The Asian financial crisis was a significant international financial predicament that destabilized the Asian and the global economy between 1997 and 1998. The Asian financial crisis started in Thailand and rapidly spread to the neighbouring countries. The crisis which started in Thailand spread to neighbouring economies when Bangkok tried to unpeg the Thai baht from the global standard currency which is the U.S dollar. This action by Thailand set off a sequence of currency devaluations as well as significant capital flights. In the initial six months of the crisis, the Indonesian rupiah lost its value by 80% and the Thai baht lost its value by 50%. However, the South Korean currency gained by 50% and the Malaysian ringgit also gained by 45% (Cho, 2020). In the first year of the Asian financial crisis, the affected economies collectively experienced a decrease in capital inflows by over $100 billion. The crisis was significant in its scope and magnitude as it spread to other parts of the world affecting the Brazilian and the Russian economies. The Asian financial crisis was multifaceted as it was a governance crisis at every level of national, regional and global politics. The countries affected could not be able to perform their required regulatory functions that included regulating the economic forces of globalization and international actors.
Most often, interest rates are viewed to be credit supply and demand factors. An increase in the demand for credit raises interest rates while a decline in the demand for credit decreases interest rates. On the other hand, an increase in credit supply reduces interest rates and a decrease in the supply of credit increases interest rates. The credit supply is enhanced by an increase in the amount of money available to borrowers. For instance, when opening an account in a bank, a customer is lending money to the bank. A certificate of deposit renders a higher rate of interest than checking an account in which the customer is allowed to have access to funds at any time. The bank may be able to use the money for its operational and investment activities. The more banks can lend to their customers, the more credit is easily accessible in the economy. As the credit supply increases, the interest, which is the price of borrowing, decreases.
The quantity theory of money states that the increasing supply of money increases the rate of inflation. Low interest, therefore, leads to high inflation while high rates of interest tend to reduce inflation. The quantity theory of money also suggests that inflation is determined by the supply and demand for money. When the supply of money increases, prices of products tend to increase as the value of money tends to decrease in value. Inflation refers to the consistent rise in the prices of products and services in the economy over a specified period (Al-Mulali, 2014). The rate of inflation quantitatively measures the average amount of goods and services, and it is usually illustrated as a percentage. Inflation shows that the purchasing power of the currency of a country has decreased. Inflation in a country affects the cost of living in a country, and the central bank of the nation controls it by keeping it within acceptable limits for the economy to run smoothly. The change in the consumer price index is used in calculating the rate of inflation in a country.
According to Obstfeld, Clinton, Kamenik, Laxton, Ustyugova, & Wang, (2016) interest rates are major determiners in terms of lending whereby an increase in interest rates results in decreased money circulation whereas a reduction in interests rates results in an increase in money in circulation. This phenomenon is mainly based on the fact that increased interest rates will discourage individuals from seeking loans from banks as the interest rates will be prohibitive. Consequently, consumers will have a limited amount of money to spend on the purchase of goods and services. This will subsequently result in less purchasing power and as such aid in stabilizing the prices of goods and services. It, therefore, follows that increasing interest rates will work towards preventing the risk of inflation in the future based on the fact that there will be a lower amount of money in circulation. As shown by Obstfeld et al (2016) this is vital for the continued optimal performance of a country on a global platform.
The raising of interest rates also tends to encourage more savings. The increase in interest rates implies that bank customers will be able to earn more for their deposits. This as such will result in more individuals depositing their money as they are likely to make more earnings. In essence, this phenomenon will result in the transfer of a large fraction of the money in circulation towards the banks. Resultantly this will result in the reduction of money possessed by the consumers and aspect which is bound to maintain the cost of goods and services at stable levels (Brouillette, & Savoie-Chabot, 2017). As indicated above, the amount of money held by consumers is one of the greatest determiners of inflation. It, therefore, follows that rising interest rates, in this case, will contribute towards lowering inflation.
International trade also helps increase the rate of employment as people are directly employed in goods production and indirectly. Without the introduction of necessary interest rates, in this case, there is a likelihood that the country will experience an increase in inflation. This is based on the fact that the current trends will result in more money in supply as compared to the goods in existence and subsequently contribute to inflation. The tendency of such trends to continue is bound to result in an increase in the amount of money in circulation and the deterioration of the overall economy (Poloz, 2016). It is, therefore, necessary that the various stakeholders anticipate such aspects and take corrective measures through raising interest rates.
