX- DATE DUE ^ — TO \ L 'L L zzzpz: ■ - — ■ . — i — GAYLORO 1 PRINTEDINUSA STX FACULTY WORKING PAPER NO. 1234 Intarffetional Transmission of Inflation. ItSrtconomics and Its Politics Grzegorz W. Kolodko College of Commerce and Business Administration Bureau of Economic and Business Research University of Illinois, Urbana-Champaign BEBR FACULTY WORKING PAFER NO 12 3 4 College of Commerce and Business Administration University of Illinois it Urbana-Champaign March 1 9 8 o International Transmission of Inflation Its Economics and Its Politics Grzegorz W. Kolodko, Visiting Professor Department of Economics Digitized by the Internet Archive in 2011 with funding from University of Illinois Urbana-Champaign http://www.archive.org/details/internationaltra1234kolo International Transmission of Inflation. Its Economics and Its Politics (abstract) This paper discuses major conduits for the international transmission of inflation with special attention to the system of exchange rates, money and capital markets, and the terms of trade, and the mechanism of transmission between West, South and East. Contemporary worldwide inflation reflects the economic contradictions not only within individual countries, but on the world scale as well. At present inflation cannot be combatted within a single country. With inflation internationalized, it is now too late for this. But at the same time, it is too early-as usual, for political reasons- for the launching of necessary measures coordinated on the global scale. 1 It is a characteristic feature of economic relations that they have grown increasingly internationalized. Economic ties, whether in production, investment, commerce, finance, or technology, have been transcending the boundaries of national economies to assume a global character, in a trend reflecting the general regularity of economic development. An important role in the process of internationalization of economic relations is played by the world market. It may be viewed from many different angles, but here I am going to confine myself to discussing its two aspects - and only as they could be seen from one concrete standpoint in the past several years. The world market is, on the one hand, used by individual countries as a device to cushion their internal troubles, and on the other it provides a "transmission belt" for unfavorable economic processes developing on the world scale. This is also true of inflation, which affects all the countries in contemporary world (see Table 1 and 2) . Inflation should be viewed in its broad sense. It reflects the economic contradictions not only within individual countries, but on the world scale as well. Furthermore, when economic contradictions increase - and they are not solved in proper time by adequate methods, what often occurs - then it results also in increasing political contradictions. Because of numerous shortcomings of inflation, every country wants to get rid of it as soon as possible. Table 1 : The rate of inflation in selected countries in 1980s Country 1980 1981 1982 1983 1984 1984 1979=100 OECD France 13.3 13.4 11.8 9.6 7.4 169.1 Germany, Federal Republic of 5.5 6.3 5.3 3.3 2.4 124.9 Great Britain 18.0 11.9 8.6 4.6 5.0 157.5 Italy 21.2 17.8 16.5 14.7 10.8 211.4 Japan 8.0 4.9 2.6 1.8 2.3 121.1 Sweden 13.7 12.1 8.6 8.9 8.0 162.8 USA 13.5 10.4 6.2 3.2 4.3 143.2 CMEA a ) Bulgaria 14 1 3 1 119.8 Czekoslovakia 2 1 4 L 1 109.3 Germany, Democratic Republic of 1 101.0 Hungary 9 5 7 7 8 141.5 Poland 9 21 101 20 15 365.8 Romania 2 2 17 5 8 138.0 Soviet Union 1 1 4 1 - 1 106.1 Less Developed Countries Argentina 100.8 104.5 164.8 343.8 626.7 17604 Chile 35.1 19.7 9.9 27.3 19.9 271.3 India 11.4 13.0 7.9 11.9 8.3 164.6 Korea, South 28.7 21.3 7.3 3.4 2.3 177.2 Nigeria 11.4 20.8 7.7 23.2 39.6 249.3 Singapore 8.5 8.3 3.9 1.2 2.6 126.8 Tunisia 10.0 8.9 13.7 8.9 8.4 160.8 a ' In the CMEA countries it is used to round the consumer price index to entire digits. In the socialist countries - with the exceptions of Hungary, Poland, and Romania - the rate of price inflation is very low but it is necessary to emphasize that in centrally planned economies simultaneuosly exist repressed inflation and the shortages. On this subject see Kolodko and McMahon (198-6) . Source : Data for OECD and Less Developed Countries from: International Financial Statistics . IMF, Washington, D.C., November 1985, for CMEA countries from "Rocznik Statystyczny 1985", ("Statistical Yearbook 1985"), GUS, Warszawa, 1985. Table 2 : Consumer price indexes in 1981-85 (1980=100) 1981 1982 1983 1984 1985 a) World 114.1 128.1 144.2 164.2 190. 