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Chapter 2: literature review: 2.1 Income disparity Issues Prevailin...

Income disparity is a widespread phenomenon in not only the developing economies, but the developed world as well. Shift towards the studies relating to income inequality occurred in 1990s, thus conducting a study under a time period from 1990 to 2009 will be quite relevant under current situation. Unequal income distribution is an economic issue that links its roots with other important and complex economic problems; such as, increasing poverty, corruption, petty thefts, increasing crimes etc. this issue can create a total political deadlock if we take a wider perspective. According to many economists, such as; Romer and Romer, 1998 Bulir, 2001;Easterly and Fischer,2001 inflation, yet another economic problem highly positively correlates with income disparity, and this correlation is the subject matter of this paper as well. Rubens P. Cysne, Wilfredo L. Maldonado, Paulo Klinger Monteiro (2005), link the income disparity with the inflation under the shopping time approach, the welfare cost of the inflation. According to them; “Our main conclusion is that under such assumptions, a formal link between inflation and the Gini coefficient of income distribution can be theoretically proved. For transacting technologies in which the productivity of the interest-bearing asset is high enough, an increase of the inflation rate unequivocally leads to a deterioration of the income distribution.” [Rubens P. Cysne, Wilfredo L. Maldonado, Paulo Klinger Monteiro (2005)]. Under the assumption taken by the above mentioned article, the role of interest bearing assets in linking inflation with income inequality becomes important. Economists have linked inflation with inequality using other economic variables as well. This article is a good example of that.

The employment paper “Is inflation bad for income inequality: The importance of the initial rate of inflation” by Rossana Galli and Rolph Van Der Hoeven explores theoretically and empirically the effects of monetary policy and inflation on the income inequality, but in the developed economies. It basically tries to solve the inflation inequality puzzle, that is, that both the variables have mixed correlations, this paper suggests a U-shaped relationship between both the variables with inequality decreasing as inflation first rises and then lowers down and inequality increasing as inflation is further reduced. The paper has basically focused on the developed economies, unlike that of Pakistan. In Pakistan’s case, we may assume for now a curve which shows a direct relationship between the inflation and income inequality that is as the inflation increases, the income gap between rich and poor enlarges.

Moreover, “Income inequality: does inflation matter” by Ales Bluir, contributes to the income inequality literature. This paper is based on the traditional Kuznets model. This paper improves upon the Kuznets model by incorporating inflation in the model, a variable, which was not initially considered important by the older economists. According to this article, reduction in inflation from hyperinflationary levels to very low level seems to bring slight added gains in the income inequality, the GINI coefficient. Incorporating inflation in Kuznets model is the main focus of this mentioned article. Again, we may negate the findings of this model as it relates to the developed world and since the economic settings of developed country differ quite a lot from a developing one, there is a high probability that results obtained there are inconsistent in Pakistan.

In addition to this, the paper written by Roel M.W.J Beetsma and Frederick Van Der Ploeg; provides cross country evidence on a positive link between inflation and income inequality for the democratic countries. We may relate the findings of this paper with our paper as Pakistan is taken to have a democratic ruling party since 1990s, excluding the Musharaff’s era, the martial law period. The paper provides a positive relationship between the income inequality and inflation, which is what exactly presupposed in our working paper.

Developed world has been successful to an extent in resolving their income disparity concern, but the developing nation needs to really work upon it. This unequal distribution of income is also the main root cause of poverty in these countries, destroying the financial health of all such nations. Developing economies are expected to have the social indicators in the favor of the upper class compared to the lower class, that is, the development works in the economies like that of Pakistan, help the richer population and not the poor ones, thus, increasing the income disparity.

Income disparity, alone can impact various economic indicators directly or indirectly. For instance, income inequality can impact poverty and the growth rate of a country. “Low inequality can, therefore, benefit the poor in two ways: by increasing overall growth and average incomes, and by letting them share more in that growth.” [Haroon Jamal (2006)]. Since it can be seen that the income inequality impacts poverty in a manner that may be enough to cater to that issue, resolving the income disparity issue becomes important. In other words, one economic issue can be the cause of several others, thus catering to one may help resolve the rests of the problems as well.

