post Soaring Inflation

May 31st, 2008

Filed under: Economy — Lissan Magazine @ 12:40

“These days, those of us who are supporting family by sending money back home are aware of the uncanny economical development there. Life is too expensive to survive in Ethiopia and whatever amount of money sent there won’t help much. 100 kg Teff for over 1000 Birr? What is going wrong in Ethiopia? Who is responsible for this mess?” (Lissan)

Ethiopia: Soaring Inflation Deepens Economic Crisis
by: Side Goodo

1. Introduction
Soaring inflation is deepening Ethiopia´s economic crisis. According to the foreign based Ethiopian sources, inflation in the country has reached an alarming 35% in January 2008 while the government sources indicate that it is about 20%. In either case, there is real evidence of sustained increase in the general price level in the country since 2005. The price of cereals has increased fourfold while the prices of raw materials have more than doubled during the past three years.

photo: kully ballagan (Flickr)

In the country where over 80% of the population lives below US$2 a day, i.e. below poverty line, inflationary pressure of this magnitude puts the basic survival of the majority of the population at stake. In urban areas, many households are said to be already dependent on the government cereal handouts. In rural areas, inflationary pressure is exacerbated by the recurrent drought which exterminated crops and live stocks in many regions. According to both the UN and local sources, an estimated 9 million Ethiopians need urgent food aid for 2008; the never ending problem of this country.

The Ethiopian government admits that the inflationary pressure has become very severe. However, it also claims that the economy has been growing at 10% for five consecutive years and it is healthy at present. This can not be trusted for two reasons. First, if the economy has been growing at such robust rate, the country should be able to feed itself. Why do we continue to beg food aid if our economy has been growing at this rate every year for many years? Second, double digit inflation is clearly the sign of unhealthy economy.

Because of such wrong diagnosis of the economic problems facing the country, the government recently declared a wrong strategy to control inflation. Instead of devising appropriate economic policies that help tackle the root causes of inflation, the Ethiopian government recently declared a war on what it termed as “greedy” and “criminal” business persons. The same route was followed by Mugabe in Zimbabwe, where inflation is now over a 1000%.

The rest of the article is organized as follows: section 2 presents an overview of the causes of inflation. Section 3 deals with the strategies to control inflation. Section 4 analyses the Ethiopian strategy for controlling inflation while section 5 concludes.

2. Causes of Inflation
In the mid-twentieth century, two camps of economists proposed two different causes of inflation. The monetarists argued that money supply was the most dominant determinant of inflation while for Keynesians the real demand was more important in determining inflation than changes in the money supply. Currently, many economists agree that inflation is caused by the combination of both real demand and changes in the money supply.

Based primarily on the Keynesian tradition, economists identify two types of inflation: cost-push and demand-pull inflation. Cost-push inflation is caused by the decrease in aggregate supply. Decrease in aggregate supply is in turn caused by increase in prices of production inputs, primarily, labour and raw materials. Ceteris paribus, the higher the cost of production, the lower is the amount of goods and services produced and hence the lower the aggregate supply of goods and services.

However, other things will not always remain constant and the supply of goods can be influenced by other factors than the increase in the prices of inputs. Therefore, not all inflation resulting from the fall in aggregate supply can be categorized as cost-push inflation.

In Ethiopia, the fall in aggregate supply can not be solely attributed to an increase in the input prices. The archaic production technique used in the agricultural sector which employs 85% of the population coupled with the recurrent drought in many parts of the country have caused persistent fall in the production of agricultural output. Therefore, the current inflationary pressure in the country is due to the combination of both cost-push and structural economic problems.

The cost-push inflation is aggravated by increased oil prices and prices of other raw materials. Due to the combination of politics and scarcity the international price of oil has increased tremendously during the past two years. The oil price reached the all time high of over US$100 a barrel in 2008. Although the Ethiopian government tried to subsidize oil consumption in the country, the price increase has been significant. In addition to this, the price of other raw materials such as cement has at least doubled in Ethiopia during the past three years due to the combination of increased demand and limited production facilities.

On the other hand, demand-pull inflation is caused by an increase in aggregate demand which in turn is the result of increase in either private or government consumption or both, increase in investment demand, increase in money supply and so on. The demand pull inflation is caused by increase in the demand for goods.

Therefore, any strategy to control the level of inflation should be based on the economic assessment of the causes of inflation.

3. Economic Strategies to Control Inflation
In many countries, the control of inflation has become one of the prime objectives of government economic policy. Effective policies to control inflation must focus on the root causes of inflation in the economy. If inflation is caused by increased inputs costs and consequently the fall in aggregate supply, the production costs must be reduced to curtail inflation. If the cause is excess demand, the government should reduce the aggregate demand.

In most advanced countries the main cause of inflation is excess demand. Accordingly, they focus on the control of the growth of demand through the use of monetary policy instruments, viz, interest rate and real money supply. Monetary policy can control the growth in demand through increase in interest rates and reduction in real money supply. The transmission mechanism of monetary policy is complex. In conventional macroeconomic models the interest rate channel is the primary mechanism of transmission. However, Bernanke and Gertler (1995) have pointed out that the macroeconomic response to policy induced interest rate changes is considerably larger than that implied by the conventional estimates of elasticities of consumption and investment. Therefore, other channels such as the Bernanke credit channel may also be at work.