3 Industrial Countries 109.9 118.1 124.1 130.1 135.9 Developing Countries 127.8 164.1 228.9 336.1 533.0 Africa 119.7 134.8 159.6 191.6 209. 9 b) Asia 109.3 115.5 122.7 131.0 138.3 Europe ) 124.8 155.0 192.0 253.5 339.1,, 199. 9 d) Middle East 116.4 133.3 153.2 178.1 Western Hemisphere 159.6 276.6 601.5 1479.6 4187.0 *) July 1985 b April 1985 c ' In this group of countries IMF's data include European countries which are the members of IMF but which are not included in industrial countries. They are: Cyprus, Greece, Hungary, Malta, Portugal, Romania, Turkey, and Yugoslavia. d) May 1985 Source : International Financial Statistics . IMF, Washington, D. C. , November 1985. Irrespective of a host of internal measures aimed at this goal, steps have been taken to arrange for the "export" of inflation. This should not be taken to mean that all processes going on in the field are consciously guided. On the contrary, they quite often are largely uncontrolled. By its nature, inflation is hardly "marketable." Is, then, the export of inflation possible? First, let us try to answer the question of what the "export of inflation" means. On the surface, it appears that the tendency towards rise in the general level of prices is caused - in the final analysis - by the excess flow of effective demand over supply or by growing input costs. The problem of the export of inflation is thus reduced - in a simplified presentation - to the "export" of this surplus demand or/and to the passing of rising costs of input to external partners. It turns out that to some extent this is possible. But the whole complexity of the problem consists in the fact that such behavior is sought by many, as a result of which this peculiar export intermingles with import. The international transmission of inflation thus seems to be a more appropriate description of this feature of the contemporary world. System of Exchange Rates Of principal importance in the process of international transmission of inflation is the system of exchange rates as shaped in the early 197 0s. It was then that, under the influence of growing cracks in the exchange-rate system, the principle of fixed rates - adopted by leading Western nations under the Bretton Woods treaty of 1944 - was abandoned. A special role in this abandonment was played by West Germany which in 1971 opted unilaterally for a floating rate of the Deutsche mark to the dollar. This rate - and later the rates of other currencies to the US dollar - was to be shaped by market interplay. The breakdown of the system of fixed rates against the privilleged US dollar was sealed by the latter 's two devaluations against gold - by 7.89% in December 1971 and by further 10% in 1973. Since that time, the system of floating rates has reigned supreme - and, incidentally, it is this system that many economists perceive as a major factor behind the growing inflationary processes over the past fifteen years. The exchange rate is the price of foreign bills as expressed in the domestic currency. It provides the information on how much a unit of foreign currency costs. For example, the acquisition of one pound sterling cost the US economy around $2.2 at the end of 1980 and only $1.2 at the end of 1984. Such changes bear enourmous consequences for the pattern of real economic processes at the national and the world scale - and especially for inflation. In a clear interdependence, the stronger the currency of a country (which depends primarily on the strength and stability of its economy) , the lower the inflation rate. It should be stressed that, by the very nature of the system, the floating exchange rates may alter in any direction. But as things were developing recently - and, as usual, not without reason - there was a tangible decline in the exchange rates of the currencies of highly advanced capitalist countries against the US dollar. And as for the national currencies of developing nations, their rates to the world's strongest currency - that is, the dollar - were falling, sometimes at a breath-taking pace, although there were also some exceptions (see Table 3). The importance of the exchange rate for inflationary processes is the greater, the higher the foreign trade's share