Inflation in Latvia: Causes, Consequences and Government Response
Inflation is a phenomenon defined as a persistent rise in prices. There are two major reasons that inflation increases, demand-pull and cost-push. Demand-pull is when the supply of products is low and the increase in demand shifts the aggregate demand curve to the right, thereby raising prices. Cost-push is when the costs of production increase and producers pass these costs onto consumers by raising prices. This causes the short run aggregate supply curve to shift to the left. There are many consequences to high inflation. One of these consequences, according to the Phillip’s Curve, is low unemployment. The theory is that as prices rise and producers make high profits, the demand for workers increases as producers require them to keep up their current levels of output. Another consequence of high inflation is that exports become less competitive, because their prices are so much higher than other countries’ exports. There are two types of policies that a government could follow to potentially lower the inflation rate in their country. These would be fiscal and monetary policies. Fiscal policies deal with adjusting the aggregate demand of a country through the usage of government spending and taxes, monetary policy adjusts the amount of money in circulation. Fiscal policy can help reduce inflation because it can move the aggregate demand curve to the left, therefore lowering prices. Monetary policy can lower inflation because it can raise interest rates and move the aggregate demand curve to the left as well.
In the case of Latvia, there are many reasons for the extreme rise in their inflation rate between 2004 and mid-2008. The first of which is that their economy was overheating. This was shown in a report done in 2006, "Given these high growth rates and declining unemployment rates the Baltic countries are above trend growth i.e. productivity may be increasing fast but not as fast as GDP, which is being ‘pulled up’ by growing domestic demand. Output growth in excess of long run potential is a clear sign of overheating.” (Hansen 2006, 12). Another cause of inflation in Latvia is something called persistence. "The idea that observed high inflation because of a tight labor market is incorporated into people’s inflation expectations.” (Hansen 2006, 13). This is shown in Latvia when the Producer Price Inflation is compared with the wage rates between the years of 2004-2007. The wage rates varied exactly with the PPI except that the fluctuations in the wage rates occurred 15 months before the changes in the PPI, as is shown in Image 1(Hansen 2007, 8). The third major cause of the high inflation in Latvia was the credit boom. The M2 growth in Latvia between the years of 2004 and 2005 was between 30-35%, as shown by Image 2(Hansen 2006, 14).
The consequences suffered by Latvia due to their high inflation were that they were unable to adopt the Euro as scheduled and their exports suffered. In 2006 the plan was to adopt the Euro in 2008 but since then plans have changed. "…the debate is about euro adoption in 2010, 2012 or even later.” (Hansen 2007, 3). Their exports were also under pressure, "The deteriorating level of Latvian competiveness has been associated with a rapid decline in the growth rate of the volume of exports to the point where in both of the last two quarters the volume of exports was actually lower than the year before.” (Hansen 2007, 16).
The government response was an anti-inflation plan put forward in 2007. The description of it was that, "The government anti-inflation plan has five broad sets of measures. Three measures-budget policy, real estate taxation and measures to dampen the credit boom…the other measures aimed at the labor market, productivity, energy efficiency and increased competition…”(Hansen 2007, 17).
The causes of the Latvian inflation are a mixture of demand-pull and cost-push. The credit boom and overheating were demand-pull, but the persistence, which caused wages to increase, was a cost-push. As such, it seems that the Latvian inflation rate just kept going up due to an inflationary spiral. An inflationary spiral is when the prices go up, because the aggregate demand curve shifts to the right and raises prices. Then the SRAS curve shifts to the left because wages are increased by workers who need more money to afford the higher prices. This increases prices further. Then, because of their new wage rates, workers spend more and push the aggregate demand curve to the right again and the cycle begins all over again. The policies which the Latvian government set out to cure their high inflation are fiscal in the most part. However, the policies would have to be implemented consistently to be of any good.