Price increases rates in Sweden are calculated by variation of the consumer price index.Sweden’s inflation rates in the 1960-2009 periods were relatively high, as compared with prior periods. The country experienced some of the highest inflation rates in the 1970s, along with other countries. This was partially due to the global oil crisis in the same period which made the prices of commodities, and the costs of production high.
Inflation rates declined initially in the first five years of the 1980s, but skyrocketed again in the late 1980s. This is explained by expansive economic policy initiated by the Swedish government that was meant to make the country more competitive in the global economy. The expansionary policy was largely financed by currency devaluations and large budget deficit levels that heavily indebted the country. The country was also experiencing increases in wage levels and also increases in official welfare payments.
The increases in wage and social benefits led to increases in money supply in the economy, and combined with the country’s budgetary deficits, led to inflationary pressures. Lending in the economy had also increased in the same period, further creating inflationary pressures. As a result, inflation rates jumped to 10.5 per cent from 6.4 per cent in a period of one year, from 1989 to 1990. (World Bank)
At the beginning of the 1990s, inflation rates begun to decline whereby Inflation rates fell sharply from 9.3 per cent in 1991 to 2.3 per cent in the following year.
The country started to reel the effects of an economic crisis due to the to the huge budget deficits. Sweden slid into a recession in the early 1990s in what is often termed as the crisis of the 1990s, whereby the GDP declined by 5 per cent in the period between 1990 and 1993. Employment levels fell, and the real estate bubble created in the 1980s burst, causing the country’s assets to decline. The recession of the early 1990s was largely responsible for the drop in inflation rates.
At the time, Sweden was implementing a fixed exchange rate regime and the government had to switch to a floating exchange rate in order to help curb the economic crisis. The government also changed from its expansionary economic policy to a monitory policy that would focus more on stabilizing prices.
Sweden’s central bank was responsible for ensuring that inflation rates stabilized at around 1.99 per cent. As a result of all the policies, inflation rates remained generally low in the following years, reaching a high of 3.5% in 2008 as a result of the global economic recession. The country’s inflation rates have been lower than those of the Euro zone and the United States.
From the charts below, it can be observed that growth in Sweden’s money moved to reflect changes in the inflation rates, implying that changes in money supply are not the causes of the inflation levels in the country. Money and quasi money supply growth in the country remained between 6% and 20% before the 1990 recession.
The sharp drop in money and quasi money supply growth in 1989-1990 were as a consequence of the unexpected high inflation rates experienced in the same period, causing the Riksbank to react accordingly in order to contain the high inflation rates. In Sweden, the Riksbank is responsible for supplying money in the economy, implying that the bank has an important role in keeping inflation levels competitively low.
As per the theoretical model of money supply and inflation, increases in money supply will lead to inflationary pressures. Monetary policies are not always enough in the maintaining stable inflation levels because the inflation rates may also be influenced by changes to the global economy. Sweden was affected by the oil crisis in 1970 and the recent global financial crisis in 2008.
Works Cited
World Bank. “World data Bank.” World Bank. 2010. Web.
In the recent past, there has been an unprecedented easing of monetary and fiscal policies in many countries. This has raised widespread concerns that the policies may plunge the world economy into a period of hyperinflation. Already in Saudi Arabia, inflation has been rising. This has been attributed to the government’s recent expansion of fiscal lending, which makes a rise in inflation inevitable. The main factors that drive Saudi’s inflation include food prices, high inflation in trading partner’s economies, and a rise in domestic rent.
Methodology
In the eighties and nineties, inflation in Saudi Arabia was maintained at a low of 1%. However, since 2003, the inflation rate has risen rapidly and by 2008, it exceeded 11%: a phenomenon that has negatively affected the citizens (Mehran, 2009, p. 3). Although the World financial crisis resulted to a temporary decline in the inflation rate, it again started rising since 2010.
This paper, using the quarterly data from 1980 to 2010, examines the causes behind the inflation in Saudi, its effects, and the effectiveness of the counter-strategies and policies the Saudi government has put in place to curb the rising inflation. The paper will also investigate the solutions provided to the problem of runaway inflation and give recommendations on the same.
The paper utilizes a methodology that incorporates both foreign and domestic factors that affect the inflation rate in the Saudi context. It will examine the external factors as a source of inflation in Saudi, given the open trade nature of the Saudi economy characterized by oil exports and importation of consumer goods from overseas.
The rise in the prices globally will be examined alongside the Saudi domestic prices. Given Saudi’s dependence on exports, fluctuation in the value of the US dollar is a fundamental determinant of the rate of inflation in Saudi both in the short-term and long-term.
Additionally, the rise in the domestic demand fuelled by the sharp increase in oil prices has also accelerated the rate of inflation in Saudi Arabia. By focusing on each factor in turn, this paper aims to find the correlation between inflation in Saudi’s trading partners (OECD countries) and the domestic inflation rate. The paper will also undertake a food price outlook in the wake of rising inflation rate and its effects on Saudi staples such as rice and wheat.
What is Inflation?
Inflation is a common term in economic circles, but its meaning is often misconstrued. Inflation, in simple terms, refers to a continuous increase in prices of goods and services in an economy (Dhakal, & Kandil, 1993, p. 414). More specifically, inflation refers to the continuous increase in prices as measured by consumer indices like the Consumer Price Index (CPI) or a price deflator such as that used for the determination of Gross National Product (GNP) (Juselius, 1992, p. 401).
Inflation can also be described as the loose of the purchasing power of a country’s currency because of too much money in circulation, or rise in consumer demand. Under these circumstances, more cash is needed to purchase goods previously bought at a lower price.
Thus, in defining inflation, two terms must be clarified. First, is the general or aggregate; this implies that the inflation rate constitutes the rise in prices of the entire goods in an economy as opposed to focusing on an isolated increase in the price of a given commodity (Juselius, 1992, p. 402).
Here, the implication is that a rise in prices of a single commodity cannot serve as an indication of inflation in an economy. However, in some circumstances, a rise in the price of a single commodity can lead to a rise in the prices of other products. An example here is oil prices. Nevertheless, such an isolated rise in prices of a given commodity does not indicate inflation, unless the price induces the aggregate price level of an economy to rise.
Second, the increase in the aggregate price level must occur over a given period; that is, it must be sustained for inflation to occur. In other words, the aggregate price level must rise continuously over a given period or period intervals separated by one sharp increase in the price level.
Types of Inflation
The types of inflation are distinguishable based on the magnitude of the rise in annual prices and the period over which it continues to rise. As such, inflation conventionally ranges from mild inflation to severe inflation.
An annual price rise of 1% for several years amounts to mild inflation, which does not warrant much attention given that the price index figures may not be remarkably accurate. For instance, in times of war, quality or quantity of goods may deteriorate resulting to a rise in the real price level, which the price index may not capture.
On the other hand, an aggregate price level that rises at an average of 2 or 3 percent annually cannot be ignored especially if it continues over a prolonged period (Juselius, 1992, p. 404). It may not be serious if it continues for a few years after which the prices decline or stabilize at a lower level. However, if the annual price rise is continuous with no spans of lower prices, then it presents a serious problem even at 2 or 3%.
Inflation can be grouped into four broad categories based on its magnitude; creeping inflation, walking inflation, running inflation and hyperinflation (Juselius, 1992, p. 407).
Creeping inflation-is the inflation that occurs when the annual price rise is low. A continuous annual price rise of not more than 3 % per annum is a creeping inflation. It is considered ineffectual and necessary for economic growth. If this inflation continues for a prolonged period, it is referred to as chronic creeping inflation, which can be intermittent or continuous.
Walking Inflation- is the inflation that occurs when the annual price rise is moderate. The inflation rate in this case is a single digit usually above 3% but less than 10% per annum. Walking inflation indicates that the government must implement policies to control it before it becomes a galloping or trotting inflation.
Running Inflation- is the inflation that occurs when the price rise is rapid and accelerated at a rate of 10 to 20% annually. It is also known as galloping or trotting inflation. Running inflation has profound adverse effects on the middle class and the poor citizenry of a country. It calls for strong fiscal and monetary policies to control it. When it happens, creditors demand protection from anticipated lose of the currency’s purchasing power while debtors get the impression that they will reap from the higher rates.
Hyperinflation- is the inflation that occurs when the annual price rise is unusually high with double or triple digit inflation rates. At hyperinflation stage, the inflation rate is immeasurable and uncontrollable. As such, the prices of commodities can rise continuously in a short time resulting to a continuous decline in the currency’s purchasing power.
Causes of Inflation in Saudi Arabia
Previous studies on the reasons behind inflation in most countries identify some domestic and external factors as the causes of inflation. These factors include demand, monetary factors, cost-push, and foreign inflationary trends. Hasan and Alogeel (2008, p. 45), while focusing on Saudi Arabia and Kuwait, established that currency supply and demand affect the inflation rate in the short run while inflation in foreign trade partners influences inflation in the two countries in the long run.
In contrast, Darrat (1985, p. 211) established that inflation in Libya, Saudi Arabia and Nigeria is affected by minimal growth in real income and higher currency supply. He also established that Saudi’s inflationary rate is more affected by prices in international markets than by fiscal or monetary policies.
Another study by Alshathree (2003, p. 12), examined the causes of inflation in the countries that make up the Gulf Cooperation Council (GCC) of which Saudi is a member. He found that internal factors such as GDP growth and currency supply and external factors such as high world prices, import prices and interest rates globally influenced inflation in these countries.
Additionally, Alshathree (2003, p. 17) established that inflation is not a serious threat to Gulf countries at least I the short run. However, it has the potential of causing harm to the economies of these countries in the end. Thus, the world prices and interest rates is a leading cause of inflation in the GCC economies because of their reliance on imports.
However, Kandil and Hanan (2009, p. 4) believe the contrary; that world prices are not the main cause of inflation in GCC economies, rather oil prices are. They contend that oil prices influence the world prices leading to a sharp rise in the prices of imports. Additionally, the increase in oil prices results to increased government spending due to a rise in oil revenues, in these countries. This in turn results to a rise in domestic demand pushing up inflation.
By using a methodology that includes both internal and external factors, this paper will investigate inflation in a Saudi context. The economy of Saudi Arabia is an open trade economy given that the country is a significant exporter of oil products and a net importer of a variety of products.