in the given country's economy. And since this share has been growing in step with economic development and international division of labor, so has been (leaving aside the periods of recession) the importance of the prices of foreign currencies. The growth of the prices of foreign currencies, or the fall of the exchange rate, results in higher cost of input, reflecting the increased cost of so-called foreign content which sometimes is substantial. In consequence, the costs of final output drawing on imported components increase, and so do the domestic prices. This alone may prove sufficient to set in motion a self-propelling, -cumulative mechanism of cust-push inflation. 2 And to its already identified elements, new ones are added - the internal costs and prices grow, and so do the prices of exported goods as expressed in a t— l tu 3 ct cf v 0) 3 — > 3 DJ -. cf H- TJ O 3 ►— 0) D) H 3 Q. TJ H- -> 3 3 fl> 3 = O H- rz CD 01 h- > cf H- 00 cf 3 QJ M cf h- 1 H- CO ~ cf V H- 3 o ?r CO »• o ■^ 1— t 2 tj -n o ■* h- > V s: 3 0) Q. CO • 3" H- 3 OP cf O 3 ■* O • o • - c— CD 3 C CD 3 «< _, vO —J J> ■ CD 3 a z o < a> 3 CT CO 1 _, vO 00 VJN H CO 2 1— I 00 n r* 33 TJ 33 n C_ 1— 1 03 o 33 ^ o **l Q c H' CD 3 3 o CD o o c 12 CD cf "3 3 CO CD CO 1 m 3 3 N a B) c CO 3 h- ' 3 CD T3 0J H- >D •o a 3 0) o H- OP H" M- N 3 CO CD O) w 3=> CD l-l cf cu C CD 3 3 a u CD O CD H- r^ 3 3 CO 3 «< CD cf CT 3 5) O H- ■a O h-^ 7S o H- Q. ~5 H- H V 3 CD CD o 3 CO co ca (0 < CO H O ■o CO ca CD «< 3 O o -> t-^ ~ a CO TJ 33 O r* CN ~Q K r~ TJ 2 a ^1 t- 1 - o H« CO c 3 CD h^ O CO H- O CD CD 3 3 1— • 3 CO ■a C H- O 3 3 3 C ■s c CD Bl H OP CO N CO cf H> CO n 3 3C cf 3 3 CD CD Cfl CD CD «< 3 a a. CO 01 o CO 3 CO •a o 3 CO ea H- u ca ft CT CO o 3" CD 0Q o ui on o l\> 00 PO -0 j> UI ON vO O on rv> _» o PO ro 00 0> • • • • • j> OJ —j CO _k » ro ro a PO ro JD O • • • • • j> _» -j _» kO a On ■O ro j> o ro ro -j ro • • to • • OJ _i 00 ^o kjl vO on ^* ro ON o ro OJ -J UI • • • • • J> o OJ ^o on ro vO OJ ro ro 3 ro O vO -^ • • • • • on o ro -» >00 ro on o ro vO ui a ro ON ^o ro • • • • • c* _> on ON —J ^0 ^ OJ _ vO X- -• 00 O ro OJ O J> • • • • -J _i 00 i- OJ OJ vO OJ ^ _fc vO -J 00 a ro ro ro j> • • • • oa _i CT j> -»j 00 vj-i ro x- • ro — > j> o mo o o uo on -» OJ OJ oo -» \J\ ON -> OJ 0J CDOU1 O O ON -» OJ CJ oo -» ro • • • o oo ro -> OJ OJ U1 J> £• O J> J> -» 00 LJ on on mo o 00 00 ro ON on ro o 00 IV) ~0 o ro • • • o U1 ro - — k 00 LO o o • • • ON MO oo OJ ro CD UJ C VO J> o — > • • • —J -O ^j VJ1 OJ ro VO Q OJ OJ o O — > • • • o x~ vO ro ON _» ro ro ^ O ^jD o o ro • • • mD on ro ro on rvj u OJ ~J vJ-1 o o ro • • * • O ON OJ ro 00 ^ ro >3N OJ CT> r^j o o ro • • • ro ON -0 vO (NO _» INJ a Ul 0J — t o^ O OJ • • • _> 00 _» ON Ul on on ro j> 00 o ro on ro on on ON —J 0J 00 LJ on vO ON o o H o 0) c O" 3 H cf CO T *< OJ n c T T CO 3 O << CO a o vO o < CD — k H vO C —J CD ^J O "5 2 CD » cf vO H- -~J o 00 3 CD !—• n c — k "1 vO T -J CD vO 3 O «< •a CD — > 3 vO 00 G o vO 00 vO oo ro vO oo OJ vO 00 J> H rr CO CO X o 3- CD 3 oq CO 3 CD cf CD O »"* CO CD h- 1 CD O cf CD Q. O C 3 3 CO 3 O H- CD CO CD CD H- 3 CO 00 a. o vO o I vO 00 x~ units of the national currency - which may make it harder to place this output in foreign markets, leading in turn to a new devaluation of the currency so as to keep the profitability of exports and raise their competitiveness in foreign markets. The costs of imports are growing again, with all inflationary consequences for the dynamics of the general level of prices. The purpose of devaluation, or the official lowering of the exchange rate of the currency, is to raise the competitiveness of exports through the reduction of prices expressed in those foreign currencies in respect to which the exchange rate is reduced. Sticking to the above mentioned example, this means that while in 1980 a £.1,000 worth of British good cost around $2,200 in the US market, four years later, other factors being equal, the Americans had to pay for it just slightly more than $1,200. In such situation, the task of boosting exports to the US market is much easier. The purpose of this is to raise net export revenues with a view to balancing foreign payment. But the cost that has to be borne is the growth of the general level of domestic prices in the British market, as the costs of imports from the US grow accordingly. This mechanism played a not unimportant role in accelerating inflation in many