Inflation Gone Wild

by William Chiu

With an annual inflation rate of 1,600%, Zimbabwe currently holds the world title for
fastest-increasing prices. As the late Milton Friedman put it, “Inflation is always and
everywhere a monetary phenomenon. To
control inflation, you need to control the
money supply.” The inflation
cure seems simple to understand
from a textbook perspective:
drastically cut back the money supply in
order to lower the expected
inflation rate.
Unfortunately, the cure might be
worse than the disease. With the
current unemployment rate at 80%,
drastic cuts in the money supply could
increase unemployment and cause a
coup d'état before the expected
inflation rate falls. The monetary
contraction is inevitable if Zimbabwe wishes to tame the inflation monster, and
the International Monetary Fund has urged the government to liberalize its exchange
rate regime as a means to cushion the unemployment effects.

In order to understand the IMF’s position on Zimbabwe’s exchange rate, we must examine
how maintaining an overvalued currency might contribute to soaring inflation, and how
floating the currency might provide relief to both inflation and unemployment.

The graph on the left shows the market for Zimbabwean dollars. Assume that the
government fixes the exchange rate at E1. A fixed exchange rate is the official value of
the currency despite fluctuations in supply and demand. Initially, the official value equals
the market value where D1 intersects S1 (point A). Then, due to unsustainable fiscal
deficits and government land reforms that usurp private property, foreign investors flee
Zimbabwe. Consequently, the demand for Zimbabwean dollars decreases from D1 to D2.

If Zimbabwe were under a floating exchange rate regime, the fall in demand for
Zimbabwean dollars would result in the depreciation of the currency from E1 to E2 (point
B). But because Zimbabwe’s government insists on a fixed exchange rate regime, the fall
in demand for Zimbabwean dollars will cause a surplus of Zimbabwean dollars (Q1 - Q2).
At point C, the currency is considered overvalued because the official value is greater than
the market value. In order to eliminate downward pressures on the currency, Zimbabwe
will instruct its central bank to buy the surplus of Zimbabwean dollars (and sell U.S.
dollars), which will return the market to point A. Zimbabwe's central bank will eventually
deplete its U.S. dollar reserves as the economy deteriorates from questionable domestic
policies, and will borrow U.S. dollars in order to maintain the fixed exchange rate.

Since the loans are denominated in U.S. dollars, Zimbabwe must make periodic payments
in U.S. dollars or face getting cut off from all sources of international capital. Due to
disastrous domestic policies, the government has little tax revenue to make those periodic
payments, and the only way to service their international debts is to print more money,
just as Germany did after World War I. As the central bank expands the money supply to
pay international debts, inflation increases, which places additional downward pressure on
the Zimbabwean dollar: as foreigners demand less and less of the failing currency,
Zimbabwe has to print more and more money, and sooner or later, everything will spin
out of control.

One solution is to eliminate the fixed exchange rate regime altogether and allow the
Zimbabwean dollar to float freely. If the currency were allowed to float today, its value
would fall tremendously, which would stimulate exports and reduce imports. The graph on
the right shows that as the exchange rate falls from E1 to E2, net exports increase from
NX1 to NX2. A floating exchange rate would boost job creation as the central bank
institutes the tough medicine of curing inflation by drastically reducing the money supply.