Raising interest rates will be the best approach to handling inflation. This is based on the fact that increased interest rates will make it more difficult for the consumers to get access to money and as such maintain the value of goods. In addition to that, raised interest rates will encourage individuals to make deposits as attributed to the fact that they will stand to get more earnings from their deposits. The above-highlighted measures are effective in reducing the amount of money in circulation and as such ensuring that inflation levels do not increase. The raising of interest rates is also bound to work in addressing inflation based on the fact that the country is experiencing increased productivity, an aspect which is associated with an increased supply of money in the economy and subsequently inflation. It, therefore, follows that raising interest rates will be effective in addressing numerous scenarios that lead to the emergence of inflation. To avoid the disadvantage of higher interest rates and to crowd out in the expansionary fiscal policy, this policy will decrease the interest rates and the cost of borrowing which will encourage more spending and investment by consumers and firms. It will also reduce the incentive to save encouraging consumers to make buying decisions. This will again shift the price level up as a result of an increase in aggregate demand. However, there are chances of conflicts between government objectives. For example, changes in interest rates will also cause changes in the exchange rate which means to pursue domestic purposes, the economy will have a particular impact on its foreign sector objectives. As revealed by (Franco Medeiros de Morais, 2008), the determinants of the market rate include the following factors:
The rise can be termed as a general increase in the price levels over time in an economy. It can be measured by using the Consumer Price Index (CPI), which is a measure of the cost of the goods and services which are purchased by a typical household in the economy. An economy can also calculate the core rate of inflation by developing a CPI that does not include products with higher price volatility such as food, fuel, and energy. However, deflation is a sustained decline in global prices of goods and services over time.
The article states that even after price rises of several commodities, there are hardly any increases in the Consumer Price Index. A prominent reason for this could be the reluctance of consumers to buy goods as they are too price-sensitive, which results in keeping the prices down to avoid losing customers. Another reason could be the way of measuring inflation which is CPI. It is possible that there are changes in the consumption patterns of the consumers, and they have started consuming goods that are not included in the basket used to measure CPI. Furthermore, there are always introductions of new products in the market which cannot be accounted for in the CPI. This measure only focuses on inflation at the consumer level which means the increase of distribution and input costs will not be included which are also a crucial reason for price rises in Japan as the sellers are passing on the costs to the consumers.
Another threat to the economy of a country is that too-low inflation can be turned into deflation. People who have borrowed money and firms who pay fixed wages to their employees can be severely affected because of falling price levels. However, individuals with fixed income, lenders, and holders of cash get benefits as the real value of their income increases. The economy is worsened because of high unemployment and stagnation as people postpone their buying decisions as they think prices will decrease more. To increase inflation, the government can implement an expansionary fiscal policy which is done by increasing government spending or decreasing personal and business taxes.
The diagram above shows the effects of expansionary fiscal policy. As a result of tax cuts, consumers will have higher disposable income which will lead to an increase in the aggregate demand for goods and services. Hence there will be a shift in the total demand curve from AD1 to AD2. The price levels will increase from PL1 to PL2, which will result in inflation. This policy will also increase employment and bring the economy close to producing at its potential output where it can experience economic growth. Government borrowing can increase the demand for payment which will increase the interest rates and result in private firms lowering their spending, which is termed crowding out. Another policy that can be used by the government is expansionary monetary policy which includes cutting interest rates and increasing the money supply to increase aggregate demand.
The Asian economies took several measures to control the crisis. The first step was to implement an expansionary fiscal policy which is done by increasing the government spending or decreasing personal and business taxes.
The diagram above shows the effects of an expansionary fiscal policy. As a result of tax cuts, consumers will have higher disposable income which will lead to an increase in the aggregate demand of goods and services. Hence there will be a shift in the aggregate demand curve from AD1 to AD2. The price levels will increase from PL1 to PL2 which will result in inflation. This policy will also increase employment and bring the economy close to producing at its potential output where it can experience economic growth. However, the government might have to borrow money in order to increase the spending which can result in increased debts. Government borrowing can increase the demand for money which will increase the interest rates and result in private firms lowering their spending which is termed as crowding out.
Another policy that can be used by the government is expansionary monetary policy which includes cutting interest rates and increasing the money supply to increase aggregate demand. In order to avoid the disadvantage of higher interest rates and crowding out in the expansionary fiscal policy, this policy will decrease the interest rates and the cost of borrowing which will encourage more spending and investment by consumers and firms. It will also reduce the incentive to save encouraging consumers to make buying decisions. This will again shift the price level up as a result of an increase in aggregate demand. However, there are chances of conflicts between government objectives. For example, changes in interest rates will also cause changes in the exchange rate which means in order to pursue domestic objectives, the economy will have a certain impact on its foreign sector objectives too.
Cho, J. H. (2020). East Asian financial contagion under DCC-GARCH. International Journal of Banking and Finance, 6(1), 17-30.
Hormats, R. (2013). The Secrets of Economic Indicators Third Edition. In R. Hormats. New Jersey: Pearson Education INC.
Obstfeld, M. M., Clinton, K., Kamenik, M. O., Laxton, M. D., Ustyugova, M. Y., & Wang, H. (2016). How to improve inflation targeting in Canada. International Monetary Fund.
Poloz, S. S. (2016). Dosage des politiques monétaire et budgétaire et stabilité financière: le moyen terme est encore le message. Canadian Public Policy, 42(3), 237-249.
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