Case study 3: French inflation in 1790s

Introduction

Governments have an insatiable appetite for the wealth of their subjects. When governments find it impossible to continue raising taxes or borrowing funds, they will invariably turn to printing paper money to finance their growing expenditures. The resulting inflations have often undermined the social fabric, ruined the economy, and sometimes brought revolution and tyranny in their wake. The political economy of the French Revolution is a tragic example of this.

Causes

Before the revolution of 1789, royal France was a textbook example of mercantilism. Nothing was produced or sold, imported or exported, without government approval and regulation.

While the French king’s government regulated economic affairs, the royal court consumed the national wealth. Louis XVI’s personal military guard numbered 9,050 soldiers; his civilian household numbered around 4,000—30 servants were required to serve the king his dinner, four of whom had the task of filling his glass with water or wine. He also had at his service 128 musicians, 75 religious officials, 48 doctors, and 198 persons to care for his body.

The nobility and the clergy were mostly exempt from paying taxes, so the tax burden fell on the “lower classes.” When Louis XVI assumed the throne in 1774, government expenditures were 399.2 million livres, with tax receipts only about 372 million livres, leaving a deficit of 27.2 million livres, or about 7 percent of spending. Loans and monetary expansion that year and in future years made up the difference.

In an attempt to put the government’s finances in order, in July 1774 the king appointed a brilliant economist, Anne-Robert-Jacques Turgot, to serve as finance minister. Turgot did all in his power to curb government spending and regulation. But every proposed reform increased the opposition from privileged groups, and the king finally dismissed him in May 1776.

It was the chaos of the king’s finances that finally resulted in the Estates-General’s being called into session in early 1789, followed by the beginning of the French Revolution with the fall of the Bastille in Paris in July 1789. But the new revolutionary authorities were as extravagant in their spending as the king. Vast amounts were spent on public works to create jobs, and 17 million livres were given to the people of Paris in food subsidies.

On March 17, 1790, the revolutionary National Assembly voted to issue a new paper currency called the assignat, and in April, 400 million were put into circulation. Short of funds, the government issued another 800 million at the end of the summer. By late 1791, 1.5 billion assignats were circulating and purchasing power had decreased 14 percent. In August 1793 the number of assignats had increased to almost 4.1 billion, its value having depreciated 60 percent. In November 1795 the assignats numbered 19.7 billion, and by then its purchasing power had decreased 99 percent since first issued. In five years the money of revolutionary France had become worth less than the paper it was printed on.

Effect

The effects of this monetary collapse were fantastic. A huge debtor class was created with a vested interest in the inflation because depreciating assignats meant debtors repaid in increasingly worthless money. Others had speculated in land, often former Church properties the government had seized and sold off, and their fortunes were now tied to inflationary rises in land values. With money more worthless each day, pleasures of the moment took precedence over long-term planning and investment.

Goods were hoarded—and thus became scarcer—because sellers expected higher prices tomorrow. Soap became so scarce that Parisian washerwomen demanded that any sellers who refused to sell their product for assignats should be put to death. In February 1793, mobs in Paris attacked more than 200 stores, looting everything from bread and coffee to sugar and clothing.

On whom did the burden of the inflation mostly fall? The poorest. Financiers, merchants, and commodity speculators who normally participated in international trade often could protect themselves. They accumulated gold and silver and sent it abroad for safekeeping; they also invested in art and precious jewelry. Their speculative expertise enabled many of them to stay ahead of the inflation and to profit from currency fluctuations. The working class and the poor in general had neither the expertise nor the means to protect the little they had. They were the ones who ended up holding the billions of worthless assignats.

Measures

Finally, on December 22, 1795, the government decreed that the printing of the assignats should stop. Gold and silver transactions were permitted again after having been banned and were recognized as legally binding. On February 18, 1796, at 9 o’clock in the morning, the printing presses, plates, and paper used to make assignats were taken to the Place Vendôme and before a huge crowd of Parisians were broken and burned.

Price Controls Follow

As the inflation grew worse, an outcry was heard from “the people” that prices must be prevented from rising. On May 4, 1793, the National Assembly imposed price controls on grain and specified that it could only be sold in public markets under the watchful eye of state inspectors, who were also given the authority to break into merchants’ private homes and confiscate hoarded grain and flour. Destruction of commodities under government regulation was made a capital offense.

In September 1793 the price controls were extended to all goods declared to be of “primary necessity.” Prices were prohibited from rising more than one-third in 1790. And wages were placed under similar control in the spring of 1794. Nonetheless, commodities soon disappeared from the markets. Paris cafes found it impossible to obtain sugar; food supplies 

Case study 2:Inflation in Pakistan

Introduction

According to the Pakistan Bureau of Statistics, inflation measured by the Consumer Price Index clocked in at 5.8 percent in April over a year ago. This is the lowest level since April 2004 when CPI inflation stood at 5.99 percent. Inflation in Pakistan had slipped to a nine-year low in April despite an expansionary fiscal policy pursued by the finance ministry.

