Inflation is a regular annual occurrence in modern economic systems

02Jan 2017
Muharram Macatta
The Guardian
Inflation is a regular annual occurrence in modern economic systems

As prices for goods and services that we consume increase, inflation is the result. The inflation rate is used to measure the rate of change in the overall price level of goods and services that we typically consume.

If the price of a good is increasing, the consumer will seek out cheaper substitutes.

While inflation is a regular annual occurrence in modern economic systems, it only becomes a policy concern when reaching unacceptably high levels. As we shall see, many modern economic policymakers have developed a short fuse for reacting to potential increases in inflation.

If the price of a good is increasing, the consumer will seek out cheaper substitutes. The wise food shopper will adjust his grocery list to reflect changes in fresh food prices. Either rich or flippant is the shopper who insists on buying peaches in a drought year.

During the 1970s oil shocks sent energy prices soaring by 218 per cent between 1972 and 1980. Consumers flocked to alternatives such as fuel-efficient automobiles, insulation for their houses, and public transportation.

Consequently, consumer outlays for energy during this period increased by only 140 per cent. The CPI overestimates inflation by failing to allow for substitutes in consumption as relative prices change.
Of course, these changes can be accounted for in the reevaluation of the CPI market basket that occurs every decade, but only after the fact.

Due to the above factors, the best guess is that the CPI overstates inflation by 1% to 1.5% on an annual basis. This is an important point, since economic policy often strives to achieve the lowest inflation rate possible.

The implications are important for policy-makers, who could mistakenly aim for an inflation rate equal to zero, which could cause economic growth to disappear. Comparing actual apples to apples is simple, but considers the case where a shopper wants to trade in his 1998 TOYOTA for a 2015 model.

The price for a new model may have increased by several thousand dollars between 2015 and 1998, but the 2015 may also have standard features that include an improved electrical system. Additional safety features, include a theft alarm, and most importantly, a deluxe CD sound system is now standard, while in 1998 TOYOTA may have been trying to cut costs by making the then-extinct 8 track tape player as the standard.

For reasons that include the failure of the index to fully account for consumer substitution when the prices of some goods rise and improvements in quality (e.g. 2016 cell phones vs. 1992 cell phones), an independent commission found that the CPI overstated the actual inflation rate by 1.1 percent.

In many ways the problem with inflation is not the higher prices, but the way it can creep up, suddenly creating a big stir and causing us to lose our balance and spill our cup of tea. Or put another way, as long as we properly anticipate inflation, we can prepare and absorb much of its shock.
Problems occur when inflation is greater than we predicted when it is unanticipated. When the actual inflation rate is greater than the anticipated (planned for) rate, several problems may arise.

A redistribution of income and wealth within the economy; institutions that lend money, such as banks, hate inflation. When a bank makes a loan, it charges an interest rate based on projections of future inflation, tacking on a few percentage points for profit. If inflation rises above the anticipated level, then profits are eroded or even eliminated.

Profits are hurt because of the way banks make money. Banks pay depositors interest to attract funds, which they can loan out at a higher rate. However, the rate paid to depositors adjusts more quickly to market conditions than the interest rate that banks charge borrowers.

If inflation shoots upward, interest rates immediately follow. Banks are forced to quickly raise the return to depositors, while the rate on the overall portfolio of loans lags behind. Although banks are increasingly making flexible-rate loans and taking other defensive actions (such as interest rate swaps) they still prefer a low, steady, and predictable inflation rate.

There are several other economic impacts to consider as a consequence of high inflation. Inflation has an impact on the output and employment decisions by firms that are altered by high inflation. Some possibilities include: Inflation distorts the price mechanism by making it difficult to distinguish changes in relative prices from changes in the general price level.

Changes in relative prices may be offset by the substitution of lower price inputs used in production. If almost all prices are rising rapidly, there is little incentive to search for cheaper substitutes that could help keep production costs low.

Inflation creates uncertainty. If businessmen are unsure about the future level of prices, and thus of real interest rates, they will be less willing to take risks and invest, especially in long-term projects. As investment is reduced, so is the long-run growth potential of the economy. There may be a redistribution of resources and production into areas less affected by high inflation rates.

