0.1 Economic development is about all of economics  (Page 13/14)

7) The Importance of Price Stability

Experience over centuries furnishes ample evidence that sustained inflation at rates much above 2 percent per year is, everywhere and always, a result of monetary expansion. Most commonly, inflation in poor countries has been the consequence of monetary expansion used to finance domestic budget deficits often exceeding 10-15% of GDP. Some nations especially in Latin America and Africa have experienced the trauma of hyperinflation (inflation>100% year) which sometimes reaches 2,000% per year. Governments often attempt to suppress inflationary pressures by resorting to price controls and by clinging to a fixed exchange rate. The usual result is serious resource misallocation, economic misery and a badly misaligned exchange rate that cannot be sustained. One of the important questions we will address in Econ 460: How can it be that budget deficits of 6-8% GDP are not very inflationary in the U.S. but can be very inflationary in poor nations?

Countries that chronically suffer from domestic inflation in excess of world inflation strongly tend to have lower economic growth. Chronic inflation has insidious effects: it reduces investment and warps it toward shorter time horizons. It undermines domestic tax systems and weakens domestic financial institutions. And finally, inflation really worsens income distribution worldwide; the brunt of the burden of inflation has long been borne by the weakest, poorest groups in society.

8) The Role of Financial Institutions, Financial Development and the Real Interest Rate

For three decades after World War II, governments on all continents (to one degree or another), sought to subsidize loans to favored groups or economic sectors. How? By holding nominal interest rates not only below market rates, but also below inflation rates. This results in negative real interest rates, which in turn results in what is called “ shallow finance ” that typically has resulted in hollowing out of the domestic financial systems. Shallow finance reduces the overall availability of finance, and at the same time misdirects financial flows by under-pricing of capital. It has corrosive effects upon growth and income distribution. Shallow finance is also bad for employment in labor-surplus nations (most lesser developed countries, or LDCs) because it produces artificial incentives for capital-intensive techniques of production. Therefore shallow finance is also bad for income inequality.

There is an alternative that has been used successfully by several countries: a strategy of deep finance. Countries employing techniques of deep finance, especially the maintenance of positive real interest rates (interest rates in excess of inflation) have reaped large benefits. Deep finance is an essential component of “bottom-up development.” It fosters sustained, healthy growth in the real size of the organized financial system with consequent improvements in growth prospects. It also helps improve income distribution . How can it do that? Deep finance allows greater access to credit and economic empowerment for small businesses and for marginalized groups in society. The much vaunted, and generally successful micro finance movement in India, Indonesia, Peru and Mexico, among other nations, is but one of the outgrowths of deep finance strategies. Readers of this collection will come to understand something of the importance of key MACRO prices in economic growth. Like the real exchange rate, the real interest rate, the wage rate, as well as basic prices of agricultural products.