There are many reasons for income inequality to be high in Pakistan, such as market imperfections, poor governance, lack of transparency in economic policies, high level of corruption, burden of debts and interest rate payments on debts, worsening situation of law and inappropriate implementation of economic policies, lack of proper strategy plans etc.

Muhammad Shahbaz and Naveed Aamir (2008), well stated in their article that as generally the developing countries have a high rate of population growth and lower investment rate, it results in lower economic growth, thereby adding more people in the poverty bracket or making income distribution worsen. It can be widely agreed that the development factors, such as FDI, the trade openness benefit the upper class more than the lower class, thus worsening the income equality. Same article states; “in empirical psychology, results reveal that increased FDI in Pakistan worsens income distribution because it is focused towards capital intensive industrial and services sectors of urban localities. Economic growth also makes income distribution more unequal following upper echelon trend. Relation between income distribution and trade-openness according to Leontief paradox i.e. more trade promotes rich class more. Government size is associated negatively with income distribution showing exploitation of poor segments through elite class.” [Muhammad Shahbaz and Naveed Aamir (2008)], this statement clearly depicts the situation of this country. Policies employed work for the betterment of the already better lot of the country. The poor population, that is the major portion of population of Pakistan is well ignored, thus, the main lot is left under the poverty line, increasing the income disparity. Catering to the poor population will help solve this problem. Thus it can be concluded that focusing on the ways richer get to accumulate wealth is creating the whole problem.

Dollar and Kray (2001), also mention in their paper that “social spending in developing countries often benefits the rich and middle classes more than the poor”, [Dollar and Kray (2001)], again contributing to the fact that development expenditures done in the developing economies increase the income disparity. Similar is the case with the Pakistan, where policies need to change and focus more upon the lower class than upper class. In Pakistan, the rich are accumulating the wealth; the poor are left at their mercy and in the end suffer. Developing economies have a rich population which is a very small % of the total population. Thus, if the poor lot, that is the major one isn’t made better off, disparity would keep rising.

2.2 Inflation in Developing Countries

It has been unanimously agreed by the policy makers that every country should be able to achieve a stable price level or a small, steady inflation rate. There are varied determinants of inflation in a developing economy, such as; the purchasing power parity, increase in money demand, increase in labor cost or rising costs of factors of production, when there is an excess demand for goods, expectations about future inflation rates also determine the inflation, political decisions and institutional factors also play a role in the determination of inflation, certain structural factors also affect the CPI, growth rate, exchange rate and level of imports also impact the inflation.

Inflation affects the economic growth of the country to a very large extent; it actually deters the condition of the country. There is clear agreement that even moderate levels of inflation damage real growth [Cecchetti (2000)]. Considering such unfavorable impacts of inflation on the economy, there is a consent among the worlds’ leadinby the economists and central banks that the price stability is the main purpose of monetary policy [King (1999); Blejer, etal. (2000)] and the central banks are working diligently to the low inflation rates [Goodfriend (2000)].

Inflation may be a cause of demand side or supply side factors. Either way it is harmful for a developing country. Such is the reason; the central banks of the developing economies try to target a stable inflation rate, for price stability purposes. According to an article; “The possible sources of inflation include rising costs such as wages, profits, imported inflation—exchange rate, commodity prices, external shocks, exhaustion of natural resources and taxes.” [Abdul Qayyum (2006)]. Thus, we see that inflation can be a cause of both, the demand side and supply side factors. Both side factors need to be catered for to achieve price stability.

