The True Underpinnings of our Inflation

In response to an article written by Charles Ross, posted in the Jamaica Observer on May 4th, 2008, titled "What is really behind our inflation rate?".

(Note: The arguments contained herein are those of the author and should not be considered the position of the PSOJ.)

Is the case of Jamaica's recently high rate of inflation due mainly to the changes being observed in its monetary aggregates?

It is Milton Friedman, awarded the Noble Prize in Economics in 1976, who told us that Inflation is always and everywhere a monetary phenomenon, Is this True or False?

True by both Keynesian's and Monetarist standards but is the evidence clear? Milton Friedman clearly stated that "whenever a country's inflation rate is extremely high for a sustained period of time, its rate of money supply growth is also extremely high" (Mishkin F. S. (2004), p632). This suggests that for an inflation rate that significantly deviates form the norm over time, one can expect to find money supply exceeding the level required to pay for available goods and services given at their starting period prices. But let us consider two scenarios and examine what this really means:

Scenario 1 (more money followed by increased prices): Consider a country where the supply of goods and services are relatively unchanging during a year. Consider also that for some reason the central bank decided on redeeming a considerable value of its locally issued financial instruments. This will undoubtedly increase money supply and generate a greater demand for goods and services within the local economy. This is what economists consider to be an excess demand over supply.

The Law of Demand and Supply suggests that whenever there is excess demand, prices will move-upward should suppliers find it difficult to immediately adjust there inventories. Here, one sees where a greater money supply generated increased demand for goods and services and lead to inflated prices within the market. But does this fully explain what Friedman is saying? What if the supply of goods or services was temporarily disrupted by some major external factor such as a hurricane? Let us consider such a scenario below.

Scenario 2 (increased prices followed by more money): Imagine a small country that has a significant portion of its consumer basket reflecting price changes within its agriculture sector. Consider an unfortunate year when a serious hurricane hits the island and local produce became significantly scarce. This will undoubtedly lead to higher prices causing the consumer basket to reflect a higher rate of inflation.
In such a scenario, the central bank recognizes that there is an increased level of demand for money to meet regular spending habits at higher prices. The market would reflect some tightness and would require an open market (buy) operation to supply more money to the market. In this situation, one can point out a similar correlation between inflation and money supply, both trend in the same direction. We observe that inflated prices resulting from a supply shock was followed by an increase in the supply of money by the central bank.

The question that remains to be answered is this. Is it greater money supply that is causing inflation or is it some other factor that cause a rise in inflation triggering a central bank response of increasing the money supply? One simply looking at the correlation between money supply and inflation would conclude that there is undoubtedly a strong relationship. But, there is clearly a chicken and egg situation. Truth is, the literature highlights that the statement: "Inflation is always and everywhere a monetary phenomenon" is a reduced form evidence based only on a striking correlation of money supply with inflation, but one cannot definitively say that one causes the other in all cases.

It is true that if money supply is increased more than needed then inflation will increase (scenario-1). But this is not always the case as factors such as supply shocks (scenario-2) and even non-monetary-related demand shocks can cause inflated prices within the short-term. Additional money supply cannot instantly increase the supply of oil, corn, yam and bananas at a time when they are in shortage. As long as commodities are scarce, the prices will tend to remain high whether additional money is pumped into the market or the stock of money supply remains the same. In both cases there will be more money than is needed to match the available goods and services.

The point that must be made is that money supply can become more than needed (excess) even if the stock of money supply does not change or even if it falls. For example, if all supermarkets, wholesalers and retailers colluded and went on strike for a week because the government decided to tax them more, then there would be too much money floating in the economy during that week. Even if the BOJ mop-up some of the excess money in supply, it might not be enough to prevent from escalating prices on the streets.

Market Adjustment:

In the short to medium term, it is the surplus money supply that generates the needed demand that will signal to producers and suppliers to increase their inventories and correct the shortage that exist within the market. In economic terms, the market will always tend toward equilibrium where the amount demanded will eventually be the same as the amount supplied. Some schools argue that the market should be left alone so that these forces can work effectively.

