Inflation is defined as continued inrease in price level and it has negative influence on economy and society. When inflation increases, the living standards will decline. Because the certain goods and services are more expensive now with regard to previous prices. That’s why keeping inflation rate in control is one of the primary aims of the government. Also reasons of inflation vary from developed countries to developing countries. For developing countries main reasons for increasing inflation rate are government spendings, money supply growth and oil prices. In case of such countries, increasing public spendings result in budget deficit and it has positive effect on price level. Also an increase in oil prices can be inflationary for these countries. Because economies of developing countries are based on imports. So an inrease in oil prices will inrease production costs for developed countries and it will result in rising price levels in developing countries.
Sometimes government itself gives up “stable prices” in order to reach sufficient economic growth by implementing loose (expansionary) monetary policy. Expansionary monetary measures are usually used to defeat negative effects of recession. In the long-run, there is positive relationship between expansionary monetary measures and inflation. If it is necessary to simplify, as money growth increases, inflation will also increase. According to quantity theory of money, inflation is equal to money growth directly. It means that inflation will change in same size with the money growth. It’s true that expansionary monetary policy is often used to expedite economic growth. However, if this type of monetary policy is implemented without evaluating country’s current economic conditions such as inflation expectations, market expectations and etc. volume of inflation will be much more than expected. In developing countries, most dangerous and experienced type of inflation caused by increasing money supply is demand-pull inflation. Demand-pull inflation occurs when aggregate demand (AD) exceeds aggregate supply (AS) in an economy, and it shows how price-inflation starts. This type of inflation will not be experienced, unless the economy is at full employment. However, for developing countries “full employment” level is inaccessible. If it is necessary to explain deman-pull situation briefly, after increasing money growth unemployment will decrease, AD will increase in larger proportion than price level, output (Y) will also increase. However, aggregate supply curve (AS) will be vertical at one point, and an increase in price-level will exceed growth in output, and price-inflation will start. For instance, after 1996, Indian government did not even borrow from central bank to exercise their development activities, money needs for development of infrastructure were met by selling bonds to commercial banks. After all, government expenditures increased, productivity also increased but less than demand and prices. Demand-pull inflation was effective in housing sector during 2000s in India.
2.0 Literature Review
Expansionary monetary policy is used to boost economy either with cutting interest rates or increasing money supply. This type of monetary policy is really effective in the short-run, but in the long-run it will cause high inflation (Mishkin, 1999).
According to Ahiabor (2013), main problem in implementing effective expansionary monetary policy in developing countries is that monetary authorities – central banks in these countries don’t have independency.
Sargent and Wallace (1981) investigated the relationship between public debt and inflation in highly indebted developing countries. The results show that high level of government spendings to expand economy force them to finance these expenditures by internal and external borrowings. It leads to deficit for balance of payments. Hence, expansionary monetary policy becomes a part of this activity to ward off this deficit, and it leads to higher inflation.
Nachane and Ghosh (2002) analyzed the impacts of expansionary monetary policy on various developing countries. The results of this study show that countries with best enhanced banking basis are more suspective to the result of loose monetary policy.
“In contrast to the studies mentioned above, Bhattacharya, Patnaik, and Shah (2011) find weak monetary policy transmission in India, in line with other lowincome economies that have a small, weak financial sector. Their evidence shows that the interest rates do not affect aggregate demand.” (Salunkhe, Patnaik, 2017. p.117)
Patnaik (2017) emphasized the importance of output gap in order to implement expansionary monetary policy. He suggests that central bank should change strategy on the basis of interest rates. Because if the output gap is positive, there will be observed an increase in market prices.
In this section, objectives of this study is mentioned:
(1) discuss the reasons that cause higher inflation in developing countries
(2) describe relationship between these reasons and expansionary monetary policy
There may be two significant reasons for why expansionary monetary policy causes higher inflation in developing countries.
