Macroeconomics for Business Term Paper 2011

Possible sources of the inflationary process taking off in Paraguay

5-May-

There cannot, in short, be intrinsically a more insignificant thing, in the economy of society, than money; except in the character of a contrivance for sparing time and labour. It is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machine, it only exerts a distinct and independent influence of its own when it gets out of order (John Stuart Mill, 1848).) 1) Introduction As J. S. Mill stated in 1848, money provoke a distinct influence in the economy when it gets out of control. This is, probably, one of the main reasons why nowadays Central Banks around the world take this continuous rise in price level; mostly known as inflation, as a matter to control no sooner the economy provides signals of suffering from it. After the Great Depression of the 30s, the monetary policy was not one of the best friends of influential Central Bank economists in the world. Its role was only assigned to promote price stability and to preserve the gold standard, according to Milton Friedman. Today, almost 80 years after, Monetary Policy is not only one of the Central Banks best friends to combat inflation, but it also became a guidance for the economic agents who embrace in this policy the governments truth wordiness in keeping its word to promote economic stability, low prices and, somehow, high employment (Milton Friedman, 1968). This paper aims at providing insight about the latest (yet slight) inflationary process in the Paraguayan economy in the last 12 months. In the theoretical frame it will be introduce how the Paraguayan Central Bank operates with its Monetary Policy, which are the intermediate variables that it manages to achieve a stable monetary policy, and which is its main objective as the maximum monetary authority in the country. Furthermore, this section will also present the sources of inflation which are mostly common in developing countries (according to the IMF, 2001). The empirical section provide data and analysis of each of the sources of inflation presented on the theoretical frame and will provide an explanation of which sources are the ones behind this inflationary process Finally, the concluding section will provide a thorough summary of the potential sources for this slight inflationary pressure in the Paraguayan economy and will also address other matters which have to be taken into consideration to reduce the general price levels. 2) Theoretical Frame The Paraguayan Central Bank (hereafter, BCP), by law, is the countrys economic authority in charge of designing the monetary policy. According to Law N 489 Carta Orgnica the fundamental objectives of the Paraguayan Central Bank are to preserve and keep the stability of the value of money, and to promote efficiency and stability in the financial market (Law N 489 Carta Orgnica Banco Cenral del Paraguay, 1995). To achieve its objectives, the BCP makes use of the monetary policy in two ways:

1- Control of the interest rate (or the cost of money) in a short term basis; 2- Control of the monetary base (money supply) in a medium term basis.

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Macroeconomics for Business Term Paper 2011

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These two strategies have the ultimate goal of influencing on intermediate variables, which will finally influence on the level of inflation. By keeping inflation under control, the BCP provides a frame for growth and economic stability in the long run. According to Miles and Scott, along the 21 st century governments no longer saw fiscal policy as an effective tool for manipulating short-term demand, choosing this way the monetary policy as an instrument to control inflation influencing this way the level of consumption and investments through adjustments in the interest rates. The Paraguayan Central Bank is in a process of adjusting its monetary policy. Nowadays it is applying an inflation targeting policy which is somehow a mixture between controlling aggregates and interest rates. Before, it has been controlling only the amount of money in the market which made it harder to influence on the economic instability and inflation volatility as fast as it was needed. The reason why the BCP is still partly controlling for the amount of money in the market is due to the poor developed financial market. This makes it difficult for the Central to change completely from controlling money aggregates, to controlling interest rates as the only intermediate goal of the monetary policy. After giving a thorough explanation of what is the monetary policy that the BCP follows, and understanding its role to control the price level to achieve an inflation target, we can go on to define how inflationary disturbances might arise in a developing country. In order to proceed with explaining the inflationary process, and to try to understand why it is happening, we will focus on a study made by the IMF: Sources of inflation in Developing Countries. This study is based on four types of inflationary sources which are grouped by region and exchange rate regime (fix or floatable). According to this study made in 2001, the sources of inflation in developing countries might be:

Money growth and exchange rate: underlying fiscal imbalances which might lead to crisis in the balance of payments of the governments, this increase the amount of money in the economy by more expenditure and leads to exchange rate depreciation. Overheating economy: inflation in developing countries might indicate an overheating economy. Supply- Shocks: inflation might be drive by supply shocks which are price increases in particular goods such as oil, or non-oil commodities1 which lead to increases in the overall price level. Past realizations of inflation: Inflation might have an inertial element which might derive from adjustment of inflationary expectations (existence of staggered wage contracts).