Having recognized that an increased or fixed money supply will have little or no effect on prices of scarce commodities, one might desire to know what will happen if the central bank reduced money supply. Is this a recommended strategy given a situation of higher prices and inflexible supplies? It turns out that, limiting the money supply in a time of scarcity can result in one of two things:

Lower demand pressure (too little money in circulation) will motivate suppliers to lower their prices and eliminate the incentive needed for farmers to improve their stocks. This will stifle the sectors performance (e.g. agriculture) and keep prices continually depressed. Or.
Prices remain high where suppliers are inflexible in order to make breakeven profits. In such cases lower money supply and high prices will place unneeded pressure on consumers especially if the commodity is a necessary one such as oil.

Reducing money supply in a situation of scarcity will therefore disrupt the market adjustment mechanism and make matters even worse.

The Right Money Supply:

Who determines when money supply is more than needed? Clearly there must be some lag to determine this. One can only say that there is too much money supply pushing prices higher when observation shows that over a reasonable period of time prices are rising at high rates. Otherwise, this can only be predicted with historical information while allowing for some level of uncertainty. Using predictions however, the central bank can reduce the lag time of open market operations (OMO's) geared at controlling inflation. It is the definite effect that money supply has on inflation (scenario 1) that gives the central bank the tools to effectively influence economic fundamentals by way of Open Market Operations.

The Evidence of Supply Shocks:

In scenario 2, it was made evident that supply shocks can cause prices to inflate and then trigger a central bank policy response of increasing money supply to deal with the tightness that would have developed in the financial market. Though highly correlated, in this instance prices rose first and then money supply (contrary to scenario-1). This central bank response would be the recommended policy if it is also concerned about maintaining stability within the foreign exchange market.

Inflation was 5.8% in 2006 which is almost a third (1/3) of the 2007 inflation rate of 16.8%. In 2007, Jamaica experienced hurricane Dean followed by prolonged rainfall leading to a shortage of local agriculture produce. There were also supply shortages of commodities on the international markets for oils, grains and fertilizers during the year. With little surprise, the Food and Non-Alcoholic Beverages contributed a 9.25% points to the 16.8% annual inflation in 2007, making it the largest contributor to inflation during that period. Of this contribution, 96% represented changes in the price of food items only. In 2006, considered to be a year of favorable weather, the segment contributed only 1.8% points of the 5.7% annual inflation. In that period, starchy food prices actually fell due to recovery of the sector following hurricane Ivan in 2004.

The second largest contributor to inflation was the segment "Housing, Water, Electricity, Gas and other Fuels". This was not a surprise either representing 2.68% points of the total 16.8% annual inflation. Close to 70% of this contribution was attributed to "electricity, gas and other fuels" only. These extraordinary changes in prices were without a doubt the underlying cause for the higher levels of inflation during the 2007 period. Similar trends were observed in other years of natural disaster.

The true circumstances that prevail reveal that Jamaica is situated within a hurricane belt where such events ever-so-often disrupts our food supplies. Food continues to represent a significant 35% of our Consumer Price Index (CPI). Electricity, gas and water represent another 7% along with (closely related) transportation costs representing approximately 13% of the CPI. Jamaica relies on externally imported oil and grains for inputs into its productive sector. There are little to no substitutes for such imported commodities which leave the nation at the whim of external pressures.

There is no doubt that external factors (hurricanes, oil shocks, foreign policy etc.) remain a significant influence on local price trends. Money supply, however, having a direct impact on inflation has contributed less than significantly to the resulting trends in prices. BOJ in my opinion have eliminated the inflationary risks associated with changes in monetary aggregates (diversifiable risks if you may) leaving non-monetary factors as the cause of the spurious movement in inflation that is being observed. Meanwhile, changes in money supply will continue to closely mirror changes in inflation as the central bank remains committed to keeping money supply within reasonable ranges to prevent instances of hyper inflation and significant fluctuations in the value of the local currency.

James Robinson
Research Economist
The Private Sector Organisation of Jamaica
39 Hope Road, Kgn 10.
Tel: 927-6238 Ext. 2248 Fax: 927-5137
Website: www.psoj.org Email: jamesr@psoj.org