In any case, increased interest rate reduces aggregate demand in a number of ways: (a) discouraging borrowing by both households and firms, (b) increasing the rate of saving, (c) increasing cost of funds and reducing business investment and (d) leading to the fall in monetary inflation, by reducing the demand for lending and the growth of broad money.

Demand-pull inflation can also be controlled using fiscal policy. A government can reduce aggregate demand by increasing direct taxes which leads to the fall in personal disposable income and consumption. A government can also reduce aggregate demand by reducing its spending and its borrowing levels.

Other economic policies used to control inflation include revaluation of exchange rates and incomes policies or the direct control of wages. Effective control of inflation can only be achieved if there is effective control of aggregate demand through a combination of both fiscal and monetary policy and improvements in the supply side of the economy. Introduction of inflation targets can also enhance the credibility of the inflation control policies.

4. Ethiopia´s Inflation Controlling Strategy
The Ethiopian government recently announced what Heinlein (March 2008) termed as “Tough Anti Inflation Measures”. The core of these measures include a crackdown on what the government calls “economic criminals” referring to business people whom it blames for the recent price increases that boosted inflation rates to 20%. Accordingly, the government established a task force to punish what it calls “greedy and illegal” business persons and asked the public to provide information about those involved in price gouging.

However, the crackdown on private businesses does not address the underlying causes of inflation in the country. This strategy is based either on the misconception of the country´s economic dynamics or the deliberate attempt to shift the burden of the failed economic policies to the private sector. According to McMahon (2006), many people mistakenly believe that prices rise because businesses are “greedy”. This is not the case in a free enterprise system. Because of competition, the businesses that succeed are those that provide the highest quality goods for the lowest price. So a business can’t just arbitrarily raise its prices anytime it wants to. If it does, before long all of its customers will be buying from someone else. Thus unless the Ethiopian business firms blamed for increased prices are monopolies, there is no way that they will be able to increase prices on all commodities as they wish.

Therefore, the Ethiopian government targeted the wrong causes of inflation and hence its measure is bound to be counter productive. Ethiopia´s inflation is primarily cost-push inflation and what can be termed as structural. It is caused by the fall in aggregate supply of goods. The increase in the cost of raw materials including the price of oil has contributed to the fall in aggregate supply. Speculative behaviours caused by the expectation of increasing prices can exacerbate inflationary pressure. However, since the Ethiopian inflation is primary driven by the sustained increase in food prices, speculative behaviour can not be considered as the driving force behind the current inflationary pressure. Moreover, oil price has increased globally. It can not be the main cause for soaring inflation in Ethiopia.

The archaic nature of the production system in the agriculture sector which employs 85% of the country´s population could not keep with the pace of the population growth in both rural and urban areas. This coupled with recurrent drought in many parts of the country has significantly reduced the supply of food grains in the country. The persistent supply shortages led to the persistent rise in the general price level.

Thus it is the combined effects of cost-push inflation and structural economic problems that are behind the sustained increased in the general price level in the country.

This trend is likely to continue unless the government devices an appropriate policy to improve the supply side problems of the economy. Cracking down on the business people is another grave mistake this government must avoid at all cost. Countries in crisis such as Zimbabwe have followed this route and have failed miserably.

The other inflation fighting measures announced by the government include an end to sales tax on food grains and restrictions on the growth of money supply. An end to sales tax on food grains is a good news. However, an imposition of VAT on other activities is likely to counter balance this effects. The reduction in real money supply presupposes that the cause of inflationary pressure is excess demand. In any case, increase in money supply while there is the shortage of aggregate supply of goods is likely to fuel inflationary pressure and hence it is appropriate to keep the pace of real money supply with that of the growth in the real sector.

These are appropriate economic policies to control inflation. However, they should be backed by efforts to improve the supply problem.

5. Conclusion
The underlying causes of the current inflationary pressure in the country are both structural and are linked to increased input costs. The government has to focus on these causes if it is to effectively control inflation in the economy. The policy of cracking down on the business people is likely to be counter productive because it fails to address these underlying causes of inflation.

The suggested changes in monetary policy and sales tax are useful. However, they must be backed by effective measures to improve the supply side problems. Improvement of the supply side problems requires further changes in macroeconomic policies. These include creating conducive environment for private investment; full privatization of government and party owned companies on food security and other related policies. The country must set its economic priority right. The country must be able to feed itself!! The main driving force behind the current soaring inflation is food prices. Radical policies must be devised to ensure food security as a matter of urgency.

If the government is serious about addressing the underlying causes of inflation in the economy, introduction of inflation targeting may improve the credibility of inflation controlling measures.


1 Comment »

  1. food aids are badly needed by third world countries and we really need to give something to the poor…*

    Comment by Jack Carter — 19. July 2010 @ 13:26

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