Description
Documentation about the difference between inflation and hyperinflation, various hyperinflationary models, reasons of hyperinflation in zimbabwe. It also covers various approaches to tackle inflation.
Hyperinflation in Zimbabwe
Contents
1. Inflation and Hyperinflation .................................................................................................................. 1 1.1 How is Inflation Measured? ................................................................................................................ 1 1.2 Hyperinflation ...................................................................................... Error! Bookmark not defined. 1.2.1 Common Factors which have caused Hyperinflation in the past ............................................. 2
1.2.2 Past Hyperinflation instances .......................................................................................................... 2 1.3 Difference between Inflation and Hyperinflation ............................................................................... 2 2. Hyperinflationary Models ......................................................................................................................... 3 3. Seigniorage & Hyperinflation .................................................................................................................... 3 4. Reasons of Hyperinflation in Zimbabwe ................................................................................................... 4 4.1 Unstable Government......................................................................................................................... 4 4.2 Lack of Fiscal Discipline ....................................................................................................................... 5 4.3 Timeline of Events ............................................................................................................................... 5 GDP - real growth rate (%) ......................................................................... Error! Bookmark not defined. 4.2 Application of Theoretical Models ...................................................................................................... 7 5. Possible Approaches to Hyperinflation ..................................................................................................... 8 5.1 Dollarization ........................................................................................................................................ 8 5.2 Free banking system ........................................................................................................................... 9 5.3 Currency board ................................................................................................................................... 9 6. Current situation ....................................................................................................................................... 9
1. Inflation and Hyperinflation
Inflation is defined as a continuing and rapid rise in the price level. According to MiltonFriedman, it is “always and everywhere a monetary phenomenon”. Most economists whethermonetarists or Keynesians, agree that proposition.
Thus,Inflation is the increase in the overall price level or decrease in the value of money caused by ? An imbalance between the money supply and the goods and services in an economy ? And/or when confidence in the currency is eroded
1.1 How is Inflation Measured?
Inflation is measured as the percentage rate of change of a price index over a particular period of time, normally a year.Therefore, if inflation for a particular week is say 7%, it means the index is 7% higher, than it was in the same week during the previous year. The two most important price indices in India are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). The WPI is India’s most watched cost monitor. Most developed countries use the CPI as an index over the WPI.
1.2 Hyperinflation
Hyperinflation is often defined as inflation that exceeds 50 percent per month,which is just over 1 percent per day. Compounded over many months, this rate of inflation leads to very large increases in the price level.An inflation rate of 50 percent per month implies a more than 100-fold increase in the price level over a year and a more than 2-million-fold increase over three years.
Pt=Po(1+r)t Po=Current Price Pt= Price after time t R= inflation rate
1.2.1 Common Factors which have caused Hyperinflation in the past
? Hyperinflation often occurs when there is a large increase in the money supply not supported by gross domestic product (GDP) growth, resulting in an imbalance in the supply and demand for the money. Left unchecked this causes prices to increase, as the currency loses its value. Hyperinflation often occurs when there is a loss of confidence in a currency's ability to maintain its value in the aftermath. Because of this, sellers demand a risk premium to accept the currency, and they do this by raising their prices.
?
1.2.2 Past Hyperinflation instances
Weimar Republic One of the most famous examples of hyperinflation occurred in Germany between January 1922 and November 1923. By some estimates, the average price level increased by a factor of 20 billion, doubling every 28 hours. Yugoslavia Between October 1, 1993 and January 24, 1995, prices increased by 5 quadrillion percent. This was mainly because of the excessive printing of money by the government to cover the budget deficit and irrational economic policies.
1.3 Difference between Inflation and Hyperinflation
Inflation refers to any sustained increase in the “cost of living” expenditures. It is usually thought in the terms of Consumer Price Index (or CPI). And, hyperinflation refers to an “out of control” increase of prices, resulting in diminishing value of a country’s currency. This occurs when there is an increase in the money supply in the domestic market which fails to satisfy the very reasons it seeks to combat. Another difference is that while inflation works towards securing the economic stability of a country, hyperinflation seeks to demobilize the same economy further into the web of debts. In Zimbabwe, the economy was in such a condition that the prices of even the basic items are not less than few million dollars. For example, the price of three eggs was 100 billion dollars and the price of a dozen tomatoes varied between 3-5 million dollars. This shows that during hyperinflation, there are irrational increases in prices which not at all help in any sense, thereby, failing the government to achieve its targets. In other words, hyperinflation is generally associated with paper money as it can easily used to increase the money supply. It effectively destroys the purchasing power of the private and public savings, distorts the economy in favor of extreme consumption, and hoarding of real assets, causing the monetary base (hard currency), to escape the country, while making the afflicted area anathema to investment. Hyperinflation can be characterized by the following conditions: 1. The general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency. Amounts of local currency held are immediately invested to maintain the purchasing power. 2. The general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable foreign currency. Prices may be quoted in that foreign currency. 3. Sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during the credit period, even if the period is short. 4. Interest rates, wages and prices are linked to a price index and the cumulative inflation rate over three years approaches, or exceeds, 100%.
