Financial systems and development

Table 4.1 Average annual inflation rates, 1965 to 1987
(percent)
Item 1965-73 1974-82 1983-87
High-income countries 5 9 4
Developing countries 10 26 51
China and India 3 4 7
Other low-income 20 16 13
Highly indebted countries 14 45 120
Other middle-income 6 15 12
Number of developing countries
with inflation rates in excess of
20 percent 4 15 27
30 percent 2 9 17
100 percent 0 1 7
Note: The average annual rate of inflation is measured by the growth rate of the GDP implicit deflator. Aggregates for country groups are GDPweighted
averages. Data for developing countries are based on a sample of eighty-eight countries.
deposit rates or higher lending rates. Explicit taxes ments kept interest rates low partly to encourage
on financial intermediation, as in Turkey and the investment, partly to redistribute income, and
Philippines (see Box 4.6), exerted additional up- partly because they themselves wished to borrow
ward pressure on the spread between deposit and cheaply. Many governments also believed that low
lending rates. deposit rates (the corollary of low lending rates)
would not discourage financial saving.
The impact of interest rate policies and inflation
Experience has shown that some of these ideas
were wrong. As Chapter 2 pointed out, there is
Interest rate controls and inflation have set back strong evidence that real interest rates and inflafinancial
development in many countries. Govern- tion have a significant effect on financial savings,
Box 4.5
The inflation tax
An economy's willingness to hold money-that is, its centage of GNP, the central bank must issue a larger
demand for money-generally grows with its real GNP. amount of money and generate a higher inflation rate
Such demand may also change in response to yields on to secure a given amount of revenue.
other assets and expectations. If the money issue exceeds
the increase in the economy's willingness to hold
money, the result is inflation, which operates like a tax. Box table 4.5 The inflation tax in selected
Asset holders "pay" the tax by losing purchasing countries, 1987
power on their money holdings. Those who have issued
money liabilities "collect" the tax in the form of a Inflation tax Reserve money Inflation
reduction in the real value of their liabilities. To the (percentage (percenztage rate
extent that the money issuer pays interest on these County of GNP) of GNP) (percent)
liabilities, it returns some of the tax to asset holders. Argentina 4.0 6.3 174.8
Central banks typically do not pay interest sufficient to C6te d'Ivoire 0.5 14.4 3.4
offset the tax on their money issue: they pay no interest Ecuador 2.0 8.1 32.5
on currency and usually a below-market interest rate Mexico 3.7 6.0 139.2
on reserves. Box table 4.5 provides estimates of the Nigeria 0.9 9.6 9.7
inflation tax (as a share of GNP) flowing to the central Peru 4.8 9.1 114.5
bank on reserve money for ten countries in 1987. Philippines 0.6 8.0 7.5
It might seem that a high inflation rate implies a high Turkey 2.8 7.9 55.1
inflation tax as a percentage of GNP, but this is not Zaire 4.2 8.2 106.5
always so. High inflation rates (that is, high rates of Note: The inflation tax is defined as the decline in the purchasing
inflation tax) discourage people from holding money. power of average sIFS, reserve money line 14) due to inflation. It is
calculated as M x [i! I (I -r i)l. where M is the average reserve money
When the money stock held by the economy is a small at year-end and year-beginning and i is the decimal inflation rate
percentage of GNP, the inflation tax will be corre- measured by the change in the CPI from December to December.
spondingly small. Hence, if inflation has been high and lOver any interval for which the prices rise by i, each money unit
S loses ill (I 1 i) of its purchasing power.]
th oe tock-the tax base-has declined as a per- Sorce: IMF, International Financial .Statistics, and World Bank data.
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