This means that Saudi is prone to inflation resulting from a rise in the price imports from inflation-affected countries. At the same time, Saudi can transfer inflation to its trading partners via oil exports. Additionally, the domestic price is largely influenced by the cost of non-tradable items that rely on a number of monetary factors.
Normally, the price level, an indicator of inflation, is determined as a weighted mean of the cost of both the tradable and non-tradable goods (Engle, & Granger, 1987, p. 252). Tradable goods rely on external factors such as exchange rates and world prices. The prices of non-tradable goods, on the other hand, depend on the domestic demand, which is a product of the domestic money market conditions.
Thus, in a Saudi context, the external factors are the principal causes of inflation, which arises from the fact that the Saudi economy is an open economy with high import volumes from oversea markets. As a result, a rise in world prices and the fluctuation in exchange rates i.e. the Riyal against the Dollar stimulate inflation in both the short run and long run. Additionally, a rise in domestic demand in Saudi resulting from a sharp rise in oil prices, has also led to a rise of the inflation rate.
Effects of Inflation in Saudi Arabia
A small inflation rate or creeping inflation is a praiseworthy thing in any economy. In contrast, deflation tends to reduce domestic consumption as it makes households postpone expenditure by expecting a further drop in prices.
This, in turn, influences firms to reduce their investment as the consumption rate declines. Subsequently, the national output begins to shrink resulting to unemployment and slow economic growth. Additionally, the real interest rates increase resulting to a credit crunch and massive defaults. Nevertheless, high inflation is problematic.
It distorts prices of commodities adversely affecting savings and the value of earnings, which discourages investment. It also stimulates capital flow into foreign assets and unprofitable real estate thereby affecting economic planning. Hyperinflation can trigger political and social unrest. Thus, an average, predictable and sustainable inflation rate is the ultimate goal of any monetary policy as it protects producers and consumers and encourages saving.
Saudi’s experience with rising inflation has had profound effects on its economy
Given the rise in inflation, the cost of living index (CLI) Saudi rose by an average of 9.9 % in 2008 indicating a rise in prices of consumer goods (Hasan, & Alogeel, 2008, p. 34). The wholesale price index also increased by 9% over the same period, which indicates a further pressure on consumers. In particular, the inflationary pressures were felt in the food and beverage index that rose by an average of 14% in 2008.
Large increase were evident in the cereal sector with rice, a key staple food for Saudi citizens, cooking oil and dairy products; all of which are imported from other countries. The trend reflected the global oil prices, which rose by an average of 38% during in 2007/2008 period, consequently raising transportation costs for food products.
Furthermore, there has been a general rise in consumer inflation in Saudi’s main trading partners in 2008 occasioned by the global financial crisis.
Indeed, the majority of Saudi’s main import markets have experienced a rise in the inflation rate with the inflation rate in the US (the utmost import market of Saudi Arabia Kingdom) rising from 2.9% in 2007 to 3.8% in 2008. The inflation rate also rose in other import markets including Germany (from 2.3% to 2.8% in 2008), India (6.4% to 8.3%), Korea (2.5% to 4.7%), and China from 4.8% to 5.9% (Dhakal, & Kandil, 1993, p. 419).
This general rise in the inflation rate in Saudi’s leading import markets triggered a price increase involving a broad range of imports including chemicals (rose by 14% in 2008), manufactured products (increased by 14%) and machinery and other equipment (rose by 6.2%). The Saudi inflation resulted to weakening of the exchange rates with leading currencies including the US Dollar against the Saudi’s Riyal.
The current economic growth in Saudi began in 2003, but this did not translate to higher rents as much of the labor comprised of expatriates. However, in 2008, the rents began to rise because of the higher inflation rate. In particular, real estate and commercial establishments, which are in high demand, have registered increased rents occasioned by inflation.
Inflation in Saudi Arabia from 1980 to 2010
The inflation rate in the Saudi economy has been low for the period 1980 to 2003 largely because of the oil boom experienced in the seventies. During this duration, the Saudi’s inflation rate fluctuated between a deflation and a small inflation with the average rate being less than 1% (Dhakal, & Kandil, 1993, p. 421).
However, since 2003, the rate of inflation has increased rapidly reaching a maximum of 11% in 2008. Then, between the last quarter of 2008 and the year 2009, it slowed down to an average of 4% in the aftermath of the global financial crisis. Nevertheless, the inflation rate began rising beginning in 2010 to about 6% currently. Thus, Saudi Arabia has a history of fluctuating inflation.
In particular, the consumer price index in most of Saudi’s history has been low. In the period between 1990 and 1999, the consumer price index rose by an average of only 1.3% while from 2000 to 2006, it increased by just 0.1%.
The slow inflation rate indicated several factors including the availability of low-cost imports, average economic growth, capital mobility and high flexibility of the labor market. Additionally, the fixed exchange contributed significantly to a lower inflationary rate.
Serious inflation only started in the year 2007. In this year, the average consumer-price inflation rose to an average of 4% annually in the first quarter (from 2.4% reported in 2006) to a high of 6.5% in the last quarter of 2008. The consumer prices gathered pace in this year, resulting to an inflation peak of 11.1%. This weakened the exchange rates. Nevertheless, lending by commercial banks was expanding, and by the second quarter of 2008, it stood at 35% just like in all other GCC countries.
Global Financial Crisis and the Saudi Inflation
The global financial crisis in 2007/2008 resulted to a decline in the inflation rate in most economies including Saudi Arabia because it resulted to a decline in liquidity and demand. However, there are indications that the inflation rate will not return to a low of 1% as experienced in the 1980s. Already, the inflation rate started rising in 2010 despite government intervention policies eliminating any hopes that it will come down further.
The Inflationary Spike in the 2007/2008 period (Government expenditure 2004-2009 as a percentage of GDP
As shown in the graph, in the 2007/2008 period, Saudi experienced the highest inflation in the country’s history. The IMF identified various factors as responsible for this unprecedented inflationary spike. The rise in food prices by an average of 7% during this period resulted to a pronounced Cost of Living Index of 4%. The food products that experienced sharp rises in prices included; vegetable (rose by 12%), cereals (by 7%), fish (by 12%), legumes (by 30%) and meat products, which rose by 6% (Hasan, & Alogeel, 2008, p. 38).
The inflation in other countries (trading partners) is also considered responsible for this inflationary spike. Since it is not easy to disentangle the inflation involving the global food prices, it is a leading cause of inflation in Saudi Arabia. In 2007/2008, inflation was also felt in many countries including Germany, China, the US, which form the principal import markets of Saudi Arabia. The trends increased in the 2007/2008 period with the CLI standing at 9.9%.
The Computation of Inflation in Saudi Arabia
In Saudi Arabia, inflation is computed by the Central Department of Statistics and Information, a government department that operates independent of the Saudis central bank, the Saudi Arabia Monetary Agency (SAMA).
This department uses two different indices in computing inflation: the Whole Sale Price Index and the Cost of Living Index (CLI), both of which are surveyed regularly by this department. However, the inflationary trends and the labor productivity are not regularly surveyed (Mehran, 2009, p. 3). Historically, Saudi has had a low and stable inflation.
The CLI, in the context of Saudi, incorporates the prices of a broad range of products. The CLI relies on a 1999 index (Hasan, & Alogeel, 2008, p. 41) whereby approximately 44% of the CLI comprises of rental and food costs. About 10% of the goods or services included in the CLI are the goods subsidized by the government such as electricity and petroleum products. In Saudi, the prices of these subsidized goods are set, and as a result, they have no impact on the CLI.
In Saudi Arabia, the central bank, SAMA, is responsible for stabilizing the prices and the exchange rates. In theory, the maintenance of exchange rates is given a priority by SAMA to price stability. For a long period, this has been the case in Saudi’s economy. The consumer prices only rose by an average of 1.3% in the 1990-1999 periods and only 0.1% during the 2000-2007 periods (Wang, & Wen, 2007, p. 204).
During these periods, the exchange rate remained relatively stable. The inflation rate during these periods was low attributable to cheap imports from import markets, flexibility in capital and labor markets and a moderate economic growth. Evidently, the fixed exchange rate lowered the inflationary rate.
How Does Inflation Affect the Society, Firms and the Government?
The effects of inflation in an economy are everywhere. It affects people, various firms or government economic agents in different ways. In any society, there are two broad economic groups: the flexible income group and the fixed income group (Keran, & Al Malik, 1979, p. 11). During periods of inflation, individuals in the flexible income group gain while those belonging to the fixed income group lose.
This arises because the price or cost of various goods and services is not uniform. Usually, during inflation, although the aggregate price level rises, the rate at which the cost of individual goods increase differs. In other words, the prices of some goods or services may rise while that of other goods remains relatively unchanged.
The middle class and the poor, whose salaries are largely fixed even as the prices of consumer goods continue to increase. By contrast, people in the flexible income group including the industrialists, traders, speculators, businesspersons, and real estate developers, gain from the rise in prices of goods. Thus, the second category becomes rich at the expense of the first group.
This means there is a net movement of wealth and income from the poor in the society to the wealthy individuals. In general, the income group in the society that loses or reaps from high inflation is largely dependent on anticipatory practice of individuals. The individuals who anticipate inflation accurately, can change their buying, lending or borrowing practices to avoid either lose of income or gain wealth from inflation (Engle, & Granger, 1987, p. 253).
The effect of inflation on individuals is different, and as such, it is vital to discuss the effect on various groups separately
Debtors and Creditors- In times of inflation, the creditors, in general, are adversely affected. The real value that they can get from money lent out is pegged on the inflation rate. On the other hand, the debtors benefit during periods of inflation as they pay significantly less than the amount they had borrowed in real value (Engle, & Granger, 1987, p. 253). As such, inflation affects the creditors while favoring the debtors.
Wage Earners – This group may lose or gain during inflation based on how their wages respond to increases in prices. If the wages appropriately respond to the rising prices of goods, then their wages may be pegged on the Cost of Living Index. If this happens, then the wage earners get protection from the adverse effects of inflation. However, more often, there is a delay between the rise in prices and the increase in the employee’s wages by employers, which exposes the wage earners to the negative effects of inflation.
The Salaried individuals- Normally, white-collar jobs adjust to inflation slowly than other jobs, as they are performance-based and contractual. Thus, during inflation, individuals with white-collar jobs lose as their salaries are fixed.
