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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 Page 1 of 12 Chapter Two Inflation 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 Page 2 of 12 Chapter Two Inflation 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. Page 3 of 12 Chapter Two Inflation 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. Page 4 of 12 Chapter Two Inflation 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 Page 5 of 12 Chapter Two Inflation 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. Page 6 of 12 Chapter Two Inflation 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. Page 7 of 12 Chapter Two Inflation 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 Page 8 of 12 Chapter Two Inflation 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. Page 9 of 12 Chapter Two Inflation 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. Page 10 of 12 Chapter Two Inflation 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.” Page 11 of 12 Chapter Two Inflation 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 Page 12 of 12