2. Hyperinflationary Models
1) Confidence Model: Some events or series of event cause the people to lose confidence on the money issuing authority. Because of this, people prefer either keeping goods or money of some other nation. The suppliers start charging premium for their products which is much higher than the actual price. To overcome this, the best policy is changing the backing of the currency by issuing a new currency. 2) Monetary Model: The money issuing bodies start printing money to pay the debts or to cover costs coming up because of social unrest or war. When businesspeople perceive that the issuer is committed to a policy of rapid currency expansion, they mark up prices to cover the expected decay in the currency's value. The money issuing authority must then accelerate its expansion to cover these prices, which push the currency value down.
2. Seigniorage & Hyperinflation
Seigniorage is the revenue earned by the government by printing money.
Seigniorage Laffer Curve It shows the relationship between steady state inflation rate and Seigniorage revenue. It indicates that seigniorage revenue must rise for a while and then fall again as inflation rises. Thereforethere is an inflation rate that produces a maximum amount of seigniorage with a stable rate of inflation. Above that steady state inflation rate, it is possible to collect more seigniorage than SEmax, the maximum amount, but only if the inflation rate is constantly increasing.
4. Reasons of Hyperinflation in Zimbabwe
At Independence in 1980, the Zimbabwe dollar was worth about USD 1.25. Since then, rampant inflation and the collapse of the economy have severely devalued the currency, causing many organisations to favour using the US dollar or South African rand instead. Inflation was stable until Robert Mugabe began a program of land reforms that primarily focused on taking land from white farmers and redistributing those properties and assets to black farmers; this in turn sent food production and revenues from export of food plummeting. Though inflation in Zimbabwe was a monetary phenomena (the result of Mugabe's government printing money) as can be seen by the appearance of ever higher face value printed notes (whose face value exceeded the sum of all previously existing notes).
4.1 Unstable Government
According to Transparency International, (Released on 1st Dec 2011) Zimbabwe's government ranked154th out of 182 in terms of institutionalized corruption. This corruption directly affected the country causing instability and negative economic effects. The violent land reform program destroyed the agricultural sector in Zimbabwe and in particular the tobacco industry which accounted for one-third of Zimbabwe's foreign exchange earnings. The manufacturing and mining sectors also suffered great declines. Instead of instituting constructive policies, the government continued to spend and print money.
4.2 Lack of Fiscal Discipline
Mugabe's government was printing money to finance troops in the Democratic Republic of the Congo. In 2000 Mugabe authorized Zimbabwean troops to fight in the Second Congo War. The involvement in the Congolese war cost millions of dollars a month. One of the main costs of this war involvement was paying higher salaries to army and government officials. This required the printing of currency. Zimbabwe was grossly under-reporting its spending involvement in this war to the International Monetary Fund. Some reports cite a discrepancy of $22 million a month. Zimbabwe was involved in this conflict not because the Democratic Republic of the Congo was a bordering nation and posed a threat, but instead because rebel territory contained diamond mines. These mines were the motivating factor for involvement in the conflict. The Government of Zimbabwe struck a deal with the Government of the Democratic Republic of the Congo that involved a joint venture in diamond and gold mines to serve as payment for involvement. It has been rumoured that many of the diamonds and the revenue from the mine have been funnelled into the corrupt government purse or former soldiers have illegally removed diamonds from the mines.