Causes

Non-productive Expenditures

Government of Pakistan has to make a lot of non-productive expenditures like defence etc. Such unproductive expenditures lead to the wastage of economy’s precious resources and also lead to inflation.

Corruption & Black Money

Corruption and black money leads to increase in aggregate demand, which is cause of inflation. These evils increase aggregate demand and import volume.

Foreign Remittances

Increase in foreign remittances is increasing the money supply in our country. Increase in money supply leads to inflation.

Foreign Aids

Foreign aids are also a source of mobilization of resources form rich countries to poor countries. It is also a cause of inflation in Pakistan.

Consumption Trends

Pakistanis are starting to follow consumption trends brought over from the West. In a bid to mimic luxurious lifestyles, there has been in an increase in consumption trends. This thus leads to inflation.

Population Bomb

As the population of Pakistan is increasing day by day, overall demand for goods and services will also increase, hence contributing to inflation.

Slow Agricultural Development

Low growth rate of agricultural sector causes a shortage of productivity. It results in low supplies of goods and services and the inevitable increase in price level.

Slow Industrial Growth

Pakistan's industrial sector is not as developed technologically developed. Inferior production rates also creates shortage in market and caused in inflation.

Increase in Wages & Salaries

Labour costs have increased in Pakistan, resulting in an increase in factors of production. On the other hand, due to more wages and salaries there is an increase in income and it causes inflation.

Effects

One of the most significant issues in Pakistan would be the astonishing numbers of child labourers.  In order to meet the over-excessive demand of resources, and due to the fact that many live in impoverished circumstances, child labourers are apparent as families need to make ends meet. The Human Rights Commission of Pakistan estimated in 2005 that there would be 10 to 12 million child workers in Pakistan by 2010-11. However, according to an All-Pakistan Labour Force survey, this number has doubled to about 21 million child workers. It shows the gravity of the situation. The main reason is poverty, while the low literacy rate has also contributed to the problem to a large extent. According to the above survey, over 21 million child labourers between the age of 10 and 14 years are working in the country. Out of which 27 per cent are girls and 73 per cents are boys. Children who are our future are uneducated, and parents treat them as a burden.

Measures

At present, the government has implemented a few measures to reduce the impact of inflation on the lower level income groups. For one, the government has sold essential commodities at cheaper rates. The government has also allowed the import of various items through land routes from neighbouring countries in a bid to reduce the prices of certain goods.

Possible measures would include the encouragement of domestic production rather than imports. Investments should also be focused on the production of consumer goods rather than luxuries., Agriculture sector should be given subsidies, foreign investment should be attracted, and developed countries should be requested for financial and managerial assistance. And lastly a strong monitoring system should be established on different levels in order to have a sound evaluation of the process at every stage. This monitoring system should be in place to inflict strict control over the supply of money and evading any relaxation to the supply of money. 

Case study 1 : Inflation of India

What causes Inflation?

In India, the wholesale price index (WPI), which was the main measure of the inflation rate, consisted of three main components - primary articles, which included food articles, constituting22% of the index; fuel, constituting 14% of the index; and manufactured goods, which accounted for the remaining 64% of the index.

For purposes of analysis and to measure more accurately the price levels for different sections of society and for different regions, the RBI also kept track of consumer price indices. The average annual GDP growth in the 2000s was about 6% and during the second quarter (July-September) of fiscal 2006-2007, the growth rate was as high as 9.2%. All this growth was bound to lead to higher demand for goods. However, the growth in the supply of goods, especially food articles such as wheat and pulses, did not keep pace with the growth in demand. As a result, the prices of food articles increased. According to Subir Gokarn, Executive Director and Chief Economist, "The inflationary pressures have been particularly acute this time due to supply side constraints of food articles which are a combination of temporary and structural factors."

Measures Taken

In late 2006 and early 2007, the RBI announced some measures to control inflation. These measures included increasing repo rates, the Cash Reserve Ratio (CRR) and reducing the rate of interest on cash deposited by banks with the RBI. With the increase in the repo rates and bank rates, banks had to pay a higher interest rate for the money they borrowed from the RBI. Consequently, the banks increased the rate at which they lent to their customers. The increase in the CRR reduced the money supply in the system because banks now had to keep more money as reserves. On December 08, 2006, the RBI again increased the CRR by 50 basis points to 5.5%. On January 31, 2007, the RBI increased the repo rate by 25 basis points to 7.5%.

