Inflation is the general rise in the prices of goods and services produced over time within a country. It has immense impacts on consumers, businesses and investors. It also has effects on the overall economy in a country. Economists are of the opinion that moderate inflation has been enduring in the developed economy for more than a century. They also suggested that it is useful to differentiate between the inherent effects of inflation and those occur when inflation becomes unusually high.
David Floyd, a well-known economist proposed key elements of inflation: it is a continued and broad-based increase in the prices of goods and services through time. It erodes the purchasing power of consumers over time. Economists agree that a small but positive rise in price is economically useful. On the other hand, high inflation feeds on itself and impedes the long-rum performance of the economy. During a rise in inflation, some economic sectors outperform others; real estate, energy, and value of stocks have historically performed well during rising inflation. Developing countries, including Ethiopia, are bound to face such impacts of inflation.
It has been observed that bonds and stocks tend to lag since inflation lowers the present value of their future cash flows to investors. This is a risk investors are bound to face. As risk takers, investors have deeper understanding of the various causes and impacts of inflation.
Inflation negatively affects consumers who are bound to lose their purchasing power whenever prices rise. A slight inflation is not a cause of concern; however, it can create serious problems when prices rise very fast. As David Floyd indicated, some of the most common causes of rapid inflation include: an Imbalance in the supply and demand for goods and services. Inflation tends to rise when consumers’ demand for goods and services is greater than their supply. Also, disruption in supplies and tightening of the market responses causes price to increase. It is underlined that expectation of inflation may lead to rising prices.
Consumers often demand higher wages and salaries to get prepared for future price increases. Workers and trade unions in Ethiopia, for example, may often expect prices to rise and such expectation entails demand for higher wages. Ethiopian producers and enterprises, on the other hand, tend to increase prices to cover increases in wages, and this leads to a rise in inflation which has major impacts on the Ethiopian economy. It erodes the purchasing power of Ethiopian workers or consumers. This is the first and most pervasive or dangerous effect on the economy.
In other words, an overall rise in prices over time negatively affects the purchasing power of consumers due to a fixed income that may cause progressively less consumption. Thus, Ethiopian consumers lose their purchasing power irrespective of whether the inflation rate is low or high. This implies that they generally lose the capacity to buy faster when inflation rises at a higher rate. Ethiopia is not an exception to these economic tendencies. Other African countries have also faced the same economic trends during inflation.
In practice, inflation measures the increase in prices over a period of time for a given basket of commodities. These prices are supposed to represent the overall consumer spending. The consumer price index (CPI) is the best measure and indicator of inflation. In Ethiopia, the Ethiopian Statistical Service (ESS) is the only authoritative government institution that issues data and information on CPI.
Based on information provided by the ESS, researchers conduct studies on the impacts of inflation on consumers. They conduct studies on the impacts of inflation on low income consumers and these are used by economic policy makers to design strategies for minimizing impacts. Low-income consumers tend to spend a higher share of their incomes on basic necessities. They have lesser means of cushioning against the loss of purchasing power caused by inflation. Thus, policymakers and market participants tend to focus on the causes and effects of core inflation.
Generally, in measuring inflation the prices of food and energy are excluded because they tend to be more volatile and less reflective of trends of longer-term inflation. But low income earners tend to spend a relatively high proportion of their household budget on food and energy. These items are hard to substitute or avoid even when prices rise high. The poor consumers tend to be less likely to possess assets such as real estates or houses which would serve as protection against inflation.
Similarly, recipients of social security benefits or pensioners and other recipients of transfer payments have protection against inflation in the form of annual cost of living adjustments that are based on the CPI for wage earners. This mode of payment is practiced in the developed countries. Cost of living adjustment is difficult to practice in developing countries such as Ethiopia where CPI for hourly wage earners and clerical workers is difficult to apply.
Economists assert that inflation has the capacity to keep deflation at bay. Deflation is reduction of the general level of prices in a given economy. Advanced countries set a target for the rate of inflation over the long run. This allows them to meet their mandates for stable prices and high employment. They focus on modest inflation rather than fixed prices because a small rate of inflation drives commerce.
