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Articles |
Curbing inflation - I....
BY : MOHAMMED ASHRAF
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ARTICLE (March 04 2010): Originally, "inflation" was used to refer simply to
monetary inflation, whereas in present usage, it
often refers to price inflation. Members of the Austrian School of
Economics, also dominating Pakistani economists, make no
such distinction, maintaining that monetary inflation is inflation.
Consequently, the earlier governments of Pakistan, including the present
one, have always tried to deal the issue of
inflation through interest and exchange rate adjustments apart from money
supply and maintenance of financial discipline in
borrowings that is, from monetary policy perspective.
This attitude has turned blind eyes towards the fiscal policies
responsibility, corruption and parallel economy that led our
policies to limit the inflation in astray. The ministry of finance never
tried to align the fiscal and monetary policies even
during the current recessionary period in line with history. Further, they
never tried to use fiscal policies for combating
recession except for adjustment of tax rates, curtailing exemptions and
government spending that also remained unaligned with
the monetary policy.
The idea of using fiscal policy to combat recessions was introduced by John
Maynard Keynes in the 1930s, partly as a response
to the Great Depression. Many nations of the world have enacted fiscal
stimulus plans in response to the global recession
during 2000s. These nations have used different combinations of government
spending and tax cuts to boost their sagging
economies.
Most of these plans are on the Keynesian theory that deficit spending by
governments can replace of the demand lost during a
recession and prevent the waste of economic resources idled by a lack of
demand. Even the International Monetary Fund has
recommended implementation of fiscal stimulus measures equal to 2% of their
GDP to help offset the global contraction.
Without understanding the ground realities of inflation, our economists
would tinker at the edges of problem instead of
resolving the same. This article is meant for back to basics to unfold the
terms price and monetary inflation in recessionary
period, including the concept of business cycle, gross domestic product and
capacity utilisation apart from concluding about
the optimal solution from Islamic economics, which is followed globally in
the name of fiscal stimulus plan.
INFLATION This refers to general level of prices of goods and services in an
economy over a period of time. People generally
understand that during the period of rise in price level each unit of
currency buys fewer goods and services, that is,
erosion in the purchasing power of money.
In other words, this erosion is a loss of real value in the internal medium
of exchange and unit of account in the economy.
The chief measure of price inflation in Pakistan is the inflation rate, an
annualised percentage change in a general price
index (commonly known as Consumer Price Index) over time.
Inflation is uncomfortably high in almost every corner of the world,
creating serious difficulties for policymakers.
Everywhere, the root-cause is raising food and fuel prices underpinned by
surging demand from fast growing developing
economies like China.
The longer food and energy prices keep pushing up overall inflation, the
greater the chance that expectations of higher
inflation would lead to bigger pay demands, thereby triggering a wage-price
spiral, as witnessed in the 1970s.
In Pakistan, signs of consumers' angst about the inflation outlook are
emerging as prices of oil, food and other commodities
are rising. Inflationary pressure is not likely to ease owing to continuing
increase in global food and fuel prices apart
from monetary overhang from the unprecedented government borrowing from the
SBP for budgetary financing.
POSITIVE AND NEGATIVE INFLATION Inflation was always been portrayed as a
monster before the citizens of Pakistan, although it
can have positive effect on an economy apart from its negativities.
Negative effects of inflation include a decrease in the real value of money
and other monetary items over time as uncertainty
about future inflation may discourage investment and saving, while high
inflation may lead to shortages of goods, if
consumers begin hoarding out of concern that prices will increase in the
future.
Positive effects of inflation include a mitigation of economic recessions,
and debt relief by reducing the real level of
debt. Today, most mainstream economists around the globe favour a low steady
rate of inflation. Low (as opposed to zero or
negative) inflation may reduce the severity of economic recessions by
enabling the labour market to adjust more quickly in a
downturn, and reduce the risk that a liquidity trap preventing monetary
policy from stabilising the economy.
Before we move on to the details of food and monetary inflation along with
fiscal and monetary policies let's take a brief
overview of some basic terminologies like recession, business cycle, gross
domestic products and capacity utilisation.
RECESSION A recession is a business cycle contraction, a general slowdown in
economic activity over a period of time. During
recessions, many macroeconomic indicators vary in a similar way. Production
as measured by gross domestic product,
employment, investment spending, capacity utilisation, household incomes,
business profits and inflation all fall during
recessions; while bankruptcies and the unemployment rate rise.
Recessions are generally believed to be caused by a widespread drop
spending. Governments usually respond to recessions by
adopting expansionary macroeconomic policies, such as increasing money
supply, increasing government spending and decreasing
taxation. Surprisingly, we are working on the other way round that is
working on contractionary macroeconomic policies.