Rising inflation can create enormous amount of problems for the developing as well as developing economies. For instance; take an example, if process keep on rising, such as a state of hyperinflation is reached, the worth of the incomes will keep on falling that is the purchasing power of income would decrease. Fixed income earners might want to find a job somewhere else; this would increase the rate of search unemployment. During such a phase the depression faced by the citizens, the crime rates and other such problems might keep on increasing. Thus, we see that a problem like inflation can have huge direct, indirect and after effects.

Catering to inflation is important, especially in developing economies where the monetary policy applied has not yet been able to achieve a constant CPI rate.


2.3 Inflation in Pakistan

Price stability and low inflation should be the goal of every country’s macroeconomic policies. A target inflation approach can be adopted to make sure that factors affecting inflation act in a way that they do not cause the inflation rate to go above a certain limit; 3% to 6% can be taken as a good range for the CPI rate. Inflation in Pakistan is one of the most complex issues which require being resolved. Persistent increase in prices is something extremely bothering to every citizen of this country. Wages, incomes are constant, but prices keep on increasing, reducing the real income of a normal Pakistani.

The determinants of inflation as identified by Khan, Abdul Aleem; Ahmed, Qazi Masood and Hyder, Kalim (2007) include; “First, increased domestic demand due to remittances from abroad and liberal demand-management policies outpaced the domestic production, creating a positive output gap, which in turn put upward pressure on prices. Second, the growing gap between domestic demand and domestic production was filled by a sharp increase in net imports, which grew by over 40 percent in FY05 and by 24 percent in FY06. Third, fiscal policy has remained expansionary in the last few years. Expansionary fiscal policy fuels domestic demand and puts pressure on the current account deficit. In other words, it widens the investment-saving gap, which has to be financed externally. Fourth, the expansionary monetary policy through high growth in money supply and loose credit policy was also believed to be contributing to high inflation” [Khan, Abdul Aleem; Ahmed, Qazi Masood and Hyder, Kalim (2007)]. The determinants of inflation pointed out in this article basically sum up to be the demand related factors, either it be demand for goods or demand for money. All these factors highly imapct the inflation.

Inflation can make growth detrimental and erode the rich poor gap. For around 11 years of the past 32 years, inflation in Pakistan has been more than 11%. Fiscal factors or monetary shocks, all contribute to the inflation. Double digit inflation is not good for the financial health of a country, especially a country like Pakistan where poverty is a wide spread phenomenon and the majority of the population is finding it hard survive through the everyday life. Thus, the central bank of Pakistan is taking certain steps to cater to this issue.

The State Bank of Pakistan has a clear directive to achieve price stability and promote growth. In order to control inflation within the targeted limit set by the Government, the SBP used money supply as an instrument. According to stats, money supply growth exceeded its target levels for four consecutive years (2002-2005) because of an easy monetary policy attitude to support the growth process. However, the expansionary monetary policy ended up in rapid inflation reaching double digit inflation in 2005. “With the rising inflation from 2005 monetary policy stance has tilted towards the containing of inflation” [State Bank of Pakistan (2006)].

An article quotes; “The important policy implication is that inflation in Pakistan can be cured by sufficiently tight monetary policy” [Abdul Qayyum (2006)]. The formulation of monetary strategy must consider growth in the real and financial division and treat them as constraints on the policy [Gordon (1985)]. Thus, according to these articles, a proper monetary strategy should be adopted to cater to the issues concerning inflation.

In case of Pakistan the economists have concluded that in the long run surplus money supply is the key factor in charge for inflation, however at the same time it also has been pointed out that other factors, such as the structural problems also affect the rate of inflation. A lot of studies have been carried out to check either inflation in Pakistan is a monetary phenomenon or there are other factors responsible for rise to inflation. Hossain (1990), Khan and Qasim (1996), and Nasim (1995) have shown that inflation is a monetary phenomenon. Studies such as Hossain (1986, 1990), Bilquees (1988), Naqvi, et al. (1994), Hasan, et al. (1995) and ABN AMRO Bank (1995, 1996) have related inflation to supply-side blocks, adjustment in government-administered prices, exchange rate adjustments, growth in indirect taxes, and inflationary expectations too. Ahmad, et al. (2005) shows that the monetary narrowing first leads to a fall in domestic demand, financed by bank loan, which ends up in a gradual reduction in price pressures that eventually reduces the overall price level with a lag. Husain and Rashid (2006) obtained univariate causality from money to prices in the long run and in the short run they conclude that money affects price level with a lag of two years. Khan and Schimmelpfennig (2006) conclude that in the long run, money is the main cause of inflation in Pakistan. Naqvi and Khan (1989) conclude that inflation is either explained by a year’s lag money supply or its own lags.