Firstly, in developing countries such as Indonesia and Pakistan have high level of poverty and unemployment. If central bank increases money supply, growth rate of GDP will increase. Most of unemployed people will meet with new job opportunities. As the income of such people increases, overall demand will increase in the market. New equilibrium will be reached at higher prices and higher inflation. For example, according to datas of Reserve Bank of India (RBI), during 2008-2010, it was aimed to stimulate the economy by increasing money supply. However the results were not as intended. GDP growth declined from 9.32 to 8.59, because downtrend in interest rates could not compensate the increasing in aggregate demand. On the other hand, inflation rate increased from 4.80% to 8.00%. Khundrakpam (2011) explained that elevation of poor people to “middle class” resulted in excess demand and inflation rate nearly approached to GDP growth rate.
Second reason may be higher level of public debt. In case of developing countries, their economies need more and more investment. Less collection of public revenues, lack of confidence to such countries from the aspect of foreign investors push government to borrow. Excess borrowing causes budget deficit. In this sense, monetary authorities usually find the solution in “printing money”to finance budget deficit. Hence, it is typical expansionary monetary policy and inflation will increase again.
There are two methods that will be used in this study: quantity theory of money and Vector autoregression (VAR) model.
According to supporters of classical theory of inflation, money growth should be considered as a primary cause of inflation. It’s true, but not adequate. Because according to quantity theory of money which Friedman studied for first time in 1963, velocity of circulation (V) should be considered. For instance, if the money stock was expanded by central bank, however this money was not spent in market, how will inflation occur ? In conclusion, equations of velocity of money will be used to describe the relationship between prices (P), money supply (M) and real GDP.
There will be used VAR model to show the relationship between public debt and inflation. It is generally seen that developing countries find the solution in using loose monetary policy to finance public expenditures, and this action unavoidably will lead to increase in price levels. For this reason, VAR model will be used to observe the relationship between debt amount and inflation. After the results that will be achieved by applying this method, predictions can be estimated to make significant policies for financing public debt using monetary policy. Epitomes for this study will be intended for 2000-2014 datas of 35 developing countries. Studies of Ahiabor (2013) on the basis of VAR model suggest that:
-Money supply (M2), interest rates (I) and exhange rates (ER) should be considered on this model
– M2, I and ER as independent variables, but inflation rate as dependent variable
5.0 Significance of the study and Conclusion
It can be better to touch on the problems of develeoping countries that they stand face to face while using loose monetary policy. Main problems are lack of information about current economic conditions of that country and staying focused on only one side of economy. The outcomes that came in view from my researches for this proposal show that there are two major points that can be taken into account as a contribution to literature.
Firstly, Central bank should aspire after to increase the effectiveness of loan subsistence for households to spend. For achieving this goal, government should keep out of using expansionary monetary policy to finance budget deficit.
Secondly, when monetary authorities want to implement expansionary monetary policy to boost the economy, production capacity of that country should be considered. Because before anything else, in developing countries capacity of economy is limited due to poor infrastructure. To reach the sufficient growth rate, first of all, there should be tendency to magnetise foreign investors to country. There is one way for this action: while the interest rates are high in the country, it should be used to attract the foreign investors. Because after increasing money supply, interest rates will decline in the long-run, and there will occur capital outflow. Thus, while the production capacity is near to full and central bank chooses to expand money stock to ward off flatness of economy, inflation rate will be much more higher than growth rate.
Putting expansionary monetary policy into practice is difficult in developing countries due to poor infrastructure, and it requires to pore on deep-seated strategies and policies to reach the goal. On the other hand, inflation is irresistible phenomenon that resurges as a result of rising money stock. However, it is fact that the effects and rate of inflation are more formidable in developing countries. Most dangerous type of inflation which caused by expansionary monetary measures on such countries is demand-pull inflation where the money does not have power to buy something, because produced goods are limited. In summary, all the statements mentioned above conclude us that if developing countries are the case, there will always be need to implement loose monetary policy for development in different periods, and the impacts of this type of monetary policy will always be more inflationary in such countries until the deficiencies in domestic market are solved.