Afghanistan’s economy is unstable and dependent on foreign resources, with its macroeconomic policies being subject to the actions of foreign donors and remaining completely passive. In other words, macroeconomic indicators such as economic growth, inflation, per capita income, and investment volume are highly influenced by the practical plans of donor countries in Afghanistan. Additionally, the political and security dynamics have indirectly transformed these indicators. In fact, political and security instability remains the key reason for economic instability in Afghanistan. Following the withdrawal of foreign forces and the collapse of the political system in 2021, the ensuing Afghan economic system also collapsed, resulting in a deep recession, the dismantling of the banking system, and ultimately an unprecedented reduction in the value of the Afghan currency against foreign currencies and an increase in the inflation rate. According to United Nations field studies and the recent report of the World Bank, the unemployment rate has soared with the poverty rate increasing to more than 70%. On the other hand, the international community and the US government tried to deter the aggravation of the economic and humanitarian crisis in Afghanistan. Therefore, through humanitarian aid and the injection of dollars into the Afghan currency market, the decline in the value of the Afghan currency was stopped. This situation resulted in a 20% decrease in the value of Afghan currency with the release of a part of the frozen foreign assets of the Central Bank of Afghanistan, which was declared to be over three billion dollars. Since imports constitute more than 80% of the country’s trade volume, the price of imported goods dropped unprecedentedly following the drop in the dollar rate, with the inflation rate dropping by approximately 13%, and the monthly inflation rate reaching -7%.
Over the past two years, the Taliban-controlled central bank helped bolster the Afghan currency by simultaneously adopting a strict contractionary monetary policy (preventing the creation of new money) and a contractionary fiscal policy (increasing tax revenues). The Taliban regime always tries to consider the phenomenon of negative inflation in the Afghan economy as an economic achievement. At the same time, the situation of stagnation in production is still prevailing and the level of poverty has increased, the volume of trade has decreased by 50% compared to 2020. As the import has a direct relationship with the national income, with the increase in national income, the import volume has also decreased, indicating that the people of Afghanistan have lost the ability to buy, thus resulting in a decline in the import of goods. Having said this about the country’s economic situation, the question now arises whether the negative inflation rate can be considered a positive signal in the Afghan economy or not. This analytical article delves into the consequences of negative inflation in the country’s crisis economy.
What is negative inflation?
Negative inflation or deflation means a gradual decrease in the general price of goods and services, and an increase in the value of the national currency to purchase goods and services in a country. When the inflation rate reaches below zero, the price of goods will gradually decrease and people can purchase more goods with the money they own. Negative inflation should not be equated with disinflation. In disinflation, the inflation rate is still above zero but decreases. When inflation is negative, the inflation rate reaches below zero. According to this definition, negative inflation may initially seem optimal, but the consequences of this phenomenon show the opposite of this issue.
How does negative inflation occur?
The formation of inflation stems from two standpoints: inflation caused by supply and inflation caused by demand. Specifically, the inflation that occurs from the supply side is due to the increase in production costs and import costs. In an import consumption economy, the increase in the foreign exchange rate (US dollar) increases the price of imported goods and services inside the country, and the rate of Inflation also increases. Inflation caused by demand pertains to the volume of demand for goods and services in the country. If the amount of consumption and production demand increases, the scarcity of goods and services causes the price of goods and services to increase, consequently increasing the inflation rate. However, this trend is currently reversed in Afghanistan. This signifies that the inflation pressure has been reduced from two sides. From the supply side, the dollar rate has dropped unprecedentedly, which has caused a decrease in the price of imported goods and services, and from the demand side, insufficient income has caused a decrease in the number of people’s purchases, subsequently bringing about a decrease in prices and downward inflation. It has even become negative. This reverse trend has intensified with the continuation of the unbridled supply of dollars in the currency market.
