How Does Inflation Affect the Imbalance of Payments

Inflation rate is a significant variable in economy and affected nation’s balance of payments. It is determined as a stable increase in the overall price level of goods and services in the economy. According to Quah and Vahey (1995), inflation rate is general increase in prices measured against the country’s purchasing power. The most popular evaluate of inflation is the Consumer price index (CPI) which evaluate consumer prices in a nation. The increase in inflation will decrease the growth of economy and this means that an inverse relationship. Inflation decreased the standard of living due to the citizen have to pay higher price for the same goods and services. If income does not increase in parallel with the inflation rate, it cause people’s standard of living will damage. While balance of payments (BOP) makes detailed information regarding to the demand and supply of a nation’s currency and plays a significant role in economic development of a nation (Obstfeld, 1984). BOP should be persistent, thus it should not be in deficit or in surplus. This will cause unfavorable if the BOP is not same as zero. Furthermore, BOP can also be used to measure the performance of the nation in the international competitive advantage. Then, there will be some keys and problems the inflation affect the balance of payment whether decline or rise in inflation.

According to McGurk (2019), inflation rates not only produce problems in the economy, but also in the area of external trade of a nation. That is, nation’s trade balance with the rest of the world. Country’s trade links with the other countries contained exports and imports of goods and services and how much of a country will trade, amongst other thing, on the domestic price level and variation in it, that is, the rate of inflation. Country’s operation with the other countries, which are recorded in BOP, acquire negatively affected if the domestic price increase is high. High rate of inflation in the domestic market makes domestic goods expensive and unattractive to the international trade caused to reduce in demand for exports. In addition, due to high domestic prices, citizen also preferred to purchase foreign goods, which indicate that increase in imports. This caused falling exports and rising in imports, because of great domestic inflation, is the negatively disequilibrium in the BOP, it can result in serious proportion and BOP will in crisis (McGurk, 2019).

In other hands, the other components of current account affect the local economy such as: current transfers and the balance of services. Current transfers, means that mainly in foreign support and workers' remittances, support to make the high liquidity to help the economic development plans and production as well as to satisfy consumers’ needs, which by turn positively affect the economic growth. The inflation will affect BOP imbalance will surely affect the internal balance of the economy and other economic variables. Some researchers have found that economic growth depends on the standard of economic policies, financial development, foreign support, moreover to the disruption of the inflation and the BOP (Alawin, & Oqaily, 2017). Domestic inflation can affect export by one way, which is they proportionally affect local demand through what is known as “Exported Inflation Phenomenon”. This process happen when structural imbalances in some economies, brings to the emergence of multiple problems like food and energy gaps, which move the nations to decrease in exports (Nazeer, Shafi, Idrees, & Hua, 2015).

Based on study from Blejer (1977), this concludes that there is a direct relationship between balance of payments and the inflation rate in Kenya. A rise in inflation rate in Kenya caused to a relative increase to Kenya’s balance of payment deficit. This observation supports the purchasing power parity theory that mentioned that when the price of a good differents between two countries, it produce an opportunity for profit seeking sellers and buyers to import the good in the lower price and resell it in higher price market. With increase high price in goods and services in domestic, residents will decrease purchasing power and thus less demand for domestic product. If the import is cheaper than domestic products, residents will switch to imported products and lead to BOP deficit (Mwai et al, 2015).

In 1991, India was experience BOPs crisis. The standard wisdom between the notable resident Indian economists at the time of the BOP crisis was that it was caused by an increasing trade deficit. Role of invisibles is indicates to be much more significant than foreseen by anyone at that time or by those who have written since on the BOP crisis. The analysis also shows that the rupee depreciated which is in real terms in the eighties at a rate equal to that in the post oil shock seventies, and the trade deficit was on a downward trend in the second half of the eighties (Virmani, 2002). Policy mistakes in the form of increase and untenable fiscal deficit financed through creation of new money lead to high growth in total of money supply. The causing inflation entered into high growth in imports than exports and in the end lead to a very serious BOPs crisis including sharply decline in foreign exchange reserves and increase the probability of default on external payment front. Thus, it creates perfect sense to revise the correlation between the rate of inflation and some significant components of BOPs such as growth in exports and imports, trade balance, exchange rate of the domestic currency and foreign exchange reserves (Kumhof, & Yan, 2016). The limited relax on import controls and primarily for exporters in the eighties which along with some industrial license contain other positive effects. The former included a much easier regime for import of capital goods by exporters along with lower import duties subject to export commitments. A combination of these movements and the gradual depreciation resulted in the rise in India value.

A study in Blecker and Ibarra (2013), an upward pressure in movement price of an imported raw material will increase the cost of production in some of the sectors where the manufacturers will charge higher price on domestic market since the home currency is depreciate against foreign currency. Likewise, change in the exchange rate of the currency can impact domestic inflation by changing the import prices. If the inflation keeps rising, the manufacturer will cut off production and layoff the workers and this will lead to unemployment increase in the home country. Therefore, the relationship between rate of inflation and various components of BOPs is more complex than is usually perceived. In a study conducted by Cuddington and Vinals (1986), Canada gives the only modern example where an advanced country has experienced with flexible exchange rates. According to author argues the experiment may largely failure as far as stabilization is concerned. This is because of the factor immobility between regions an rise in foreign demand for the goods and services of one of the regions would cause an appreciation of the exchange rate and hence rise unemployment rate in the remaining regions, a process which could be adjusted by a monetary policy which aggravated inflationary pressures in the first region. Every movement in demand for the products in one region is likely to induce opposite movements in other regions which never entirely changes by national stabilization policies. Likewise the high level of external capital mobility is means to interfere with stabilization policy for completely various reasons such as to reach internal stability of the the central bank can alter credit conditions yet it is the change in the exchange rate rather than the alteration in the interest rate which creates the stabilizing effect. This indirectness means to a cyclical approach to equilibrium. Even an explicit empirical study is important to verify that the Canadian experiment out of expectation to the claims made for flexible exchange rates, the prima facie evidence shows that it has not. It must be emphasized that a unsuccessful of the Canadian experiment would cast doubt only on the effectiveness of a flexible exchange system in a multiregional country, which is not a flexible exchange system in a unitary country.

