Inflation: Causes, Dynamics,
and Consequences
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PARMESHWAR RAMLOGAN
IMF RESIDENT REPRESENTATIVE
1 7 TH M A Y 2 0 1 0
Organization of the Presentation
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 The “Evils” of Inflation
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Inflation harms economic growth
Inflation increases poverty and income inequality
Inflation generates financial instability
 Causes and Dynamics of Inflation
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International price shocks
Autonomous wage increases
Domestic supply shocks
Excess demand
Inflationary Expectations
 The International Shift To Inflation Targeting
Inflation Harms Economic Growth
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International Experience
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Low and stable inflation promotes
economic growth.
There is a threshold rate above which
inflation reduces economic growth.
The threshold inflation rate is low: single
digits, even low single digits.
The negative effect on growth is highest
just after the threshold is crossed, and
tapers off as the inflation rate increases.
Inflation Harms Economic Growth
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 Experience of Mongolia
 In light of international experience, the
inflation outlook for Mongolia is
disturbing. Inflation could reach –
percent in 2010.
 Such a high inflation rate would
seriously damage Mongolia’s economic
growth prospects.
Why Does Inflation Harm Economic Growth?
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Reduces consumption.
Reduces investment.
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Negative real interest rates lower saving.
Uncertainty about future inflation
increases the riskiness of long-term
financial contracts and investment plans.
Reduces external competitiveness
through real exchange rate
appreciation.
 Generates financial instability.

Inflation Increases Poverty and Income Inequality
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International Experience
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Inflation increases poverty levels and rates.
Inflation can cancel out the positive effect of economic
growth on poverty. That is, higher economic growth
does not reduce poverty if it is accompanied by higher
inflation. Countries may be better off with low growth
and low inflation than with high growth and high
inflation.
Clear policy implication: Any policy measure to reduce
poverty may be self-defeating if it raises the inflation rate.
Why Does Inflation Increase Poverty and Inequality?
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 Inflation affects households unequally.
 Inflation has the biggest impact on the
real income and consumption of the
poor.
 Why?
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The income of the poor is not indexed, or not
fully indexed, to inflation.
Savings of the poor are more likely to be in
cash or unhedged instruments.
Inflation Generates Financial Instability
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Inflation may provoke currency and banking crises.
How?
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Inflation leads to dollarization, capital flight, and deterioration
of the trade balance
These lead to pressures on the currency to depreciate.
Expectations of depreciation may result in a speculative
attack on the currency.
The currency crisis may lead to a banking crisis because of:
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Currency mismatches on banks’ balance sheets
Rising non-performing loans of firms due to increased debt
service costs
Capital flight may lead to run on bank deposits
Causes and Dynamics of Inflation
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 International Price Shocks
 Example: International fuel and food price increases in 2008
 Impacts directly on consumer price index or indirectly via
production costs.
 Impact may be magnified by subsequent currency
depreciation.
Causes and Dynamics of Inflation
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 Autonomous wage increases
 Wage increases not stemming from, or in excess of, prior
inflation
 Wage increases in excess of productivity increases, usually
stemming from demonstration effects
 Leads to a wage-price spiral
Causes and Dynamics of Inflation
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 Domestic supply shocks
 Example: Current meat price increase in Mongolia due to the
dzud.
 Inflationary impact depends on the policy response.
Causes and Dynamics of Inflation
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 Excess demand
 Domestic demand too high relative to the production capacity
of the economy
 Acts directly on prices of locally-produced goods or indirectly
on prices of imports through currency depreciation
 Major source is excessive government spending financed by
money creation
 Sources of inflationary financing: (1) revenue shock in the
mineral sector in Mongolia, (2) the central bank, or (3)
external borrowing
 Assumption: no central bank sterilization
Causes and Dynamics of Inflation
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 Inflationary Expectations
 Public expectations of inflation generate behaviour that feeds
back onto the inflationary process. Inflation becomes a selfgenerating process.
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Examples: indexation of wage contracts, capital flight.
Sources of inflationary expectations:
Past history of inflation. History of high inflation can lead to
inflation inertia.
 Inflationary fiscal and monetary policies.
 Lack of credibility of the central bank

The International Shift Toward Inflation Targeting
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 More and more countries are using inflation targeting to
anchor inflationary expectations.
 Core elements of inflation targeting:
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Set a target inflation or inflation range
Communicate that target clearly to the public
Do everything possible to achieve that target or target range
 Currently 26 countries have formally adopted inflation
targeting. Including major copper producers such as
Chile, Peru, Australia, Indonesia, and Canada (Table).
 Inflation targeters appear to have achieved better
macroeconomic performance than non-targeters
(Charts).
The International Shift Toward Inflation Targeting
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The International Shift Toward Inflation Targeting
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The International Shift Toward Inflation Targeting
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The International Shift Toward Inflation Targeting
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