Outlook

Several analysts were of the view that the RBI could have handled the 2006-07 inflation without tinkering with the interest rates, which according to them could slow down economic growth. Others believed that high inflation was often seen by investors as a sign of economic mismanagement and sustained high inflation would affect investor confidence in the economy. However, the inflation rate in emerging economies was usually higher than developed economies.



However, by looking at the inflation rate of 2006-2007, we will find the contractionary monetary policy taken by India government did not cure the inflationary growth. In long run, supply-side policy which increases the productive capacity of India should be taken instead.

Cures for inflation

Cures for demand-pull inflation 

Short-run policy: Aim to bring down Aggregate Demand

1.Contractionary monetary policy (Rise in the interest rate)

The government will raise the interest rate in order to reduce the money supply. A rise in the interest rate will cause a rise in the opportunity cost of consumption and therefore reduce it. Also, the higher interest rate lowers the expected net return on investment, hence lowering the level of investment. As consumption and investment fall, the aggregate demand falls in turn and therefore demand-pull inflation is reduced.

Limitation:

When investment and consumption are interest-inelastic due to optimism of investors and consumers, expected return may rise as the increase in revenue outstrips the increase in cost. A rise in interest rate may not be sufficient in curbing rising investment and “inrational exuberance” of consumers.

2.Contractionary fiscal policy

The government will reduce government spending or increase taxes. Reducing government spending will directly cause the aggregate demand to fall. A rise in income tax reduces disposable income and hence reduces consumption. A rise in corporate tax reduces the post-tax returns on investments, hence reducing the level of investment. These two will also drag down the aggregate demand. As the aggregate demand falls, the demand pull inflation is reduced.

Limitation:

In reality, contractionary fiscal policies such as raising direct taxes and reducing government spending will have adverse long term supply-side effects and conflict with other macroeconomic goals of growth and employment. Much of government expenditure is tied to long term contracts, such as education and healthcare, such as construction of roads and hospitals. Therefore, contractionary fiscal policy does not help to cure demand-pull inflation in the long run.

Long-run policy: supply-side policy

As the demand-pull inflation is the consequence of the actual growth outstripping the potential growth, cures can be slow down the actual growth as well as increase the productive capacity of the economy using supply-side policies. As long as LRAS grows as the same pace with aggregate demand, the economy will achieve non-inflationary growth.

Cures for Import-price-push inflation and cost-push inflation due to negative supply shocks

Short-run policy: price ceiling

The government can implement price controls to prevent cost-push inflation from entering the domestic market. The price ceilings on basic essentials such as food and fuel are to ensure the basic survival of the people.

Long-run policy: Find or develop cheaper alternatives

Economies which are heavily dependent on imports may be easily subject to an increase in the price of imported goods. One way to reduce the cost-push inflation is to reduce the overdependence on trade by finding or developing cheaper alternatives through the use of R&D.

Limitation: 

R&D is usually expensive and time-consuming and no one can be sure of its success. Moreover, the opportunity cost of it is high since resources may be diverted away from other key developments in education, defense, healthcare, and other aspects of the economy.

Cures for profit-push inflation

Short-run policy: Price controls

Profit-push inflation is caused by monopolies in the market. To control monopoly power, governments can adopt short-run policies that include price controls such as marginal-cost-pricing and average-cost-pricing.

Limitations:

As monopoly powers are usually international corporates, the price control policy may lead those transnational companies give up this area and it is people suffer from loss of job and of access to their goods.

Long-run policy: legislation and deregulation

Legislation is regulation set by government to balance between the profits incentives that make industries efficient as well as the costs of living and business costs. One example is Energy Market Authority of Singapore.

Deregulation is a pro-competition policy that allows for more players into a particular industry or a sector of the economy. Deregulation encourages more competition in the supply of goods and services. Increased competition can lead to increased efficiency, more consumer choice and lower prices, therefore reducing the profit-push inflation.

Effects of inflation

Just as how there are two sides to every coin, similarly, there are pros and cons to inflationary growth as well.

Negative effects of high inflation

Falling investment, employment and economic growth

If cost-push inflation is present in the society, firms which do not improve productivity and efficiency, will not be able to keep up with the rising costs and eventually experience a decline in profit. Investments will be discouraged, thus affecting economic growth as well as the unemployment rate. In addition, inflation may discourage savings, which is a key source of funds for investments. This is because inflation causes the real value of savings to fall. People will be encouraged to consume more, propagating the vicious cycle. The result is a loss of business confidence in the economy and the inevitable decline in growth and investments

Decline in net export revenue

A country suffering from high inflation rates will also suffer a simultaneous fall in its exports, as its trading partner switch to relatively cheaper alternatives from other countries. High prices at home will most likely increase the demand for imports, as foreign goods are now relatively cheaper than domestic goods. Thus, a falling export revenue and rising import expenditure will cause the balance of trade to worsen. Ceteris paribus, the balance of payments will also deteriorate and the exchange rate may also weaken.