Fixed Income group of individuals- This group comprises of pensioners, persons under social security, and unemployment benefits among others. Additionally, the recipients of rent also fall under this category. They lose because the payment they receive is fixed, while the prices of goods continue to rise and the value of money deteriorates.
The Investors- The investors fall under the flexible income category; they gain from increased demand. During inflation, the rising prices mean that the company reaps more and more profits. Consequently, the value of the shares or equities held continues to increase as does the dividends. However, investors in bonds and debentures, which have a fixed interest rate, do not gain during inflation as they receive a fixed income even as the value of money declines.
Businessmen and other Traders- This group comprises of real estate developers, producers and businesspersons. They gain during inflation as the prices of the goods or property they are trading in rises. At the same time, the cost of production does not increase in line with the prices. Thus, when the price of the trader’s products rises, the income also rises by the same proportion especially in the short run. For real estate developers, the prices of land and property rise at a faster rate during inflation and hence they make a profit. However, prolonged instability in prices hampers accurate business decision-making. Thus, in the end, wages may rise and subsequently reduce the profits, which in turn would affect future investments.
Agriculturalists and Peasant Farmers- This group include peasant farmers, property owners and agriculturalists with no land ownership. The property owners receive fixed rents despite the increase in prices; thus, they loose. In contrast, the peasant farmers gain, as they own land and cultivate goods whose prices keep on rising during inflation. In times of inflation, though the cost of production increases, the prices of agricultural products increase at a much faster rate (Nelson, & Plosser, 1982, p. 141). In other words, the cost of farm inputs and land rates do not increase at the same rate as the increase in the prices of agricultural products. Thus, peasant farmers who own and cultivate crops gain during inflation as the general prices of food crops rise. On the other hand, agricultural workers who are landless and rely on wages paid by the owners of farms lose during inflation, as their wages remain the same even as the prices of consumer goods increase. Additionally, since they often lack trade unions to lobby for wage increment, they are losers during inflation.
The Government- The government loses and gains during inflation as inflation affects the government both positively and negatively. As a debtor, the government gains from inflation through high interest paid by creditors, usually households. This arises from the fact that, “during inflation, the interest rates on debentures and government bonds remain fixed” (Engle, & Granger, 1987, p. 254); they are not raised to offset the corresponding increase in prices. Additionally, the government through the tax levied can pay off its domestic debt. Inflationary finance obtained from the tax can help the government to fund its activities. As the level of income of employees in response to inflation increase, the government gains through taxation and levies on the incomes and goods. As a result, the government revenue increases as prices rise during inflation. However, the government can also lose through the rise in the salaries of public servants and the rise in the cost of financing public projects including infrastructure, healthcare and schools or educational facilities.
Policies taken by the Saudi Government to Curb Inflation
The decline in Saudi’s inflation during the 2007 world financial crisis was attributed to several reasons. Among them is the fall in prices of commodities in Saudi’s import markets, a reduction of oil prices, a reduction in domestic demand, and the rise in the Dollar value against leading currencies globally.
However, the outlook of Saudi’s inflation indicates that inflation is likely to increase again despite the government policies to curb it. The expected rise in oil prices, which will result to increased public spending, prolonged dollar weakness, expected increases in world prices of agricultural products and the rise in public expenditure are among the factors that would lead to the rise in inflation again.
The government policies in response to inflation have not been effective as indicated by the rise of the inflation rate since 2010. The SAMA tightened the monetary and fiscal policies during the inflationary spike. These included an increase in the value of reserve requirements for commercial banks and tightening of the treasury bills issues.
However, the ineffectiveness of these measures prompted SAMA to change focus to exchange rate control especially the pegging of the Saudi riyal to the US dollar. Commentators made two observations; first, the pegging of the riyal on the dollar created imported inflation as indicated by the sharp rise in inflation during the weakening of the US dollar relative to leading world currencies (Kandil, & Hanan, 2009, p. 7).
In 2007, the US dollar’s Nominal Effective Exchange Rate i.e. its value against weighted value of principal currencies depreciated by 4.3% in 2007 compared to only 1.5% the previous year. This resulted to increase in import prices and subsequently on Saudi’s retail prices.
The second observation regarded the monetary policy. The pegging of the riyal on the dollar limited SAMA’s policy options especially with regard to reducing credit and interest rates. If SAMA increased or lowered the interest rates without consideration of the US rates, then this will attract capital inflows, which in turn would result to a rise in the exchange rate.
The 2007 financial crisis did little to dampen lending by commercial banks, which stood at 35%: an indicator that, Saudi’s economy was growing remarkably fast (Kandil, & Hanan, 2009, p. 9). However, the rate cutting by the US during the same period meant that SAMA had limited options of redeeming liquidity growth to curb inflation.
In particular, many policy options are available to the Saudi government to curb inflation. The first policy option involved government’s intervention in the determination of the prices of essential goods. The mechanism here involved price control of commodities especially food products.
However, this presented a problem; it affected investment and affected the privatization program in a market economy. The second policy involved government intervention to prevent the rise of rents and real estate rates through the determination of the annual rent increases.
However, this had the potential of affecting the real estate sector, reducing investments into the sector and encouraging capital outflow into other investment destinations abroad. Ultimately, this would create a shortage of real estate in the country. A third policy option involves delinking the evaluation of the riyal on the US dollar or raising its value to a higher level. However, this would enhance speculation on the riyal, which would hamper investment and the riyal’s stability.
Other policies available include reducing the export of agricultural goods whose prices are high especially agricultural products. The mechanism here involves taxation to reduce the export volumes.
However, this affects investments in production and agricultural sectors. Another policy option involves increasing the interest rates to discourage borrowing and encourage saving and reduce liquidity. However, this again affects investment as the cost of borrowing increases. The other policy option involves the reduction of the government expenditure especially in public projects. However, this hampers economic growth rate and recovery as distinguished projects are delayed.
The Solution Provided for these Problems
The policies implemented by the Saudi government were largely ineffective as the inflation rate, which declined to 4% in 2009 rose to 5% in 2010 (Kandil, & Hanan, 2009, p. 4) The solution provided here is to implement policies that curb inflation but do not affect the national economy or conflict with market mechanisms.
The policies need to be comprehensive with fewer impacts on the market economy. In particular, maintaining the stability of the Saudi currency is paramount in curbing inflation. However, this does not mean fixing its value at a higher rate relative to other currencies. Instead, it implies not pegging the Saudi Riyal entirely on the US dollar as this affects the monetary policy especially when the value of the dollar, relative to capital currencies, declines.
By not pegging the riyal on US dollar, agricultural goods will attract other investors dealing in other leading currencies, which would raise the world food prices. Additionally, this would result to increased domestic investment especially in the housing sector and ultimately raise the rent rates.
However, the mortgage law, which has been proposed, could serve to alleviate the rental pressures by discouraging investments in real estate and commercial buildings by encouraging investments in middle-level residential housing. Thus, the solution is two pronged: not pegging the riyal on the US dollar alone and the proposed mortgage law.
Conclusion
This paper involved a study of the causes and effects of inflation in Saudi Arabia between 1980 and 2010. This period showed a significant fluctuation of inflation due to both external and domestic factors. Evidence from the 2008 inflationary spike indicates that, external factors are the prime determinants of Saudi’s inflation; a finding that agrees with the fact that Saudi’s economy is an open trade economy with oil exports and import of many commodities from abroad.
The rise in world prices, accompanied by the decline in the value of the US dollar relative to the world main currencies, helped trigger inflation in Saudi during the 2000-2006 period. Additionally, domestic factors such as the rise in demand occasioned by a rapid rise in oil prices also contributed to the high inflation in Saudi. Nevertheless, the high inflation appears unrelated to money supply in Saudi’s economy.
This could be explained by the observation that the riyal is pegged on the US dollar and, therefore, Saudi interest rate is consistent with the fed interest rates. As a result, the low interest rate involving the US dollar has led to low interest-rate effect on Saudi inflation. On the other hand, the low interest rate has presented challenges to Saudi’s monetary policy.
Thus, in order to curb inflation in Saudi, monetary policies have to be formulated in a way that diversify the Saudi economy and encourage local output to cut down on imports. Also, reviewing the exchange rate policy by avoiding the pegging of the Riyal on the US dollar can be helpful in combating the high rate of inflation in Saudi.
Recommendations
To control inflation rate in Saudi in light of external factors, this paper proposes the following recommendations:
The adoption of a monetary policy that targets the inflation rate. The fiscal and monetary policies should be based on the inflation rate framework so that the exchange rates and wages are adjusted in line with the prices.
For this monetary policy to become successful, the government must reveal the inflation target to all citizens, investors and business community when presenting the national budget so that the interest rate of their savings is adjusted in this regard. Additionally, the Saudi Arabian Monetary Agency (SAMA) should show commitment in achieving target inflation rate by enhancing transparency in the computation of inflation. Period publications, which show the inflation rates and the deviation from the target inflation rates, can also be useful.
The government must also illustrate the approaches of dealing with inflation and strategies of mitigating the effects of inflation, in order to cushion investors and savers from unpredictable interest rates and prices.
In controlling inflation or its effects, the government must not rely on policies that in any way affect the market mechanisms and force as this will affect liquidity.
The government must undertake to increase the national output, especially of agricultural and food products to cut down on imports. The findings in this paper indicate that import inflation is largely responsible for the current high inflation in Saudi. Thus, by reducing increasing production, imports from inflation-prone economies will be reduced.
Lastly, the Saudi government must seek a solution for the high rents for real estate and housing sector through the mortgage law. Otherwise, inflation and its effects will continue to affect the national economy.
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Inflation is a condition of persistent increase in prices of products, especially the consumer products in an economy. It is measured by Consumer Price Index (CPI) and the GDP deflator. China has been experiencing inflations for several years. The country experienced the highest inflation rate in 1994.
During this period, the inflation rate was at 27.70%. The lowest inflation rate experienced in the country was -2.20% in 1999. It was reported that the country had an inflation rate of 5.5% in October 2011. Consumer prices increased by 5.5 percent in 2011 because there were few supplies compared to the high demand (Back, p. 1). The global economic crisis that was experienced in 2008 had a great impact on the economy of China.