4.3Timeline of Events
- Early in the 21st century Zimbabwe started to experience chronic inflation. Inflation reached 624% in 2004, and then fell back to low triple digits before surging to a new high of 1,730% in 2006. During that time, the Reserve Bank of Zimbabwe revalued its currency on 1 August 2006 at a rate of 1,000 old Zimbabwean dollars to 1 revalued Zimbabwean dollar. - In June 2007 inflation in Zimbabwe had risen to 11,000% year-to-year from an earlier estimate of 9,000%. - On 5 May 2008 the Reserve Bank of Zimbabwe issued bank notes or "bearer cheques" for the value of ZWD 100 million and ZWD 250 million. Ten days later on 15 May, new bearer cheques with a value of ZWD 500 million (then equivalent to about USD 2.5) were issued. Five days later on 20 May a new series of notes in the form of "agro cheques" were issued in denominations of ZWD 5 billion, ZWD 25 billion and ZWD 50 billion. An additional agro cheque was issued for ZWD 100 billion on 21 July. Meanwhile inflation has officially surged to 2,200,000% with some analysts estimating figures surpassing 9,000,000 percent. - As of 22 July 2008 the value of the ZWD had fallen to approximately 688 billion per 1 USD, or 688 trillion pre-August 2006 Zimbabwean dollars. - On 1 August 2008, the Zimbabwe dollar was redenominated by removing 10 zeroes. ZWD 10 billion became 1 dollar after the redenomination. - On 19 August 2008, official figures announced for June estimated the inflation over 11,250,000 percent. Zimbabwe's annual inflation was 231,000,000% in Jul(prices doubling every 17.3 days). - For periods after July 2008, no official inflation statistics were released. Prof. Steve H. Hanke overcame the problem by estimating inflation rates after July 2008 and publishing the Hanke Hyperinflation Index
for Zimbabwe.Prof. Hanke’s HHIZ measure indicates that the inflation peaked at an annual rate of 89.7 sextillion percent (89,700,000,000,000,000,000,000%) in mid-November 2008. The peak monthly rate was 79.6 billion percent, which is equivalent to a 98% daily rate. At that rate, prices were doubling every 24.7 hours. - At its November 2008 peak, Zimbabwe’s rate of inflation approached, but failed to surpass, Hungary’s July 1946 world record. - On 16 January 2009, Zimbabwe issued a ZWD100 trillion bill. The hyperinflation officially ended in January 2009 when official inflation rates in USD were announced. - In February the government of Zimbabwe revalued its currency. One of these new Zimbabwean dollars is worth one trillion of the previous. This move took the number of decimal places removed during the period of hyperinflation to 25 (1025 = 10 septillion short scale; thus, if no revaluations had taken place, Zimbabwe would now be issuing 10 septillion dollar notes).
Umemployment Rates (%)
GDP - real growth rate (%)
4.2 Application of Theoretical Models
According to “Quantity theory of money”, Massive imbalance between the supply and demand of a certain currency or type of money, usually due to a complete loss of confidence in the currency similar to a bank-run causes hyperinflation. This situation occurred in Zimbabwe because of the following reasons: 1. The unbudgeted government expenditure of 1997 (to pay the war veterans gratuities) 2. The publicly condemned and unjustifiable Zimbabwe’s intervention in the Democratic Republic of Congo (DRC)’s war in 1998 3. The expenses of the controversial land reform (beginning 2000) 4. The parliamentary (2000/2005) and presidential (2002) elections 5. Introduction of senators in 2005 (at least 66 posts) as part of ‘widening the think tank base’ -the international payments obligations 6. Especially since 2004, all resulted in massive money printing by the government. IMF has said however that the principal causes of inflation, chiefly reckless state spending, arbitrary government controls and the flight of foreign investment remain unchanged, and warns that little change can be expected until issues of political governance are deal with. According to Cost-Push Theory of Inflation, Prices rise due to increasing cost of the factors of production. Given the acute shortage of foreign currency in the country since 2000 (due to, and not limited to, exports decline, closed donor community, dried foreign currency reserves and reduced financial aid from IMF and World Bank), most imports have been financed by expensive foreign currency from the black market, thus resulting in higher output costs surfacing in higher market/consumer prices.Presently termed "supply shock inflation," it is caused by drops in aggregate supply due to increased prices of inputs, for example. Unavailability of forex being a key driver of cost push inflation in Zimbabwe.
According to Demand-Pull Theory, Inflationary pressures arise because of excess demand for goods and services resulting from expansionary monetary and fiscal policies. Zimbabwean situation has been compounded by shortages of basic commodities (i.e., mealie-meal (staple diet), cooking oil, flour, fuel, sugar, to mention a few), thus result in pent-up upward pressure in the overall prices. Inflation and Expectations: Both households and firms form their expectations of inflation based on recently observed inflation and this may affect the general price level. Proponents of the theory maintain that prices are rising because people expect them to rise and they expect them to rise because they have seen them rising. Structural Factors: The effects of droughts since 2000 coupled with under utilization of most commercial farms (after the land reform) have also resulted in production decline and shortages of most locally produced consumption products. Other factors: Foreign currency shortages as well as exchange rate misalignment have also resulted in general increase in prices. Added to the shortage is the exchange rate misalignment where by the official exchange has been far below the market-determined rates, resulting in a growing black/parallel market for foreign currency. Due to this shortage, imports of raw materials have been acquired using expensive foreign currency from the black market. The ultimate effect of this has been cost-push inflation.
5.Possible Approaches to Hyperinflation
The quickest way to stop hyperinflation is to replace central banking with a new monetary regime. This would instill confidence in the currency. In Zimbabwe’s historical experience with a variety of monetary systems, only central banking has produced hyperinflation. Similarly, throughout the world, hyperinflation has been a phenomenon linked to central banking or its close cousin, the direct issue of currency by a government’s treasury. During the transition, real interest rates become punishingly high, and long-term loans in local currency become difficult to obtain. As a result, economic growth becomes relatively slow, general living standards become stagnant, and the scourge of poverty spreads. For replacing the central bank with some other monetary regime thereare 3 options available 1) Dollarization 2) Currency board 3) Free banking These options are not mutually exclusive. For example, a currency board system could be combined with official dollarization, as in the monetary systems of Lesotho, Namibia, and Swaziland.
