The Impact of Inflation on Economy and Finacial Sector
I.INTRODUCTION 1.1 background
A large body of facts associates’ financial sector development leads to boost the Ethiopian economic growth or vice versa, yet the channels through which inflation affects this relationship are not as much of systematically explored. The effect of inflation occurs through a wide variety of direct and indirect channels. Inflation increases transactions and information costs which directly inhibit economic development. For example, economic agents will find planning difficult when inflation makes nominal values uncertain. Firms and individuals will be reluctant to enter contracts when inflation is imperfectly predicted and judgments about absolute and relative prices are uncertain. The reluctance to enter contracts over time will inhibit investment and entrepreneurship, which will affect resource allocation and economic growth.
The extent that high inflation disrupts the smooth operation of a nation’s financial markets and institutions, it also discourages their integration with the rest of the world. Since high inflation is often variable inflation as well, there will be considerable uncertainty about future prices, interest rates, and exchange rates, which in turn increases the costs of hedging financial risks among potential trade partners. If inflation also increases a currency’s vulnerability to speculative attack, hedging instruments will become even more expensive and difficult to price. All of this will discourage trade and inflows of foreign capital. (Bruno and Easterly, 1998)
A few studies examine the inflation-finance-growth nexus. Haslag and Koo (1999) and Boyd et al. (2001) show that inflation is associated with financial repression. Rousseau and Wachtel (2002) identify an inflation threshold for the finance-growth relationship, finding that finance affects growth positively only when annual inflation can be held below a threshold that lies between 13 and 25 percent for the world, depending on the measure of
A large body of facts associates’ financial sector development leads to boost the Ethiopian economic growth or vice versa, yet the channels through which inflation affects this relationship are not as much of systematically explored. The effect of inflation occurs through a wide variety of direct and indirect channels. Inflation increases transactions and information costs which directly inhibit economic development. For example, economic agents will find planning difficult when inflation makes nominal values uncertain. Firms and individuals will be reluctant to enter contracts when inflation is imperfectly predicted and judgments about absolute and relative prices are uncertain. The reluctance to enter contracts over time will inhibit investment and entrepreneurship, which will affect resource allocation and economic growth.
The extent that high inflation disrupts the smooth operation of a nation’s financial markets and institutions, it also discourages their integration with the rest of the world. Since high inflation is often variable inflation as well, there will be considerable uncertainty about future prices, interest rates, and exchange rates, which in turn increases the costs of hedging financial risks among potential trade partners. If inflation also increases a currency’s vulnerability to speculative attack, hedging instruments will become even more expensive and difficult to price. All of this will discourage trade and inflows of foreign capital. (Bruno and Easterly, 1998)
A few studies examine the inflation-finance-growth nexus. Haslag and Koo (1999) and Boyd et al. (2001) show that inflation is associated with financial repression. Rousseau and Wachtel (2002) identify an inflation threshold for the finance-growth relationship, finding that finance affects growth positively only when annual inflation can be held below a threshold that lies between 13 and 25 percent for the world, depending on the measure of