During this period, China had a high inflation rate in 2008 but this started to decline as time progressed to 2009. By July 2009, the country had the lowest inflation rates, but the rates started to increase rapidly in 2010. In the year 2011 the country had experienced inflation rates ranging to 7 percent. During the first quarter of the fiscal year 2011 the country experienced an increasing inflation rates. However, towards the last quarter of 2011 the inflation rates started to drop (Song and Golley, p. 157).
Description of the Chinese inflation
The escalating oil prices have been blamed for the inflation in China. Economists provide that global oil prices have been increasing uncontrollably, and this has affected the productivity of the Chinese economy. With the increase in oil prices, energy costs have increased, and this has resulted into an increase in the prices of products manufactured in the industries. Cost of production has increased, and most manufacturers find it impossible to manufacture some products.
In some cases, manufacturers have been forced to provide goods and services at high prices to cater for the production costs. This has caused reduction in the output from most industries. In addition, this has resulted into uncontrolled price increases because the output has not been commensurate to the demand for such products. The supply-demand gap has resulted into price inflation on most consumer goods (Song and Golley, p. 157).
In 2009 the government made a policy to increase the liquidity of the economy. This policy has worsened the inflation in the country. The People’s Bank of China issued excess currency to the economy and this affected most of industries in the economy. This policy was followed by an increase in the money supply in the economy.
The economy is suffering from the side effects of the policy. Control measures to reduce money supply in the country have been put by creating monetary policies. These policies have focused on improving the economy of most industries in the country. Interest rates have been increased to reduce the lending rates, and to obtain the excess money in circulation. The excess liquidity has affected other sectors of the economy such as stock market, housing industry and others (Shaw and Liu, p. 160).
Output gap has also caused the inflation. The high demand of consumer goods has increased inflation because there is a large difference between output and consumption demand. The reduction in outputs has been caused by the increasing cost of production. Most manufacturers find it costly to produce goods and services.
This has resulted into the prices of products increasing at a high rate. The decline in output has forced the country to depend on imports. Depending on imports has caused the economy to experience increase in foreign debts. For example, farmers in the country incur a lot of costs to produce farm products. This has caused food prices to escalate. In addition energy prices have increased rapidly. It is estimated that the prices of food and energy products have increased by 24% and 32% respectively in 2011 (IMF, p. 57).
In China the housing prices dropped by 25 percent in 2011. Housing industry has been affected by the inflation. In fact, the housing boom was reported to be the major cause of the inflation in 2008. The banking industry had issued subprime debts, and this caused a high crisis when the lenders were unable to repay the debts.
The banking sector made a lot of losses and this lead to spillover effects to other industries in the economy. The housing industry has not yet recovered from the shock, and it is expected that a decline in the industry will continue. Most investors have lost confidence in the housing industry, and this has caused a lot of losses to be made in the industry (Shaw and Liu, p. 161).
The capital market has been by the inflation because most of the stock prices have reduced tremendously. The capital market has been providing the country with a lot of foreign exchange, but with the inflation most investors fear Chinese stocks. This has affected the stock prices such that most companies are finding it hard to raise capital from the market. This has affected the productivity of most industries (Shaw and Liu, p. 162).
Unemployment in china increased during the inflation because most industries were unable to accommodate the high labor force in the country. Most industries had to cut down the labor force because the productivity had reduced.
Retrenchment strategy was adopted by industries to reduce the costs of production. The high rates of unemployment have affected the stability of the economy and the government is worried about the progress of its labor market. The government has imposed strict measures to increase employment opportunities (Shaw and Liu, p. 165).
In October 2011 the country started to experience decline in inflation rates. According to Black (2011) “China’s inflation slowed significantly in October, potentially opening the door for policy makers to begin to loosen the reins on the nation’s economy, as worries over a global slowdown supplant fears of inflation as their main concern,” (p.1).
Tourism industry has reflected some improvement after the country started to recover from the inflation. The country has started to gather investor confidence and it is predicted that the economy will regain its performance in the near future. Food prices have started to decline, and it is expected that the government will be able to improve the living standards of its people (Zhang, Song and Liu, P. 114).
Solutions to the problem
Both monetary and fiscal measures have been enacted to improve the inflation rates in the Chinese economy. The monetary policies have focused on regulating money supply in the economy. Fiscal policies have focused on increasing the rate of employment, government expenditure, taxes and other fiscal tools.
The government has adopted selective easing to some industries as a control strategy to maintain the inflation rate. Small businesses have been supported to improve the income and living standards of small income groups in the economy. Projects have been established to provide low cost housing to the citizens affected by the housing boom. The government has established strategies to construct public housing.
This strategy is aimed at improving the living standards of the affected families. The government aims at supporting the investors who lost their capital during the housing boom. Improving investor confidence in the housing industry has been a major project by the government. This strategy has been focused to maintain the housing industry, and to increase global investor confidence (Lin, p. 228).
The government has published a plan that will run for twelve years, and it is aimed at increasing the economic growth by at least 7 percent. Development objectives by the government were provided in the strategic plan. Environmental plans have also been included in the strategic plan to ensure that the country’s economy develops while maintaining the environmental safety standards.
Income distribution has been placed as a major aspect to be achieved in the strategic plan. It was observed that the inflation in China resulted to income differences such that the poor have become poorer while the rich have become richer. To create economic balance, the government has put a requirement that the strategic plan will focus on creating income equality (Organization for Economic Co-operation, p.26).
The government has put strategies to improve the quality and quantity of exports as one of the measures to reduce inflation. The 12 year strategic plan aims at increasing the GDP of the country by encouraging all the economic sectors to increase efficiency and effectiveness of their production.
The government has encouraged investment growth by encouraging private consumption. This plan will help reduce government expenditure, and this will maintain low public expenditure. The government has also encouraged the growth in the service sector, as one of the strategic plan to alleviate the inflation rates (Organization for Economic Co-operation, p.26).
Increasing subsidies to farmers has been another strategy used by the government to maintain low inflation rates. This policy has been introduced to increase food supply in the country. Transport charges have been reduced to enable farmers produce food products at low costs. Some companies offering farming inputs have been refrained from increasing prices, so that farmers can easily access inputs at reduced prices (Lin, p. 229).
The interest rates have been increased to as high as 21.5 percent to reduce the money supply in the country. The People’s bank of China aims at reducing the borrowing power of people in the country. The bank increased interest rates by about five times since October 2010.
This has boosted the reserve requirements of the bank nine times. This strategy has caused a lot of complaints from small businesses because they cannot access credit. The government has resolved to cut down the taxes to companies, to enhance high production in the economy (Lin, p. 230).
Intervening in the problems facing the housing industry has been controversial because the government is not ready to waver in the real estate industry. Economists propose that the government need to reduce the housing prices to reasonable levels. The housing industry has affected the economy and the government fears cases of future crisis in the industry.
The government cannot deregulate the housing industry because this may affect other industries in the economy. Previously, the housing boom had been caused by regulation policies created by the government. However, after experiencing crisis from the industry, the government has reinstated the regulations in the industry to contain the situation (Bardhan, Edelstein, and Kroll, p.276).
Proposed solutions
The government ought to regulate the housing industry. This sector was one of the major causes of the inflation in the country. This should be enacted by putting in place strict laws to regulate the industry. The government should have a commission to oversee the prices and activities of the industry.
This will help reduce adverse effects of unregulated industry performance. This strategy is cost effective because the commissioners will be sourced from public service. Controlling the housing industry is practical because the government can put sanctions or policies to reduce the influence of the private sector in the industry.
Establishing laws to reduce activities in the industry is feasible because law makers need to amend the constitution of the country to fit the prevailing conditions. The short term impact of the strategy will be that government will be put at task to establish a workable commission. The long-term effects are that the housing industry will be properly regulated and investors will have better returns and fewer risks.
The government should reduce taxes on farm inputs. This will help farmers produce at reduced costs, and food prices will be reduced. The high food prices experienced in the country have resulted from the high farming costs. The strategy of reducing taxes on farm inputs is feasible because it will provide the government with proper mechanisms of improving food supply.
Food exports will also increase, and the government will collect more income from exports. However, reducing taxes on farm inputs will affect the revenues collected by government from the inputs. This will have the government budget in the short term. In the long term, the economy will achieve more gains because food production will increase and exports will be improved. As such, the output gap will be reduced, and the economy will experience low foreign debts.
Conclusion
China has experienced inflation which has affected the economy. The inflation started in 2008 and has been spreading over the years up too date. It has been explained that the inflation has been caused by collapse in housing sector, poor government policies and inflation from other countries.
The inflation was worsened by the policies government made in 2009 to increase liquidity in the economy. This increased the supply of currency in the economy. Food prices escalated and most industries started to drop in production. The inflation has resulted into drop in the export of the country, and decline in the performance of most industries. The rate of unemployment has also increased due to reduced economic performance.
The government has put fiscal and monetary measures to control the inflation. This has achieved some positive results because the inflation was reported to decline in October 2011. The government ought to reduce the taxes on farm inputs as a strategy to reduce the costs incurred by farmers. In addition, the housing industry should be regulated to minimize the negative impacts of the industry on the economy of the country.
Works Cited
Back, Aaron. China’s inflation slows. The Wall Street Journal, November 2011.
Bardhan, Ashok D, Robert H. Edelstein, and Cynthia A. Kroll. Global housing markets: crises, policies, and institutions. Hoboken, NJ: Wiley, 2011.
Edwards, Nick and Langi, Chiang. Chinese industrial output grew at its weakest annual pace in a year in October and inflation fell sharply, raising expectations Beijing will do more to support economic growth by “fine tuning” policy. Reuters, November 2011.
IMF, Regional economic outlook, Asia and pacific, April 2011. International Monetary Fund, 2010.
Lin, Justin Y. Demystifying the Chinese economy. Cambridge: Cambridge University Press, 2011.
Organization for Economic Co-operation. African economic outlook: 2011. Organization for Economic, 2011.
Panckhurst, Paul. China’s case for stimulus mounts as inflation slows with property cooling. Blomberg, 2011.
Shaw, Daigee and Bih J. Liu. The Impact of the Economic Crisis on East Asia: Policy Responses from Four Economies. Cheltenham, U.K: Edward Elgar Pub, 2011.
Song, Ligang, and Jane Golley. Rising China: global challenges and opportunities. acton, A.C.T: ANU E Press, 2011.
Zhang, Guangrui, Rui Song, and Deqing Liu. Green Book of China’s Tourism 2011: China Tourism Development Analysis and Forecast. Heide: COTRI, 2011.
