Inflation: What’s bad and worse about it, and how to prevent the ugly?

By Mussie Delelegn Arega (PhD)

Part 1

As many economists have reminded us repeatedly, economics is not a natural or experimental science, despite what many other economists would like to think. Indeed, the subject of economics is known for controversies and conflicts of ideas. It is known also for hypothesizing abstract economic theories and the underlying conceptual frameworks of the complex world. A good example is the notion of “full or near-full employment”. In the real world, this theoretical scenario cannot be achieved due to internal dynamics and random shocks. In theory, full employment occurs when total expenditures in an economy are equal to total national income, and when total savings are equal to total planned investments. Such an equilibrium can be achieved at local level, but it is more daunting to attain at the economy-wide level or on a global scale. Full employment also means that all scarce resources, particularly labour and capital, are fully employed and when prices and wages are harmoniously stable. In such situations, the economy can be said to be in equilibrium. The assumption is that the saving-consumption ratio of households, the volume of investment and total government spending determine the equilibrium level of output or the gross national product (GDP).

However, a single shock such as a rise in general prices can disrupt an equilibrium, even if it were to be achieved for a short period of time. For instance, an increase in prices of all or most consumer items can cause a gap between total expenditure and national income-usually known as an “inflationary gap”. The desired objective is not to achieve zero inflation rate on a permanent basis. To the contrary, a manageable level of inflationary gap can be good for the economy if there are sound polices and instruments to put effective checks and balances to contain further price rises. In fact, moderate inflation or a manageable level of inflationary gap is more desirable to an economy as it can act as an incentive to producers to boost supplies. This notwithstanding, the inflationary gap that potentially leads to higher prices needs to be reduced or eliminated. This can be done through a mix of monetary and fiscal policy instruments such as taxation, interest rate management and a reduction in government expenditure for maintaining the economy at equilibrium level. However, this is not straightforward or automatic and policy instruments may not be able to reduce the inflationary gap or curb inflation, particularly in developing countries that face a series of structural challenges.

The main objectives of this article are two-folds: (a) to articulate the concept of inflation its underlying causes in a way that non-economists can understand; and (b) to provoke an informed and evidence-based discussion on the subject while offering insights as to what can be done to curb inflation in Ethiopia and other countries of sub-Saharan Africa (SSA). By using the Consumer Price Index (CPI) and the average growth rates in general prices, the article compares inflation in Ethiopia with the average of sub-Saharan Africa, Africa as a whole, and the developing world. It also provides a data-driven and evidence-based comparison of the devaluation of the Ethiopian Birr vis-à-vis the US Dollar in relation to the Ethiopian Consumer Price Index. The article proposes a series of policy measures and institutional mechanisms to decisively deal with inflation. These include fostering economy-wide productive capacities to boost the supply of goods and services to exact higher demand, while generating long-term inclusive growth.
Productive capacities are key for economic growth and export diversification, including value addition as well as removing supply-side distortionary trade barriers. Additional policy proposals include the need to fight corruption and improve governance; and build peace and social cohesion to ensure political stability. The article calls for putting in place independent institutional arrangements, such as central banks, effective policy instruments, including inflation-targeting frameworks, transparency in monetary and fiscal policies, managing market expectations and improving market information systems. The ultimate objective of these recommendations is to keep moderate inflation side-by-side with monetary stability and sustainable economic growth with higher levels of employment and substantial poverty reduction. The aim is also to explore ways and means of assisting how to best protect the poor and more vulnerable sections of society who are the direct victims of price rises. Low wage earners and populations with fixed incomes such as pensioners are among the casualties of high inflation who need social protection in the form of safety nets.

What is inflation and what are its plausible causes?

