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1. Why inflation is bad in any situation


(i) High inflation (or hyperinflation) has a destructive effect on economic activity and employment.

(ii) High inflation decreases the efficiency of the price system in allocating resources, because the rise in the variability of relative prices makes them less reliable as a source of information and a greater source of risk.

(iii) Inflation destroys the various conventional functions of the currency -- that is, unit of account, store of value, and transaction facility. This can lead to replacement by a foreign currency, or the introduction of a new (differently valued) domestic currency.

(iv) Taxation through inflation is normally very regressive. The poorest social sectors are affected the most. Inflation also decreases the effectiveness of the tax system.

(v) The most affected markets are those having to do with growth, such as real investment (saving), capital, and financial investment.

(vi) Using inflation as a tax not established by law gives a sense of illegality to all government activities.

(vii) Inflation is inclined to feed on itself.


Annual rates of inflation, Argentine


1986 ... 81,9%

1987 ... 174,8%

1988 ... 387,7%

1989 ... 4 923,6%

1990 ... 1 343,9%

1993 ... 7,5%


2. Why inflation is even more dangerous after a depreciation of the currency


(i) Depreciation immediately changes relative prices of tradable versus non-tradable goods. Prices of imported goods and services go up.

(ii) Depreciation increases income of export industries.

(iii) Depreciation should improve the balance of payments situation, which could add to liquidity.

(iv) Depreciation provides an additional stimulus to the economy that will work through to real economic activity (employment), or to prices (inflation), or a combination of the two.

(v) Experience of South American countries proved that exchange rate depreciations accompanied by expansive credit policies, large fiscal deficits, or wage indexation very quickly lost their beneficial effects for real economic activity. On the average, in most South American countries, the advantages of exchange rate depreciation were eroded within the first nine quarters of the devaluation.

(vi) A nominal devaluation undertaken with appropriate fiscal and monetary policies can generate a real depreciation and increase a country's ability to sell those goods that make it internationally competitive, and to attract the investment needed for growth.

(vii) Therefore, exchange rate adjustments can only be beneficial if it is supported by non-inflationary monetary and fiscal policies.


3. Exchange controls, exchange rates and financial stability


(i) "Generally speaking, convertibility of a currency is best contemplated after an economy has been stabilised, liberalised, and opened up, and after it has accumulated a healthy stock of international reserves".

(IMF; Approaches to Exchange Rate Policy: Choices for Developing and Transition Economies, p. 31)

(ii) Typical preconditions for the establishment of a convertible currency, besides the adoption of an appropriate exchange rate level or regime, include sound macroeconomic policies -- that is, a set of domestic financial policies which, by keeping the level and growth rate of demand in the economy in line with developments in its productive capacity, ensure a sustainable balance of payments position, and help maintain domestic price stability.

(iii) In addition, the proper environment for convertibility allows market incentives to guide economic behaviour.

(iv) A third important prerequisite for convertibility is the availability of an adequate stock of international reserves -- will buttress confidence in the exchange regime in general and the permanence of convertibility in particular.