In May 2011, China’s inflation reached 5.5% mark; this is despite all the interventions and efforts by the government to control the rise in price of commodities. China’s National Bureau of statistics realized that the inflation was more than 5.3% in April, and this led to the announcement to increase the reserve requirement ratio by China’s Central Bank (Fewsmith 48).
The increase was effected from June 2011, with a deposit of 0.5% for all financial institutions. The inflation has had impacts on the economy of China thus affecting the lives of the Chinese people. This paper will discuss the effects and causes of inflation in China.
Effects of inflation in China
The effect of inflation is felt in various ways by the economy; first, the supply of fruits and food reduced. The supply is affected by the increase of prices of food in the global market, whereby, the Chinese government finds it difficult to satisfy the food demand of the increasing population of the Chinese population.
The increase in prices of food has caused a reduction in purchasing power of Chinese people, with this; life has become more difficult for Chinese people because they cannot do without the items (Klein and Shabbir, 102). The Chinese people are now struggling to live because the money they earn is no longer enough to satisfy their needs.
The prices of other products have also increased; therefore, the cheap products produced by the Chinese people to the world markets are no longer cheap because of the inflation. The costs of raw materials together with labor wage increases has led to an increase in the costs of production; it is because of the high cost of production that the price of finished goods have increased leading to a reduction in demand of goods from China. The sector that is most affected is that producing apparel, toys and furniture.
Causes of inflation in China
The inflation is caused by few key factors, and one of them is the strict control of currency by the Chinese government. The Chinese government argues that the strict control of currency will ensure that the country always has enough funds to pay for clearing its debts; however, this control has an indirect effect on the country’s economy.
The strict control makes the importation of food as well as energy resources to be more expensive (Fewsmith 63). When the energy resources are expensive they increase the cost of production because it is one of the factors of production; this, in turn, increases the price of finished products.
The increase in price of Chinese goods in the international market has reduced the demand for the goods, which leads to a reduction in the exports.
The reduction in exports coupled with the Chinese growing population then continues to increase for consumer goods in China and because the goods made locally are expensive for the Chinese population to afford the imports becomes more (Klein and Shabbir, 99). The country contributes to increased inflation by consuming more imports than before thus increasing need to use more of its foreign exchange reserves.
The Chinese growth in population has suffered a lot because of the increase in food prices in the world market; the increase has caused an increase in food price in China as well, with the increase going as far as 50%.
This means that the little money earned by the Chinese citizen, most of it is spent on food and other products and services whose prices has increased, and as a result, the minimum wages have increased. The increased level of spending on food and other expensive products leave citizens with any fund to save or invest; also, they fear spending all of what they have for fear of the future.
The global market has also increased prices for raw materials, which take the biggest portion of cost of production; this has led to the increase of price of finished products and in turn reduced the demand for Chinese products (Fewsmith 56).
Another issue of Chinese inflation is that China exports more than it imports; this creates current surplus. The government is then is forced to print money for sale so that foreigners can have currency to buy their products, and when all these money is supplied in the Chinese economy, it increases the inflation further (Academy of Political Science (U.S.) 77). This trend will continue as long as China continues to export more and more, unless solution is sought to help China to deal with its exports without having to print currency.
Conclusion
The Chinese government is trying hard to reduce the inflation and considering the causes. It is evident that money circulation is the biggest problem and China being a country that is so active in business activities, money circulation should be under control. To control the circulation of money, both local and foreign currency, the Chinese Central bank has increased lending rate to commercial banks; this will help to strengthen the weakening Chinese currency.
Works Cited
Academy of Political Science (U.S.). China’s Developmental Experience. New York: Academy of Political Science, 2009. Print.
Fewsmith, Joseph. China Today, China Tomorrow: Domestic Politics, Economy, and Society. Lanham: Rowman & Littlefield, 2010. Print.
Klein, Robert & Shabbir, Tayyeb. Recent Financial Crises: Analysis, Challenges and Implications. Cheltenham: Edward Elgar Publishing, 2009. Print.
Relevance of Inflation Targeting in the Post-Great Recession Economic Environment
The recent global economic crunch has elicited several debates. Observably, economic policies have been affected by these debates. Coupled with high rates of underemployment and unemployment, post-great recession remains as a notable economic catastrophe (De Mello 11). Even brilliant global economies have felt the pinch considerably. Public and private debts within states have immensely grown. Economists have diverse perceptions on the concept of inflation targeting. Some policy makers have also regarded recession as a replication of consumer bubble. However, the greatest challenge for policy makers is how to get out of the economic mess.
Most policymakers still view inflation targeting to be relevant in steering economy. There have been reiterations that the challenge of high consumer debt can be solved by raising inflation levels. Indicatively, high inflation reduces the challenges associated with debts. Basically, this is because the finances that an individual or economy owe have minimal value within a longer period. As stated by some economists, inflation targeting forces the companies that hoard massive financial reserves to channel them into expenditures (Billi & Kahn, 2008).
In the long run, this has a positive impact on the entire economy. Therefore, because of inflation targeting, central banks create high levels of inflation through the increase of monetary supply. Targeting inflation remains relevant in this era. However, caution must be taken. This is because high levels of inflation may be very detrimental if not properly monitored. Debates supporting the concept of inflation targeting are premised on the idea that recession remains as a greater challenge relative to the state of high inflation.
The Principal Premise Behind Inflation –Targeting
Inflation is what occurs to the prices of basic commodities over a given period. In an economy, prices increase whenever there is a monetary expenditure. Notable impacts of inflation arise whenever there are excessive monetary expenditures within a concerned economy (Blejer, Ize, Leone, & Werlang 36). For instance, the demand is more likely to outrun the supply. Moreover, the levels of interest rates chargeable on borrowing get escalate. Technically, this initiative is undertaken to increase the loaning costs. This process also slows and minimizes the levels of cash entering a specific economy.
Generally, inflation has the capacity to wear down the worth of cash within longer periods. Inflation targeting refers to a financial policy strategy. It is dominated by a publicized arithmetic inflation target. Inflation targeting operates in a flexible manner. The process endeavors to stabilize the general inflation. Inflation targeting can operate in both an explicit and implicit form (Billi & Kahn, 2008). The inflation targeting has the unique capacity to direct monetary policies such that they do not interfere with the operations within central banks.
Generally, inflation targeting provides a basic obligation to forecasts. Inflation is forecasted through the execution of inflation targeting policies. The basis of inflation targeting is always to monitor and control the level of inflation within a specific economy. Therefore, it offers powerful probabilities and incentives for attaining optimal economic policy relative to the other monetary policies. Analytically, inflation targeting utilizes the basic theory regarding optimal policy. In this approach, its objective role is provided by the principal function of elastic inflation targeting. This summarizes the principal premise behind inflation targeting.
Evidence That Managing the Money Supply Is the Principal Task of Inflation Targeting
Inflation targeting exercises tremendous economic policies. Through this process, concerned central banks maintain inflation in a quantitatively acknowledged band. The most distinct feature of inflation targeting is that in its practice, the central bank must communicate to the general public (Cogley 97). Basically, the quantitative monitoring aspect in inflation targeting is important. This is because it entails the regulation of the amounts of money within an economy. As a policy directive, inflation targeting seeks to maintain the level of inflation within tolerable ranges. Agreeably, it is the amount of cash in circulation within an economy that results into the effects of inflation. Therefore, it can be noted that inflation targeting operates to manage the money supply within an economy.
The present research, which focuses on the effects of inflation targeting on the asset price shocks, remains eminent. It indicates how the concept operates in the management of cash flows (De Mello 38). Monetary innovations as well as globalization includes some of the topics that inflation targeting has recently ventured. From the definition, it can be deduced that inflation targeting is a significant operative tool within an economy. It emanates as a short term cash demand management technique within most global economies. Interest rates include some of the basic instruments applied to accomplish an inflation policy aim. Through this observation, most central banks periodically review their cash rates. Inflation targeting dominates as the principal operative guideline for policy communication during such periods. Thus, it is notable that inflation targeting is a crucial methodology for managing the supply of money within an economy.
An Ideal Rate of Inflation
The question as to whether there exists an ideal inflation rate has globally drawn significant debates. The realization is that even with minimal inflation rates, there are still negative economic trends. For instance, most powerful global economies have continued to experience credit or asset bubbles. Notably, these have occured even in low inflation rates. The general implication is that targeting an inflation rate might be inadequate. Most policymakers have indicated that increases in inflation rates may be significant or just benign.
Therefore, adjustments on the rates of inflation would have unpredictable long run implications on the economy (Cogley 199). This issue has considerable debates. The prevalent conclusion is that no one has an absolute justification of an ideal rate of inflation. An increased inflation rate may lead to various alterations within an economy. For instance, it may result into limited cases in which monetary policy gets trapped. This normally occurs against a specified zero bound. This impact is widely viewed as positive. However, an increased level of inflation also presents significant challenges.
Price distortion is the most important and largely experienced difficulty of an increased inflation rate (De Mello 65). Observably, prices do not inflate in a similar trend or pattern. Therefore, a high inflation leads to the development of considerable price disturbances in the economy. Consequently, resource misallocation may be experienced within an economy.
It is imperative to indicate that there is a direct proportionality in the relationship between high inflation rate and the level of price misallocation (Blejer, Ize, Leone, & Werlang 42). After a comprehensive consideration of the costs and merits, most economists propose an optimal target of below 2 per cent. There are several factors to be considered in setting the optimal target of inflation within an economy. The charge of evading a zero bound is dictated by the extent of severity of specific macroeconomic situation. It is agreeable that there seems to be no ideal inflation rate.
Monetary Policy Makers and Policy Initiatives
Presently, extensive research aimed to aid the comprehension of economic factors influencing inflation rate is underway. Generally, it is evident that most policy makers are ill-informed of the underpinning factors of inflation rate. This is because most monetary policies have failed to comprehensively tackle the current economic fluctuations (Blejer, Ize, Leone, & Werlang 69). There is an increasing concern that an elevated inflation rate will force inflation to be highly volatile. Policy makers have also realized that an elevated target may not be adequate to counteract a severe recession. The failure of most economic policies to challenge the recent economic crisis is indicative of the dearth of knowledge. Particularly, this is on the side of policy makers. The need to increase the levels of global economic research as outlined in most policy briefs is a positive observation.