BUSINESS CYCLE Business cycle (or economic cycle) refers to economy-wide
fluctuations in production or economic activity over
several months or years. These fluctuations occur around a long-term growth
trend, and typically involve shifts over time
between periods of relatively rapid economic growth (expansion or boom), and
periods of relative stagnation or decline
(contraction or recession) and that's what happened globally with no
exception to Pakistan.
These fluctuations are often measured by using the growth rate of real GDP.
Despite being termed cycles, most of these
fluctuations in economic activity do not follow a mechanical or predictable
periodic pattern.
GROSS DOMESTIC PRODUCT The gross domestic product (GDP) or gross domestic
income (CDI) is a basic measure of a country's
overall economic output and represents the market value of all final goods
and services made within the borders of a country
in a year. The GDP can be determined in three ways - product (or output)
approach, the income approach, and the expenditure
approach and all give same result in principle.
The most direct of the three is the product approach, which sums the outputs
of every class of enterprise to arrive at the
total. The expenditure approach works on the principle that all of the
product must be bought by somebody, therefore, the
value of the total product must be equal to people's total expenditures in
buying things.
The income approach works on the principle that the incomes of the
productive factors ("producers," colloquially) must be
equal to the value of their product, and determines GDP by finding the sum
of all producers' incomes.
In the name "gross domestic product," "Gross" means that GDP measures
production regardless of the various uses to which that
production can be put. However, production can be used for immediate
consumption, for investment in new fixed assets or
inventories, or for replacing depreciated fixed assets. If depreciation of
fixed assets is subtracted from the GDP, the
result is called the net domestic product; it is a measure of how much
product is available for consumption or adding to the
nation's wealth. In the above formula for the GDP by the expenditure method,
if net investment (which is gross investment
minus depreciation) is substituted for gross investment, then net domestic
product is obtained.
"Domestic" means that the GDP measures production that takes place within
the country's borders, in the expenditure-method
equation given above, the exports-minus-imports term is necessary in order
to null out expenditures on things not produced in
the country (imports) and add in things produced but not sold in the country
(exports).
Economists have preferred to split the general consumption term into two
parts; private consumption, and public sector (or
government) spending. Two advantages of dividing total consumption this way
in macroeconomics are:
-- Private consumption is a central concern of welfare economics. The
private investment and trade portions of the economy
are ultimately directed (in mainstream economic models) to increases in
long-term private consumption.
-- If separated from endogenous private consumption, government consumption
can be treated as exogenous, so that different
government spending levels can be considered within a meaningful
macroeconomic framework.
The GDP is often positively correlated with the standard of living, though
its use as a stand-in for measuring the standard
of living has come under increasing criticism and many countries are
actively exploring alternative measures to the GDP for
that purpose. On the contrary, we are still stuck-up with the fashionable
berths like tax-to-GDP ratio, which represents the
market value of all final goods and services made within the borders of a
country in a year just to see how much tax was
contributed by the society out of its production not profit. Probably the
government is well aware of its taxation policies
like minimum tax and indirect taxes etc.
CAPACITY UTILIZATION This refers to the extent to which an enterprise or a
nation actually uses its installed productive
capacity. Thus, it refers to the relationship between actual output that
'is' produced with the installed equipment and the
potential output, which 'could' be produced with it, if capacity was fully
used the other day. Excess capacity means that
insufficient demand exists to warrant expansion of output.
If market demand grows, capacity utilisation will rise. If demand weakens,
capacity utilisation will slacken. Monetary
economists and bankers often watch capacity utilisation indicators for signs
of inflation pressures. They presumably believed
when utilisation rises above somewhere between 82% and 85%, price inflation
will increase. Excess capacity means that
insufficient demand exists to warrant expansion of output.
All else constant, the lower capacity utilisation falls (relative to the
trend capacity utilisation rate), the better the
bond market likes it. Bondholders view strong capacity utilisation (above
the trend rate) as a leading indicator of higher
inflation. Higher inflation (or the expectation of higher inflation)
decreases bond prices (producing a higher yield to
compensate for the higher expected rate of inflation). This is against the
very principles of Islamic economics by looking at
the concept of Zakat, Sadqa and Islamic financial instruments.
Implicitly, the capacity utilisation rate is also an indicator of how
efficiently the factors of production are being used.
Much statistical and anecdotal evidence shows many industries in the
developed capitalist economies suffer from chronic
excess capacity. Critics of market capitalism, therefore, argue the system
is not as efficient as it may seem, since at least
1/5 more output could be produced and sold, if buying power was better
distributed in line with Islamic economics principles.
It is pertinent to that level of utilisation somewhat below the maximum
nevertheless prevails regardless of economic
conditions.
(To be continued)
taxonomy.ashraf@gmail.com
Copyright Business Recorder, 2010
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