Eric Koechlin Hyperinflation in Peru during the government of Alan Garca (1985-1990) History Section During the elections

of 1985, young and eloquent Alan Garca (36 year politician known as the Latin-American Kennedy), successfully won the elections due to hs incredibly skillfull abilities as a spokeman and statesman, and his leftwing radicalism which was very common at the time in Latinamerica. During the last couple of decades South America was being affected by a growing inflation that was affecting most of their countries including the Andean country. Garcas administration received an economy with a negative economic growth of 9% (due to a fall in exportation prices) with a trade deficit where there was no investment in the generation of new capacity investment was considerably below the countrys production levels. Besides they had to deal with the Shinning Path: a communist/Maoist terrorist-insurgent organization. During the former government, the World Monetary Fund forced Peru to reduce its governments budget and devaluate their currency making the dollar more expensive in order to reduce its imports. As a result, there was a decrease in demand that caused recession. Tariffs went up and affected individuals income as well as the governments due to a reduction of state money coming through taxes. Garcia solutions were the drastic reduction of inflation, the reactivation the economy, the restructuration production, and inducing real salaries. Garca decided to

declare a limit on the debt repayment equal to 10% of the Gross National Product from exports. As a result, Peru suffered from an isolation of the international financial markets, especially the International Monetary Fund. He decided to increase and freeze the price of several goods and services like gas, food, rent. He did this by implementing subsidies were the government help the consumer acquires those assets. The price on tariffs also increased electricity, water, postal service, etc. The dollar was devaluated and the Inti (Perus new currency during this administration) frozen to an especific exchange rate for half a year. Corporations decided to take advantage of the government who was financing and subsidizing them in a n unsuccessful attempt to stimulate production and investment. Establishing fixed prices and a fixed exchange rate increased inflation. The increase in public prices and the commercial unequilibrium distorted prices and decreased the national reserves. On the other hand, by going against IMF, Peru had a hard time obtaining the technology and inputs that were needed and could only be obtained by importing them from other countries. The IMF thought inflation was a cause of excess demand. Garca didnt follow any advise from the IMF and decided to elevate prices in order to produce more money to as an alternative solution to deal with the fiscal deficit. Eventually the government could no longer afford to implement subsidies. As a result, seigniorage and a major production of money were imposed into the economy. Garca didnt realize in the lack of supply in the economy, that is why he thought that by increasing prices consumption wouldnt be affected and therefore there will be a solution to pay the debt and decrease the deficit.

The reason he decided to go against Halls and Keynes suggestions on inflation what the former president was doing before him is because he thought that by doing this, it will end with inflation as well as serving as a fast incentive for economic growth. As a result, by 1986, the government achieved a 10 percent growth rate during the first year and the economy seemed to recuperate inflation decreased by more than 3%. The sectors that depended on the national demand grew: agriculture, manufacturing and construction industries. However, those dedicated to exports did not: fishing and mining industry. On the other hand, in 1985 the Gross Domestic Product falls by 49% as well as general incomes. There was a great necessity for foreign loans for Peruvian production, which Peru (as mentioned above due to the imposed limits on the IMF) was no longer able to obtain. All these resulted in an inflation of costs affecting four basic prices: wages, utilities, interest rates and exchange rates. A return cycle was created where everything was repeated. As wages increased, imports did as well and exports decreased creating a shortage of liquidity in the economy. This was the beginning of hyperinflation. By 1987 there was a crisis in the balance of payments without doing nothing while hoping the economy will keep growing, and by 1988, they had to accept the increase of prices and wages as well as the devaluation of the currency. They came to a point where the government had to ask loans to firms. As a result, firms where forced to buy bonds from the government. After a while this plan got canceled because it drew firms to economic instability.

Another measurement the government took in 1988 was to nationalize the banks in order to rearrange the economy and exit the economic crisis. The economy was paralyzed and an immense shortage in all of the economies sectors was produced, which forced the government to back up. Everyone was affected by this shock, which Garca though that by nationalizing the bank, it will help shorten the distance between the poor and the rich by allowing the government to distribute democratic money lones includying the informal sectors (such as the agricultural sector) that will reactivate the economy by increasing both the demand and the supply. This improvised measures resulted in a negative balance of $900 million in the national reserves by the end of Garcas government. The GDP dropped by 20% and the average annual income fell to $720 (less than in 1960). By 1990 hyperinflation reached 7,649% with a cumulative total over 2,000,000% during the five years of Garcas administration.