1) Empirical Context This section will analyze four possible sources of inflationary pressure in developing countries base on data about the Paraguayan economy. The aim is to define, to some extent, which sources are triggering the increase in the price level in the Paraguayan economy. Before diving into the analysis of the possible sources, we will first see what has been going on with the inflation rate in the Paraguayan economy and how comes it has become a concern for the BCP. 1 Some of the most important non-oil commodities are: cereals, vegetables oil, oil seeds, beef, lamb, sugar,
bananas, coffee, cocoa, tea, timber, cotton, wool, rubber, tobacco, hides, copper, aluminum, iron ore, tin, nickel, zinc, lead, fertilizers, etc.

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Macroeconomics for Business Term Paper 2011

5-May-

The inflation level of the Paraguayan economy has been under control for the last 4 years (2007 - 2010), which means that the monetary authority has been able to achieve the inflation target of those years. Since 2007 the Paraguayan economy has been experiencing relative price stability. The lowest level inflation has been register in 2009 with only 1.9%. And the years 2008 and 2010 the price level has been just on the border line with the inflation target of 5% (+/- 2%). Figure 1: Inflation Rate in Paraguayan Economy
InflationR in Parag ate uayanEconom y
8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 2007 2008 2009 2010 2011 (Jan+ Feb)

7.5 6.0

7.2

3.1 1.9

Inflation Rate

Source: Paraguayan Central Bank For 2011, the inflation target is set again on 5% (+/- 2%) which become a challenge for the BCP given the latest figure for 2010 and the first two month of 2011. In the figure we can see that the increase in the price level in this year has already reach 3.1%. But also, the year-on-year inflation has been raising considerable since the February 2010; the figure for the year-on year inflation in February 2011 was 9.5%. Figure 2: Year-on-year Inflation
Y onY Infla ear ear tion
1 0.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 9 .5 7 .2 6 .1 5 .2 7 .8

e g n a h C %

Oct-09 /Oct-10 Nov-09/Nov-10 D ec-0 ec-10 Jan-10/Jan 11 Feb-10/Feb-1 9/D 1 Year on Year Inflation

Source: Paraguayan Central Bank Since February 2010 the BCP have been feeling that inflationary pressures are just around the corner. The monetary authority did not hesitate to take the decision of starting to raise the interest rates of monetary instruments to draw money from the

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Macroeconomics for Business Term Paper 2011

5-May-

market. This measure tries to reduce consumption by the households, which in 2010 has increase 10% in comparison to the previous year. Furthermore, the BCP has been facing a pressure to maintain the value of the US$ against the Gs.2, but the efforts made cannot stop the American currency to keep losing value against the Gs., which is mainly explained by the increasing value of goods exports from Paraguay. There has been an average quarterly increase of almost 11% in the change of the value of the goods exports in year 2010 which is outstandingly high. The figure for 2009 shows that there has not been a positive quarterly average change in the value of goods exports, on the contrary, there has been a -0, 35% variation. This figure coincides with the growth figures for 2009 of -3.8%. In 2010, the Paraguayan economy achieved the highest growth rate in Latin America with 14.5%. Next, we will take a closer look at the possible underlying causes of inflationary movements in the Paraguayan economy. 1. Money growth and exchange rate By taking a look at the first source, we go straight to the government balance sheet of the past 6 years in order to check for deficit expenditure. A study made by Catao and Terrones in 2001, about fiscal deficit and inflation, shows for 107 countries over 1960 2001 a strong positive association between deficits and inflation among developing country groups. According to the data the Paraguayan government has been achieving fiscal surpluses for the last six years. Figure 3: Fiscal Surplus (last 6 years)
F cal S is urplus (las 6years t )
2,500,000 2,000,000 1,500,000

. G f s n o l i M

1,000,000 500,000 0 2004 2005 2006 2007 2008 2009 2010

Fiscal Surplus

Source: Paraguayan Central Bank The data shows us that the government has been having more revenues than expenditures in these years. This is a sign that the recent increase in the price level might not be related to this source of inflation3. 2 Gs = Guaranes (Paraguayan currency).

3 It has to be specified that since 1995 to 2003 the Paraguayan government has experienced a continuous
deficit in its accounts, which somehow are one of the explanations of the high levels of inflations that the economy had experienced in those times.

