How to fight inflation - South African rand

1 How to fightinflation3 IntroductionFact sheet No. 2 in this series indicates that inflation isa process of continuous increase in the general pricelevel, and that inflation is bad for the economy and forthegeneral do you stop inflation ?One approach to stop inflation would be to freeze allprices. Many countries have attempted this over thecenturies. For example, in the year 301, the Romanemperor Diocletian froze all prices and wages andmade the infringement of this edict punishable bydeath. In spite of some executions, inflation was notcontained. Eventually this law against price and wageincreases was repealed. Later attempts at directlycontrolling price increases also failed because allthese controls addressed the symptoms, but not triggers price increases?Price increases can be triggered by many developments,such as: an increase in international oil prices; a fall in the exchange rate; a nationwide excessive salary and wage hike; or an increase in food prices caused by a sustains inflation ?

2 For a continuous rise in the general price level, themoney supply has to keep on expanding. Only with"too much money chasing too few goods" can thegeneral price level continue to increase. Graph 1clearly illustrates that high rates of growth in themoney supply in South Africa in the past went hand inhand with high rates of inflation . The only effective wayto contain inflation in the long run is therefore torestrict the growth in the money supply. The likely rateof increase in the quantity of goods and serviceswhich can be maintained without inflationarypressures is usually related to more labour,entrepreneurship and capital goods, and better skills,management and technology. Growth in the moneysupply should accordingly be linked to sustainablegrowth in excessive money supply growth istherefore a crucial element in combating inflation .

3 Buthow is this done?2 Graph 1: Money supply growth and inflation in South AfricaMoney supply growth and inflation in South AfricaPercentage change over one year 5-year moving average051015202530 Money supply growthInflation72 74 76 78 809092 94 96 98 00 02 04 0684 86 88823 Preventing excessive money supply growthThe banks in South Africa are usually indebted to theSouth African Reserve Bank (the Bank). Although theamount of funds which they borrow from the Bank issmall compared to the amount of funds which theyobtain in the form of deposits, their borrowing from theBank is important. This is because the Bank is theonly supplier of legal tender notes and coin tothe economy. The terms and conditions under whichthe Bank is willing to supply cash to the banks areimportant factors when the banks set their interest Bank lends cash to the banks at an interest ratedetermined by the Bank's Monetary PolicyCommittee.

4 This interest rate is called the Bank'srepurchase rate, or repo rate for short. Banks set theirdeposit interest rates somewhat below and theirlending rates somewhat above the repo rate. Throughthe repo rate, the Bank indirectly has a stronginfluence on all the short-term interest rates in thebanking the Bank's analysis shows that inflation is going tobehigher than the inflation target set by thegovernment, it has to put a brake on the inflationprocess. This is done in the following way: The Bank raises the repo rate. Banks thereafter usually raise their lending anddeposit rates. When people face higher lending rates, they buyfewer goods on credit. This causes less credit to be used and less moneyending up with shopkeepers. With less money, credit and expenditure in theeconomy, it becomes more difficult to raise pricesand wages.

5 Therefore, inflation is , if the Bank's reading of the economyindicates that inflation is going to fall below the inflationtarget, it would reduce the repo rate and this wouldreverse the sequence described a rule of thumb, lending rates must be significantlyhigher than the inflation rate if excessive credit growthand money supply growth are to be prevented. Inaddition to the repo rate, the Bank can also influencethe banks' ability to lend out money by usinginstruments such as open-market operations ( and selling financial assets in the open market)and cash reserve requirements ( requiring thebanks to deposit part of the funds they receive fromthe public with the Reserve Bank).Although inflation can only be sustained if the amountof money in the country is rising excessively, theReserve Bank's task can be made easier by both thegovernment and the public.

6 Monetary policy will bemore effective if it is supported by fiscal discipline, the government does not overspend or rapidly runup its debt. Inflationary pressures will also be alleviatedif the general public works harder and smarter, if animprovement in productivity raises the quantity (orquality) of the goods and services lineCombating inflation requires the prevention ofexcessive money supply growth. In turn, this requiresthe private-sector banks to maintain interest rates atlevels that are high enough to prevent excessivegrowth in bank credit extension. To this end, the Banksets its repurchase rate at an appropriate level. Thiswhole process of changing interest rates to influencecredit, money supply and inflation takes time to workthrough; this is why monetary policy requires is the third in a series of fact sheets on the South African Reserve Bank, compiled by the Research Department: Information Division anddistributed by the Executive Management Department: Communications : further information on the content or to obtain printed hard copies:Click on the contact us icon to submit your requestTo access an electronic copy of this fact sheet: Click on About us > Fact sheetsThe content of this fact sheet is subject to change at any updated: July 2007