Inflation crises in low-income countries: policies for economic stability and growth

Abstract

High inflation is associated with numerous disturbances in economies including higher probability of e.g., fiscal crises and slowdown of growth. Low-income countries experience more problems with inflation than advanced economies. These economies are largely focused on primary commodity production, which is an important source of inflationary development. Primary commodities are subject to frequent shocks in e.g., prices and cause turbulence in these economies. This thesis studies two research questions: <how can low income countries manage inflation and avoid inflation crises?= and <do commodity prices cause inflation crises in low-income countries?=. The first question is answered mainly through a literature review and the second question through an empirical study following the methods of Eberhart & Presbitero (2021), in which they study how commodity prices cause banking crises in low income countries. First, I study characteristics financial, fiscal and inflation crises in poorer countries. All crises are found to be interrelated and amplify each other. I then study important factors affecting economies and economic development of low-income countries such as choice of exchange regime and characteristics of primary commodity prices. Important characteristics of primary commodities found include long-term decline of prices as per Prebisch-Singer hypothesis and high volatility of prices. Also, the need to control positive shocks such as discovery of natural resources, as they may cause problems for economies. Price shocks in general are found to be an important source of disturbances and elevated inflation in these economies. The choice of an exchange rate in lowincome countries is found to be an important yet difficult decision. Fixed exchange rates are found to be more effective towards controlling inflation, however, price shocks have a greater effect on the real economy as opposed to floating regimes. Soft currency pegs are found to be a viable option of exchange rate regime to these economies. Inflation targeting requires fiscal, monetary, and financial stability in economies and thus in addition to policies aimed directly towards reducing inflation, policies for growth and stability are also endorsed. Economies can reduce financial fragility to price shocks through e.g., diversification, stabilization funds and foreign exchange reserves. Financial buffers are found to be a viable option to increase economic resilience, as lowincome economies are usually limited in their ability to conduct countercyclical fiscal policy through lending, due to lack of creditworthiness. Volatility in primary commodity prices is found to have detrimental effects on economies due to their effect on e.g., physical capital accumulation. The independence of central banks and developing institutions is especially significant for efficient control of inflation and economic development and stability. As for the second research question I find that in periods of frequent crises, price volatility has the strongest effect on the propensity of inflation crisis. Countries with a larger portion of exports accounted for by primary commodities and a flexible exchange rate also show a larger effect on inflation crises propensity from commodity price volatility, but commodity price growth effect is not visible. In Eberhart & Presbitero (2021) when countries have fixed exchange rates and hard pegs, price volatility is found to cause banking crises. Thus, I deduce that as countries with flexible exchange rates can conduct monetary policy, they end up experiencing inflation crises but are able to avoid banking crises.