Cindy Diana Gmez Alder

Macroeconomics for Business Term Paper 2011

5-May-

2. Overheating economy The second possible source is an overheated economy. To analyze this source we should know what overheating economy means. According to the Cambridge Dictionary: an economy overheats when it grows very quickly so that prices (level of prices) increase quickly. We can definitely see that the Paraguayan GDP has experienced an important growth in 2010 (14.5%) after suffering in 2009 from a contraction of -3.8%. This improvement is supported mainly by the agriculture sector which conforms 20.2% of the GDP, followed by the retail sector with 17.7% and the industrial sector with 12.2% of participation in the GDP. Growth of 2010 GDP is explained mainly by:

Low interest rates: this promoted high levels of investment. We can see productive investments such as factories and agriculture improvements. Excellent weather conditions: it was vital to have products from the agriculture and breeding sectors to be exported, example: sugar cane and beef meat. Improvement of the global demand: increase of the demand for Paraguayan exports in the world. Example: beef meat. Improvement of local demand: this can be explained not only due to the good economic conditions for the businesses, but also due to the access to consumption loans. Low interest rates in this aspect where the boom for consumption in year 2010.

From these factors that explain, in part, the outstanding growth experienced in 2010 (14.5%), we can see some signals that lead to possible (most likely) inflationary pressures in the short run. The financial sector (banking system) plays a fundamental role in the creation of money. Given the circumstances experienced in year 2009, when the Central decided to drop the interest rates almost near to zero (0,6 % in may 2009) to help banks have liquidity to face eventuals related to the global meltdown of 2008, the interest rates were kept on very low levels until may 2010 causing stimulus to consumption through credit. After the crisis has passed, the BCP continued with its monetary strategy of keeping the average rates low; creating this way, not only incentives to carry on investing in the productive sector, but also motivating short term credit consumption. What has happened from May 2010 (0.3% of interest rate on monetary instruments) is that the BCP has started raising the interest rates (especially the short and medium instruments rates)4 almost on a monthly basis. It can be seen on Figure 4 that the relative increase on average rate of instruments from BCP has been of around 20%, and a 5.3 percentage points.

4 The short term action of the central bank since April 2010 has been raising the interest rate from those
instruments which are of short investments period. The rates for short-term instruments such as 7 to 45 days, 60 to 90 days and 120 to 180 days are the ones that have been experiencing continuous readjustment to collect short-term liquidity from the commercial banks and reduce consumption through loan/credits.

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Macroeconomics for Business Term Paper 2011

5-May-

Figure 4: Average Monetary Instruments Rate (from January 2008 to February 2011)
AverageMonetary InstrumentsRate
8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0

20%

Source: Paraguayan Central Bank From Miles and Scott, 2005 we know that M0 is the total amount of currency in circulation in the economy, M1 is currency plus demand deposits (which are amounts available on short notice) this is money readily available to make transactions. M2 equals M1 plus savings deposits. M3 equals M2 plus deposits and longer maturity financial assets. This last one is the less liquid denomination of money supply. The average monthly variation in the type of money M0 has been reduced from a 0.02 increase (from May 2009 to February 2010) to 0.0136 in the period May 2010 to February 2011. This figures show somehow that the level with which the monetary base was increasing has been slowed down with the short-term measures of the BCP to contain inflation. Another factor related to the possible source of inflation overheated economy is the appreciation of the exchange rate. On a study develop by the World Bank 'Latin America and the Caribbean's Success Put to the Test it is stated that Latin American countries are under the threat of suffering for inflationary pressures, appreciation of currency and the perspective of economic overheating from the economic recovery in 2010. Figure 5: Exchange Rate Gs./US$

n a8 J -0 r a 8 M -0 y -0 a M8 l u8 J -0 p e 8 S -0 N -0 v o 8 n a9 J -0 r a 9 M -0 y -0 a M9 l u9 J -0 p e 9 S -0 N -0 v o 9 n a0 J -1 r a 0 M -1 y -1 a M0 l u0 J -1 p e 0 S -1 N -1 v o 0 n a1 J -1
Average MonetaryInstruments Rate

Cindy Diana Gmez Alder

Macroeconomics for Business Term Paper 2011

Exchange rate Gs/US$
5,200 5,100 5,000 4,900 4,800 4,700 4,600 4,500 4,400 4,300 4,200

