Wednesday, 27 November 2013

Politics of inflation

The article is published in the Money Matters on 25 Nov 2013

Every political party emphasises the need to reduce inflation, create employment and alleviate poverty before elections. Inflation and unemployment are among the major concerns for policymakers as well with both variables of core importance while making macroeconomic policies.

Inflation is currently on the rise and it is expected that it will reach double digits in the current fiscal year against the target of 9.5 percent. The State Bank of Pakistan (SBP) has recently increased the discount rate by 50 basis points to reduce inflation. The PML-N government has been under attack since it came into power by other political parties as well as its critics due to the increase in inflation. The policies of the current government are being held responsible for higher than expected inflation. The agreement with the IMF is also severely criticised for playing a role in increasing inflation while some critics associate the programme with excessive borrowing by the government, buying foreign exchange from the market and depreciation in the exchange rate.

Economists, in general, associate inflation to the money supply in the long run, especially the excessive money supply. However, researchers have also tried to link inflation with the political economy, fiscal and structural variables. Without any doubt these variables have some effect on inflation in the short run but in the long run the sole determinant of inflation is money supply.

Contrary to these popular beliefs, an excessive increase in current inflation can be linked to four political factors which are strongly associated to the 2013 elections. However, in the end we’ll see that political factors are subjective and in reality it is the money supply which contributed to inflation only.

The federal government as well as the provincial governments increases their spending on the development projects before the elections to show their determination and commitment to development of Pakistan. The increase in development expenditures from 3.6 percent of GDP in 2011-12 to 4.4 percent of GDP in 2012-13 strengthens our claim that excessive money is spent on development projects before the election year. Thus money/funds which were hoarded are spent before the election to gain support of nation to vote for them.

Subsidies are among the most important variables which negatively affect inflation in the short run but in the long run they may affect the inflation rate positively depending on the financing process of subsidies. However, subsidies given to the farmers in the name of support price lead to an increase in inflation. Therefore, the nature of subsidies is also important. It can be in the form of cash transfers such as income support programmes, support price to specific a sector, interest free loans or loans provided at a lower rate than the market prevailing interest rate such as an export finance scheme, tax holidays and rebates to different sectors such as duty drawback to the export sector. Before the elections subsidies are also used to control the prices if they are expected to go up. The best example in our context would be subsidies given to the energy sector. Circular debt was the outcome of several subsidies given by the government not to increase the price of electricity.

An excessive increase in the money supply to mitigate the gap between potential and actual employment is a major socio-political economic policy. This policy leads to trade-off between inflation and employment since increase in money supply may increase employment in the short run but eventually contributes to inflation. However, excessive monetary borrowing was carried out to finance the budget deficit before the elections and continuous purchase of domestic assets to increase foreign exchange injections into the market to control the exchange rate may not give us a clear illustration of our claim. 

Moreover, money spent on election campaigns including public meetings, poster printing etc increases domestic commerce activity. Politicians and political parties spend billions of rupees on their election campaigns every five years. The money hoarded by either politicians, political parties or their financers is given to the people who are involved in their election campaigns.

Furthermore, black money is also involved in elections, which is either used to gain the support of leaders in the villages or given to their workers, mostly belonging to lower middle class who will do various chores for them related to election campaigns. Nevertheless, money circulation will increase in the economy which increases the purchasing power of the people to spend on various items, particularly food. Therefore, expectations of an increase in the purchasing power lead to increase in food prices. This is also evident in the first three months of the current fiscal year with food inflation more than non-food inflation, opposite to the trend in 2011-12.

The above discussion on a possible increase in inflation is based on politics. However, each case presented in this article is related to circulation of money in the economy which leads to inflation. Research tells us that the impact of money supply affects inflation with a nine to ten month lag. The effect of money supply on inflation may take more time if it is hoarded by people or institutions for a longer period. Therefore, we can conclude that current rise in inflation is the lag effect of previous year’s policies of the last government which are strongly associated with the 2013 elections and the money spent on elections by politicians and political parties. Moreover, as economists suggests it is the money supply which is the sole determinant of inflation.
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