highly developed countries at the beginning of the 197 0s. A special case here is Great Britain where, following several devaluations of the pound sterling, the cumulative mechanism of costs, prices, and wages has been set in motion on a large scale, resulting in nearly 25% rate of inflation in the mid-1970s. But devaluation as a means of raising exports profitability is not always effective. It brings the expected results only when, as a reaction to its announcement, adequate changes occur in the size of exports (increase) and imports (decline, coming as a result of their being expensive) . The desired scope of these changes is defined by Marshall-Lerner formula according to which the devaluation of the national currency contributes to an improvement in the balance of payments when the sum total of price elasticity of foreign demand for goods exported from a country and of price elasticity of domestic demand for imported goods is higher than unit. If this is not the case, we have a so-called perverse effect of devaluation which helps to worsen the balance of payments rather than improving it. This is a rare development in highly developed countries which are capable of defending against such consequences. But it is very frequent in developing nations. There, one devaluation may follow in the footsteps of another, with the inflationary price increase acting as oil poured on the flames. The devaluation winds up inflation which, in turn, necessitates a new devaluation, and the latter hardly contributes to an improvement in the balance-of -payments situation of backward countries. This is a major source of their chronic balance-of-payments 10 incapacitation and huge, steadily growing foreign debt. Needless to say, this is primarily the debt to leading Western countries and their largest commercial banks. There can be no doubt that the main direction of the export of inflation through the system of exchange rates is from the highly developed capitalist world to the Third World. The latter' s economic position is still so weak as to prevent it from effectively countering this kind of the transmission of inflation. The socialist countries, isolated from the influence of exchange-rate fluctuations in the capitalist world, are involved in this process in only a limited degree. Much depends here on the geographical structure of their foreign trade settled in convertible currencies. They may either benefit from these processes or lose on them. If, for example, exports are charged in US dollars, whose rate against currencies of other capitalist countries goes up, and if these dollars are used for import purchases in countries with declining rates of national currencies, then the same volume of export may buy more imports. The problem is, however, that the reverse is often the case. So there are grounds to say that the international transmission of inflation, as seen from the viewpoint of the contemporary system of exchange rates, consists in keen competition within the group of highly developed capitalist countries, 5 a sort of "one-goal game" against less developed countries, coupled with a great deal of isolation on the 11 part of the socialist countries. The latter stick in principle to the policy of relatively rigid exchange rates, both in respect to convertible currencies and within their economic grouping (see Table 3) . The system of floating rates can hardly be assessed as unequivocally negative. Its impact may be exerted in various directions - be it inflation or other economic processes. But the fact is that the crisis of the world system of exchange rates has played the principal role in making inflation international, introducing to it some added elements of uncertainty. The system of floating rates, while making international economic relations more flexible and permitting necessary processes of adaptation to the changing economic determinats in the world, at the same time exerts a destabilizing influence upon these relations. More than that, it permits various speculatory measures which on such scale would have been impossible at the time of fixed rates of exchange. Because of the speculatory game in the international foreign exchange market, the economic processes, inflation included, often depend not on the real economic processes in the sphere of production and international trade - but rather on disturbances in the system of international