5.1 Dollarization
1. Unofficial
When individual holds foreign currency, bank deposits or notes to protect against the inflation in domestic currency.Zimbabwe was already unofficially dollarized to the extent that Zimbabweans held South African rand, U.S. dollars, pounds sterling, and other foreign currencies as stores of value. Zimbabwe was already unofficially dollarized to the extent that Zimbabweans held South African rand, U.S. dollars, pounds sterling, and other foreign currencies as stores of value. 2. Semi-official Under semiofficial dollarization, foreign currency is legal tender and may even dominate bank deposits, but it plays a secondary role to domestic currency in paying wages, taxes, and everyday expenses such as grocery and electric bills. Unlike officially dollarized countries, semiofficially dollarized ones retain a domestic central bank or other monetary authority and have corresponding latitude to conduct their own monetary policy. 3. Official Official dollarization could be based on, for example, the South African rand, the U.S. dollar, or the euro. For Eg: If Zimbabwe used the rand, it could negotiate a profit-sharing agreement such as Lesotho and Namibia now have, and which Botswana and Swaziland formerly had. Under these agreements, South Africa shares the profit (seigniorage) it derives from issuing currency, according to estimates of how many rand notes (paper money) and coins are in circulation in the partner country.
5.2 Free banking system
A completely free banking system has no central bank, no lender of last resort, no reserve requirements, and no legal restrictions on bank portfolios, interest rates, or branch banking. Free banking systems existed in nearly 60 countries during the 1800s and early 1900s. In general, these systems were relatively stable, issued currencies convertible into gold or silver at fixed exchange rates, and were not purveyors of inflation. Zimbabwe had free banking from the time its first bank was established in 1892 but it was replaced by currency board in 1940.
5.3 Currency board
Zimbabwe had currency board in 1940. A currency board is a monetary institution that issues notes and coins. A currency board’s monetary liabilities are fully backed by a foreign reserve currency (also called the anchor currency) and are freely convertible into the reserve currency at a fixed rate on demand. The reserve currency is a convertible foreign currency or a commodity chosen for its expected stability. A currency board holds low-risk, interest-earning securities and other assets payable in the reserve currency. A currency board holds reserves equal to 100 percent or slightly more of its notes and coins in circulation, as set by law.
6. Current situation
Zimbabwe’s current inflation stands at 4.3% YOY as of September 2011. Its economy is slated to rise from 7.8% – 9% in 2012. What caused such a drastic change? In January 2009, Zimbabwe government abandoned the Zimbabwe dollar and allowed trading in US dollars or other foreign currencies. Since February 2, 2009 Zimbabwe has adopted hard currencies for transactions. On March 19, 2009, the South African rand was announced as the reference currency.
Zimbabwe dollar-denominated currency is not functional, and there is no functioning foreign exchange market for Zimbabwe dollars. In April 2009, Zimbabwe abandoned printing of the Zimbabwean dollar, and the South African rand and US dollar became the standard currencies for exchange. The de facto exchange arrangement is classified as other managed exchange arrangement. And the government does not intend to reintroduce the currency until 2012. While five foreign currencies have been granted official status, the U.S. dollar has become the principal currency. Budget revenue estimates and the budget expenditure allocations for 2010 were denominated in U.S. dollars. For noncash transactions, the market is exhibiting a strong preference for theU.S. dollar. Banks estimate that some four-fifths of all transactions are takingplace in U.S. dollars, including most wage payments. Furthermore, stock exchange trading takes place in U.S. dollars, the payments systems operate in U.S. dollars, and the banking system and the Reserve Bank of Zimbabwe (RBZ) maintain accounting in U.S. dollars. In cash transactions, the U.S.dollar is the currency of choice, but the rand is prevalent in the South of thecountry, and it also circulates in the rest of the country, in particular coins.
The multicurrency system has provided significant benefits. Inparticular, it fostered the re-monetization of the economy and financial re-intermediation,helped enforce fiscal discipline by precluding inflationary financing of the budget, and brought greater transparency in pricing and accounting after a long period of high inflation. As a result, the price level in U.S. dollars declined during 2009, while the economy started to recover. The multicurrency system also poses a number of challenges. First, prices and wages are usually agreed and quoted in U.S. dollars, while South Africa is Zimbabwe’s main trading partner and country of origin of capital inflows. Movements in the U.S. dollar/rand exchange rate therefore have considerable effects on Zimbabwe’s competitiveness and international investment position. Second, shortages of small-denomination U.S. dollar banknotes and coins pose difficulties for retailers. Third, some politicians have expressed concern that loss of the national currency and seigniorage is an undesirable erosion of sovereignty and monetary independence.
doc_716972893.docx
Documentation about the difference between inflation and hyperinflation, various hyperinflationary models, reasons of hyperinflation in zimbabwe. It also covers various approaches to tackle inflation.
