The Effects Of Inflation In Sri Lanka

Inflation means a sustained increase in the aggregate or general price level in an economy. In Srilanka inflation in is measure by Colombo Consumers’ Price Index (CCPI). According to the diagram average consumer price index (refer page -24- for the diagram) we could see that from 1989 to 1990 the inflation rate increases from 12% – 21% until 1991. However during the period of 1991 to 1995 the inflation decreases by approximately 2.5%.

The below diagram “B” (refer page-24/25-) shows the consumer prices. In 2003 the inflation rate is approximately 9 per cent where in 2004 it has been decreased at the rate of nearly 7 per cent. However in the year 2005 it has been decreased further more at the rate of 5 per cent. From 2006 to 2007 the inflation rate has been increased by 1 per cent during the period.

The CCPI recorded a 4.8% increase on a year on year basis and a 3.4% increases on annual average basis, the lowest and year annual average rate recorded for a period of more than two decades. The decline in inflation in 2009 was consequential upon both the demand and supply factors. Price increases in domestically produced goods, which on average accounted for around 72% of control monthly consumption expenditure in 2009, largely impacted on inflation during the year.

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The major contribution of inflation came from the food and non-alcoholic beverages sub-index, which has the highest weight of 46.7% in the CCPI. The decline in average prices of certain domestic agricultural product, especially of rice, pulses, vegetables and coconuts, due to the increase in domestic supply conditions contributed to lower the price pressure.

Price stability, which refers to achieving and maintaining a low and stable level of inflation, is the prime objective of many central banks. In order to achieve price stability, central banks conduct monetary policy with a forward looking perspective as monetary policy actions affect inflation with a time of lag.

Inflation at the primary market level as measured by the Wholesale Price Index (WPI) showed high volatility in 2009. On annual average basis, the whole sale price index declined by 4.2 per cent as at end 2009.

TASK 2

Definition of inflation

Causes of inflation

Inflation means a sustained increase in the aggregate or general price level in an economy.

“Inflation means that your money won’t buy as much today as you could yesterday.”

(Source: – http://www.economicshelp.org/macroeconomics/inflation/definition.html)

The Keynesians View

Demand-pull inflation

Demand-pull inflation is initiated by an increase in aggregate demand. Keynesians have traditionally argued that inflation occurs because of changes in real variable in the economy. If aggregate demand exceeds aggregate supply, the price level will rise and therefore there will be inflation. According to the diagram “c” on (Page26) economy is at full employment at income “Yf”. If there is a rise in aggregate demand the curve would shift from AD to AD1, it’s because consumer confidence increases, which raises autonomous consumer spending. Alternatively there might be a rise in export due to a strong economic growth in other countries. The result of these increases in real expenditure in a rise in both output and inflation. Therefore output rises from OA to OB whilst the price level rise from OE to OF. Rising output will lead to a fall in unemployment.

Cost- push inflation

If there is an increase in the costs of firms, then firms will pass this on to consumers. There will be a shift to the left in the AS. Cost push inflation would the second Keynesians theory of inflation. Cost-push inflation is caused by changes in the supply side of economy, which increases the cost of production. The major sources of increased costs are:-

1) Wages and salaries

If trades unions can present a common front then they can bargain for higher wages, this will lead to wage inflation.

2) Imported goods

An increase in the price of finished manufactured imports, will lead directly to an increase in the price level. An increase in the price of semi manufactured goods and raw materials will feed through indirectly via an increase in the price of domestically produced goods.

3) Profit push inflation

When firms push up prices to get higher rates of inflation.

4) Taxes

Government can raise indirect tax rates or reduce subsidies, thus increasing prices.

The monetarist view

Monetarists argue that if the money supply rises faster than the rate of growth of national income then there will be inflation. However if money supply increases in line with inflation then there will be no inflation.

Quantity theory of Money

MV=PT

M = Money Supply

V= Velocity of circulation

P= Price Level

T = Transactions

In the short run, increases in “M” will feed through to higher levels of transaction and fall in “V”. This is known as the MONETARISTS TRANSMISSION MECHANISM. However in the long run, with “V” constant, increase in “M” over and above the rate of real growth in the economy (the change in “T”) will feed through to changes in “P”.

TASK 3

Effects of inflation on:-

-Saves money

-Borrows money

-Lends money

(Approximately 500 words)

An individual who keeps all his money in a box under his bed.

Inflation makes the value of money reduce. If an individual decides to store money under the bed, the real value of money would decline over the period. When the money is withdrawn to use, it would buy fewer goods and services compared with the time it was first stored. However the real impact on the loss of real value of money stored depends on the extent of inflation in the country over the period of time. That is during hyper inflation the impact on the individual would be much worse than during times of creeping inflation.

b) Someone who is borrowing money at the current rate of inflation but who does not have to pay this back for a number of years.