settlements, purposefully arranged with some gains in view. 12 Money and Capital Market Another major conduit for the international transmission of inflation is provided by the money and capital market. It, too, has become highly internationalized, assuming a worldwide dimension and leaving a deep imprint on inflation as a global phenomenon. The interest rate is of special importance here, and the leading role is again played by the United States. Not without the influence of monetarist concepts, this rate in the US money/capital market has run for the past years at an exceptionally high level. This is supposed to restrict demand for investment credit, which in turn should slow the growth-rate of overall domestic demand, thus contributing to the lowering of inflation in the US economy. And this indeed is the case. But, just as there are two sides to every coin, the record-high interest rate had a simultaneous effect of attracting foreign capitals into the US. This stimulated the demand for dollars, the exchange rate of which had been running at a high level. The consequent relative cheapness of goods in the US market - or, more accurately, the slower price growth - is a factor behind the reduction of the rate of inflation. Also relatively cheap are the goods imported to the US - but at the same time, the goods exported by that country are correspondingly more expensive, which directly influences a higher rate of inflation in other countries. 13 This influence is the greater, the higher the share of imports from the US in total purchases of a given country. Clear interconnections can be seen here among the level of the interest rate, the demand for dollars, the exchange rates, the costs of production, and the level and dynamics of domestic prices. Hence, the strong pressure from the remaining OECD and developing countries on the US for the reduction of its interest rate, since this would no doubt result in lower rate of the dollar and, consequently, in lower rate of inflation in other countries (but this rate would rise in the US) . The launching of this process is inevitable, because the rate of the dollar - pushed up under President Reagan's economic policy - is overvalued, and as such cannot be held in the longer run. An interest rate set at a very high level affects inflation in various ways. It contributes to a slowdown in domestic demand and to the export of inflation, but at the same time results in an increase in production costs which has inflationary effects not only in the United States. This is because in the worldwide money/capital market other Western countries are bound to follow their leader. And since the costs of credit - affecting costs of domestic output and prices - are higher accordingly, the consequences are borne virtually by the whole world. And finally, the excessive rate of inflation has the effect of slowing economic activity and the rate of growth, as well as affecting unemployment. 8 14 In discussing the impact of world inflation upon the course of inflationary processes in developing nations, it is necessary to mention the importance of the pumping of dollars to the world circulation of money. By increasing the financial liquidity on the international scale, it contributes to strengthening the demand-pull inflation. And this is precisely that peculiar form of the "export" of surplus demand which, since that time, becomes the headache of others. But this direction of the inflation transmission leads not only to the Third World countries, which incidentally suffer an accute shortage of foreign exchange. This transfer takes place primarily within the group of highly developed capitalist countries, while the socialist economic system, for which an excess of dollars in circulation is hardly a problem, is excluded from it. This brings us to the so-called external dollars, or the US dollars in circulation outside the United States. They consist of dollar reserves held by nearly all countries, so-called petrodollars held by oil exporters, and eurodollars circulating in Western Europe and other nations of highly developed economies. Their amount rose more than ten times in the past twenty years, exceeding an estimated $1,000 billion in 1985. It turns out that the world monetary system is so designed that "the US can finance its guns-and-butter spending at the expense of its major foreign allies, onto whom the inflation is largely passed. 