Hyperinflation in Zimbabwe
Contents
1. Inflation and Hyperinflation .................................................................................................................. 1 1.1 How is Inflation Measured? ................................................................................................................ 1 1.2 Hyperinflation ...................................................................................... Error! Bookmark not defined. 1.2.1 Common Factors which have caused Hyperinflation in the past ............................................. 2
1.2.2 Past Hyperinflation instances .......................................................................................................... 2 1.3 Difference between Inflation and Hyperinflation ............................................................................... 2 2. Hyperinflationary Models ......................................................................................................................... 3 3. Seigniorage & Hyperinflation .................................................................................................................... 3 4. Reasons of Hyperinflation in Zimbabwe ................................................................................................... 4 4.1 Unstable Government......................................................................................................................... 4 4.2 Lack of Fiscal Discipline ....................................................................................................................... 5 4.3 Timeline of Events ............................................................................................................................... 5 GDP - real growth rate (%) ......................................................................... Error! Bookmark not defined. 4.2 Application of Theoretical Models ...................................................................................................... 7 5. Possible Approaches to Hyperinflation ..................................................................................................... 8 5.1 Dollarization ........................................................................................................................................ 8 5.2 Free banking system ........................................................................................................................... 9 5.3 Currency board ................................................................................................................................... 9 6. Current situation ....................................................................................................................................... 9
1. Inflation and Hyperinflation
Inflation is defined as a continuing and rapid rise in the price level. According to MiltonFriedman, it is “always and everywhere a monetary phenomenon”. Most economists whethermonetarists or Keynesians, agree that proposition.
Thus,Inflation is the increase in the overall price level or decrease in the value of money caused by ? An imbalance between the money supply and the goods and services in an economy ? And/or when confidence in the currency is eroded
1.1 How is Inflation Measured?
Inflation is measured as the percentage rate of change of a price index over a particular period of time, normally a year.Therefore, if inflation for a particular week is say 7%, it means the index is 7% higher, than it was in the same week during the previous year. The two most important price indices in India are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). The WPI is India’s most watched cost monitor. Most developed countries use the CPI as an index over the WPI.
1.2 Hyperinflation
Hyperinflation is often defined as inflation that exceeds 50 percent per month,which is just over 1 percent per day. Compounded over many months, this rate of inflation leads to very large increases in the price level.An inflation rate of 50 percent per month implies a more than 100-fold increase in the price level over a year and a more than 2-million-fold increase over three years.
Pt=Po(1+r)t Po=Current Price Pt= Price after time t R= inflation rate
1.2.1 Common Factors which have caused Hyperinflation in the past
? Hyperinflation often occurs when there is a large increase in the money supply not supported by gross domestic product (GDP) growth, resulting in an imbalance in the supply and demand for the money. Left unchecked this causes prices to increase, as the currency loses its value. Hyperinflation often occurs when there is a loss of confidence in a currency's ability to maintain its value in the aftermath. Because of this, sellers demand a risk premium to accept the currency, and they do this by raising their prices.
?
1.2.2 Past Hyperinflation instances
Weimar Republic One of the most famous examples of hyperinflation occurred in Germany between January 1922 and November 1923. By some estimates, the average price level increased by a factor of 20 billion, doubling every 28 hours. Yugoslavia Between October 1, 1993 and January 24, 1995, prices increased by 5 quadrillion percent. This was mainly because of the excessive printing of money by the government to cover the budget deficit and irrational economic policies.
1.3 Difference between Inflation and Hyperinflation
Inflation refers to any sustained increase in the “cost of living” expenditures. It is usually thought in the terms of Consumer Price Index (or CPI). And, hyperinflation refers to an “out of control” increase of prices, resulting in diminishing value of a country’s currency. This occurs when there is an increase in the money supply in the domestic market which fails to satisfy the very reasons it seeks to combat. Another difference is that while inflation works towards securing the economic stability of a country, hyperinflation seeks to demobilize the same economy further into the web of debts. In Zimbabwe, the economy was in such a condition that the prices of even the basic items are not less than few million dollars. For example, the price of three eggs was 100 billion dollars and the price of a dozen tomatoes varied between 3-5 million dollars. This shows that during hyperinflation, there are irrational increases in prices which not at all help in any sense, thereby, failing the government to achieve its targets. In other words, hyperinflation is generally associated with paper money as it can easily used to increase the money supply. It effectively destroys the purchasing power of the private and public savings, distorts the economy in favor of extreme consumption, and hoarding of real assets, causing the monetary base (hard currency), to escape the country, while making the afflicted area anathema to investment. Hyperinflation can be characterized by the following conditions: 1. The general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency. Amounts of local currency held are immediately invested to maintain the purchasing power. 2. The general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable foreign currency. Prices may be quoted in that foreign currency. 3. Sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during the credit period, even if the period is short. 4. Interest rates, wages and prices are linked to a price index and the cumulative inflation rate over three years approaches, or exceeds, 100%.