In simple non-technical terms, inflation is a consistent and prolonged general increase in prices for a basket of goods and services consumed or used on a day-to-day basis by households. Such an increase in the prices of consumer goods and services also reduces the purchasing power of the income of households and the value of the local currency. This means that a temporal or periodic roller-coaster price rise of a few goods and services with little or no impact on the purchasing power of societies does not qualify as inflation. Inflation also means that consumers will pay more for the same quality and quantity of goods and services when compared with a pre-inflationary period. With inflation, food, school supplies for children, fuel, shelters (rentals), electricity, transportation, clothing, and footwear, as well as medicines will become more expensive than they used to be. Households with low and constant income will forgo some of the goods and services they used to afford in lower or inflation- free times. As shall be discussed in detail in this article, high inflation makes an economy anemic by heightening systemic risks, uncertainties, and structural vulnerability. Not only does it affect current socioeconomic performance, but it also erodes past gains and undermines future growth and the development prospects of developing countries. If not contained, high inflation may also entrain social unrest, corruption and political instability, frustrating efforts to foster political consensus and nation-building.
Inflation is transmitted across sectors, to societies and the real economy through diverse channels and mechanisms. It weakens the purchasing power of the local currency, erodes investor confidence, undermines savings and investments, leads to persistent budget and trade deficits, as well as to heavy indebtedness. Depending on the speed and magnitude, inflation adversely impacts the purchasing power of the local currency, diminishing the ability of households to pay for goods and services with their income, compromising their overall economic wellbeing.

Based on underlying causes, inflation can be grouped into three broad categories: The first is demand-pull inflation which is the type of inflation caused by an excess in aggregate demand for goods and services over aggregate supply in the economy. Excessive aggregate demand over aggregate supply can be caused by scarcity of production (supply shocks), increases in expendable income of consumers, increase in exports of domestically consumable goods, hoarding and due to population growth or the combination of these. It can also occur because of the availability of easy credit, increase in government expenditures and indirect taxes, availability of excess money supply in an economy, continuously growing budget deficits or expansionary monetary policies, etc.
The second type of inflation is cost-push inflation, which occurs due to an increase in the cost of production of goods and services. A sudden rise in intermediate goods used in the production of goods and services such as energy (an increase in oil prices or the prices of electricity), wages, and taxation can trigger inflationary pressure in an economy by pushing up the cost of production of goods and services. Similarly, uncontrollable price increases in farm inputs such as fertilizers, variety seeds or pesticides can also trigger food inflation.

The third type of inflation by causative factors is structural inflation or bottleneck inflation. This type of inflation is caused by deep-rooted structural rigidity in an economy such as poor infrastructure, supply chain disruption, market imperfection, institutional bottlenecks and due to bad policy formulation and implementation. In structurally weak and vulnerable economies such as Ethiopia and others in sub-Saharan Africa (SSA), the three types of inflation can coexist in parallel or in combination. Identifying and understanding the type of inflation in an economy is critically important to formulate and implement appropriate mitigating policies and strategies. In sum, inflation is the cause and effect of asymmetry in aggregate demand and aggregate supply, combined with expectations and random (unexpected) shocks.