Economic Consequences of Negative Inflation
In a modern economy with a monetarist approach, negative inflation is basically the result of a decrease in the monetary base due to a lack of bank credits, a decrease in the volume of liquidity, and also a decrease in the speed of money circulation. In mainstream economics, negative inflation is the result of the combination of supply and demand for goods and services and supply and demand for money, which shortly means to decrease the supply of money and increase the supply of goods. Naturally, Afghanistan’s economy is no exception to this rule. The contractionary monetary policy in the country, despite being rooted in the lack of foreign exchange resources in the central bank’s monetary base, still shows the Taliban’s insistence on maintaining this strict policy with the increase in foreign aid and personal remittances. The current situation of the currency and goods and services market is the result of this inflexible policy. Therefore, the apparent consequence is the aggravation of the recession and the reduction of real investment motivation. In other words, the permanent decrease in the value of the US dollar as the base currency against the national currency causes the transfer of wealth from borrowers (investors) to lenders (bank savers). For example, as the exchange rate depreciates, investors who have invested at higher exchange rates will lose a significant amount of the value of fixed capital (capital goods and services purchased at higher rates) and will instead lose the value of the investor’s debt, which is owned by lenders and the rate of return on capital will continue to decrease. According to the latest economic thinking, negative inflation is associated with risk. When the asset return risk turns negative, investors and buyers turn to holding cash instead of investing. Failure to finance production projects and withdrawal of liquidity from the economic cycle can create a recession in the economy. In fact, there will be a negative inflation spiral. A negative inflation spiral is a situation where a decrease in prices causes a decrease in production and a decrease in production causes a decrease in wages and demand, with a decrease in wages and demand also leading to a further decrease in prices. Since a fall in the general price level is called negative inflation, a negative inflation spiral is when falling prices create a vicious cycle in which a problem exacerbates its own cause. The Great Depression of 1930, which occurred in the American economy, was considered by some to be a spiral of negative inflation. The negative inflation spiral is the new macroeconomic definition of the 19th-century oversupply debate.
The consequence of the continuation of the stagnation in production will be the closure of manufacturing companies, enterprises, and even the bankruptcy of businesses, and ultimately, the increase in the unemployment rate in the labor market. Only in one case, negative inflation may not harm businesses, and that is when it is accompanied by the growth of technology in production and service provision. In this case, the new technology will help in reducing the cost of production and providing services.
Another consequence is negative inflation on the market for selling goods and services. A dollar-based economy is one in which the share of imports in the gross domestic product (GDP) is much larger than other economic activities. In this case, the dollar will rule the goods and services market. Changes in the dollar rate in the country’s foreign exchange market readily determine other sectors of the economy, including the price level of goods and services in the market. A sustained decrease in the dollar rate will also reduce the price of goods and services. In this case, importers or sellers of goods and services enter the loss phase and lose the motivation for commercial activities and sales. If importers or sellers continue to operate in the market, they will lose a part of their capital along with the gradual decrease of the dollar rate.
The effect of negative inflation on consumer behavior appears somewhat seductive at first glance. Consumers think that with the lowering of the price of goods and services, their purchasing power has increased and compared to the past, with a certain income, they can buy more goods and services, probably enjoying more prosperity in a short period. However, the continuation of price reduction will harm the production and sale of goods and the supply of services. Production stagnates. Due to the spiral property between negative inflation and unemployment, the unemployment rate increases and causes the wage rate to decrease. The income of the families will decrease significantly compared to the previous period, as a result, the well-being of the consumers will also decrease.
In the existence of negative inflation and recession, the worst livelihood and economic situation in society will be overshadowed when liquidity (maintenance of cash by people) is withdrawn from the economic cycle, the efficiency of the banking system is also faced with the challenge of lack of monetary and financial resources. Therefore, the losses and consequences of negative inflation in the economy will not be less than the bad effects of high inflation rates. Just as high inflation challenges production, commercial activities, and the welfare of consumers, negative inflation also changes economic indicators in an unfavorable direction and reduces the welfare of society.
Solutions to Deal with Negative Inflation
To deal with inflation, governments and central banks use different ways:
Adjusting the interest rate: The central bank can adjust the interest rate to curb or reduce inflation. Due to the uncertainty in the money and capital market in the Afghan economy and the banking system being locked (restrictions on bank receipts and payments), this solution is not very useful.
Reducing production costs: The government can reduce inflation by applying policies to reduce production costs, such as reducing tariffs and taxes.
Demand management: the government can increase the supply of money and raise the general demand of the society by applying policies and thus reverse the direction of negative inflation. This solution is used in conditions of lack of demand and lack of purchasing power of people in Afghanistan.
Control of currency fluctuations: The price of the dollar affects the price of many goods, and its continuous fluctuations lead to inflation. Stabilizing the exchange rate can be an important way to curb negative inflation.
Reforming the budget structure: lack of liquidity, the government’s budget deficit, and the way it is financed are the main factors of negative inflation. Therefore, reforming the structure of the government budget is a fundamental step toward curbing negative inflation.