Understanding Economics: (13)-Inflation and cost of living |02 April 2008

A fall in purchasing power means that less can be bought from the same amount of money.  By implication, the rate of inflation is the percentage change in the prices of goods and services over time, normally calculated on a monthly basis. 

The most commonly used measure of inflation is the Consumer Price Index (CPI).  The CPI computes the average change in the price of a fixed basket of consumer goods and services.  Based on the results of a survey, the basket is composed of the monthly average expenditure on goods and services of a typical household. 

The basket is assigned an index of 100 in the base period and future movements in the price of its items generate a change in the index which is expressed as a percentage.  For example, if the CPI moved to 110, this is interpreted as an inflation rate of 10% implying that goods and services are in general 10% more expensive.  Notable is that this should not be interpreted as the rate of increase in prices of everything sold but the average rise in the price of the items in the basket.  Moreover, a change in the inflation rate from 10% to 5% does not mean prices have fallen but rather the average increases have been at a reduced pace.  A general decline in price level is referred to as deflation and this is when the calculated change is negative.

Inflation may be as a result of a number of factors.  In most cases, it is experienced when businesses adjust their selling price in order to maintain their profit margin following a rise in production cost.  This is referred to as cost-push inflation. 

Production costs may increase due to various reasons.  One of the main factors is a rise in the value of imported goods which is commonly observed in Seychelles given that the inputs for most businesses are imported.  The increase in import costs may be because of high inflation internationally, particularly in the markets from where the home country sourced its commodities. 

For example, the present increase in oil prices globally translates into a higher domestic price for fuel in oil-importing countries.  In some economies, through the use of policies, the government may limit or control the impact of international price increases on domestic consumers.  This may be by means of subsidising or reducing the rate of applicable tax on some products purchased from abroad. 

Price increases are additionally experienced when the value of the domestic currency weakened against the currencies used to pay for imported goods.  This is because a depreciated currency results into a direct increase in import costs since more of the importers’ money is required to pay for the same price of a good in foreign currency. 

The level of government tax will also influences the price at which commodities are sold in a country.  For example, if the government increases taxes such as import duty or other indirect taxes, this is likely to result into higher price level because of the resulting impact on costs to producers.

From another perspective, price increases tend to occur when the supplies of certain commodities are not enough to meet the quantity demanded (shortage of supply or excess demand).  This situation or scarcity in the market would normally encourage suppliers to sell their products at the highest possible price.

To the majority of people, inflation is unacceptable since it makes a person poorer on the basis that higher prices mean a reduction in the amount of goods or services that can be purchased from the same amount of money; consumers experience an increase in the cost of living.  Therefore, it is logical for consumers not to welcome price increases that are at a faster pace than an upward revision in their salaries.  The natural behaviour by workers when inflation is high is to, where possible, negotiate for salary increases.  Of note however is that a higher salary is able to translate into an increase in (payroll) cost which may force companies to raise the price of their goods or services further, thus resulting in a second round of price increases. 

Nonetheless, there can be an advantage to consumers in an environment of persisting high inflation.  When prices are increasing, a consumer who borrows today gives up less purchasing ability when the loan is being repaid in the future.  This is because the value of the loan can purchase less goods or services in the future since prices have risen.

In most countries, notwithstanding the security aspect, it is not rational for economic agents to hold large cash balances since interest is being forgone.  An environment of high inflation or prolonged periods of price increases give extra incentives to minimise the amount of cash in the hands of individuals because of the resulting loss in purchasing power over time. 

The logical behaviour is for agents to bank the cash in order to at least maintain the purchasing power of their money balance by earning interests.  However, if the rate of interest on bank deposits is lower than the inflation rate then the interest rate is said to be negative in “real terms” which implies that banking the money still result in a loss in purchasing power.  When this is the case, agents tend to acquire fixed assets such as house or land in order to maintain the value of their assets. 

Despite being seen as unacceptable to many consumers, in most cases, inflation is viewed as a normal economic development so long as it remains within a level considered as acceptable and from a macroeconomic perspective desirable.  To policy makers, inflation has a very important role to play in the economy given the vital price signals that it portrays.

Contributed by the Central Bank of Seychelles:  E-mail: enquiries@cbs.sc