economics

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What is the effect of inflation on the economy

Inflation is a wide spread dilemma whose origin goes to times way back into the history. Yet, to date, it is such an influential phenomenon that it has the potential to traumatize the everyday life of a common man and bring about a dire international crisis. What is inflation: it is the sustained increase in prices, which curbs the real value /purchasing power of money. Maintaining a low and stable level of inflation is one of the three widely acknowledged and recognized aims of macroeconomic policy [1] .

An unstable and high rate of inflation is regressive and adverse for the savings and economic growth: it educes the real income and enhance uncertainty(Qayyum ; 2006). It hurts the real returns of financial assets and consequently lowers the investment (which results in stunted growth). Inflation also affects the international competitiveness of our exports by appreciating the real exchange rate and negatively affects the trade balance. These leads to cost push inflation based on imported raw materials and expected inflation in the economy rises too leading to more wages and salaries resulting in more cost-push inflation. (Hasan,Khan Pasha, Rasheed ;1995). Thereby, it is detrimental to the real economic growth (Qayyum; 2006).

Inflation can either be a cost-push phenomenon [2] or an impact of demand-pull factors [3] . The monetarists claim that “inflation is a monetary phenomenon”, whereby money supply /growth and inflation have a positive correlation (Qayyum; 2006). However, based on understanding of historical trends and analysis, there are two inferences about cost-push inflation:

(a): it has been more dominant persistently; and

(b): it has been closely associated with monetary policy,

based on which the relative significance of monetary variables in determining the rate of inflation is hypothesized (Javed, Farooq, Shama; 2010).

Amongst various supply side factors, the wage increases have been the one of the more influential ones n bringing about inflation, whether the increase comes about as result of unions’ bargaining, increased productivity or increased demand (for the products). Also, existence of monopoly power in industries has an analogous effect, defined as “administered-price theory of inflation”. Petroleum price level, yet another supply-side factor, has had a huge impact on the inflation worldwide. Economic theory explains this impact as an adverse supply shock, which affects the local as well as international prices of the products, connected through linkages (Javed, Farooq, Shama; 2010).

One of the demand-side factors that impinge on inflation is people’s expectation about future rate of inflation: via generating greater demand for money (for future consumption), people’s expectations/speculations about the future rate of inflation also have an adverse impact on the actual rate of inflation (Qayyum ; 2006).

Yet, the most predominant monetary factor that affects inflation is the money supply. The debate does not only revolve around its nature (whether it acts a demand-side factor or a supply side factor) but also on the extent of its impact (its impact in the short run and long run). Amidst the differing views of classical, neo-classical, monetarists and Keynesian economists, the consensus is that money supply leads the price level(s) to rise sustainably, affecting the overall stability of macroeconomic environment (Javed, Farooq, Shama; 2010).

Theoretically speaking, the viability of the claim that “inflation is a monetary phenomenon”, is based on the “quantity theory of money”: even the root explanation of cost-push inflation and/or supply shocks lies in the central control of rate of money growth. Inflation occurs when the (rate of) growth of money exceeds that of economy overall (Qayyum ; 2006). Based on the “quantity theory of money”, i.e. M*V = P*Y, the rate of growth in prices (gp or inflation) can be expressed as a function of the following: rate of growth of money supply (gm), rate of growth of income velocity of money (gv) and rate of growth of real income (gy). However, amongst the three stated explanatory variables, only rate of growth of money supply is the key factor (Qayyum ; 2006).Real income growth comes by an auspicious change in labour, capital and technology. In other words, it is connected with money demand, rather than money supply. On the other hand, the income velocity is associated with fiscal policy (as opposed to monetary policy) and holds significance (in the correlation between money supply and inflation) only if it is relatively nominal.

An advanced econometric model by Javed, Farooq, Akram (2010) breaks down the money supply into four variables: narrow money supply (M1), broad money supply (M2), lag value of M2 (LM), and Lag value of CPI (LCPI). The analysis regarding the correlation of money growth with inflation, stands firm for each of the above-mentioned variables, with two additions:

(a): relatively, Broad money supply (M2), has lesser impact than the other units of money supply (given that it has a positive coefficient in the model but is statistically insignificant)

(b): Money supply impacts the inflation with a lag of one year, which substantiates the hypothesis that it is in the “second round” (i.e. with a lag one fiscal year) that it reveals a significant correlation with inflation. The immediate of increase in money supply is merely on real GDP growth (Qayyum ; 2006).

Yet in another inflation model by Khan, Schimmelpfennig (2006), The findings reveal that the monetary factors accounts for the inflation in Pakistan. Broad money and private sector credit growth rate are the main variables that that explain inflation with a lag of around 12 months. And wheat price only affect inflation in the short run but has no affect in the long run.

One particular implication of the above analysis is in terms of the policy measure (to control the rate of inflation is) to keep the money supply in tight centralized control (Qayyum;2006). In case of a failure to do so, as did the State Bank of Pakistan, inflation would reduce the real income and enhance uncertainty; thereby detrimental to the real economic growth. Therefore, the primary focus of the monetary policy should be to maintain a low level of inflation, whether by immediate instrument (via keeping a tight money supply) or indirectly (through any other means). If the monetary policy were to be held tight (as suggested), it would make it possible for people not to speculate a rise in prices; based on the certainty that money supply would be held stable at a reasonable level by the central bank.

Another very crucial factor, which contributes to high inflation, is the wheat support price (Javed, Farooq, Akram ; 2010) (Khan, Gill; 2010) and its administered prices along with the imported inflation .The depreciation of Pakistani Rupee and consequent increase in the value of imports, due to exchange rate depreciation and rising international prices, has played its role in shooting up the CPI. The general perception is that the budget deficit creates inflation but findings in this paper suggest that budget deficit over the period of 1971-72 to 2005-06 has not played any role in inflation in the long run (Khan, Gill; 2010).

However, there is one questionable finding: amongst the factors in the other model by Javed, Farooq, Akram ; 2010), including exchange rate, wheat support price, annual wage in the perennial industries, real gross domestic product and a dummy variable (to gauge impact of natural disaster on macro economic variable), other than real GDP, all the mentioned variables have a positive correlation with CPI. Regarding their statistical significance, all the variables stand firm except for real GDP and wheat support price.


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