Developed countries provide a margin of error in case the inflation rate is overestimated and arrests deflation. It is known that the general decline in prices may be more destabilizing than inflation. This event is also true in the economies of the developing countries, including Ethiopia. In these countries lending banks may charge interest to offset the inflation that may lead to devaluation of repayments. This measure also helps borrowers to service their debts by allowing them to make future repayments with inflated currency. But deflation makes it more expensive to service debt in real terms because incomes would be likely to decline along with prices as we see it today.
Why modest inflation rather than deflation is the model is that wages are sticky or do not decline downward. Workers tend to strongly resist any attempt to cut their wages during an economic depression. Enterprises facing a decline in demand for their products tend to lay off workers as this is the likeliest alternative for them. There is also a positive inflation rate that allows a wage to freeze and serve as a reduction in the cost of labor in real terms. This is the benefit of inflation that provides insurance against deflation.
Deflation is actually a departure from the reality and it may also cause expectations for additional deflation. This situation leads to more spending, decline in income, and defaults in loan repayment. This results in a banking crisis and economic disruptions. Economists warn that economic policy makers in developing countries such as Ethiopia have to follow up inflationary and deflationary situations very closely and take measure in time to keep economic disruptions at bay.
What is unique about inflation is that it feeds on itself when it is high. A small inflation may indicate a healthy economy and it may not arouse high inflation expectations. A small rise in inflation is mostly an indication for enterprises, workers, and consumers to expect inflation to remain at low rate. However, expectations of future inflation will influence a rise in inflation rate that accelerates sharply and remains high. These situations force workers to demand higher wage increases and these expectations cause employers to pass those costs by raising prices on output. This leads further to a wage-price spiral, one causing the other.
Mismanaged policy response to high inflation may lead to hyperinflation, which is a worst situation. A rising expectation of inflation raises annual inflation to a higher level resulting in unemployment and recessions. History of economic development in the developed countries revealed that Inflation during WW I had increased to a level of more than 1.5 trillion times its pre-war levels. Today, the developing countries, including Ethiopia, have to deeply understand the causes, effects and remedies for inflation and deflation before it is too late.
Also, the history of economic development informs economic policy makers that inflation raises interest rates. Governments and central banks have powerful incentive to keep inflation at bay. A familiar approach over the past century has been to manage inflation by using monetary policy. Economists suggest that policymakers may raise the minimum level of interest rate and make borrowing costs higher across the economy. This is done through constraining the money supply when inflation exceeds the target set by the central bank. As a result, inflation and interest rates tend to move in the same direction.
Central banks may raise interest rates as inflation rises or they may risk a pressure of rising price. Economists suggest that inflation may lower debt service/repayment costs. But, new borrowers are likely to face higher interest rates when inflation rises, but those with fixed rate mortgages and other loans get the benefit of repaying these with inflated money. In other words, this lowers their debt service costs after adjusting for inflation.
Economists assert that inflation raises growth and employment in the short run. Higher inflation may lead to faster economic growth in the short term. However, in the long run, very high inflation discourages saving because it erodes the purchasing power of persons who saved over time. This situation may encourage consumers to spend and enterprises to invest. In these circumstances, unemployment may initially decline as inflation rises as a result. This confirms the concept of the “inverse correlation between unemployment and inflation.” Higher inflation may spur demand while lowering costs of labor, generating employment.
Persistent high inflation may eventually come in the form of painful expectations. The result is, therefore, chronic economic underperformance. Inflation also results in painful recessions. The problem with the trade-off between inflation and unemployment is that higher inflation caused by higher wages (which reduce demand for labor) can lead to further inflation or stagflation. Stagflation is the simultaneous appearance in an economy of “slow growth, high unemployment, and rising prices.” It is, therefore, advisable that the concerned policy makers in Ethiopia take the right measure to control the effects of inflation in time.
BY GETACHEW MINAS
THE ETHIOPIAN HERALD THURSDAY 2 JANUARY 2025