The borrower of a large sum of money who’s obliged to pay it pack after number of years may gain as a result of increase in inflation. Initially if the borrowed money would be of real higher real money compared to the time it is going to be repaid due to the inflation substantial increase in inflation. Every year is likely to cause the real value of money to fall. However whether the borrower is favored during times of inflation depends on whether or not the lender charges an interest. If the lender chooses to charge an interest, the lender may charge an interest from the borrower in order to compensate for the loss of money value, when the borrowed money is repaid. If the inflation rate moves along with inflation then the borrower experiences no change in his state of affairs. However if the interest is set below the inflation rate by the lender due to poor information availability then the borrower is likely to gain. The real rate of interest falls as a result of inflation there would be transfer of resources from the borrower to the lender.

While the price of money is considered the factor which decides the redistribution of benefits between the lender and the borrower, it depends on the type of borrowing whether formal or informal. If the borrower obtains money from a relative or friend it may be interest free or he may be given an interest allowance if the borrower has obtained a long term bank loan. Then the borrower maybe to a great extent taxed for inflation. If the interest rate is fixed over the period and there occurs unexpected inflation. Then the borrower is likely to gain.

Someone who has lent money out at the current rate of inflation but will not be repaid for a number of years.

The lender as discussed in part “B” simultaneously loses if the borrower gains and wise versa as a lender of money who expects it to be repaid after number of years. His real purchasing power declines after number of years, when he’s repaid. He needs to accurately identify expected inflation over the maturity period and fix an interest rate equal to or above the expected inflation rate. However if the interest rates are placed high the external value of money may due the country would lend out less. This would reduce exports and cause a drop in aggregate demand. Reduce in inflation cause due to overheating. This will allow the lender to gain if he lends at a fixed interest rate. However the degree depends on how effective the country has been, over the past years in lending out to the other countries (pvt lending) and is true for formal lending such as bank loans.

TASK 4

Reasons for tackling inflation

Remedy for different types of inflation

(Approximately 500 words)

The government may want to tackle inflation because it tends to redistribute income in favor of those with stronger bargaining powers and debtors and penalizes those with weaker bargaining power, creditors. It may also lead to deterioration in the balance of payment. An increase in the inflation would lead workers and firms to raise wages and prices by amount which takes into account in the past, present and also when future price increases.

FISCAL POLICY

Decisions made by the government on its expenditure, taxation and borrowing would be a fiscal policy. This may be implemented to reduce inflation arising from a variety of causes.

Demand pull inflation

At full employment a government can employ deflationary fiscal policy. This will involve raising taxation. Increasing income tax will be likely to lower consumer spending, reducing government spending will lower aggregate demand and raising in corporation tax will tend to lower investments in a country. A reduction in all of these components of aggregate demand will have a downward multiplier effect and may succeed in removing an inflationary gap.

Increase in income tax may cause price to rise if it stimulate workers to press for wage rises to maintain their real disposable income. Disposable income is the income that households have to devote to consumption and saving, taking into account payments of direct taxes and transfer payments. It may prove difficult to cut government spending and reducing public and private sector investment will lower future potential out put.

Cost push inflation

Fiscal policy measures includes reducing indirect tax, cutting income tax in attempt to lower wage claim, reducing the price charged by government concerns, subsidizing production costs and lowering wage rises in the public sector.

Monetary inflation

Lowering expenditure by more than the tax revenue is a fiscal policy approach which might also be adopted if the cause of inflation is thought to be the money supply growing faster than the out put due of government borrowing.

MONETARY POLICY

Deflationary monetary policy may also be employed against demand pull inflation. Rising in interest rates will be likely to lower investment and reduce consumer spending, on housing and other items bought on credit. However the increase in interest rate depends very much state on consumer expectations.

Central banks may seek to reduce inflation by encouraging a rise in the exchange rate. A higher exchange rate can reduce inflation in three main ways. It lowers the imported finished goods which count in the RPI and reduce the costs of raw materials which have been imported. A high exchange rate can have an adverse effect on employment and economic growth. A fixed exchange rate also can be used as an anti-inflationary measure.

The main of an income policy, introduced to reduce inflation, is to link the growth of incomes to the growth of productivity so as the prevent the excessive rises in factor incomes which raise cost and hence price. Price controls stop rising prices. However, attacks the symptoms of inflation rather than causes. Where the cause of inflation is excess demand, price controls will lead to create a demand for a system of rationing.

TASK 5

Supply side economy

(Approximately 500 words)

Supply side policy is a range of measures intended to have a direct impact on aggregate supply and specifically the potential capacity output of the economy.

Supply side policy in UK

Since 1979 the government has been committed to implementing supply side policies aimed at improving the workings of free markets. A wide range of measures have been introduced as following:-

• The labour market
• Help to business
• Goods market

The labour market

• Trade union power

The power of trades unions has fallen because of laws making it more difficult for unions to operate. As well as supply side policies, the decline of manufacturing industries reduced the influence of trades in many industries like coal and steel… There are now fewer days lost to strikes and wage inflation has not been a problem like in the 1970s. However many workers are less protected and may get lower wages leading to greater inequality.