Policy Section By 1985 Garca received a country with a high degree of inflation and the devaluation of the national currency. In order to restore the economy and increase the economys production Garca decided to drastically change the fiscal policy with several expansionary policies that included multiple active policies: automatic stabilizers and government regulations. Due to the excess of demand on imports, before Garcas administration, the International Monetary Fund had forced Peru to reduce the fiscal budget and devaluate the national currency to make it harder for Peruvians to import in order to stop the trade deficit (Imports > Exports). As a result, Peruvians will start to import less, producing more (increasing supply to meet demand) and transition to a balance trade or trade surplus (Exports > Imports). However, this caused a recession due to contraction in demand. Garca decided to go against the IMF as he intended to increase imports because Peru needed technology and capital from another countries in order to increase their production because technology (A) and capital (K) are two predominant variables in the Production Function of an economy that determine the output/GDP. As a result, Garca believed that paying the external debt was counterproductive to restore the economy, so he decided to use that money for the government to invest on imports and expansionary policies. As a result, years later when Peru needed the help of these organizations (World Bank and IMF), several restrictions were imposed to Peru and it was harder for Peru to get into the world market, which also contributed to its trade deficit. Garca believed the government should supply what the people demanded and he will do it by subsidizing producers and fixing prices and wages. It seems that in someway, the IMF tried to find a solution through Says law/long run approach of Supply

creating its own Demand (ignoring demand while increasing supply within Peru that will later meet/create domestic demand), while Garca had a more Keynesian/short run view where Demand creates its own Supply (letting Demand work freely). However, in this case, demand didnt create supply so he decided the government should create supply to meet the existing demand. Neither of the policies the IMF suggested nor the ones Garca applied were the most beneficial. In order to stop the increasing inflation rate, instead of using inflation targeting by working with the Central Bank to target the interest rate and manage inflation efficiently, Garca decided to implement sticky prices to stop inflation. As a result, due to the existing inflation, it was impossible for firms to supply goods and services at the fixed prices the government was imposing, so the government had to pay some of the production real cost so both the supply and the demand could produce and consume at a nominal fixed equilibrium price that did not match the real price of the market. At the time, most of the market was controlled by oligopolies, which by having the government paying for a substantial amount of the real production cost, never intended to invest in production, technology, capital or labor to increase their production output as Garca hoped they would as this variables (A, L and K are the responsible for the increase in Y on a production function). This resulted in an enormous budget deficit and intragovernment debt due to the fall in reserves the government had to use to sustain production at fixed prices. After a while the government could no longer supply the cost of production for the producers, which resulted in a huge drop in the production function of the economy and the supply in the economy. As the supply fall, eventually workers start earning less money and demand fall as well.

Garca, in order to promote imports that will result in investment in technology and capital (as mentioned above) and to stop the devaluation of the national currency, decided to implement a sticky/fixed currency exchange rate between the Peruvian Inti and the US dollar. By doing this, only importers were benefited while making it substantially difficult for exporters to export more than ever before. Exporters had to stop exporting because inflation continued and they were still getting the same amount of Intis for every dollar paid in the fixed exchange rate while every day the real value per Inti decreased considerably. This created the biggest trade deficit in Perus recent history. At the other hand, as a result of the fixed exchange rate, people who earned in dollars (as many workers in Peru do) or people who had their savings in dollars lost most of the real value in their savings accounts. Garca implemented high sticky wages as well to control inflation. As a result, Peruvians started earning more money that they used for imports together with the lack of domestic supply and the fixed exchange rate that contributed towards a higher increase in imports and a higher trade deficit. During the economic chaos Garcas expansionary policies could no longer sustain the economy and its production. Reserves dropped considerably and contractionary policies were almost impossible to apply because the SUNAT (National Superintendency of Tax Administration) was a mediocre governmental body unable to work due to corruption both in the SUNAT and the government that rose due to the countrys economic, fiscal and governmental chaos. As a result, when the government tried to implement contractionary policies both people and businesses stopped paying taxes as the SUNAT was unable to regulate them so the governments monetary policy consisted on a irresponsible monetary expansion policy that continued to increase the