Thus, different studies have been conducted by certain economists on the issue of inflation in Pakistan, but it can be summed up, that Pakistan’s central bank, the State Bank, needs to adopt a monetary stance that is consistent with other economic issues and helps achieve a low, steady inflation rate.

2.4 Other Factors Affecting Income Inequality

This paper has been basically designed to focus on the impact of inflation on income inequality. For that, the framework I selected includes a number of variables which are supported by the literature and the current economic condition of Pakistan. Keeping all the literature in mind, other factors that affect income inequality other than inflation (for this thesis paper) include; Unemployment (% of total labor force), Services, etc., value added (% of GDP), Investment: gross capital formation (% of GDP), Trade openness, Public expenditure: development exp Rs. Million, Fiscal policy: direct taxes as % of total taxes, Net current transfers from abroad (current US$), Foreign direct investment: net inflows (Bop, current US$) and Financial development: gross fixed capital formation SME. All these variables are selected carefully from the literature that was reviewed and the relationship of these variables with the GINI is developed upon the economic settings of Pakistan.

According to an article “the study found inflation, sectoral wage gap, and terms of trade in favour of manufacturing as the significant positive correlates of inequality, while progressive taxation, investment and development expenditure on social services are negatively impacting on inequality.” [Haroon Jamal (2006)]. This article clearly identifies variables other than inflation that affect the income inequality in a country. Some of these variables have already been identified in the theoretical framework of this paper as mentioned above. All the top quoted variables of the article positively correlate with the GINI, that is, if any of these increase, the income inequality increases as well.

Moreover, article by Seeme Mallick (2007) says “We have observed in the income distribution section that to achieve both sustainability and full employment there is a need to divert investment towards employment creation and maintenance and restoration of the natural environment.” [Seeme Mallick (2007)]. This article identifies natural environment to be a significant variable with respect to income distribution of a country. Such a relationship, which is between the income distribution and natural environment, can be significant in developed countries, where the natural environment is given a lot of importance. Countries like Pakistan, which are already finding it hard to survive through do not attach a lot of weight to the natural environment, thus such a variable can be ignored in study settings like Pakistan.

Same article quotes; “This entire discussion, shows that imperfection of financial markets creates inequality as the benefits from high-return investments are acquired by those who are already stable and have wealth in hand” [Seeme Mallick (2007)]. Moreover, Galor and Zeira (1993), Banerjee and Newman (1993) and Aghion and Bolton (1997) concluded that inequality leads to a lower economic growth because of the imperfections in the credit market. Thus it can be inferred from such articles that the market imperfections also affect the income inequality, yet again, in Pakistan these credit markets are not developed to a significant extent to affect income inequality greatly. Here, in Pakistan, we first need to start off with basic variables that are identified in the framework and work along them.

Article by Muhammad Shahbaz, Naveed Aamir and Muhammad Sabihuddin Butt (2007) says “Our empirical analysis suggests that improvement in financial performance declines the rural-urban income inequality in the case for Pakistan. In contrast, economic growth widens the rural-urban income gap in long span of time. Openness in foreign capital and trade worsen rural-urban inequality situation in Pakistan. Finally, low inflation is associated with high rural-urban income gap in the country.” [Muhammad Shahbaz, Naveed Aamir and Muhammad Sabihuddin Butt (2007)]. Inflation is again taken to a variable affecting the income inequality which shows the significance of this variable. Other variables identified in the article are again either taken in the framework or they were rejected as they did not prove to be theoretically or statistically significant in the current settings, the last two decades of Pakistan.