A global analysis of the disparities in monetary policies within different states reflects the appalling situation (Billi & Kahn 245). There is notable reluctance by different states to adopt more robust and strategic monetary policy initiatives. For instance, it is observable that relatively few states have adopted the inflation targeting policies. Instead, there are a lot of criticisms within the public domain concerning ineffective monetary policies. Therefore, it is important for policy makers to understand and act along these notable economic patterns. This initiative will enhance the formulation and implementation of effective monetary policies. Consequently, it will improve the economy of most countries.
Works Cited
Billi, Roberto, & George Kahn. What Is the Optimal Inflation Rate? 2008. Web.
Blejer, Mario, Alain Ize, Alfredo Leone, & Sergio Werlang. Inflation Targeting in Practice: Strategic and Operational Issues and Application to Emerging Market Economies. Washington, DC, 2000. Print.
For many years now, the Consumer Price Index (CPI) has been used as the standard gauge for inflation in different economies. It measures the changes in the cost of a fixed basket of products and services consumed by ordinary consumers in a specific period of time (Moulton 4). To most economists, inflation is caused by a general increase of money in a specific economy.
In this case, the volumes of money being circulated exceeds the supply of goods and services in the same market thus leading to an upward adjustment of prices in order to absorb the extra monies in the economy. But why is measuring inflation important in economies, one may ask?
Well, In the United States for example, the government factors in inflation when paying its citizens for programs such as social security and retirement benefits. This means that erroneous representation of inflation rates would lead to erroneous government financial projections.
This research paper has established that the CPI as used to measure inflation has several biases. As such, the study seeks to pinpoint the biases.
Biases as identified by the Boskin commission
In 1995, the US senate appointed the Boskin Commission to study the computation of CPI and reveal any biases that could exist therein. On December 1996, the commission issued a report which declared that several biases had led to an overstatement of inflation by 1.1 percent in 1996 alone and 1.3 percent in prior years (Gordon 4). Baker supports the Boskin Commission Report’s findings by stating that there is an approximate 0.5 %- 1.5% overestimation of inflation annually in the United States (1).
While explaining the biases that exist in the CPI, the report stated that the major cause of bias was the use of fixed weight index as a representation of the cost of living (Boskin Commission Report VI). According to the report, the cost-of-living Index should be ideally used as a reference point and should be attained using other research methods rather than through the fixed-weight index.
The report further states that, “the fixed-weight index exaggerates the effect of price changes on the cost of living, because it fails to allow for substitutions that enable consumers to avoid the full impact” (VI). This is especially so because as people become wealthier, they demand more products and services, to which the market responds by supplying more dynamic and diverse products and services. In such a situation, it becomes inherently challenging to use the fixed-weight index as a suitable measure for CPI.
Substitution Bias
According to QuickMBA, when prices of specific products rise substantially, consumers usually purchase a substitute cheaper product especially when their income levels remain fixed. The fixed-weight Index used to measure CPI however is not flexible enough to capture such substitution, and hence fails to accurately estimate the effect of price increases on consumer’s budgets.
Quality Bias
As technology advances, its use in the production of good and services improves and leads to improved production quality. As a result, services and products are more useful and last longer than was the case in the past. While the Boskin Commission Report (V) acknowledges that the CPI has been able to capture the effect brought about by quality changes in some products, it argues that a lot other products have been ignored by the Index.
This has eventually led to an increased quality-consideration bias across product categories. According to Schulkin, quality bias is often difficult to quantify especially in a market where competition lead most manufacturers to keep improving the quality of their products and services (1).
New product Bias
According to QuickMBA , the Index waits until new products become common in the market for them to be integrated in the Index (2). This in turn means that price reductions associated with the introduction of new products and oftentimes new technology is not captured or reflected in the CPI.
The Boskin Commission Report estimates that the bias occurring in the CPI by not factoring in new products introduced in the market sooner, amounts to an average of 0.25 percent bias annually (V). Notably, most new products are factored in the CPI almost a decade after they penetrate the market. By this time, their prices are markedly lower than the initial introductory prices they retailed in when they were first introduced into the market (Gordon 14)
The Boskin Commission report notes that on introduction of most new products, the prices are usually high, and the products not as good as they evolve later on in the product-development cycle. As the product matures overtime however, production increases, improvements on the product are made and eventually the product retails at reduced prices thus making a larger percentage of the population to afford the same. This however does not excuse the delayed incorporation of new products in
Outlet bias
According to QuickMBA, consumers usually shift from one purchase outlet to another based on the benefits earned from the outlets (4). With the advent of online retailers, more consumers are for instance opting to do their shopping online since they can earn points or discounts. Others have learned the benefits of buying their supplies in bulk and therefore have shifted from purchasing products from retailers and instead have joined wholesale clubs.
Schulkin observes that the availability of generic products which retail at lower prices, the presence of low price stores, and the increased use of mail orders as a purchase method where consumers do not have to pay sales tax, have increased the outlet options for the buyers (1).Usually, the CPI does not consider such changes in purchase behavior, which occur when the consumer have many retail options offering different prices. As a result, the compiled index becomes a biased representation of household spending across the country.
Others
Schulkin also observes that in addition to the four main biases identified in the Boskin Commission report, using the Fixed-Weight Index to measure inflation ignores the many discounts availed to consumers in a given economy (2).
Examples include cash rebates offered when people use their credit cards, promotional prices offered for airline tickets during the low-travel season, promotional prices for products and services and the countless coupons offered to the consumer market by different manufacturers trying to promote their products or services in the market at any given time.
Notably, the CPI is calculated by factoring in the after-tax prices of products and services in an economy. However, it fails to consider the benefits accrued by the taxes. As Schulkin notes, tax proceeds are mainly used by the government for spending in law enforcement, welfare, infrastructure development, deficit reduction and spending in education among other social issues (1).
Taxes imposed on tobacco and alcohol on the other hand leads to reduced consumption of the same by the general population. In the past, CPI completely disregards these benefits. Of late however, Williams reports that the government is understating CPI by a rough 7 percent per year (2). He says that this happens because the government has redefined how CPI is calculated, most notably the introduction of the variable-basket goods that factored in substitution
Gordon Also states that although changes in CPI are published on a monthly basis in the United States, they cannot be revised even when the estimates there in are questionable (11). This in turn means that the CPI is methodologically inconsistent and contains biases which occur because the index cannot be revised backwards.
In a suggestion borrowed by the commissioned mandated to investigate biases in CPI in the US in 1995, Gordon recommends that since the CPI cannot be revised backwards, it should be supplemented with a research-based index, which should be published annually and, which should be more flexible to allow for continued revisions in order to slot in new research findings (18).
Research findings
Errors in CPI measurement often results in faulty payments especially by government and private sector players who rely on the index to adjust the benefits paid to beneficiaries of government programs or workers. An upward CPI bias often raises the benefits paid to the recipients in an equal proportion to the proportion increase of the index annually (Duggan et al. 4).
This means that if CPI was at 1.1 percent in 1998 and 2.1 percent in 1999, benefits advanced to recipients would be proportionate to the percentage difference between the two years. In an upward bias, the recipients usually benefit from an erroneous compensation which is as a result of the misrepresentation of the CPI.
Continued overestimation of CPI is also likely to continue having a ripple effect every year, thus meaning that the economy will continue to have a series of overestimated inflation estimations (Moulton 2; Schulkin 2).
This is especially because economic analysts use CPI in construction of national income accounts thus meaning that biases often lead to misrepresentation of growth and productivity in the economy. An over-estimation of inflation leads to an overestimation of poverty thresholds in any economy, which in turn means that the government underestimates the economic growth and the well-being of the populace.
Baker also found out that though it’s widely thought that most services and products improve in quality as competition among the different providers intensify; this is not always the case (4). An example in the medical insurance sector suggests that most consumers spend significant amount of resources both in terms of money and times shopping around for the most ideal policy to adopt.
Even after making their minds, they are forced to spend some more time filling the forms and should they need to make claims, even more time is spent filling the claim forms and pursuing payments from the insurance firms. Since the CPI just examines health care expenditure based on the monetary value projections, the costs of time wasted comparing the policy providers, and the cost of time lost pursuing claims is ignored.
This study found out since population census are held every ten years in countries like the United States, there is a probability that the population-expenditure weights are not a true reflection of the inflation. Baker notes that in rapid population growth areas, price increases are likely to be higher than slow population growth areas (4).
With population estimates captured ten years apart, it would be challenging to capture population growth rates accurately hence presenting the probability that CPI is undercounted or over-estimated in different regions depending on the pace of the population growth rate.
The Bolskin report recommended several approaches to resolving the biases. Among them was the adoption of a weighted geometric mode of indexing, which would allow the CPI to factor in substitution of products and services by consumers. A superlative index used at the stratum level was also recommended for use in CPI formulation since such would eliminate irrelevant market baskets and speed up the introduction of new products in the basket for indexing (Gordon 18).
In the United States, it is estimated that a third of all federal spending is indexed according to the CPI. Income tax is also indexed according to changes in the CPI thus affecting federal revenues (Baker 1). With the biases discussed above remaining in place deficits in federal spending and federal revenues are both affected.
The 1996 Boskin Commission Report argued that “if the CPI overstated the change in the cost of living by an average of 1.1 percentage points per year over the next decade, this bias would contribute about $148 billion to the deficit in 2006 and $691 billion to the national debt by then” (6). This would make the bias the fourth most expensive undertaking after the country’s social security program, health care program and defense.
With an overestimated CPI, one can therefore conclude that the average growth in wages have been better than predicted. This however does not scrap away wage inequalities which lead to worse living standards for a section of low-income earners in the society. As Baker suggests, this should stress the importance for the government to lay more emphasis on addressing inequality. This would help the overall growth of the economy since the low income earners would be empowered economically by providing them with more disposable income.
An overestimated CPI would also mean that the concerns that future generations would have to put up with declined living standards is unwarranted. As Baker notes, if it is indeed that the mode of indexing has misled economic analysts to believe that the economic growth and the general savings was well below what it should have been, a change in this would mean that indeed the country’s growth was and still is at a healthy level.
Conclusion
While the Laspeyres index, which is based on a fixed-based mode to calculate the CPI has been common use in the past, economists now are suggesting the uses of other indexes such as Paasche, Fisher-Ideal and the Walsh-price as alternatives. Considering the fast pace of changes in contemporary economies however, it is almost obvious that whichever index is used, arriving at an all encompassing CPI will be a challenging undertaking for the government.
