Inflation in Latvia: It’s Causes, Consequences and Government reaction.
Inflation is defined as a persistent increase in the average price level in the economy. Governments desire a low inflation rate, which cannot always be assured. There is the so called demand-pull inflation, which occurs as a result of increasing aggregate demand, which can be due to high consumer’s confidence and demand for a country’s exports or an increase in government spending. This can occur in different situations; either when the economy is approaching full employment or when the economy is at full employment and output cannot be increased anymore, thus inflation increases when the aggregate demand curve shifts to the right. There is also the cost-push inflation, which occurs as a result of an increase in the costs of production; raw materials become more expensive, workers want higher wages, etc. Short run aggregate supply will fall, the average price level will increase and real output will fall.
The costs or consequences of inflation depend on the country, but generally speaking the loss of purchasing power; the effects on saving, interest rates and international competitiveness, as well as uncertainty are the biggest problems. If the inflation in a country is 3% goods cost 3% more, which is okay as long as wages increase equally. If not people cannot buy as much as they used to, which is a loss of purchasing power. It is similar with savings; put in 1,000€ in the bank and have an interest rate of 4%, but an inflation rate of 6% and money is lost. In order to prevent that when lending money to people banks increase their nominal interest rates, which can lead to uncertainty – firms don’t want to borrow money or invest in the economy. International competitiveness can decrease if the inflation rate of a country is not similar to the inflation rate of countries that are trading partners, too. This can lead to more imports and less exports as foreign goods are less expensive.
The drastically increasing inflation rate in Latvia from 2004 to 2008 was mostly due to the overheating of the Latvian economy. "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). The general overheating was the reason for the first rises of the inflation rate, which then lead to further overheating of the labour market. "… It (the surge of the inflation rate) is the result of overheating in the labour market as well as of higher inflation expectations.” (Hansen 2007, 5). Workers therefore demand higher wages, which leads to higher costs of productions and higher inflation. It seems like an endless spiral that damaged Latvia’s exports greatly and their plans of adapting the Euro in 2008. "By now those plans are indeed history and the debate is about euro adoption in 2010, 2012 or even later.” (Hansen 2007, 3). This is a great set-back for Latvia and only in 2007 the government took action by introducing an anti-inflationary program: "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).” Latvia’s government started to take the right actions, but they have to stick to them in order to see their efficiency.
Vanags, Alfs, and Morten Hansen. "Inflation in Latvia: causes, prospects and consequences." Stockholm School of Economics in Riga. BICEPS and Stockholm School of Economics in Riga, June 2007. Web. 8 Sep 2010. <http://www.biceps.org/files/Inflation report II BICEPS web page version 6 June.pdf>.
Vanags, Alfs, and Morten Hansen. "Inflation in the Baltic states and other EU new member states: Is there a mystery to unravel?." Baltic International Centre for Economic Policy Studies. BICEPS and Stockholm School of Economics in Riga, May 2006. Web. 8 Sep 2010. <http://www.biceps.org/files/Inflation%20paper.pdf>.
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