15 Contributing to this are also the big direct investments made by the US abroad which - through the nearly chronic deficit of the US balance of payments - result in added inflationary processes there. To a large extent, this deficit is covered by the additional issue of dollars which remain ouside the US economy. Their growing supply often forces the central banks of leading capitalist countries to intervene in their foreign exchange markets, by buying dollars in order to prop up the exchange rates of the national currencies. As a result, additional money is created in domestic market, which stimulates demand-pull inflation. This is because the said creation often fails to be covered by a matching increase in domestic output. But on the other hand, this mechanism has anti-inflationary effects if the investments contribute to raising economic efficiency, which most often is indeed the case owing to the accompanying technological and organizational progress. The improvement in efficiency has always anti-inflationary effects. So this time again we can see a multi-faceted influence of one phenomenon upon another. But it seems - especially in view of the clear narrowing of the technology gap - that the resultant of these two lines of direct investments' impact and the functioning of external dollars has the effect of intensifying the ' inflationary processes outside the United States. 16 Terms of Trade The international transmission of inflation is affected not only through changes in economic regulators, such as exchange rates or flows of money and capital. An important role is also played by the movement of goods, or more accurately the movement of their prices in international trade. In extreme cases, it is precisely this area where some economists locate the main causes of the present world inflation. In respect to this aspect of the international flow of inflation, the principal role is performed by movements in raw material prices, which went up noticeably in the past several years. Their growth was particularly steep after the oil price explosion enforced on the world by OPEC - largely, for political reasons related to Middle East developments . The strong upward trend in prices collapsed in the early 1980s, when wholesale prices for both raw materials and food went down (see Table 4) . Inflation, however, continued, although the said price trends were not without influence upon its weakening in many countries. Thus, there seem to be grounds for the claim that the operation in the past several years of the cost-related factors of inflation - even though these are not confined* to raw material prices alone - has been weaker than in the 1970s. Does that mean that the greatest beneficiaries of price movements in that period have been the countries exporting 17 CO o c 3 o CD 3 n> ~i 3 fl) ct H- o 3 ft) CO ri- ft) n- H- w ct o co •n w CO 3- H- 3 0<5 ct O 3 n 5 w o CD s: O N CO ro *TJ TJ O 8? O :? c o n o o H- C C Hfl) O o CD OP ■-•J 0) o ft 3 "O CT ■< CT TJ c V 0) w ~> ~) H C* o n> cr Z 3 X> X H ct "J CD O 3 tD O O CD (-• n> 3 "3 2P O CO •a 3" ft) ct CD 3 O 1— T Q. CD C 3 CD ro ui _» _» ro ru -J o X- o o o -» —j oa r\j X- -J rv) ro ro -» rv> ro X- vJD o^ ro o mm* — * — » oo ro vO 00 _> ro x~ -» rv) l\) 00 X- -J — > ro OJ -J UI mD 0> —j CO ro ro ro _i ro no U) ^O v£) o co ro ro -J cr> x- x- — » IV) CO UJ ro ro ro vO UI ro ro -J x» -» UI o — » cr* X- 00 —J —0 00 oo r\j -» ro ro j> -» -» oo ro iv) U1O0X--JIM0OI--J -.WOvOUl-JCCO ro ro — » —> oo ro ro ^-^viDOOODvO^Ja) outcoouivo-o.o ro ro ro -» vo co ro OUOOMJHC->-J OOCJUIX-LOOOOO l\) l\) IM l\) U3 u w o co x- — > — jvorocjN ro co co co co — » co ro ui w - > cr> o x- o — J — »-jx-uiuiooui ro CO x- oo ro CO ro ro j> co co ro -> UI CO — » co -q -» — i x» UI -» UI v£> O UI o o UJ 00 X- CO UI UI — J vO U) <7> UI UI -» —J U) £- U) -» u> ro -» -» u> vo — » X- -J X- X- UI vO LJ ro ro co ro co ui -* ui co oo-vi— j u> o ro — > x- OOvOOn— JOCJOUI ro ro co ro k CO ro ro co ro U) UI mmk X* CO vO -J UI 00 o o UI CO —- ro -J a vO — O CO 00 X* UI o — » o vO UI UI S> ro x- ro co ro _» ro ro 00 ty UI 00 00 ro Ul ro a\ 00 ~J X- ro co ro — ' ro ro -g _» o — vo o> CT» OD 00 ON UI -» VO o CO ON ro rocorocoro— > -MJ ui-»x-roui— >roco oo on o>- j co ro x-x- ro co co ro co o co co oocoro— '^ocjjo rovo-JOo-»oo^-J — '-<) o*co^ on-j o ~J U- J w>o U-J o r\j Ov -J x- a> -j ON-^rovocjooo o o o Q. vO _» -J