Severe inflation over a prolonged period of time may also cause businessmen and foreign investors to lose confidence in the local currency and lead to a capital flight if left unchecked. This will worsen the financial account, exacerbate balance of payments problems and hamper economic growth.

Redistribution of income

Inflation causes a redistribution of income, as certain groups of people benefit whilst others suffer from inflation. The “losers” and “winners” are grouped as follows:

Winner	Loser
Variables income earners, income varies in tandem with inflation, hence their real income does not fall.	People whose incomes are fixed in money terms. This group includes those whose incomes are derived from fixed interest-securities, controlled rents and private pension schemes. All recipients of fixed incomes will suffer a fall in their incomes if inflation is higher than the increase in nominal wages.
Debtors (borrowers) Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The real interest on a loan is the nominal rate minus the inflation rate.	Creditors (lenders)

Positive effects of low inflation

Contrary to popular belief, inflation isn't necessarily bad for the economy as a whole. Inflation can bring about further economic growth as well.

Promotes business investment, employment and economic growth

Low inflation or price stability provides certainty which makes it easy for investors to make projection on costs and returns of their investments. Higher investments mean a rise in aggregate demand causing the national income to increase by a multiplier effect, and reducing cyclical unemployment.

If inflation is a mild demand-pull, firms may experience higher profit margins amidst the rising prices since factors costs are unlikely to rise in the short-term due to contracts agreed upon earlier. Thus, this will encourage both investment and growth. In the long run, the productive capacity of the economy also increases.

Also, low inflation encourages savings which is needed to fund investments.

Modest increase in prices is also a sign that business in profitable. Demand is buoyant; sales healthy. In short, it is sign of vibrant economic activity and the economy is not in the doldrums.

Increase net export revenue

Low inflation helps to keep export competitive in the international market and hence helps a country to achieve favorable trade balance. When a country has a relatively low inflation rate compared to others, the price of export are relatively cheaper so export revenue will rise.

Also, there will be currency stability. There is no fear of devaluation and potential capital flight if a country is able to export and earn sufficient to pay for their imports and other international obligations.

Encourage consumer spending

Furthermore, in contrast to deflation, a process which discourages consumer spending and hence lower economic growth and possible leading to stagflation, it is better to have moderate amounts of inflation to encourage foreign investment as well as encourage people to spend. This is much more crucial for a country like Singapore, which is highly susceptible to the changes in the global economy. By spending more and obtaining more investment, there is more income flowing in the economy according to Keynes's theory of circular flow, creating a positive cycle where the more income flows into the economy, the more the economy grows and the more income increases.

As a whole, a moderate amount of inflation helps stimulate economic growth as it bolsters and boosts both consumers' and investors' confidence. People are often affected by their expectations in decision making. In anticipation of a future, possible recession, people may choose to save up money and reduce spending in order to be able to cope with the recession. Similarly, when a sustained economic growth is expected, people tend to spend more as a result, resulting in an increased rate of economic growth.

Causes of inflation

  

1) Demand-Pull Inflation

The output produced by the economy is insufficient to keep up with the pace of the current demand. Hence, there is a rise in the Aggregate Demand that is not matched with a similar increase in the productive capacity of the economy. This is known as the 'supply bottleneck'.

This can be attributed to the fact that there is simply too much money for too few goods. This could have happened because governments may have printed too much money to deal with a present crisis. According to the Fisher’s Quantity Theory of Money, if there is an increase in the velocity of circulation of money it also leads to inflation. Alternatively, there may be over-spending due to excessive optimism.

2)Cost-Push Inflation

This happens when the factors of production has increased resulting in a rise in the General Price Level even though the aggregate demand has remained constant. 

2a) Import-price Push Inflation

This type of inflation is caused when other countries face inflation. Hence, when purchasing their goods, the general prices seem to have risen. This will only affect the country severely if there are little to no substitutes of the goods available. However, if there are rampant alternatives, this would not affect the country purchasing the goods as much.

2b)Wage-Push Inflation

As costs of production have increased, importers will try to pass on some of the costs to domestic consumers. They do so by jacking up the prices of the goods they produce, resulting in a surge in the prices in local markets.

2c)Tax-Push Inflation

Inflation could have also been caused by the federal taxes put on consumer products. As the taxes rise, suppliers often pass on the burden to the consumer.

2d)Profit-Push Inflation

This occurs when certain suppliers monopolize the market. They are able to raise costs of their products without fearing a decrease in demand for their goods since they face few competitors. Consumers will still be forced to purchase the goods since they have no other choices to choose from. Hence, this is profit-driven and thus called profit-push.

2e)Negative Supply Shocks

These are caused by unexpected events that could drastically affect the supply of a particular good. Instances would include major earthquakes, tsunamis, or even oil spills.