Overall however, the government should avoid using any indexes that would either overestimate or underestimate inflation in the country. This then means that a lot of effort needs to be dedicated towards developing a formula that will be used to gauge inflation as accurately as possible.
Works Cited
Baker, Dean. “Revising the Consumer Price Index: Correcting bias, or biased corrections?” Economic Policy Institute Briefing Paper (1998):1-8.
Duggan, James, Gillingham, Robert & Greenlees, John. “Housing Bias in the CPI and its effects on the Budget Deficit and the Social Security trust fund.” Research paper 9701 (1999): 1-19.
Gordon, Robert. The Boskin Commission Report and Its Aftermath. National Bureau of Economic Research. (1999):1-47.
Moulton, Brent. Bias in the Consumer Price Index: What is the Evidence? US department of labor: Bureau of labor statistics 294.1(1996):1-35.
Williams, John. Consumer Price Index-“Government Economic reports: Things you’ve suspected but were afraid to ask!” Shadow Government Statistics. Oct. 2004. 5 July 2010. http://www.shadowstats.com/article/consumer_price_index
During inflation, the economy overheats, as the aggregate demand surpasses the level of economic growth. Thereby, the central bank plays a major role in employing the monetary policy, which encourages more saving than spending (Barsky and Lutz 18).
The most appropriate method is increasing interest rates, where, borrowing becomes very expensive, and people resolve to save instead of borrowing and spending money recklessly. Essentially, there is an increase in the opportunity cost of spending, and homeowners with mortgage find it too expensive to service their mortgage loans.
With a decrease in borrowings, the real money supply in the economy reduces significantly. Companies also find it very expensive to borrow monies from banks, thus, they end up making very few investments. Moreover, when the interest rate is significantly high, the exchange rate increases, and the inflation pressures reduce.
This reduces the demand for exports and makes imports slightly inexpensive. The situation becomes very difficult, as some businesses experience losses in some of their investment projects.
The entire scenario leads to an aggregate decrease in demand, where, buyers barely have enough money to spend, and the sellers have to reduce the prices of their products to obtain customers. Monetary policy is very effective in keeping inflation under control, as long as the interest rates are high.
Fiscal policy
The fiscal policy targets the demand side, and its effects to the economy resemble those of the monetary policy. During inflation, the government aims at reducing the flow of money in the economy by increasing direct taxes to the citizens.
This approach helps in reducing the amount of disposable income, as the citizens have to pay high taxes for every income that they earn or spend. High income taxes and high value added taxes play a significant role in reducing consumer spending.
Such a scenario aids and maintain steady budgeting, and thus, it supports economic growth in a given nation. The increased tariffs escalate the leakage rates, and the consumers are left with barely enough money to spend. Another approach of employing the fiscal policy is through the reduction of government spending in the economy.
In such a case, the reduced injections into the circular flow of the economy trim down the demand, which reduces inflation, and the general growth of the economy reduces significantly.
Exchange rate policy
Whenever the value of a currency appreciates, the exports become expensive, where, the volume of exports reduce significantly. Moreover, the aggregate demand for exports reduces significantly, and the firms in the country have to reduce their prices to remain competitive in the global market.
Whenever the currency in a particular nation is high, the import prices reduce significantly; therefore, firms that depend on imported raw materials experience reduced manufacturing costs. With that, the firms can sell their products at low prices, and still make profits.
Income policy
Direct wage control is an important aspect of fiscal policy because it sets limits of wage bill and decrease expenditure in the government. A government experiencing inflation can restrict pay rise for government employees to cut on its expenditures.
Moreover, the government can go ahead and persuade private sector employers to control their wage levels. Despite the fact that low wage growth moderates inflation rate and reduces forces of inflation, it does not control inflation rate effectively.
Labour market and supply side policies
Reducing persistent uncompetitive markets and creation of flexible labour markets would play a great role in reducing inflationary pressures. The government can take part in weakening labour unions and encouraging part-time employment.
Although flexible labour markets lead to an increase in job insecurity, the increased flexibility in the labour markets would play a great role in helping firms to reduce their labour costs and thus reduce inflationary pressures. The lower cost per unit of production would enable firms to achieve economic growth without necessarily increasing their prices.
Economic policies that controlled inflation in the 1970s
The United States experienced a period of stagflation in the 1970s, where, the economic growth rate was slow and the inflation rates were considerably high. However, Milton Friedman, an American economist, believed that monetary supply was the issue affecting the economy.
He therefore insisted that the monetary policy would play a significant role in combating inflation of the 1970s. In 1979, Paul Volcker, the Federal Reserve Chairperson, employed the monetary policy, which played a great role in reducing inflation.
The increment of interest rates provides a way for the government to discourage spending and borrowing. In the middle part of 1970s, the interest rates increased to about 12%, as there was an excessive growth in the economy (Biven 28). Citizens resolved to save, and the real money supply in the economy reduced significantly. Although the monetary policy was the basis of the severe 1981-1982 recession period, it played a great role in combating the inflation of the 1970s.
Phillips curve and its application in the 1970s inflation
Phillips curve seeks to analyse the macro-economic situation and explain the correlation between inflation levels and the unemployment levels in any given economy. Since its implementation, the Philips curve has played a great role in managing the trade cycle, where, it helps policy makers to manage aggregate demand whenever the economy encounters high unemployment rates, inflation, and severe recession periods.
Essentially, the Philips curve indicated that wage inflation and unemployment levels have an inverse relationship. It is evident that changes in the levels of unemployment determine the price inflation levels in any economy. If, for example, there is an increase in the demand for labour, the unemployment levels fall, as firms raise their wages to compete for the few labourers available.
During the inflation period of the 1970s, the government had to select the most appropriate rate of inflation and work towards achieving it. Friedman studied the Phillips curve carefully, and discovered that the economy consisted of a series of short run Phillips curves that explained the natural rate of unemployment.
The short run Phillips curves played a great role in determining the existing inflation rate. Indeed, the entire period running through 1970-1979 had three short run Phillips curves that explained the upward shift of inflation expectations during the period.
While applying Milton Friedman’s monetary policy, the Phillips curve was imperative, and the economists had to contract or expand the economy accordingly to achieve the most appropriate rate of inflation (Marvin and King 993). The Phillips curve was imperative in incorporating the negative supply shocks experienced during the inflation period.
Therefore, although the stagflation period presented a breakdown of the Phillips curve in the 1970s, the curve had some relevance in achieving the monetary policy that combated the great inflation.
Works Cited
Barsky, Robert and Kilian Lutz. A Monetary Explanation of the Great Stagflation of the 1970s. Michigan: University of Michigan, 2010. Print.
Biven, Carl. Jimmy Carter’s Economy: Policy in an Age of Limits. North Carolina: University of North Carolina Press, 2002. Print.
Marvin, Goodfriend and Robert King. “The Incredible Volcker Disinflation.” Journal of Monetary Economics 52.1 (2005): 981-1015. Print.
Canadian economy is recorded as one of the strongest and fast growing economy in the world. In the last two decades, the economy has recorded a fall in unemployment and economic growth, but inflation persists.
With the economy, engaging in vigorous policy and structural reforms the economy has turn out to be resilient, flexible and well integrated with worldwide markets. In the recent years the economy has be able to overcome both internal and external milestones such as a housing boom, major drought and the economic and financial crisis that had hardly hit the Canadian economy.
The country is endowed with resources and with a diverse primary sector based economy. The main exports are wool, meat, coal, iron ore, gold, alumina, transport and machinery, equipment and wheat. These exports have continued to spur the economic growth since 1788.
The gross domestic product has continuously grown with it approximating to $ 1 trillion in the year 2007. Unemployment rate on the other hand has decline from a high of approximately 11 per cent in the year 1995 to less than 5 per cent in the year 2008.
The service sector leads with an employment rate of seventy five per cent followed by the industrial sector with 21.1 per cent and finally agriculture with 3.6 per cent (Rune, 213).
The Canadian economy has also had a continued budget surplus that the government has use to service its debts. The budget surplus, between the years 2002 and 2007, averaged one and six percent on gross domestic products respectively.
As per the Economic Survey of Canada of 2007, the GDP growth rate has averaged 3 per cent per annum since 2000 and the real GDI (Gross Domestic Income) registering a growth rate of 4 per cent. The proportion of people living below the poverty line has decline up to a point where in the year 2009 none of the Canadian citizen is within the bracket of those below the poverty line.
As part of the countries reform agenda, it has removed trade barriers, liberalized its financial sector, introduced local labor laws, and spreads out its labor market among others. With no trade barriers in the transport, financial and telecommunication sectors, the economy has experienced competition in different sectors.
Canada has a desirable, well-built economy with its GDP per capita equivalent to that of four leading west European economies. Stressing on policy and structural reforms, near to the ground persistent rise in price, a housing boom in the market and growing strong relations with China forms the basis of the economic expansion that Canada has recorded over the past fifteen years.
Until the recent 2008 worldwide financial crises, the above-mentioned factors have been greatly contributing to economic growth. Consumer and industry confidence and soaring export prices for primary agricultural products and raw materials accelerated the economy to a high growth rate level in the recent years.
Shortage of rain, strong currency, and a strong import demand, raised the trade deficit, as the infrastructure holdups and a rigid labor market slowed down the growth in the number of export and stirred up inflation up to the year 2008.
During the 2008 worldwide financial crisis, the economy recorded a remarkable growth through both fiscal and monetary stimulus, buoyant export demands and investors from China together with well performing financial sector contributed to the country’s avoidance of the recession.
The Reserve Bank of Canada as one of the G20 was the initial country to constrict monetary policy right after the financial crisis through the Central bank of Canada that increased its assistance rate in October 2009.
In the year 2010, the governments plan is to increase the economic outlay, maintain the symbiotic business relations with China, enacting legislations concerning emission trade and reduction of climatic issues such as droughts and upsetting bushfires.
Policy instruments are defined as the available options that can be utilized by the government to run economic activities. Instruments are classified as either monetary policy or fiscal policy.
Monetary policy refers to the actions pursued by the central bank of a country to regulate the amount of money supply in the economy. The actions can be either on interest rates or on exchange rates.