The case of Chile in 1998 provides a case of the logic of speculative attacks under high inflation. In the first half of 1998, the Chilean Peso was strike by speculative pressure because the Asian crisis, and Russian crisis in the middle of 1998. Besides that, Brazil experienced two times of speculative pressure in 2001 and 2002, following by the inflation in 1999. The problems in 2001 were because of continued current account imbalances, electricity shortages in June of 2001, and expectation of the Argentinian default and weakening at the end of the year. Exchange rate depreciation in domestic prices was so large speculative pressure that the inflation was missed by a wide margin (Kumhof, Li, & Yan, 2007). The speculative attacks caused by the inflation and BOP deficit. For particular rates of inflation, little changes can have dramatic effects on the trade and the size of trade is affected. When money is held use for transactions purposes and factor of production are endogenous, changes in inflation can lead to change in the pattern of trade that never reflect real underlying changes in comparative advantage. A rise in inflation imposed taxes of purchases products link to leisure, and finally lower labor supply. It also imposed taxes financial investment and adjusts the long-run capital stock. Therefore, inflation affects the pattern of trade through its effects on factor supplies (Stockman, 1985).

There have an argument that many governments put effort to adjust inflation rates and exchange values via economic policy maneuvers, including direct market intervention. It is suggested that the inflation rate for one country is affected by the inflation rate in another country and the rate of change in the currency exchange rate. Discipline and independence policymakers in one country may have little or nothing to comment about the inflation rate in another country, but they can take action about the manipulate exchange value of their own currency. They can 'overvalue' it by using foreign exchange reserve to purchase their own currency to support its value. Otherwise, they can 'undervalue' it by obtain foreign exchange reserve through price depreciate disposals of their home currency. Country which increases central control at all foreign currency transactions can overvalue or undervalue their own money by making easy decisions. Moreover, inflation rate in one country can be affected if the theoretical relation holds in practice (Houck, 1979). For example, downward pressure on inflation rates can be obtained by holding low the annual rate of change in the exchange rate by overvaluing the currency of a country. This will discourage exports and encourage imports. On the other hand, if the currency of a country is systematically undervalued, upward pressure will be used to its inflation rate as its exports show cheaper on international markets and as its imports become relatively expensive. This way implies some insight into reason for policymakers in country with high rates of inflation will overvalue their currencies by resisting devaluation at least part of the grounds that would increase further fuel to domestic inflationary fires. And causing the balance of payments issue are less evident (Lélis, da Silveira, Cunha, & Haines, 2018).

In the second argument, in the event of Euro-countries, the major imbalances would exist to be wage and price rigidities. These rigidities are obviously present, and attached with the fixed exchange rate, affect the correction of real wages and relative prices. These rigidities in turn indicate a role for fiscal policy, and relative government spending. The particular form of fiscal policy relies on the particular form of rigidities. For instance, wage rigidities are symmetric. During the current low inflation situation, nominal wages may be more downward rigid (Kurtovic, & Talovic, 2015). Yet, there have conducted points to two significant issues, which are inadequate discussed in the current European policy debate: The first is the potentially significant role of active fiscal policy. It may suitable to fit in the priority, for the time concern is to save the budget deficits so as to offset the margin of guide that fiscal policy should be operate optimally. It should think harder about utilize this margin when it becomes available. Following by while fiscal policy is useful, it is a poor instrument, and the result may still be far away from the expected. This strongly recommends that governments should not grab wage and price rigidities as given. Indeed, the best way of thinking about country particular macroeconomic policy in the context of countries in a common currency field is to think of the joint use of wage and fiscal policies (Blanchard, Olivier & Francesco, 2006).

In addition, in the event of balance imbalances, the main countries involved are not restricted by exchange rate regimes such as China is free to peg or not, so wage and price rigidities seem less relevant. It is also difficult to consider of financial imperfections which would prevent a large rise in US trade output in response to depreciation (Blanchard, 2007). Therefore, unless there have raise some central imperfections, the first pass must be that the case for government intervention in the United States or elsewhere is weaken. This is due to that the shifts in private saving and private investment which increase current imbalances are themselves due, in part, to distortions. For instance, high saving in China indicates lack of retirement and health insurance, and hence precautionary saving on the part of Chinese individuals. Low investment in parts of Asia indicates poor financial intermediation. Low saving in the United States reflects in part public dissaving and private saving itself maybe according to the wrong expectations about retirement benefits and health care. Decreasing these distortions, or in the last case, decreasing the budget deficit where China should give a better retirement and health insurance to its residents and this would raise their welfare. The United States government should decrease its budget deficit and so on. Such policy changes are able to decrease balance imbalances: To the extent that providing insurance reduce saving and rise internal demand, China may find that it has to decrease external demand through an appreciation in Chinese Yuan value, which will decrease China’s current account surplus. As it decrease its fiscal deficit, the United States figure out that maintaining output at its natural level needs a reduce in interest rates and a depreciation of the dollar value, cause in decrease in its current account deficit (Clarida, 2005).