Tell them about inflation!
View(s):
Less and less demand results in a decline in inflation!
Most of the adults know what inflation is, because they have experienced it as a real-life situation. They may explain this to their children: “Those days, we took money in the wallet and brought our purchases in a basket; nowadays, we have to take money in a basket to bring the purchases in the pocket.” That is exactly, what we mean by inflation.
Those days are, however, gone now. It is not surprising nowadays, even if students learning economics have a difficulty in understanding inflation. The new generation born since the turn of the Century doesn’t have much life experience with inflation, compared to their previous generations. I am referring to the inflationary trends in the world, not just Sri Lanka alone; of course, being a small economy integrated with the international markets, Sri Lanka’s inflation has also been moving closely with global inflationary trends.
Low-inflationary era
Let me elaborate my point. About 20 years after 1978, Sri Lanka had high inflation and for most of the years it was double-digit inflation rate running at around 15 per cent; in some years it even exceeded 20 per cent. A few years before 2009, again we had a high inflation rate. Over the past 12 years, Sri Lanka’s inflation has been lower and remained at single-digit level; sometimes it fell even below 5 per cent.
Sri Lanka’s inflation moves closely with world inflation too. While the highest world inflation was in the 1970s, it was running above 10 per cent in the early years of the 1980s as well. The average rate of inflation for the period from 1981-1995 was 8.3 per cent. Then, the world inflation started to decline to 5 per cent, to 3 per cent and finally to 2 per cent during the past 25 years, although there has been a short-term increase in the rate of inflation again for a couple of years before 2009.
The world economy is passing through a “low-inflationary” era. While most of the developing countries are experiencing low inflation, advanced countries are fearful of “deflation” – a gradual decline in the average prices. Many countries in the Euro area and the Scandinavian region have intermittently experienced deflation as well. Japan already had a long-standing deflationary problem. The US targeted 2 per cent annual inflation rate after its experience with zero inflation in the mid-2010s. As the COVID-19 pandemic broke out last year, most of the efforts in advanced countries to keep inflation rate above zero level became futile.
Expectations come true
The long-term declining trend in inflation is a confirmation of the long-term recession of the world economy. After world inflation was at its peak in the 1970s, it has recorded a declining trend over the past 30 years. Until the world economy was hit by the global financial crisis in 2008/09; it continued to remain at its lower status, and then the world economy was hit by the COVID-19 pandemic last year.
When the world economy is moving along a recessionary path, inflation is due to fall. This is because of the gradual loss of private spending – consumer spending by the households and business spending by the business firms. As consumers begin to cut down their spending on food and drinks, clothing and shoes, transport and vacations, durables, and residential investments, there will be less and less purchases of the output. Similarly, as producers also begin to cut down their spending on raw materials and accessories, energy and transport, input stocks and output stocks, and new investment, there will be less and less orders to match the falling consumer demand.
As demand is falling, output is falling too. As output is falling, here comes lower economic growth with loss of income and jobs, causing a further decline in consumer spending, and hence, business spending. Less and less demand results in a decline in inflation!
It is not only the lower inflation, but also the “lower inflationary expectations” which make the matter worse. When the public begin to feel that inflation is lower, naturally they begin to build “expectations” over a further decline in future inflation; and the irony is that, it happens too. It is because the public act on their “expectations”. This means that if the public anticipate lower inflation in the future, they begin to postpone their spending decisions which will make the recessions faster and the fall in inflation greater. For the same reason, it is difficult for the countries to get out of that “deflation”, once they are caught up in deflationary situations.
Intermittent disturbances
Recessions may not be smooth movements either, because there can be many other interruptions which would affect either way, negatively or positively. As we have already outlined above, the three decades of long-term falling inflation was reversed during 2005-2008 and the world began to experience higher inflationary trends. It was caused by higher oil prices as the world oil demand rose exponentially.
At least partly, it was also caused by investment speculations because world investments moved from traditional equity markets and bond markets to safe havens such as oil and gold. As investment in oil reserves grew, both production and consumption activities in the world were interrupted. As the world was moving into alternative energy sources including biofuel, food prices increased too. Therefore, just before the 2008/09 global crisis, there was a reversal in falling inflation.
In contrast, after 2020 there was a speeding of the decline in inflation in general and causing even deflation in some countries in particular due to the COVID-19 pandemic issue. This, the severity of the world economic recession, multiplied with the COVID-19 pandemic, which pulled many advanced countries into deflation.
The experience of different countries can also be different due to their domestic factors, including the way they handle policies in the face of a world economic recession. That’s why some of the countries are still experiencing high inflation even in the midst of a lower inflationary era in the world. There are some countries which have double-digit inflation, while Zimbabwe and Venezuela are having even hyper-inflation.
New opportunity
Decline in inflation has brought about a unique opportunity for crisis-ridden advanced countries as well as developing countries to “print more money”. As we discussed last week, this has been mistaken as adopting “modern money theory”. Low inflationary era is a situation that demands money printing!
Money-printing is expected to support both fiscal stimulus as well as monetary stimulus in crisis-ridden economies. The government has to start spending more as private spending has become weaker so that the act of money-printing could support the government. Under the monetary stimulus, more money injected to the banking system leads to private credit expansion at lower interest rates. Accordingly, private spending by consumers and businesses is also expected to boost the demand side of the economy. Therefore, both fiscal and monetary stimuli are expected to mitigate the recessionary impact on the lives of people and to get the economy out of the recession.
All these expectations are, perhaps, possibilities only because there is no potential inflationary pressure. If there is inflationary pressure both – increased government spending or money printing – would lead to accelerating of inflation. This is also a possible scenario along the expansionary path of an economy.
Economic recessions with subsided inflationary pressure demand fiscal expansion and monetary growth including money-printing. On the contrary, economic expansion with rising inflationary pressure demands fiscal prudence and monetary discipline. It is just the nature of the cyclical movement of aggregate economic activities – the so-called business cycle.
(The writer is a Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk and follow on Twitter @SirimalAshoka).