The same article quotes; “In the case of Pakistan ground reality is different from figures with respect to rural-urban income inequality. Better situation of Law and Order, improved quality of institutions, proper implementation of economic policies and better delivery of social and financial services especially to the poor are essential to lower the gap between rural urban earnings.” [Muhammad Shahbaz, Naveed Aamir and Muhammad Sabihuddin Butt (2007)]. At this point, the article has identified some of the quantitative variables which also need to be accounted for to improve the situation of income distribution. Thus, to resolve the issue of income inequality both, the qualitative and quantitative factors need to be considered. My thesis paper has basically focused on the numerical factors, yet, no doubt, a better implementation of strategies and plans will lead to a better welfare of the society as a whole.

Studies including Dollar (1992), Sachs and Warner (1995) and Dollar and Kraay (2001a) Edwards (1993), have concluded a positive relationship between trade liberalization and growth. We may conclude that a higher level of growth will direct to an equal distribution of income, thus trade liberalization can directly as well as indirectly affect the income inequality. Trade openness is taken to be an important variable in this framework as well.

Furthermore, according to an article “When public sector tackles this problem then output growth and income distribution improves in the economy”, [Saima Shafique and Rashida Haq (2006)] article basically referred to the “governance”. The sentence quoted implies that if the government somehow is able to bring good governance to the state, the problem of income distribution can be resolved to quite an extent.

In addition to this, another article points out certain factors, other than inflation, that impact the income inequality; “Economic growth and the overall development level of a country — this group includes growth in the GDP, technological progress and the structure of the economy, meaning the shares of the agricultural, industrial and service sectors, secondly; macroeconomic factors are inflation and unemployment, the size of government’s expenditure, external debt and foreign reserves, changes in the exchange rate, and other factors, thirdly; demographic factors include processes of demographic development, including the age structure of population (share of economically active population), the growth and density of population; urbanisation, level of human capital, including the level of education and health condition of population, fourthly; political factors include privatisation and the share of the private sector, level of taxes and the share of the public sector, openness of a country, especially trade openness and freedom of labour movement; social policy and other decisions of economic policy, lastly; historical, cultural and natural factors , which among others include distribution of land ownership, people’s attitude to inequality, extent of shadow economy, which are all formed in the course of long history. In addition to these, there is one more factor — availability of natural resources.” [Anneli Kaasa (2003)]. It can be noted that many of the variables mentioned by Anneli Kaasa in her article are already incorporated in the framework for this thesis paper. For instance; according to the article, the demographic factor has relatively a little influence on income inequality and the component that is affected most by the government policies is the human capital creation. Each component’s impact on income inequality is discussed separately. The article can very much relate to the study settings of Pakistan because it is based on the transition economies and this nation can be characterized very much under economies that are going through a transitional phase. The income inequality can very much affect the wellbeing of the citizens there, thus needs to be addressed as soon as possible. Moreover, certain variables mentioned by the above author are also of qualitative nature which this thesis paper has not considered due to the lack of authentic data availability.

Factors mentioned by another article by Almas heshmati (2004) are no more different than already mentioned, which include; trade liberalization, skills and earnings, growth and redistributive policies and globalization.

2.5 Policy Recommendations to deal with the issue

Income inequality and inflation, as discussed above are two inter related issues with an essence of its own as a whole. On the other hand, these two issues can also be taken as two separate issues causing certain economic problems. Either way, both the issues need to be addressed as fast as possible to make sure that the developing world survives through the coming decades.