In 1971, the conservative government under Edward health passed the industrial relations act which attempt to crucial trade powers. However the legislation was flawed and trade unions circumvented the provisions of the act. The labour government of 1974-79, if anything, increased the power of trade unions by repealing the industrial relations act and giving unions further rights.

• Wage bargaining

Supply side economists view collective bargaining as an inflexible way of rewarding workers. They advocate individual pay bargaining with payment system base on bonus related pay. The government in the 1980s and early 1990s went some way to breaking collective bargaining. It encouraged employers to move from national pay bargaining to local pay bargaining. In the public sector, it attempted to move away from national pay agreements to local ones.

• State welfare benefits

In 1979 the government abolished earnings related unemployment benefits and also abolished the index linking of benefits to the rise in average earnings. In 1988 in a major overhaul of social security system, the problem of both the poverty trap and unemployment trap, where addressed by increasing benefits paid to those in low paid work and cutting benefit rates to those not in a job. In other move, the government initiated the restart programme in 1986, which forced any workers claiming benefits for being out of work to attend an interview at a jobcentre at least once a year to review his/her possession. Employers instead of deducting tax from an employee credited the low paid worker with the extra money. Effectively, it is a benefit paid through the pay packet.

• Marginal tax rates

After 1979, cutting taxes (direct) was high on the lists of government priorities. In the 1980s income tax was cut especially for the better off. The top rate of income tax fell from 60% to 40%. Overall the tax burden has not fallen because the government has increase indirect taxes such as VAT.

Help to business

If aggregate supply is to increase, the private sector needs to expand. Hence, according to the supply side economists, the government needs to create an environment in which business can flourish.

Tax privilege for saving

The tax system in the UK has traditionally favored groups saving schemes, such as pension and assurance policy.

Help to small businesses

Small business are important in the economy due they provide new jobs. Conservative government between 1979 and 1997 placed particular importance on the development of an ‘enterprise culture’. Income taxes were reduced and in small company profits taxes have been cut, and also investors in small business were given tax breaks, whilst the unemployed were encouraged to set up in business on their own through the provision of grants. The government also attempts to reduce the administrative burden on small business by cutting ‘red tape’ although this was contrary to the ever-increasing amount of legislation that business have to comply with in fields such as employment and consumer protection.

Deregulated Financial Markets

The government has deregulated the financial services market, for example building societies can act like banks, and more institutions can now offer mortgages, this led to more competition and lower borrowing costs. However, the credit crunch of 2008-09, illustrated the problem of less regulated financial markets.

3. Goods markets

Privatization.

There has been an extensive privatization campaign, most of the major utilities such as Gas, Water and Electricity were sold by the government and floated on the stock market. In some industries like telecommunications it has led to more competition, lower prices and better quality of service. However it has been difficult to introduce competition into the water industry. Rail Privatization has been unsuccessful with the government having to effectively renationalize the railways.

Encouragement of international free trade

Fierce foreign competition results in a domestic industry which has to be efficient in order to survive. Since 1979, governments have tended to advocate policies for free trade on most issues.

Supply side policy in U.S.A

“Supply Side Economics” was applied to the argument that lower tax rates would improve private sector incentives, leading to higher employment, productivity, and output in the US economy. Taxes enter many decisions, but the two most important are probably that they discourage work, since they lower the after tax return from work, and they discourage saving and investment, since they lower after tax returns.

A lower tax rate on wage income should increase the labor supply. Given the labor demand function, this increase in labor supply will increase employment, reduce the pre-tax real wage and increase the post-tax real wage.

Lower taxes on interest and capital gains, as well as tax-sheltered saving plans like IRAs and 401(k) plans, to make saving more attractive and lead to an increase in savings. In equilibrium, this will lower real rates of interest as more saving flows into capital markets, and raise investment. Over time this investment leads to higher capital, more productive labor, and higher output and wages.

Moreover, the 1980s tax cuts did not increase the rate of growth of GDP and productivity, nor the investment and savings rates in 1980s the private saving continued to decline and also in the 1973-1980, private saving averaged 7.8 percent of the economy, and dropped to 6.9% in 1986 and 4.8% in 1989. In other words, the saving rate was significantly lower after the 1981 tax cut than before it. Over the period of 1982-89 the labor productivity grew at the average rate of 1.6%.after 1973, the annual growth rate of productivity has been very close to 1.1 percent. It average around 1.1 percent also in the 1980s.Budget deficits that were equal to 40b US$ in 1979 (-1.7% of GDP) and 74b US $ in 1980 (-2.7% of GDP) increased to 221b US $ by 1986 (5.2% of GDP), and also in 19879 the GDP ratio was 26.1%, and increased to 41.2% in 1986.