Gift Mubita Kasika
There are two important terms related to inflation: inflation impulse and inflation spiral.
Inflation impulse is a one-time increase in the price level, while inflation spiral entails a series of increases of the prices which feed on itself, price increase leading to price increase. One of the causes of price increases is excessive demand, which is referred to as demand pulled inflation.
As civil servants’ salaries increase, their first reaction is to increase their purchasing pattern, leading to demand pulled inflation. Inflation spiral stems from this initial reaction from an initial price increase. If public servants decide to demand for a salary increase after an inflation impulse like the situation we have, the price increase starts to feed on itself, and that is where inflation spiral is set in motion. Inflation spiral refers to the second, third and fourth waves from an initial impulse.
When prices increase, suppliers raise their gains on real wealth at the expense of the public. This is the first generation effect. If the public subsequently reacts to these losses, not by simply accepting them, but by raising their income demands, price increases start to feed on themselves and total income claims keep running ahead of total real wealth creation of existing prices. This process continues to the second, third, fourth generation effect. An inflation spiral implies that the aggregate of all agents buy goods at higher prices, and they will need more money. This means even if your salary increases today, sooner or later you’ll need another salary increase.
A significant proportion of agents like public servants may obtain the required additional finance from their employer,s but it’s not everyone who can do it that way. Others, especially in the private sector, lose by having to pay these higher prices.
Persistent price increases will require more and more additional income if the volume of transactions are to be maintained.
On the other hand, if agents accept the loss due to a rise in the price of goods and keep on buying the goods and not raise their income demands, the initial inflationary impulse is stopped right there, and no inflationary spiral is set in motion. Inflation is essentially a conflict over income distribution, which relative prices/wages’ movements fail to reconcile.
The costs of inflation
Inflation is a costly phenomenon on the economy, and there’s a need to avoid it at all costs. People tend to have a love-hate relationship with inflation. They hate inflation, but love everything that causes it.
Inflation damages real productivity when it turns economic agents away from productive activities and productive investments, which can happen for two main reasons.
Firstly, productive investments of money and efforts are discouraged because inflation adds an extra source of uncertainty to the estimates of future profitability underlying investment decisions. It contributes towards a climate of instability and pessimism, which is always bad for investments, and hence for growth and employment-creation.
Secondly, inflation causes people to divert their efforts and capital away from productive enterprises towards non-productive investments, merely to protect the real value of their wealth.
When inflation becomes so high that it starts to undermine people’s confidence in the currency, the damage to the real economy is even more serious.
In this scenario, people will start to revert to the barter system or introduce alternative money forms, which will inevitably disrupt productive enterprise. Inflation also has adverse effects on income distribution on four main categories.
The first category is for those who lack the bargaining power to increase their incomes in accordance with the inflation rate, or even worse those who are on contractually fixed incomes, the unemployed, the un-unionised and the small business owners. Inflation tends to hit the weakest in society.
It reduces the purchasing power of money holding.
The second category consists of people who hold their wealth in the form of money, which includes all of us, but the poorest in society are worst-hit by the effect.
The third category of losers consists of creditors. People who have lent money to others, creditors are repaid in money units of lower real value.
The fourth category includes all of us. Inflation causes us to fall into a high income tax bracket, and people are required to pay more tax without necessarily increasing the real value of their income.
Besides that, the salary increase will cost government millions, which was not on the initial budget. Therefore, part of this amount will be covered from tax increases.
An inflation rate higher than that of a country’s main trading partners can also discourage foreign direct investments into the country because the exchange rate will then be steadily falling. Therefore, after having invested in the local economy, foreigners can only withdraw their money or repatriate their profits at lower values of pounds, euros, dollars and so forth.
The damage of inflation to foreign investment also has a purely psychological dimension. A high inflation rate does not look good to foreign investors in a global environment, which places a high premium on macroeconomic stability.
The above analysis leads us to the one unpleasant conclusion. Inflation can only come down when the main sectors and agents in society accept a real income reduction. It will, therefore, be beneficial for the entire economy if public servants accept a reduction in their income. If government employees pass on their inflationary cost increase on the demand for high wages, inflation cannot come down. Inflation can only come down if nominal wages paid increases with less than the inflation rate.
Of course, no one would want to make such a sacrifice, which is exactly why inflation impulses tend to turn into inflation spiral, and it becomes so hard to break these spirals to gradually squeeze inflation out of the system again.
Those of you who went to economics school might still remember the inverse relationship between inflation and unemployment as illustrated in the Philips curve. The higher the inflation rate, the lower the unemployment rate.
*Gift Kasika is a student of economics.