Inflation: not just price hike

Without understanding the benefits of inflation, people term it ‘bad’

LAHORE: In a broader more general sense not a lot of people have a vast understanding of inflation.

If you ask a person on the street or in a bazaar about inflation he will reply that goods and or services are getting dearer day by day. They think inflation is simply the increase in prices of goods or services.

The larger perception among people is that inflation is bad for them; they pass this judgment without any understanding of its benefits.  However, the cost and benefits of inflation and the way it is calculated are quite different from an ordinary person’s point of view.

Inflation calculation

The calculation of inflation in an economy is done on the basis of a basket of goods and services. A typical basket would contain expenditure on food, clothing, house maintenance, energy, health, education, transport.

This basket is decided after a family survey is conducted by an official statistical agency every 10 years in developing countries. Since developing countries are cash strapped and governments cannot commit resources frequently for these laborious exercises, such surveys are conducted after 5 years.

If family survey is done in 2016-17, that particular year may become a base year for calculation purposes. In the base year, the basket is kept fixed which means how much percentage of the total monthly expenditure would be on food and clothing.

This survey is conducted on the basis of random sampling procedure which means that statistical agency such as Pakistan Bureau of Statistics picks up certain households in a locality. Then they send an official team to ask questions related to their household expenditure.

Unfortunately the ordinary person neither has any precise information of his expenditure details nor is willing to share it with officials of statistical agency since he is not aware of how the disclosure of information would affect him.

He is also ignorant of the importance of this information in running the economy.

Under these constraints, the official team guesstimate things and a Consumer Price Index (CPI) comes into existence. Hence the quality and reliability of data becomes an issue in developing countries as far as the construction of CPI is concerned.

The CPI is the reflection of an average level of prices in a particular year. Usually, the prices of all goods do not go up or down together therefore the device of ‘average’ helps in getting some picture out of the raw data. This emerging picture becomes the basis of certain important official decisions in an economy. These decisions could be the extent of inflation and GDP targets for the upcoming years and the way they impact the poverty level in an economy.

Costs and benefits

To understand the pros and cons of inflation, we need to do cost benefit analysis. Usually, an ordinary person just looks at the cost of inflation. If you ask a person how you think that inflation is higher this year than the previous one.

He would quickly come with examples. For instance, prices of banana, pulses, milk and flour have increased more this year than the previous one. Most interestingly, the person would ignore the benefits of inflation, which include growth in income or wages at par with inflation.

Additionally for a manufacturer, high inflation means higher incentive for production. In order to forecast next year’s expenditure, an entrepreneur would look at inflation and put his forecast of expenditure slightly above that of inflation.

This practice aids him in balancing books and securing money profit. A capitalist and or entrepreneur looks at the benefit of inflation and produces more, while gives less weight to cost.

In short, inflation has its costs and benefits. In the course of development, 7-9 % inflation is a manageable figure. We can debate the costs, benefits and estimates of inflation. However, creating undue horrors of inflation is a bad strategy from the perspective of economic development.

The writer is an Assistant Professor of Economics at LUMS

Published in The Express Tribune, October 29^th, 2016.

Like Business on Facebook, follow @TribuneBiz on Twitter to stay informed and join in the conversation.