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Inflation

2 March, 2015 - 12:11

One particularly vexing problem facing transitional economies is inflation. Under command socialist systems, the government set prices; it could abolish inflation by decree. But such systems were characterized by chronic shortages of consumer goods. Consumers, unable to find the goods they wanted to buy, simply accumulated money. As command socialist economies began their transitions, there was typically a very large quantity of money available for consumers to spend. A first step in transitions was the freeing of prices. Because the old state-determined prices were generally below equilibrium levels, prices typically surged in the early stages of transition. Prices in Poland, for example, shot up 400% within a few months of price decontrol. Prices in Russia went up tenfold within six months.

One dilemma facing transitional economies has been the plight of bankrupt state enterprises. In a market capitalist economy, firms unable to generate revenues that exceed their costs go out of business. In command socialist economies, the central bank simply wrote checks to cover their deficits. As these economies have begun the transition toward market capitalism, they have generally declared their intention to end these bailouts and to let failing firms fail. But the phenomenon of state firms earning negative profits is so pervasive that allowing all of them to fail at once could cause massive disruption.

The practical alternative to allowing firms to fail has been continued bailouts. But in transitional economies, that has meant issuing money to failed firms. This practice increases the money supply and contributes to continuing inflation. Most transition economies experienced high inflation in the initial transition years, but were subsequently able to reduce it.