Inflationary hedges are used to try to keep up with the effects of inflation, possibly to the detriment of the economy. The classic inflationary hedge is gold (and other precious metals). Gold is desirable in times of high inflation because the paper currency issued by the government rapidly loses its value (purchasing power), while gold prices tend to keep pace with inflation.

The reason is that inflation increases the opportunity cost of holding paper currency (which loses its value) and gold is the closest available substitute. As the demand for gold increases, the price of gold rises (along with inflation). As savers shift their assets into gold, they reduce their holdings of stocks and bonds.

This reduces the supply of funds available for businesses to borrow, raising the cost of investment (the interest rate). The result is less business investment and a reduction in the economic growth rate.
Inflationary uncertainty pushes up real interest rates, as lenders demand a bigger risk premium on their money. Longer-term interest rates are especially punished as a high inflation premium is added to account for inflationary uncertainty.
As a result, the cost of borrowing by businesses and consumers increases substantially, reducing the rate of real economic growth. Overall redistribution of productive and financial resources may lead to a loss in efficiency.

As economic efficiency falls, so does the production of goods and services. Certain elements of the tax code are deficient in adjusting for inflation. A capital gain represents an appreciation in the price of an asset, such as real estate.

The capital gain is the difference between today's price and the purchase price (assuming that the market price has increased since the date of purchase). During times of high inflation, real estate prices usually appreciate, reflecting an inflationary adjustment among other factors.

When the capital gain is realised (the asset is sold) the amount of the gain is taxed. However, tax rates fail to properly adjust for the part of capital gains due to inflation. Individuals are taxed on both their real and inflationary capital gains, while optimally they should only pay a tax on their real (after- inflation) capital gain.

However, this analysis found that such an increase of electricity tariff would drive up the prices of all other products. The price impact, however, is not large. The distribution impact by household income quintiles is also not large.

Although the impact is not large, it would be socially difficult to implement this increase at once, particularly given that Tanzania is somehow facing high inflation rates currently at 5 per cent.

A roadmap for electricity tariff increase is thus discussed. As an emerging economy, electricity demand is expected to keep growing significantly in the forthcoming period, 2010–2030. Such rapid development raises a number of questions for the Government including (i) how to secure funds to finance such an aggressive power source development, and then (ii) how to manage the power sector effectively and efficiently.

Currently, the power sector of the United Republic of Tanzania is dominated by TANESCO, a government-owned utility. TANESCO has a majority in generation capacity and a monopoly role in transmission and sales of electricity.

Electricity retail tariff in the country is governed by the Government, and the Government (EWURA) maintains uniform national electricity tariff across the country.

The Government plans to increase the electricity tariff at 8.5% to reflect the production cost to improve energy supply security and to improve energy productivity. This action will definitely have impacts on other sectors, on macroeconomic indicators and social welfare.

In this analysis, we examine two broad questions: First, what would be the impacts of rising electricity tariff on prices of other sectors of the economy?

In connection with this question, electricity intensity of various sectors will have to be first explored. Second, what are the likely distributional impacts induced by this price rise?

Because electricity is used as inputs to produce most of the goods and services, a higher electricity price can affect the prices of other sectors of an economy both directly and indirectly.

The present slowdown of the market, lack of access to credit by producers, and increasing labour cost do not favour this. It is thus proposed that the increase in electricity tariff be gradual and separate by sectors. The policy makers may design such a policy.

To assist policy makers developing roadmaps for introducing electricity tariff increase, the CPI increase as a function of electricity increase level can also be performed.

In parallel with measures to increase tariff, the power sector should consider improving efficiency performance as this would relieve the pressure of investment and tariff increase.

The improvements would accrue to both demand and supply sides. On the supply side there must be improvement in efficiency of generation and distribution.

Finally, the large difference of electricity intensity of sectors might suggest a restructuring of the economy in the long run for the sustainable development of the country.

The idea is electricity intensive sectors that contribute less to the GDP might be reorganised and tertiary industry might be encouraged.

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