5-May-

$ S U / s G

Source: Paraguayan Central Bank Figure 5 shows us that this appreciation of the local currency against the US$ is happening5, and provides support to say that a potential source of inflationary pressure might come from experiencing an overheated economy. 1. Supply- Shocks The third source that might explain the inflationary pressure is supply shock. A supply shock is said to happen when prices of commodities, such as oil, experience global continuous increase. This affects domestic prices through a direct and an indirect channel. The first occurs through the import of oil derivatives, which prices increased; the second occurs through the imports of goods which are made with intermediate oil derivatives products, making its cost of production higher (Catao and Terrones, 2001). This second channel manifests itself with any type of commodity, whether it is oil or non-oil commodities. If these effects are only temporary, then it is less important. But if the supply shocks occur over a long period of time, then the effects on inflation will be long lasting and must be taken into account. On figure 6 we can see both the Brent petrol prices and the price indexes in the Paraguayan economy for local and imported goods. Brent petrol prices had reached a peak in July 2008, which is reflected in the imported goods price index. The interesting feature is that since the beginning of 2009 Brent petrol price have been rising at a steady pace, which can be seen in the import goods price index, but since July 2010, the local goods price index has taken over the price level of imported goods. This new situation provides us the following signal: more consumption of local products, which pushes prices upwards. The question now is: which types of products, and why? Figure 6: Petrol Brent Price Evolution and Price Index of Local Products, Import Products and General Index.

5 The depreciation of the US$ is it not only happening in developing countries which are experiencing very
high and quick growth, this loss of value of the US$ in the world is mainly explain by the outstanding amount of debt that the US government has. Very high deficit means loss of purchasing parity power compare to the rest of the world economy currencies.

n9 a0 Jr a9 M-0 y 9 a0 Ml u9 J -0 p9 e0 Sv9 o0 Nn0 a1 Jr a0 M-1 y 0 a1 Ml u0 J -1 p0 e1 Sv0 o1 Nn a1 JGs/US$

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Macroeconomics for Business Term Paper 2011

Petrol Brent Price Evolution
160.00 140.00 120.00 100.00

5-May-

Price Index of Local ProductsProducs -Import -General Price Index

425.0 400.0 375.0

%
P etro l Bren t P rice Evo lutio n

80.00

350.0 325.0 300.0 275.0 250.0

l e r a B / $ S U

60.00 40.00 20.00 0.00

n a 8 J -0 r a 8 M -0 y a 8 M -0 l u8 J -0 p e 8 S -0 v o 8 N -0 n a 9 J -0 r a 9 M -0 y a 9 M -0 l u9 J -0 p e 9 S -0 v o 9 N -0 n a 0 J -1 r a 0 M -1 y a 0 M -1 l u0 J -1 p e 0 S -1 v o 0 N -1 n a 1 J -1

Source: Paraguayan Central Bank If we take a look at Figure 7, we will have a clearer picture of what is happening with price levels of local products in Paraguay. There has been continuous increase in the price level of the following goods: beef, vegetables and sugar. The prices of these goods have been experiencing pressures since the second semester of year 2010, and the panorama for these are on onward increase. According to the report by the World Bank Latin America and the Caribbean's Success Put to the Test, there are strong signal of inflationary pressures in Latin American economies after a successful growth in 2010. They emphasis on the fact that the recovery of these economies is relying on two fronts: international front of good exports and foreign investment, and on a domestic front which shows a strong consumption and credit expansion. Consequently, these two entail risks for inflationary pressures. Paraguay fits this description perfectly. In 2010 the level of investments have increased by nearly 70%, consumption has turned stronger than in 2009, and the level of exports of commodities such as beef and sugar have been outstanding in 2010. In short, we can conclude that there are supply shocks threatening the price levels, at this early stage of inflationary pressure, the data points towards a supply shock of local products which push upwards the inflation rate. Figure 7: Main Components of the CPI (Consumers Price Index)

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n a 8 J -0 r a 8 M -0 y a 8 M -0 l u8 J -0 p e 8 S -0 v o 8 N -0 n a 9 J -0 r a 9 M -0 y a 9 M -0 l u9 J -0 p e 9 S -0 v o 9 N -0 n a 0 J -1 r a 0 M -1 y a 0 M -1 l u0 J -1 p e 0 S -1 v o 0 N -1 n a 1 J -1
Lo cal p ro d ucts price ind Im po rte d price ind ex e neral p rice index ex G

