Inflation: a complex process

By Aftab Ahmad Khan

Inflation may be suppressed or open; it is open when prices rise without check. According to the Nobel Laureate, Prof. Milton Friedman open inflation refers to an “inflationary process in which prices are permitted to rise without being suppressed by government price controls and similar techniques.” Suppressed inflation refers to those conditions in which, as a result of avoiding the policies of price control and rationing on the part of the government, prices are prevented from rising. Wartime controls are an example of suppressed inflation; post-war inflations are an example of suppressed inflation developing into open inflations. The word ‘suppression’ in the context of inflation implies: (a) postponement of the present demand to some future date; and (b) the diversion of demand from one kind of goods to another, from those goods which are subject to price control to those goods whose prices are uncontrolled and whose supplies are not rationed.

Inflation is a complex process and it is difficult to find a single empirical model that fits the circumstances of all countries. There is, however, little disagreement that in the long run, inflation is a monetary phenomenon; high rates of price increases cannot be sustained for long periods without monetary nourishment. Monetisation of fiscal deficits is frequently the major source of excessive monetary expansion in developing countries. Although sustained rise in inflation is only possible if it is accommodated by monetary expansion, episodes of high inflation can be triggered by other developments as well. Large depreciations of the nominal exchange rate are widely regarded as a cause of inflation. There is indeed some evidence that episodes of accelerating inflation in countries like Argentina and Brazil have been initiated by devaluations and thereafter sustained by an accommodating monetary policy. Another potential source of inflationary impulses is the supply shock that may have inflationary repercussions if financial policies are accommodating. Structural reforms in developing countries at the behest of International Monetary Fund (IMF) may create temporary inflationary pressures when prices are being de-controlled and subsidies cut: wage and salary increases in excess of productivity gains and infrastructure bottlenecks (e.g. energy shortage and inadequacies of transport) can also exercise inflationary pressures. The non-monetary sources of inflation, however, cannot be perpetuated unless these are sustained by inappropriate monetary policies.

Many economists have frequently emphasised that inflation is more than an economic problem. This is because of their belief that money supply in a modern economy is a sociologically determined variable. Behind the excessive expansion of money supply, lie complex socio-political forces struggling over the distribution of income and wealth. Various groups, strata and classes in contemporary economies are engaged in an organized struggle over distributive shares. This distributional struggle is not new but it has acquired certain new dimensions which compel the state to continuously increase the supply of money. In a situation of intensified struggle over distributive shares, governments are faced with a dilemma of either suppressing or mitigating the conflict which threatens the very foundation of market oriented economies.

Suppressing the distributional dissent requires curbs on trade union activity, imposing of stringent discipline on the workers by means of unemployment, curtailment of hard won political rights of the people and so on. Such a roll back of social progress or suppression of internationally recognised rights is to some extent possible under authoritarian regimes; in a democratic set up it is not feasible. Hence, the other alternative with the government is to expand money supply to meet the claims of every section and group in society. The resulting inflation thus becomes an effective short-run softener of social conflict. It is, however, also a fact that politically motivated inflation if persisted in for a considerable period could assume serious proportions with unwelcome political, social and economic consequences.

Pakistan has been grappling with inflationary pressures during its life of over 60 years. According to official statistics, consumer price index, increased forty-five fold during the period 1949/50 – 2007/8. The pace of inflation, however, has been varying at different periods of history.

Price inflation indicators for 2004-05, 2005-06, 2006-07 and 2007-08 were disturbing. The government visualised an annual inflation target of 6.5 percent during 2007-08, which was raised to 12 per cent for 2008-09.Food inflation in June 2008 soared to a record high of 32 per cent.The core inflation (non-energy and non-food) escalated to 13 per cent in June 2008 as compared with the modest figure of 5.7 per cent in the same month last year.

The Wholesale Price Index (WPI), which is generally used to measure the cost of production, registered a record increase of 16.41 per cent during 2007-08.

The Sensitive Price Index (SPI), which reflects the prices of 53 essential commodities, mostly kitchen items, recorded a disturbing rise of 28-37 per cent in the week ending July 4, 2008 over the corresponding week of 2007.

A worrisome feature of the price situation was the substantial rise of 21.83 per cent in the Consumer Price Index (CPI) in June 2008 over the corresponding month last year.

Inflationary trends have been high due to domestic supply side disturbances and the impact of increase in international prices of oil and some key food items. The costs of inflation to the economy have been considerable. Inflation has tended to accentuate inequalities and caused considerable strains on our balance of payments. It has weakened the external value of our rupee. It pushed a sizable chunk of our resources into such socially wasteful channels such as real estate, luxury housing, speculative inventories, bullion and jewellery and foreign exchange balances held abroad. Inflation has been responsible for enlivening speculation, stimulating inessential consumption and generating a climate of industrial strife in the country. Discrimination against the public services is an endemic feature of inflation without indexation. Our public administration has consequently been deeply eroded and demoralised.

In view of these massive economic and social costs there is no more important economic agenda item than to beat down the established inflation.

Money represents a claim on a share of society’s output. Stabilising the price level protects that claim while inflation reduces it. It would be inefficient to allow the length of a yardstick to vary over time. Similarly it is inefficient to change the yardstick of economic value.