However, monetarists and Keynesian economists argue that the sole cause of persistently high inflation is the oversupply of money in an economy. According to them, the cure is to reduce money supply in an economy even if this leads to “degrowth” or deceleration in economic growth. In other words, the sole cause of inflation is governments’ monetary and fiscal policies, and as such the remedies should come from them. Historical and empirical evidence show that unforeseen shocks (be they economic, financial, climate change or health related) can disturb the equilibrium aggregate demand and aggregate supply. For instance, since the COVID-19 pandemic, the global economy has been reeling from socioeconomic turbulence and tribulations including temporal general price rises. Massive injections of monetary and fiscal stimulus packages, lavish incentives, and direct cash transfers in major economies during the COVID-19 pandemic contributed to skyrocketing aggregate demand in excess of aggregate supply, causing high inflation nationally and globally. Adding fuel to the fire, the war in Ukraine has exacerbated high inflation and the resulting economic challenges for households, individuals, and economies at large. The current conflict in the Middle East may further exacerbate inflation by disrupting oil exports from the region which may heighten global risks, uncertainties, and socioeconomic difficulties, if an end is not put in place as urgently as possible. Overall, the cascading crises, random shocks and resulting headwinds are weighing heavily on the global economy. More so on the growth and development prospects of developing countries, with devastating consequences for the poor, the weak and marginalized sections of societies.
Experience shows that monetary and fiscal policies may not be the most effective policies for taming inflation. To date, despite efforts to curb inflation globally, economies across the world are having tough times to do so. This also compounds efforts to resuscitate economic growth, while at the same time, maintaining macroeconomic stability. For economies of SSA, high inflation may further deepen and entrench structural economic problems of the region. Falling international commodity prices, external debt overhang, growing trade deficits, declining agricultural production and productivity, combined with demographic trends may further complicate economic viability, revival, and overall socioeconomic progress of the sub-region. In Ethiopia, for example, a combination of a protracted civil war, the devastating impact of climate change particularly on its underdeveloped agriculture sector, excessive money supply in the economy, mounting external debt burden and galloping inflation have caused serious socioeconomic imbalances making it difficult to imagine how the country could emerge from this predicament. Under such multi-faceted socioeconomic, political, and environmental distress, it is difficult to contemplate the long-term growth and transformation prospects of the Ethiopian economy. Inflation in Ethiopia has been consistently higher than the average for sub-Saharan Africa, Africa and much higher than that of other developing economies.

As with the underlying causes, the typology of inflation can also vary depending on the speed and evolution of price rises in an economy. Creeping inflation (also called crawling, slow-moving or mild inflation) is an inflation that occurs in an economy for a longer period without being perceived by consumers or households worrying. This type of inflation (usually in lower single digits) is not dangerous to an economy. In fact, economists regard such an inflation as an incentive to producers. This is because mild inflation encourages entrepreneurs and producers to increase output to exact growing demand with sustained and long-term gains or profits. Such an inflation is also key for expanding employment opportunities without necessarily increasing wages per worker or per output. When the price rise reaches upper single digits (7%-9%), crawling inflation becomes walking or trolling inflation. Walking or trolling inflation, although still manageable, is a warning sign for policymakers to revisit their monetary and fiscal policies to curb further rises in general prices. If no action is taken to tame walking inflation, it leads to running inflation-usually at the rate of above 10 % but lower than 20%. Still monetary and fiscal authorities have ample room for maneuvering and for curbing walking inflation without austerity measures or before it inflicts significant costs to the economy and society.

When inflation rates reach double digits (between 20% and 50%) per year, it is called galloping inflation, which is regarded as very high inflation. This type of inflation has reached a level where it cannot be reduced or tamed without belt-tightening or austerity measures, often at a very high cost to the economy and society. The most worrying type of inflation is known as hyperinflation, which is not only accelerating in speed (more than 50% a year), but the range and magnitude of increase is very large, observed in a very short span of time. During hyperinflation, prices of consumer items can double or triple overnight or in a single day, with the value of local currency fast collapsing.
After World War II, Hungary has seen one of the worst phenomena of hyperinflation with prices doubling every 15 hours. In recent years (2007-2008), from SSA, Zimbabwe was a classical case for hyperinflation with prices doubling every day. In 2023, Venezuela is an exception in registering an estimated increase in consumer prices at 360 percent, according to the latest figures from the International Monetary Fund.

In all cases, hyperinflation led to acute shortage of consumer items including food and medicine, with prices skyrocketing, the value of local currency fast collapsing, and with grim overall socioeconomic circumstances. Ethiopia and other countries of SSA that have already registered or approaching galloping inflation, must undertake drastic, coordinated, and robust policy measures to avoid getting into hyperinflation. It is important to note that the above-mentioned types of inflation are not sequential occurrences or phenomena. Any type of inflation can be observed in an economy depending on the main drivers, accelerators, and key causative factors. That is to say that galloping or hyperinflation can occur without an economy necessarily passing through crawling, walking, or running inflation.