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Suppressed inflation and money demand in Zimbabwe
International Monetary Fund (IMF)
Working Paper No. 06/15
January 01, 2006

http://www.imf.org/external/pubs/cat/longres.cfm?sk=18743.0

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Introduction
Financially repressed regimes are characterized by suppressed prices, which lower the rate of real economic growth and retard the development process. Suppressed inflation describes a situation in which, at existing wages and prices, the aggregate demand for current output and labor services exceed the corresponding aggregate supply. Suppressed inflation results from the inability of wages and prices to adjust instantaneously, in response to shifts in aggregate demand or supply, to satisfy the conditions for general market clearing. This inability can result either from effective legal constraints—that is, the imposition of price and wage restrictions—or from natural frictions in the workings of the market mechanism (see Barro and Grossman, 1974).

In this type of regime, nominal income increases occur as a money illusion to minimize social discontent and provide a work incentive. This strategy increases the inflationary overhang—the accumulated and unusable purchasing power in the hands of the population. At the same time, suppressed inflation spurs maladjustments and inequities in the production processes, further reducing the supply of goods.

The underlying economic theory is based on developments in disequilibrium macroeconomics (Muellbauer and Portes, 1978; a particularly relevant example is Barro and Grossman, 1974). The latter finds that too low a price and nominal wage level and the consequent excess demand for consumables and labor services causes employment and output to be below general-marketclearing levels. That is, households react both to their increased real money balances and to the constraint in their consumption by reducing their effective supply of labor supply, and the level of output is constrained by the level of employment, by the production function.

Most of the studies on depressed inflation have been based on centrally planned economies that have suffered chronically from some significant degree of excess demand (repressed inflation), i.e., that buyers have faced quantity constraints (informal or formal rationing) on the markets for goods and labor. Whereas Portes and Winter (1978) use a market approach by supposing no excess demand in the official economy in Poland from 1953 to 1973, Charemza and Ghatak (1990) for instance suggest that shortages in the official sector are of main interest in analyzing money demand. Under shortage, households hold additional money balances. These balances are needed to make purchases at higher prices on the black market. Feltenstein and Ha (1991) went a step further and derived a variable measure of repressed inflation in China based on monetary overhang that is the excess of consumer money holdings over the nominal value of retail goods.

The aim of the paper is to explore explanations for the substantial decrease in velocity and increasing levels of real money balances that has led to a divergence between inflation and monetary expansion since late 2003 in Zimbabwe—an economy whose real GDP declined by almost 30 percent from 1997 to 2003, while inflation soared from about 20 percent in December 1997 to a peak of 623 percent in January 2004. Agricultural production—the mainstay of the economy—collapsed with the disruption caused by the violent implementation of fast-track land reform. With the official exchange held at a highly overvalued level and declining exports and foreign financing, the supply of foreign exchange to the official market shrank, leading to sharp restrictions on imports and the accumulation of external arrears.

Investment fell sharply, and shortages of food, fuel, electricity, and other basics became pervasive. Real GDP fell by about 4 percent in 2004, but year-on-year inflation decelerated surprisingly sharply from a peak of 623 percent in January 2004 to around 130 percent at end- 2004, while money growth stayed at very high levels.

The paper is structured as follows. Section II presents background information on the evolution of inflation and money aggregates in Zimbabwe. Section III analyzes the demand for money since the late 1990s. Section IV discusses other factors that can lead to diverging paths of inflation and money growth in the short run. Section V concludes.

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