production of money supply to sustain the governments expansionary policies. This seemed to be the only way the economy could continue working. The result of seigniorage resulted on an incontrollable hyperinflation that reached 7,649% by 1990. All these resulted in an inflation of costs affecting four basic prices: wages, utilities, interest rates and exchange rates. By 1987 due to a crisis in the balance of payments, the government had to change fixed/sticky prices and wages different times. The government forced firms to make loans to the government and buy bonds emitted by the government for 30% of the value of the gross profits business acquire in 1986. This created more economic instability that jeopardized even more the production sector. Another measurement the government took in 1988 was to nationalize the banks in order to rearrange the economy and exit the economic crisis. The economy was paralyzed and an immense shortage in all of the economics sectors was produced, which forced the government to back up. Everyone was affected by this shock, which Garca though that by nationalizing the bank, it will help shorten the distance between the poor and the rich by allowing the government to distribute democratic money lones includying the informal sectors (such as the agricultural sector) that will reactivate the economy by increasing both the demand and the supply. This improvised measures resulted in a negative balance of $900 million in the national reserves by the end of Garcas government. The GDP dropped by 20% and the average annual income fell to $720 (less than in 1960). By 1990 hyperinflation reached 7,649% with a cumulative total over 2,000,000% during the five years of Garcas

administration.

Para ello cambia de Ministro de Economa y pone a Abel Salinas como nuevo Ministro quien en un mensaje a la nacin anuncia su ingreso con un cambio de rumbo en la poltica econmica y ahora s habla de shock econmico como nica salida para enfrentar la crisis y es en estas circunstancias que lanza el muy recordado "Plan Cero" que trajo como consecuencia el disparo de la inflacin. Para recordar un ejemplo las medicinas subieron en un 600%, la gasolina en 400% y como estas en otros rubros igual.

Policy Recommendation During the first year of Garcas administration, the sticky public and private prices and wages, as well as fixing the exchange rate in relation to the dollar had positive results in controlling inflation and the devaluation of the Inti (Peruvian currency). Garca should have stopped fixating prices in 1986 (during his second year) before the national reserves dropped and inflation rocked, as well as his exaggerated expansionary policies. By 1986 Peru was also having a positive economic growth, thats the time where Garca should have let the market work by itself and change from expansionary policies to contractionary policies by increasing taxes in order to restore the reserves and pay the debt.

On the other hand, a more responsible fiscal policy would have been to stop the increasing inflation rate by using inflation targeting by working with the Central Bank to target the interest rate and manage inflation efficiently, instead of implementing sticky prices and wages and fixating the exchange range. Garca should have realized that by subsidizing producers that would have never incentive investment and after controlling inflation (whether by fixating prices and rates for no more than a year or not) should have applied passive policies as well instead of using the government to control the whole economy. By making the Central Bank independent or controlled by a responsible elected branch of government economists where the president or politicians do not have unlimited control over the Central Banks actions, might have resulted in more efficient inflation targeting policies and wouldnt result in a seigniorage and hyperinflation. On the other hand, Peru shouldnt have followed the International Monetary Fund advises either. The IMF advices to limit the excess of demand where the first cause of the devaluation of the currency, inflation and economic recession. Garca was right to allow imports and let demand behave naturally, but doing so at the cost of a trade deficit was his biggest mistake. Through passive policies the government should have never intervened in controlling the exchange rate which would have eventually led exports to increase and imports wouldnt have been as easy to obtain since the real value of the dollar would have been much higher than the one it was fixated with the exchange rate Garca imposed during inflation. By doing this, letting the market and the trade system work by itself without government intervention, importing would have been harder and exporting easier, eventually leading to a balance trade, trade surplus or a small trade

deficit. The enforcement of the law within public administrative offices such as the SUNAT, would have stopped corruption and allowed the SUNAT to work more efficiently in the collection of taxes, which would have allowed Garca to apply contractionary policies in order to avoid the fall of the reserves and pay the debt. Law enforcements should also have been used against the individuals and firms who didnt pay their taxes.

Bibliography http://www.ucsm.edu.pe/moodledata/portaljoomla/images/programas/File/ANALISIS%2 0DE%20LA%20INFLACION%20EN%20EL%20PERU.pdf Peru : policies to stop hyperinflation and initiate economic recovery. Washington, D.C., U.S.A. : World Bank, 1989 Demanda de Dinero, Inflacion y Politica Monetaria en el Peru: 1991-1994. CUADERNOS DE ECONOMIA -SANTIAGO- 32, no. 97, (1995): 347-378 Evaluation of wavelet - based core inflation measures : evidence form Peru. Lima : Pontificia Universidad Catlica del Per. Departamento de Economa, 2011. South America : problems and prospects. New York : H.W. Wilson Co., 1975

http://www.bcrp.gob.pe/estadisticas/cuadros-historicos-de-tasa-de-interes.html http://www.youtube.com/watch?v=CrtcGbIOFCo http://www.youtube.com/watch?v=SAiKp4PCG3s