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Research Paper: About inflation and other bad weather predictions
December 5, 2011, 12:01 pm
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Predicting economic behavior is like predicting the weather: a forecast might indicate that a rainstorm is on its way, however, air masses can change direction, temperatures on the surface of the ocean could either rise or drop and many other natural phenomena could occur, clearing the skies. Like forecasts, economic studies are based on visual data, statistics, evidence and most importantly, observed behavior. However, even with all the technology known, weather predictions most of the time fail and likewise, predictions made about the future of the Puerto Rican economy are uncertain. These measurements can only do so much to predict – and intend to solve – the problems that will arise in the future. Nonetheless, there is one economic problem that without a doubt has disappeared from the Puerto Rican economy, and it is called inflation.

The concept of inflation denotes “an ongoing rise in the general level of prices quoted in units of money (White).” It is tempting to think that, perhaps, Puerto Rico suffers from an inflationary problem. For instance, if one walks into a bakery, a dollar does not get you a whole loaf of bread; it doesn’t even buy half a loaf. Actually Puerto Rico has had the “highest flour price index in 60 years (Beaulieu).” However, thinking that because the price of flour – a single item in the economy – and its derivatives, like bread, has increased Puerto Rico is going through an inflationary period is erroneous because inflation is measured using the price indexes of various goods, not just the price index of a single item. In other words, when an item’s price index skyrockets, other price indexes might drop.

Contrary to popular believe economic growth – the expansion of the economic possibilities of a country by finding either more resources or making better use the resources they have (technology) – is not always beneficial. When countries grow quickly, like China for example, the rate of inflation rises steeply because there are not enough resources or the resources employed cannot withstand the production workload. This creates a situation in which the increasing costs of production force producers to push the costs of their products in order to minimize their losses. The Chinese government has identified inflation as “one of the main threats to the country’s economic stability” (BBC) and for months have been looking for ways to reduce their accelerated growth and with it, their increasing rate of inflation. By applying a Contractionary Fiscal Policy (CFP) – a system of economic government regulations designed to reduce production, and therefore inflation, by lowering government-related costs and increasing taxes, which in turn reduce the buying power of consumers and slows down the economy –, the Chinese government intends to solve their growth-related economic problems. For this analysis, a Phillip’s curve is used to demonstrate the relationship between employment and the rate of inflation of a country.

Phillip’s Curve

In theory, all economies in the world have two main problems and they cannot be solved at the same time. These problems are inflation and employment. In the graph, the x-axis is the rate of unemployment and the y-axis, the rate of inflation. The negative slope of the Phillip’s curve means that there is a negative relationship between the rate of inflation and unemployment: when the economy has a low unemployment rate, therefore a very high employment rate, inflation increases significantly because the payroll of the workers increases operational costs. On the other hand, when the economy is producing less, unemployment rates drop and so does inflation, because the costs of producing are significantly less. This curve is helpful in understanding the situation in Puerto Rico. The unemployment rate in the island is about 16.9%, one of the highest – if not the highest – in the world (Road to Recovery, Slide 5). Because the rate of unemployment is so high, based on the Phillip’s curve, the rate of inflation should be low. As predicted by the curve, the rate of inflation in Puerto Rico is about 5.8% (Road to Recovery, Slide 5), a pretty low rate considering that Puerto Rico is an economically developed country. Because of the incredibly high rate of unemployment, Puerto Rico has been in recession for the past five to six years.

In a recession, economic activity is minimized because the flow of currency from one person to another is limited, therefore production levels fall, bankruptcies and debt increase and the society begins to suffer from social problems like suicides, divorces and ongoing criminality. According to CBS News, “the gloomy economic reality in Puerto Rico may be partly to blame for the rise in crime (Cobiella and Doran).” Because Puerto Rico is on recession (the complete opposite to the problem China has, which was described before), the government applied an Expansionary Fiscal Policy (EFP). An EFP is a system of economic government regulations designed to increase production, and with it inflation, by increasing government-related costs and lowering taxes. However, EFP’s produce deficits, like the ones Puerto Rico has been piling for years. Because Puerto Rico’s public debt – the sum of all the previous deficits – has grown immense over the past decade, affecting adversely the credit of the island; financial agencies are not willing to lend Puerto Rico money at acceptable interest rates. Because Puerto Rico cannot improve its production (since increasing it would mean spending money they don’t have), they can’t either solve the unemployment problem efficiently. This situation forces the government to focus on then the second problem of all major economies: inflation. This is another explanation for why there are no inflationary problems on the island.

The rate of inflation in Puerto Rico, however, is not controlled by the Puerto Rican economy. In other words, another force acts upon the economy of the island. If Puerto Rico controlled its economy, it would be facing a deflationary period – a time frame characterized by a general drop of the level of prices – caused by the recession in which Puerto Rico has been succumbed for the past six years. Any important economic activity in Puerto Rico is controlled by the Federal Reserve Bank (FED), the central financial institution of the United States, and Ben Bernanke, the President of the FED. United States is not currently in recession; however, it is growing a very slow rate. Puerto Rico, on the other hand, is deep in a recession. This creates a conflict between the United States’ economic interests and Puerto Rico’s. The solution to this dilemma is called Monetary Policy and the United States Constitution saves this instrument for the FED. In times of recession, the FED reduces their reserve coefficient so banks have to pay less money in order to have reserves in the FED – having reserves in the FED is mandatory for banks to operate – and banks make money by lending their excess of reserves. The problem is the following: banks are not obligated to lend this excess currency (from Bernanke’s speech). In Puerto Rico, banks are not lending enough money to investors, mostly because the risk of lending money is very high (because of Puerto Rico’s credit reputation). The recession, therefore, could continue for many more years.

While Puerto Rico is in recession, any inflationary increase would soon be diminished. Therefore, because Puerto Rico is in a recession, inflation won’t rise significantly any time soon; however, neither will do employment. While not a good sign for Puerto Rico, knowing that prices would most likely remain constant is a better sign than knowing that tomorrow the price of eating rice could be three times higher than it is today.

Puerto Rico has enormous economic, social and political problems and the solution to all this problems seem terrible – and they are. Nonetheless, there’s one less economic woe to worry about: inflation.

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