Macroeconomics for Business Term Paper 2011

M inc m o e t o th C I a o p n ns f e P
10 9 .0 10 7 .0 10 5 .0

5-May-

x e d n I

10 3 .0 10 1 .0 9 .0 0 7 .0 0 5 .0 0

Source: Paraguayan Central Bank 2. Past realizations of inflation The last source to analyze is past realizations of inflation. According to Catao and Terrones, 2001 the past realizations of inflation in developing countries account for between ten and twenty percent of inflationary movements. This result suggests that inflationary expectations have a very important role in the influence of nominal wages and prices (Catao and Terrones, 2001). As it has been explained, the inflationary process is starting. This source is yet to explain the inflationary pressure on prices in Paraguay because the process of increase in prices has just started. At the moment the economic agents are witnessing measures taken by the BCP to cut the level of consumption which is, mainly, driving the CPI up. Monetary measures, such as increases in the interest rate, and intervention in open market operations to collect Gs. from the market are showing effects in the banking sector, reducing the level of short-term liquidity, but the final result of achieving the inflation target are yet to be seen. In the case of achieving its inflation target, the economic agents expectations will have less motives to change, and with this achievement pressures on prices will be lower. 1) Conclusion After providing a thorough analysis of data related to each of the possible sources of inflationary pressure in developing countries, it can be concluded that the raise in the price levels in the Paraguayan economy is explained mainly by the effects of experiencing an overheating economy. This is as a result of the important growth level in 2010 which motivated local consumption, and the expectations of keeping on growing above 5% for 2011.

n6 a0 Jr 6 aM0 y6 a0 Ml6 u0 Jp6 e0 Sv6 o0 Nn7 a0 Jr 7 aM0 y7 a0 Ml7 u0 Jp7 e0 Sv7 o0 Nn8 a0 Jr 8 aM0 y8 a0 Ml8 u0 Jp8 e0 Sv8 o0 Nn9 a0 Jr 9 aM0 y9 a0 Ml9 u0 Jp9 e0 Sv9 o0 Nn0 a1 Jr 0 aM1 y0 a1 Ml0 u1 Jp0 e1 Sv0 o1 Nn a1 JC erea ls Fres veg bles a pres edones h eta nd erv B s serv a ic icesa fuels (petrol) nd B eef S a s eetsa ice ug r, w nd -crea m D iryproducts a H ouserenta a m inta nce l nd a ina

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Macroeconomics for Business Term Paper 2011

5-May-

Furthermore, the increase in the level of consumption together with the increasing levels of exports of products such as beef and sugar, are creating pressures on prices due to lack of products for the local market. This is a supply shock which is yet to be dealt with by other measure than monetary, this might have to be addressed by joint efforts of governmental institutions and the society of producers of vegetables, beef, and other commodities, to deliberate about the shortages and provide solution in the short and medium term. History, according to Milton Friedman, has taught us the most important and profound lesson about monetary policy, he says it can prevent money itself from being a major source of economic disturbance (The role of monetary policy, 1968). With this he makes emphasis on the importance of avoiding mistakes when using the monetary policy to maintain the economic stability. So far, it can be said that the measures applied by the BCP are the expected ones, and are according to the situation; but unfortunately, other measures than monetary are necessary to bring down the price levels affected by the supply shock. 2) Reference

Stuart Mill, John, Principles of Political Economy, Book III, Chapter 7 Of Money, London; Longmans, Greens and Co., 7th Edition, 1909. Friedman, Milton, The Role of Monetary Policy, Vol. 57, No. 1, March 1968. Banco Central del Paraguay, Carta Orgnica, Law 489/95, Asuncin, Paraguay. 1995. Miles, David and Scott, Andrew Macroeconomics Understanding the Wealth of Nations, 2nd edition, John Wiley & Sons, 2005. Catao , Luis A.V. and Terrones, Marco E., Fiscal deficits and inflation, Research Department, International Monetary Fund, Washington, DC 20431,USA, Received 26 June 2001, Available online 1 April 2005. Cambridge Dictionary Online:

http://dictionary.cambridge.org/dictionary/british/overheat_2
Loungani, Prakash and Swagel, Phillip Sources of Inflation in Developing Countries, IMF Working Paper, WP/01/198, International Monetary Fund, 2001. World Bank, Latin America and the Caribbean's Success Put to the Test, 2011.

http://issuu.com/world.bank.publications/docs/laceconomicreport.eng? mode=embed&layout=http%3A%2F%2Fskin.issuu.com%2Fv %2Fwood2%2Flayout.xml&showFlipBtn=true

The data displayed in this paper is from the Banco Central del Paraguay (Paraguayan Central Bank).

Cindy Diana Gmez Alder