Somalia: Psychological effect of higher denomination on inflation growth
Inflation is linked to the money supply that is controlled by the private rather public sector in Somalia.
Based on the Purchasing Power Parity (PPP) that compares currencies of the different countries in the world, the value of the Somali shillings is weak where the average of the PPP is 589 shillings which means prices of the goods in Somalia are 5 times higher than in the USA.
The Figure shows that Inflation rate which is an important indicator for the macroeconomic performance had been increasing from the 1990s to 2000. But the inflation began to fall from the 2000, as a result of the lower demand rising from the fall of the income and the weak purchasing power of the household.
In the recent years, inflation pressure has been minimal and price were stable but higher. The economy of Somalia can be described a price rigid one in attribute of the dollarization. In the effect of dollarization, price is set to international prices level where inflation is controlled and prices are quite stable in Somalia.
Low class is the definite loser of the dollarization since they receive income in terms of the Somali Shilling and will be prompted to buy goods in dollar quotes.
If the issue of inflation in Somalia is to be revisited, the pending currency reformation and proposed higher denominated banknotes should be worked on expeditiously.
The Relationship between Currency Denomination and Inflation
The relationship between higher denomination and the increase of the price level has for long been an undecided argument among monetary economists. Several authors including Chen (1976), and Chen and Tsaur (1983) suggest that higher denomination increases the risk of inflation growth. In the same vein , higher denomination offers benefits to the countries experiencing deflation.
Many others argue that denomination is nothing more than a number but, market conditions and that an economy’s productive ability determines the inflation and changes of the price.
There are some countries whose higher denomination and inflation is still subdued. Currencies like, the Hungarian Forint, South Korean Won, Vietnam Dong and Japanese Yuan are all highly denominated. Vietnam has a 500,000 banknote and 1 Vietnam Dong is equal to 0.000043$. Higher denomination did not fuel inflation in Vietnam as the inflation rate was only 3.8% in the period of 2018.
South Korea is also famous for its higher denominated banknote whereby it has 50,000 Korean Won. One South Korean Won is equals to 0.00089$ and inflation in South Korea is 1.3% in 2019.
This seems to indicate that higher denomination is just a number and has no meaningful economic interpretation unless there is information attached to the currency denomination.
Some empirical studies showed that currency denomination and inflation are negatively related revealing that higher denomination results into low inflation. Such studies include Franses (2006) who studied 59 countries and found an inverse causation between inflation rate and the introduction of higher denomination.
Another empirical study was about the Euro zone that introduced higher denomination (200 and 500) but did not produce any considerable increase of the price level. The conclusion was that higher denomination had little impact on the inflation acceleration in the Euro zone.
Same is true in Africa where changes of the currency denomination did show any significant impact on the inflation. Such studies include Egbuna and Obikili (2013), who studied the impact of denomination changes on price level in Nigeria from 1973-2011. This study found that the relationship between denomination and inflation is short-lived and does not exceed one month.
This research report is provided by Syndicate Somalia