Gary A. Hoover, Daniel C. Giedeman and Sel Dibooglu (2009) in their paper; “What is principally important to note in this work is that policies designed to increase the wellbeing of the entire range along the income distribution should be tailored and exact since it is clear that persons in different income quintiles have distinctly different reactions to business cycle changes” [Gary A. Hoover, Daniel C. Giedeman and Sel Dibooglu (2009)] thus, policies should be tailored according to the need of the poor as they are in majority in Pakistan. There is a dire need to reduce the income inequality gap, which is interrelated to the inflation. Thus if inflation addressed, income inequality, itself will follow a proper channel.

Pakistan being an agricultural economy needs to work on her agricultural sector to support its growth as well as reduce the income disparity. Industrial sector, no doubt is very important for every economy and it is said that the value added goods are only created by the industrial manufacturing, but today the world has advanced so much that we can use the advanced technology to produce highly value added products using the agricultural sector and that is what Pakistan needs to follow up with.

Muhammad Shahbaz, Naveed Aamir And Muhammad Sabihuddin Butt (2007) very well state this idea in their piece of paper that the entire banking sector needs restructuring in a way that the policies drawn upon are more in the favor of the rural sector of Pakistan, that is the major population sector and also the foremost contributor to the agricultural sector of Pakistan. The fact that cottage and small scale industries do not get support from large banks leads to the increasing rural urban disparity in the developing economies like Pakistan.

Moreover, the social development factors should be drawn upon in a way that they benefit the poor population more. Pakistan is a country where the majority population lives in the rural areas, thus, strategies should be such that they prove to be advantageous to the poor lot, as Muhammad Shahbaz and Naveed Aamir (2008) say that “there is a need to revise macroeconomic policies to attract more FDI in the country. Country can get more benefits from FDI if it is converted towards agro-based industrial sector. This not only improves the incomes of skilled labor but also enhance the income levels of unskilled personals” [Muhammad Shahbaz and Naveed Aamir (2008)]. Again, well stating that the agro based economy should be highly focusing on the agro based products. This will help the small cottage, small scale industries of Pakistan to thrive, where the main employment is the agricultural sector.

Government of Pakistan should realize it that the agricultural sector is the backbone of this country and that should be focused. Working on the agricultural sector will help reducing the income inequality. Improving the agricultural sector will also help the country over all reduce the unemployment. The government spending should be done for the lower class; the fruits from trade should be reaped by the poor lot instead of making the rich richer. Rich people should stop using their political power and their access to high post people to reap financial benefits.

The policy implications suggested by Sailesh K. Jha (1999) that in “the low-income economies the redistribution should be set appropriately such that the upper income groups are not discouraged to invest in order to promote high rates of economic growth. However, during this stage of development, a worsening distribution of income must be incurred” [Sailesh K. Jha (1999)]. The author might be in an opinion to encourage the investment from the upper class people and during this stage, let the poor suffer. Such a case might only be taken into account when the investment from the rich class benefits the lower class, if such won’t be the case, the stage of transition won’t be of any use. The investment from rich won’t be of any benefit in reducing the income disparity. Only if the investment benefits the poor class in future should such a policy be drawn upon.

According to an article “The paper also shows that immigration is an important factor in explaining changes in inequality. Increases in immigration lead to significant increases inequality but it should be noted that we do not distinguish between country of origin of incoming groups.” [Gary A. Hoover, Daniel C. Giedeman and Sel Dibooglu (2009)]. Here, immigration in taken as an independent variable affecting the gini coefficient. It can be noted that variables that are taken to be important in an analysis affecting the income inequality should be controlled by the macroeconomic policies such that they do not work against the welfare of the economy. Policies should be tailored in a way that each income group is catered for. Only then it will possible for the government to draw strategies that reduce the income gap overall. All such macro or micro economic variables should be handled by the plans in a manner that gap is managed for the well fare of the whole society and not the richer part of the country.

since this paper has basically focused on the inflation as the core variable affecting inflation, the State Bank of Pakistan should make sure to adopt a monetary plan that handles the inflation in a manner which well controls the income inequality gap.

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