2. Hyperinflationary Models
1) Confidence Model: Some events or series of event cause the people to lose confidence on the money issuing authority. Because of this, people prefer either keeping goods or money of some other nation. The suppliers start charging premium for their products which is much higher than the actual price. To overcome this, the best policy is changing the backing of the currency by issuing a new currency. 2) Monetary Model: The money issuing bodies start printing money to pay the debts or to cover costs coming up because of social unrest or war. When businesspeople perceive that the issuer is committed to a policy of rapid currency expansion, they mark up prices to cover the expected decay in the currency's value. The money issuing authority must then accelerate its expansion to cover these prices, which push the currency value down.
2. Seigniorage & Hyperinflation
Seigniorage is the revenue earned by the government by printing money.
Seigniorage Laffer Curve It shows the relationship between steady state inflation rate and Seigniorage revenue. It indicates that seigniorage revenue must rise for a while and then fall again as inflation rises. Thereforethere is an inflation rate that produces a maximum amount of seigniorage with a stable rate of inflation. Above that steady state inflation rate, it is possible to collect more seigniorage than SEmax, the maximum amount, but only if the inflation rate is constantly increasing.
4. Reasons of Hyperinflation in Zimbabwe
At Independence in 1980, the Zimbabwe dollar was worth about USD 1.25. Since then, rampant inflation and the collapse of the economy have severely devalued the currency, causing many organisations to favour using the US dollar or South African rand instead. Inflation was stable until Robert Mugabe began a program of land reforms that primarily focused on taking land from white farmers and redistributing those properties and assets to black farmers; this in turn sent food production and revenues from export of food plummeting. Though inflation in Zimbabwe was a monetary phenomena (the result of Mugabe's government printing money) as can be seen by the appearance of ever higher face value printed notes (whose face value exceeded the sum of all previously existing notes).
4.1 Unstable Government
According to Transparency International, (Released on 1st Dec 2011) Zimbabwe's government ranked154th out of 182 in terms of institutionalized corruption. This corruption directly affected the country causing instability and negative economic effects. The violent land reform program destroyed the agricultural sector in Zimbabwe and in particular the tobacco industry which accounted for one-third of Zimbabwe's foreign exchange earnings. The manufacturing and mining sectors also suffered great declines. Instead of instituting constructive policies, the government continued to spend and print money.
4.2 Lack of Fiscal Discipline
Mugabe's government was printing money to finance troops in the Democratic Republic of the Congo. In 2000 Mugabe authorized Zimbabwean troops to fight in the Second Congo War. The involvement in the Congolese war cost millions of dollars a month. One of the main costs of this war involvement was paying higher salaries to army and government officials. This required the printing of currency. Zimbabwe was grossly under-reporting its spending involvement in this war to the International Monetary Fund. Some reports cite a discrepancy of $22 million a month. Zimbabwe was involved in this conflict not because the Democratic Republic of the Congo was a bordering nation and posed a threat, but instead because rebel territory contained diamond mines. These mines were the motivating factor for involvement in the conflict. The Government of Zimbabwe struck a deal with the Government of the Democratic Republic of the Congo that involved a joint venture in diamond and gold mines to serve as payment for involvement. It has been rumoured that many of the diamonds and the revenue from the mine have been funnelled into the corrupt government purse or former soldiers have illegally removed diamonds from the mines.
