Wednesday, 2 April 2008

What inflation rate should a developing country have?

I am sometimes asked what inflation rate a developing country should have. It is not an easy question to answer. The answer is highly likely to be between zero and ten percent per year in normal situations, but no-one expects an answer of 48 percent anyway as that would expose the country to hyperinflation and have some grave problems in itself. And even 48 percent might be a good inflation rate if it has been above 1000 percent for the last few years.

Usually it is a difficult question. The developing country might have an inflation rate of six percent for the last few years - should the government put in an effort to bring it down to three percent?

Good practice in analysis would start by looking at the quality of the data. Inflation data can be misreported and be higher than the real rate. If the government is targeting two percent in real rates, then the reported data rate for targeting may be four percent. If a reported data rate of two percent is targeted, then the real rate may be zero percent.

There are some general considerations which should be analysed for determining the most suitable rate for a country. Economists have listed them at length, and I will describe just a few, though I might put a more extensive analysis toolkit in my next macroeconomics course for students. The considerations include: how many people in the economy have fixed incomes such as pensions which are reduced by inflation; how stable the inflation rate is; how good businesses and the workforce are at adjusting to the inflation rate without escalating it; and what the risk of hyperinflation is.

A zero or even very low rate of inflation may not be a great target because inflation is linked to government and bank decisions to issue money. These decisions, by virtue of their redistribution effect, can result in increased economic growth. To take an extreme example: suppose all the money in the economy is in the hands of one person, who won't spend it. The government prints money, gives it to everyone apart from the one person, and they spend it. Output increases.

Another reason for zero or extremely low inflation being a less than sparkling idea is that capitalist activity can generate inflation itself. Entrepreneurs may raise their prices hoping to increase profits, or out of fear that their suppliers will increase prices and their net profits will decline. The mechanism here is less clear cut than the money creation route, but probably still occurs. In developing countries, squashing capitalist activity merely to get very low inflation would be unfortunate.

No comments: