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Chapter Two
Inflation
SUEZ CANAL UNIVERSITY – FACULTY OF COMMERCE
ENGLISH SECTION
Year Four
Spring 2011
Ismailia 41112
Egypt
http://scuegypt.edu.eg/
Tel: +2 (064) 3231636
Fax: +2 (064) 3220496
The Problem of Inflation and Its Solution Paths
Thanks go to the winner team:
Ahmed Mohsen
Ebtehal Salah
Fatma Hassan
Hoda Naeem
Islam Nasr
Maha Nageeb
Mahmoud Abo-Zaid
Mai Sabry
Nesma Anwar
Reham Hazem
Supervised by
Dr.Mostafa AboElsoud
Lecturer
Economics Department
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1-Introduction
Inflation is one of the important indicators of macroeconomic
stability. It also affects welfare and serves as a goal to public policy.
Since the floatation of the Egyptian pound in 2003, the Egyptian
economy has been subject to cycles of relatively high increases in prices.
At each time, a heated debate would renew about the accuracy of the
official inflation rates in reflecting actual changes in prices. The problem
of inflation used to be confined to national boundaries, and was caused by
domestic money supply and price rises. In this era of globalization, the
effect of economic inflation crosses borders and percolates to both
developing and developed nations. Central bankers believe that mild
inflation, in the 1 to 2 per cent range, is the most benign for a country‟s
economy. High inflation, stagflation or deflation is all considered to be
serious economic threats.
2- Definition of Inflation
Inflation means a persistent rise in the price levels of commodities
and services, leading to a fall in the currency are purchasing power. A
chronic increase in average price over time, when the purchasing power
of a nation falls due to a rise in overall prices, it decreases the value of
money and makes it more expensive to buy goods and services. In other
words, you can get less for your money than you used to be able to get.
3- How to measure inflation?
Inflation measurement is the process through which changes in the
prices of individual goods and services are combined to yield a measure
of general price change. The rate of inflation is measured by calculating
the percentage price increase in goods and services, usually over a year.
Percentage price rises are usually shown by a Price Index. In this
case index numbers or indices are simply a way of expressing the change
in prices of a number of items as a movement in just one single number.
The average price of all items selected in the first year, or base year, is
given the number 100. For instance, if on average all the prices of the
selected items rise by 25% over the following year, the price index for the
second year will be 125. If in the next year price rises average 10%, the
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price index will now stand at 137.5 (that is, 137.5 – 125 = 12.5 which is
10% of 125).Thus on average prices have risen by 37.5% over years 1
and 2.
Consumer Price Index (CPI) is the most common gauge of
inflation which measure the price increase and decrease of basic goods
and services.
Ex: Inflation rate = CPI 2 – CPI1
CPI1
CPI in Egypt tracks final consumer prices in both urban and rural
areas as well as all Egypt. If we are to look at Egypt‟s CPI – according to
the CBE‟s data – inflation in February increased by 10.7 percent
compared to last year. The picture is less pretty when we look at the
inflation of fruits and vegetables, which increased by 25.5 percent
compared to last year.
Although, some people spend more on some goods than others, the CPI
must take into account and average out price rises and their effect on
households‟ spending patterns. It includes 12 groupings covering both
goods and services.
Using this information government experts decide how much a rise
in the price of one good matters to people compared to another .For
example, spending on food represents about 18% of households‟
spending, whereas spending on tobacco only accounts only accounts for
3% of total spending. Thus, rises are given more importance in the CPI.
This would be achieved by weighting the price rise on food six times
more than the price rise on tobacco. The CPI calculates the weighted
price index for all 12 groupings of goods and services. A base year is
chosen and the average level of prices in this year is given the number
100. The base year chosen is a typical year in the sense that there is
neither very low or very high inflation, nor any extraordinary occurrences
like wars or general strikes by workers which can distort prices.
As the pattern of consumer spending changes over time so the CPI
will have to change to weights it attaches to different commodities. It
must also take into account new goods coming on to the market.
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GDP Deflator An economic metric that accounts for inflation by
converting output measured at current prices into constant-dollar GDP.
The GDP deflator shows how much a change in the base year's GDP
relies upon changes in the price level. Also known as the "GDP implicit
price deflator".
Because it isn't based on a fixed basket of goods and services, the
GDP deflator has an advantage over the CPI. Changes in consumption
patterns or the introduction of new goods and services are automatically
reflected in the deflator.
Egypt’s Trend of Inflation through the Past Decades
The above graph is, the most recent one sourced by International
Monetary Fund (IMF), Displaying Inflation rates in Egypt through time.
At the X-axis, we can see a real time trend from years 1981 – 2010,
including an IMF inflation forecast from 2011-2016. While the Y-axis,
shows percentage change in inflation rates through time.
We can see the fluctuations in inflation rates with visible high and
low points. The maximum point was approximately 25% which was
witnessed in 1987, while the inflation rate was at its minimum point with
approximately 3.1 % in 2002.
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The value of loans grew steadily in the 1980s, increasing as much
as 20.7 percent per year. After 1985 the private sector replaced the public
sector as the second largest debtor after the government. The increase in
the money supply probably also contributed to the rise in inflation levels.
Double-digit inflation marked the economy in the 1980s. Since 1987,
annual inflation rates have risen between 20% and 30%. Economists
spoke of STAGFLATION, that is the combination of low growth and
high inflation, as characterizing the Egyptian economy in the second half
of the 1980s.
The percentage change in the CPI decreased from 1995 to 2001.
Egypt‟s gross domestic product had an upward trend from 1995 to 2006.
Gross domestic product and inflation are inversely correlated. As
inflation decreased in the period 1996-2000, GDP was steadily
increasing.
This negative relationship between inflation and growth is
important, as it quite often occurs in practice, as ascertained by empirical
literature. Any level of inflation is sustainable; however, for inflation to
fall there must be a period when output is below the natural rate, which
occurred between 2001 and 2002.
In the end, what significantly matters is the Consumers‟ Purchasing
Power. The growth in Inflation rates reduces the value of money through
time, where a dollar today is worth more than a dollar tomorrow. This
narrow‟s the economy‟s ability to experience increasing aggregate
demand, as more people begin to save and spend less in the economy.
Inversely, when inflation rates fall, it is a great opportunity for spending
with the purchasing power increasing in consumer‟s hands affecting
Aggregate Demand and Aggregate GDP.
4- Types of inflation
Demand-pull (Wage) Inflation:
Occurs when total demand for goods and services in an economy
exceeds the supply of the same. Demand inflation is constructive to a
faster rate of economic growth since the excess demand and favorable
market conditions will stimulate investment and expansion. The
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failing value of money, however, may encourage spending rather than
saving and so reduce the funds available for investment.
Cost-push Inflation:
Presently termed “supply shock inflation”, occurs when there is
increase in the prices of the finished goods and services due to the
increase of the cost of production of them. For instance, the 2008 food
crisis was a situation where adverse conditions in the global market
descended upon the Egyptian population. Increased oil prices, which
peaked at $145 per barrel, and droughts in several wheat producing
countries. Since supplies were constrained by these factors, wheat
prices more than doubled leading to massive bread riots in several
countries.
Pricing power Inflation:
Occurs when the business houses and industries decide to increase
the price of their respective goods and services in order to increase
their profit margins.
Built-in Inflation:
Is caused by higher wages of workers. Induced by adaptive
expectations, often linked to the "price/wage spiral" because it
involves workers trying to keep their wages up (gross wages have to
increase above the CPI rate to net to CPI after-tax) with prices and
then employers passing higher costs to consumers as higher prices as
part of a "vicious circle."
Sectoral Inflation:
Occurs when there is an increase in the price of the goods and
services produced by a certain sector of industries. For instance, if the
price of crude oil goes up it will directly affect other sectors; its
impact on aviation industry can be seen where the fares go up. In
recession time it affects adversely and could cause layoffs. When
increase of prices in one sector of economy has its effect on other
sectors it is known as sectoral inflation.
5- Levels of inflation:
Hyper inflation: Extremely rapid or out of control inflation, occurs
during or soon after a war.
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Strato-inflation: The inflation rate ranges from about 10 percent to
several hundred per cent. Many developing countries particularly
those in Latin America experienced this.
Mild inflation: Is a slow rise in price level of no more than 5 percent
per annum. It is associated with a low level of unemployment.
6- Causes of inflation in Egypt
A) Political & Economic Instability (Revolutionary Acts):
Economic Instability:
Economists generally believe that money supply is the key cause of
inflation; in 2008, however, skyrocketing prices of oil, food and
steel caused hyper-inflation in the world economy that collapsed
only because of the global Financial Crisis.
The Revolution of 25th January 2011:
Eighteen days of protests in Egypt, sparked by falling living
standards and high unemployment as well as a lack of democratic
rights, led to the ouster of Mubarak on Feb. 11.
The inflation rate in urban parts of Egypt, the gauge that the
Central Bank monitors, rose to 11.5 percent from 10.7 percent in
February, the Central Agency for Public Mobilization and Statistics
said: Prices increased 1.4 percent on a monthly basis.
Belton Financial and CI Capital, two Cairo-based investment
banks, had forecast inflation at 10.8 percent.
B) Increase in oil prices:
The reason why this happens is that oil is a major input in the
economy, it is used in critical activities such as fueling
transportation and heating homes - and if input costs rise, so should
the cost of end products. For example, if the price of oil rises, then
it will cost more to make plastic, and a plastics company will then
pass on some or all of this cost to the consumer, which raises prices
and thus inflation.
Oil prices hovered at about $90 a barrel over the past week. Some
analysts predicted the Egyptian crisis will lead to $100 per barrel
prices sooner rather than later.
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C) Increase in food prices:
The increased prices of meat, sugar, fruit and vegetables in Egypt
have led to higher rates of annual inflation.
Prices of food and beverages, which account for 44 percent of the
weighting of the basket Egypt uses to measure inflation,
accelerated year-on-year to 17.2 percent in December from 17.1
percent in November.
D) Increase in the money supply:
 The more money injected in the economy the more will be the
inflation.
 If the money supply is not adequately controlled by the Egyptian
central bank then it may actually grow at the rate faster than that
of the potential output in the economy, or real GDP.
 As a result prices end up rising at a rapid pace to keep up the
currency surplus. This is called the Demand-Pull, in which the
prices are forced upwards because of the high demand.
 An increase in the quantity of money in circulation relatively to the
ability of the economy to supply leads to increased demands,
thereby fuelling prices. Low interest rates correspond with high
levels of money supply and allow for more investment in big
business and new ideas which eventually leads to unsustainable
levels of inflation as cheap money is available. The credit crisis of
2007 is a very good example of this at work.
E) Decline in exchange rates:
High lending levels can result in an increasing level of Inflation as
International lending and national debts have to be paid off with an
addition of interest, which ultimately end up with rises in prices in
the country as a way to keep up with the debts. This causes the
exchange rate to drop which results in more inflation, as
government has to deal with the gap created between the
import/export levels.
F) Increase in production costs:
Rise in the production cost that leads to an increase in the prices of
the end products. Expensive Raw Material leads to an increase in
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the production cost that ultimately results in the company
increasing prices of the final product to maintain steady profits.
Rising labor costs can also lead to inflation. As workers demand
wage increases, companies usually chose to pass on those costs to
their customers.
G) Rises in tax:
An increase in taxes either direct or indirect put on consumer
products lead to inflation as suppliers transfer the burden to the
consumer.
7- Relationship between Inflation and GDP
Real GDP is a measure of output held at constant prices so it
allows you to compare the actual amount of output over time.
Inflation in the long-run has no relationship with Real GDP. In the shortrun however it does. Here is how, when inflation is higher than
individuals and firms expected, firms perceive their prices to be higher
than normal, so they go out and hire more workers, increasing real GDP.
Nominal GDP is just the cash value of a countries production
during a particular time period.
Nominal GDP goes up even more now because inflation causes the
dollar to be worth less meaning everything costs more and on top of that
more is being produced because firms think their products have increased
in price relative to other prices. So inflation increases Real GDP in the
short run. Nominal GDP increases both because Real GDP increased and
because of inflation. Such can be reflected in the graph below.
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8- Governmental Debates and Control Policies
Egypt‟s economy has had witnessed continuous discordance
between macroeconomic policies and numbers published, and the ones
announced by ministers and officials, with the real facts and trends
appearing to happen in the economy. After the Revolution in the 25th of
Jan 2011, Egypt has experienced a great transmission between a past
unstable and struggling era, to an upcoming one with optimism and
promising statements by the new governmental structure.
Here, we will briefly go through the policies concerninf „inflation‟
stated by the former minister of finance Youssef Boutros Ghali, and the
present minister Dr.Samir Radwan assigned after the incidental events of
the Revolution .
I) Prior to Revolution (25 Jan 2011)
Youssef Boutros Ghali , announced July 1st 2010 that officials
decided that :“67.68 billion pounds of a state budget 489.408 billion
pounds subsidize petroleum products and 13.585 billion pounds to
subsidized ration [card] goods and to expand operations of the ration card
system to include around 63 million people, bringing the subsidies bill to
116.616 billion pounds.”. The government raised salaries for low-income
residents, benefiting more than 3.7 million people at a cost of 4.3 billion
Egyptian pounds.
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Critics quoted:
Dr. Yumna Al-Humaqi, Undersecretary of the Shura Council's
Economic Committee and a member of the General Secretariat of the
ruling National Democratic Party told Al-Shorfa: “The existence of two
prices for the most important commodities in itself constitutes a great
threat to the Egyptian economy.”
Dr. Hamdi Abdel Azim, president of the Sadat Academy for
Administrative Sciences, also quoted: “The increase in energy prices will
raise the cost of production in factories, which will increase the prices of
many commodities, notably steel and cement, this will affect the real
estate market, which has been stagnating for a long time. This decision
will also raise the price of fertilizer, and which will be reflected in the
prices of agricultural crops.”
II) Revolution Aftermaths (25 Jan 2011)
Dr. Samir Radwan, pointed out the increase in the prices of meat
and poultry amounted to about 28.7%, cereals 21.5%, bread, sugar and
sugary foods 16.3%, vegetables 11%, milk, cheese, eggs, fruit 8.8% and
4.9%.He added The price increases also included the departments of
education, and smoke, restaurants, hotels, special item ready meals. He
stated that an increase in food prices is the main engine to increase the
rate of inflation, emphasizing that the provision of food and drink
consumed the bulk of the budget of families.
He called for tightening the control mechanisms of markets in the
coming period, and the expansion of agricultural production.
“There should be a role for the State, which is not incompatible
with a market economy by offering commodities at crisis with reduced
prices and this can be done by supermarkets and food stores.”
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References
Vikesh Gokal, Subrina Hanif , Economics Department
Reserve Bank of Fiji December 2004: Relationship between Inflation and Economic
Growth
Lindsay Vacek, Dr. Parker, Economics 463Country Study #3
April 16, 2008: Egyptian Money Supply
U.S. Library of Congress
Abdel-Hameed Hamdy Nawar, Faculty of Economics & Political Science, Cairo
University, Giza 12613: Egypt PPI and Measuring Inflation in Business Transactions
in Egypt
David E. Lebow and Jeremy B. Rudd Finance and Economics Discussion Series
Divisions of Research & Statistics and Monetary Affairs
Federal Reserve Board, Washington, D.C. Inflation Measurement
Sherine Al-Shawarby, April 2008: Measuring Inflation in Egypt: Assessment of the
CPI Accuracy
Websites:
http://www.tradingeconomics.com/egypt/inflation-average-imf-data.ht
http://www.alshorfa.com/cocoon/meii/xhtml/en_GB/features/meii/features/main/2010/07/10/feature
-01
http://www.thedailynewsegypt.com/other-top-stories/egypt-inflation-edges-up-ratesseen-steady-for-now-dp1.html.
http://www.economywatch.com/economic-statistics/country/egypt
http://www.masrawy.com/News/Writers/General/2010/November/7/samir_speech.asp
x
http://finance.fortune.cnn.com/2011/02/01/egypt-and-the-growing-problem-of-globalinflation
http://www.eces.org.eg/publications/View_Pub.asp?p_id=10&p_detail_id=20
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