4.3Timeline of Events
- Early in the 21st century Zimbabwe started to experience chronic inflation. Inflation reached 624% in 2004, and then fell back to low triple digits before surging to a new high of 1,730% in 2006. During that time, the Reserve Bank of Zimbabwe revalued its currency on 1 August 2006 at a rate of 1,000 old Zimbabwean dollars to 1 revalued Zimbabwean dollar. - In June 2007 inflation in Zimbabwe had risen to 11,000% year-to-year from an earlier estimate of 9,000%. - On 5 May 2008 the Reserve Bank of Zimbabwe issued bank notes or "bearer cheques" for the value of ZWD 100 million and ZWD 250 million. Ten days later on 15 May, new bearer cheques with a value of ZWD 500 million (then equivalent to about USD 2.5) were issued. Five days later on 20 May a new series of notes in the form of "agro cheques" were issued in denominations of ZWD 5 billion, ZWD 25 billion and ZWD 50 billion. An additional agro cheque was issued for ZWD 100 billion on 21 July. Meanwhile inflation has officially surged to 2,200,000% with some analysts estimating figures surpassing 9,000,000 percent. - As of 22 July 2008 the value of the ZWD had fallen to approximately 688 billion per 1 USD, or 688 trillion pre-August 2006 Zimbabwean dollars. - On 1 August 2008, the Zimbabwe dollar was redenominated by removing 10 zeroes. ZWD 10 billion became 1 dollar after the redenomination. - On 19 August 2008, official figures announced for June estimated the inflation over 11,250,000 percent. Zimbabwe's annual inflation was 231,000,000% in Jul(prices doubling every 17.3 days). - For periods after July 2008, no official inflation statistics were released. Prof. Steve H. Hanke overcame the problem by estimating inflation rates after July 2008 and publishing the Hanke Hyperinflation Index
for Zimbabwe.Prof. Hanke’s HHIZ measure indicates that the inflation peaked at an annual rate of 89.7 sextillion percent (89,700,000,000,000,000,000,000%) in mid-November 2008. The peak monthly rate was 79.6 billion percent, which is equivalent to a 98% daily rate. At that rate, prices were doubling every 24.7 hours. - At its November 2008 peak, Zimbabwe’s rate of inflation approached, but failed to surpass, Hungary’s July 1946 world record. - On 16 January 2009, Zimbabwe issued a ZWD100 trillion bill. The hyperinflation officially ended in January 2009 when official inflation rates in USD were announced. - In February the government of Zimbabwe revalued its currency. One of these new Zimbabwean dollars is worth one trillion of the previous. This move took the number of decimal places removed during the period of hyperinflation to 25 (1025 = 10 septillion short scale; thus, if no revaluations had taken place, Zimbabwe would now be issuing 10 septillion dollar notes).
Umemployment Rates (%)
GDP - real growth rate (%)
4.2 Application of Theoretical Models
According to “Quantity theory of money”, Massive imbalance between the supply and demand of a certain currency or type of money, usually due to a complete loss of confidence in the currency similar to a bank-run causes hyperinflation. This situation occurred in Zimbabwe because of the following reasons: 1. The unbudgeted government expenditure of 1997 (to pay the war veterans gratuities) 2. The publicly condemned and unjustifiable Zimbabwe’s intervention in the Democratic Republic of Congo (DRC)’s war in 1998 3. The expenses of the controversial land reform (beginning 2000) 4. The parliamentary (2000/2005) and presidential (2002) elections 5. Introduction of senators in 2005 (at least 66 posts) as part of ‘widening the think tank base’ -the international payments obligations 6. Especially since 2004, all resulted in massive money printing by the government. IMF has said however that the principal causes of inflation, chiefly reckless state spending, arbitrary government controls and the flight of foreign investment remain unchanged, and warns that little change can be expected until issues of political governance are deal with. According to Cost-Push Theory of Inflation, Prices rise due to increasing cost of the factors of production. Given the acute shortage of foreign currency in the country since 2000 (due to, and not limited to, exports decline, closed donor community, dried foreign currency reserves and reduced financial aid from IMF and World Bank), most imports have been financed by expensive foreign currency from the black market, thus resulting in higher output costs surfacing in higher market/consumer prices.Presently termed "supply shock inflation," it is caused by drops in aggregate supply due to increased prices of inputs, for example. Unavailability of forex being a key driver of cost push inflation in Zimbabwe.
According to Demand-Pull Theory, Inflationary pressures arise because of excess demand for goods and services resulting from expansionary monetary and fiscal policies. Zimbabwean situation has been compounded by shortages of basic commodities (i.e., mealie-meal (staple diet), cooking oil, flour, fuel, sugar, to mention a few), thus result in pent-up upward pressure in the overall prices. Inflation and Expectations: Both households and firms form their expectations of inflation based on recently observed inflation and this may affect the general price level. Proponents of the theory maintain that prices are rising because people expect them to rise and they expect them to rise because they have seen them rising. Structural Factors: The effects of droughts since 2000 coupled with under utilization of most commercial farms (after the land reform) have also resulted in production decline and shortages of most locally produced consumption products. Other factors: Foreign currency shortages as well as exchange rate misalignment have also resulted in general increase in prices. Added to the shortage is the exchange rate misalignment where by the official exchange has been far below the market-determined rates, resulting in a growing black/parallel market for foreign currency. Due to this shortage, imports of raw materials have been acquired using expensive foreign currency from the black market. The ultimate effect of this has been cost-push inflation.
5.Possible Approaches to Hyperinflation
The quickest way to stop hyperinflation is to replace central banking with a new monetary regime. This would instill confidence in the currency. In Zimbabwe’s historical experience with a variety of monetary systems, only central banking has produced hyperinflation. Similarly, throughout the world, hyperinflation has been a phenomenon linked to central banking or its close cousin, the direct issue of currency by a government’s treasury. During the transition, real interest rates become punishingly high, and long-term loans in local currency become difficult to obtain. As a result, economic growth becomes relatively slow, general living standards become stagnant, and the scourge of poverty spreads. For replacing the central bank with some other monetary regime thereare 3 options available 1) Dollarization 2) Currency board 3) Free banking These options are not mutually exclusive. For example, a currency board system could be combined with official dollarization, as in the monetary systems of Lesotho, Namibia, and Swaziland.
5.1 Dollarization
1. Unofficial
When individual holds foreign currency, bank deposits or notes to protect against the inflation in domestic currency.Zimbabwe was already unofficially dollarized to the extent that Zimbabweans held South African rand, U.S. dollars, pounds sterling, and other foreign currencies as stores of value. Zimbabwe was already unofficially dollarized to the extent that Zimbabweans held South African rand, U.S. dollars, pounds sterling, and other foreign currencies as stores of value. 2. Semi-official Under semiofficial dollarization, foreign currency is legal tender and may even dominate bank deposits, but it plays a secondary role to domestic currency in paying wages, taxes, and everyday expenses such as grocery and electric bills. Unlike officially dollarized countries, semiofficially dollarized ones retain a domestic central bank or other monetary authority and have corresponding latitude to conduct their own monetary policy. 3. Official Official dollarization could be based on, for example, the South African rand, the U.S. dollar, or the euro. For Eg: If Zimbabwe used the rand, it could negotiate a profit-sharing agreement such as Lesotho and Namibia now have, and which Botswana and Swaziland formerly had. Under these agreements, South Africa shares the profit (seigniorage) it derives from issuing currency, according to estimates of how many rand notes (paper money) and coins are in circulation in the partner country.
5.2 Free banking system
A completely free banking system has no central bank, no lender of last resort, no reserve requirements, and no legal restrictions on bank portfolios, interest rates, or branch banking. Free banking systems existed in nearly 60 countries during the 1800s and early 1900s. In general, these systems were relatively stable, issued currencies convertible into gold or silver at fixed exchange rates, and were not purveyors of inflation. Zimbabwe had free banking from the time its first bank was established in 1892 but it was replaced by currency board in 1940.
5.3 Currency board
Zimbabwe had currency board in 1940. A currency board is a monetary institution that issues notes and coins. A currency board’s monetary liabilities are fully backed by a foreign reserve currency (also called the anchor currency) and are freely convertible into the reserve currency at a fixed rate on demand. The reserve currency is a convertible foreign currency or a commodity chosen for its expected stability. A currency board holds low-risk, interest-earning securities and other assets payable in the reserve currency. A currency board holds reserves equal to 100 percent or slightly more of its notes and coins in circulation, as set by law.
6. Current situation
Zimbabwe’s current inflation stands at 4.3% YOY as of September 2011. Its economy is slated to rise from 7.8% – 9% in 2012. What caused such a drastic change? In January 2009, Zimbabwe government abandoned the Zimbabwe dollar and allowed trading in US dollars or other foreign currencies. Since February 2, 2009 Zimbabwe has adopted hard currencies for transactions. On March 19, 2009, the South African rand was announced as the reference currency.
Zimbabwe dollar-denominated currency is not functional, and there is no functioning foreign exchange market for Zimbabwe dollars. In April 2009, Zimbabwe abandoned printing of the Zimbabwean dollar, and the South African rand and US dollar became the standard currencies for exchange. The de facto exchange arrangement is classified as other managed exchange arrangement. And the government does not intend to reintroduce the currency until 2012. While five foreign currencies have been granted official status, the U.S. dollar has become the principal currency. Budget revenue estimates and the budget expenditure allocations for 2010 were denominated in U.S. dollars. For noncash transactions, the market is exhibiting a strong preference for theU.S. dollar. Banks estimate that some four-fifths of all transactions are takingplace in U.S. dollars, including most wage payments. Furthermore, stock exchange trading takes place in U.S. dollars, the payments systems operate in U.S. dollars, and the banking system and the Reserve Bank of Zimbabwe (RBZ) maintain accounting in U.S. dollars. In cash transactions, the U.S.dollar is the currency of choice, but the rand is prevalent in the South of thecountry, and it also circulates in the rest of the country, in particular coins.
The multicurrency system has provided significant benefits. Inparticular, it fostered the re-monetization of the economy and financial re-intermediation,helped enforce fiscal discipline by precluding inflationary financing of the budget, and brought greater transparency in pricing and accounting after a long period of high inflation. As a result, the price level in U.S. dollars declined during 2009, while the economy started to recover. The multicurrency system also poses a number of challenges. First, prices and wages are usually agreed and quoted in U.S. dollars, while South Africa is Zimbabwe’s main trading partner and country of origin of capital inflows. Movements in the U.S. dollar/rand exchange rate therefore have considerable effects on Zimbabwe’s competitiveness and international investment position. Second, shortages of small-denomination U.S. dollar banknotes and coins pose difficulties for retailers. Third, some politicians have expressed concern that loss of the national currency and seigniorage is an undesirable erosion of sovereignty and monetary independence.
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