The main objective is to check on the rate and level of expansion of AD (aggregate demand) in the nation. Specifically it is used to control the rate of inflation and unemployment rate. Monetary policy can be either expansionary or contractionary policy.
Therefore, a target is also referred to as an objective. It is the aim of any economic policy and it can be measured in reference to an economic variable like unemployment rate, growth of Gross Domestic Product (GDP), or rate of inflation.
To achieve these targets we use policy instruments. A change in economic policy (instruments) used will led to a change on the other variable (the target). This indicates of the relationship existing among economic variables.
The main objective of Canadian government is to keep inflation as low as possible. Therefore, the country policy makers will have to adopt an inflation targeting monetary policy. Under this monetary policy, the target is to sustain inflation at a favorable range.
The inflation target is achieved through the central bank monthly modification on the interest rate target. The economy will adopt a contractionary monetary policy where the amount of money supplied in the economy is reduced making the interest rates to soar leading to low inflation rates.
When inflation rate is higher than the expected the central bank is likely to increase interest rates (Arestis 89). This is a contractionary policy since it will ensure a just economy and a low interest rate. On the other hand, in the event of low inflation rate far below the bank will respond by lowering the interest. This will increase the amount of money in circulation; hence, the inflation will be steadily increasing.
Monetary policy uses a number of tools in controlling the amount of money supplied and the interest rate to manipulate variables like joblessness, price increases, exchange rates and financial growth.
Where only the central bank is vested with the sole power of issuing currency, the bank will have the power over the amounts of money that should be in circulation. With the ability to change the amount of money supplied, it will also affect the interest rate.
It is essential for policymakers to come up with realistic announcements, and protest against interest rate targets since they are irrelevant and not essential in relation to monetary policies. When consumers and businesses consider that policymakers are devoted to keeping inflation low, they will expect prospect prices to be lower (Sexton, Fortura and. Kovacs, 134).
In addition, when an employee anticipates prices to increase in the near future, the employee will find an employment with fat wages to counter for the increase in price.
Hence, the anticipation of poor wages is indicated in wage-setting conduct between employers and employees. With low wages, there will be no demand-pull inflation and cost-push inflation since employees earn less and employers pay less respectively.
To reach the intended low inflation, policymakers should have realistic announcements. This means that private agents should consider that the announcements would indicate real future policy.
When an announcement concerning inflation objectives is made and is not understood by private firms and customers, wage setting shall foresee high inflation level implying that wages will be elevated and inflation goes up. A lofty wage will augment a consumer’s demand-pull inflation and a business’s cost-push inflation.
If policymakers suppose that private individuals and businesses expect low inflation, an expansionary monetary policy will be adopted where the extra gain per unit outweighs the extra cost of inflation per unit.
However, credible announcements are done in many ways. First is to set up an autonomous central bank with minimal inflation targets and no output objective. In this case, private individuals and firms are sure of inflation being low since it is bench marked by the autonomous institution.
This can be attained through incentives such as increase salary for the bank governor as a sign of the banks commitment to its policy targets. These means that in any policy implementation process reputation of the business plays a very important role but it must not be interplayed with dedication
Despite the fact that a central bank may possess a positive reputation based on its perfect performance in carrying out monetary policy, the bank may not have necessarily embraced any particular kind of commitment for instance aiming at a particular inflation range.
Reputation also plays an important part in establishing how well would the target markets agree to the announcement of a certain dedication by the central bank to a policy aim but reputation and dedication should not be incorporated.
In addition, in rational circumstances reputation of the policymaker concerning past policy options does not count, it is only the ideologies, public statements, professional background among others of the central bank head that matters.
In fact, many economists have argued that to do away with any pathology in relation with the inconsistencies of time during implementation of monetary policy, the chief of the central bank ought to have a bigger aversion for inflation as compared to the rest of the economy.
Hence, the reputation of the Reserve bank of Canada will be tied on institutional arrangements other than past performances when private agents are anticipating on inflation (McConnell and Stanley 103)
In a nutshell, the macroeconomic policy specifically the monetary policy embraced by the central bank of Canada in its policy and structural reforms has turned out to be fruitful.
The country has been able to combat inflation resulting to a steady economic growth. In the peak of global financial crisis the Canadian government has been able to avoid recession through its central bank firm adherence to its commitment to the monetary policy.
Works Cited
Arestis, Philip. An assessment of the global impact of the financial crisis. Basingstoke: Palgrave Macmillan, 2010. Print.
McConnell, Campbell, and Stanley, Brue. Economics: principles, problems, and policies 15th ed. Boston, Mass: McGraw-Hill, 2002. Print.
Rune, Stenbacka. Microeconomic policies in the new economy. Helsinki: United Nations University, World Institute for Development Economics Research, 2001. Print.
Sexton, Robert, Fortura, Peter and. Kovacs, Colin. Exploring microeconomics. 2nd Canadian ed. Toronto: Nelson Education, 2010. Print.
Measuring expectations for inflation is a complicated and convoluted process that requires a detailed analysis of multiple factors (Iossifov and Podpiera 12), including not only economic, but also political, environmental, sociocultural, and more. (Harris 262). The correlation between the expectations of the target audience and the actual outcomes were spotted quite a while ago by John Maynard Keynes (Barnett 11). However, even though the Keynesian Model seems to have worn out its welcome in the context of the twenty-first century and the global economy, an array of new frameworks has been suggested. The authors considered the New Keynesian model suggested by Gramlich:
(Bryan and Gavin 540). The above-mentioned model was designed to explain the high unbiasedness rates and weak efficiency rates in the forecasts made by the representatives of households, as far as the changes in inflation rates are concerned. The New Keynesian formula that the authors of the paper were trying to create, in its turn was supposed to provide justification for the lack of forecast efficacy in determining the changes in inflation rates, as opposed to the expectations of individuals in the context of a particular household. As Bryan and Gavin make quite clear, there is an evident correlation between the factors mentioned above.
Particularly, the authors of the study were clearly trying to “match the forecast horizon and the sampling frequency” (Bryan and Gavin 542) of the samples studied to understand the efficacy of household expectations, as opposed to professional forecasts. At the same time, the forecast error was identified. As a result, an accurate measurement of the correlation between household expectations and professional forecasts became a possibility (Bryan and Gavin 544).
Main Body
When considering the essential equations that determine the outcomes of the analysis, and can be viewed as the foundation on which the authors could build their approach toward the subject matter, one must mention the New Keynesian Model that was suggested by Gramlich, supposedly created based on the ordinary-least-squares (OLS) estimation of the equation provided below:
In the equation provided above, Pt denotes the inflation rate that is detected over the course of time t. The following expression: (t – 1Pei ) can be defined as the survey forecast designed over the (t – 1) to determine the inflation rates in the designated market, industry, or area. β, in its turn, is the representation of the research hypothesis, β0 being the null hypothesis, and β1 representing the alternative. In the equation provided above, β0 is assumed to equal 0, whereas β1 equals 1. The variable defined as u1 , in its turn, plays the role of a “white noise” (Bryan and Gavin 539) process.
As far as the equation designed by the authors of the article is concerned, the subject matter incorporates the following elements:
as stressed above. While β0 and β1 remain the key hypothesis of the research, the former representing the null hypothesis, and the latter being the alternative, there have been certain changes to the initial model. Particularly, the (t – 2) variable has been included in its framework. As the authors explain, the specified element is supposed to signify that the events under analysis occur within the range of six months. As Bryan and Gavin explain, the formula that they suggest helps prove that the joint hypothesis should be rejected. In other words, the researchers state quite clearly that the correlation between the expectations of household members and the statements made by the authors of professional forecasts do not have as much in common as assumed previously.
Conclusion
Evaluating the implications of the New Keynesian model in the environment of the global economy, as well as the context of a particular local market, one must bear in mind that the contemporary Keynesian frameworks hinge on the notion of a multiplier. In other words, the New Keynesian Model points quite evidently to the fact that an increase in the spending rates within the realm of the modern household triggers an immediate rise in national income levels (Smithers 30).
Therefore, the study shows explicitly that the increase in the national expectation levels may not correlate with the forecasts. Even more surprising, the former, in fact, prove to be moderately efficient, when used both in times of crisis and the epoch of economic stability. The forecasts made by experts, in their turn, seem to fall flat in the instances that can be characterized as crises. The phenomenon above can be explained by the fact that economic models designed in an economically comfortable environment cannot survive the shock of a sudden change in the state of the economy (Bryan and Gavin 543).
Nevertheless, the application of the model as the means of carrying out an analysis of expectations among the members of households may be delayed. Numerous misconceptions about the use of surveys can be considered the reason for the failure to apply the formulas to a real-life scenario. Therefore, a more elaborate framework for promoting the New Keynesian Models in the global and local economies will have to be devised (Alesina and Giavazzi 131).
Works Cited
Alesina, Alberto, and Francesco Giavazzi. Fiscal Policy after the Financial Crisis. Chicago, IL: University of Chicago Press, 2013. Print.
Barnett, William. John Maynard Keynes. New York, NY: Routledge, 2013. Print.
Bryan, Michael F., and William T. Gavin. “Models of Inflation Expectations Formation: A Comparison of Household and Economist Forecasts: Comment.” Journal of Money, Credit and Banking 18.4 (1986): 539-544. Print.
Harris, Maury. Inside the Crystal Ball: How to Make and Use Forecasts. New York, NY: John Wiley & Sons, 2014. Print.
Iossifov, Plamen, and Jiri Podpiera. Are Non-Euro Area EU Countries Importing Low Inflation from the Euro Area? Washington, DC: International Monetary Fund, 2013. Print.
Smithers, Andrew. The Road to Recovery: How and Why Economic Policy Must Change. New York, NY: John Wiley & Sons, 2013. Print.
Inflation, a persistent rise in prices, affects a country in both positive and negative ways. It needs to be managed so that an economy can function properly. The economy of Saudi Arabia is fully supported by the oil trade and is currently performing above average. The future inflation rate is expected to be quite erratic. For instance, in 2017, the inflation rate is expected to hit a low of 1.98%. In 2018, it is expected to increase to 4.7%. Further, the rate is expected to be stable at 2.04%.
Purpose of the Paper
The paper seeks to carry out an analysis of the inflation rate in Saudi Arabia. Specifically, the paper will look at the present, past, and future interest rates. Some of the other research questions that the paper will answer are listed below.
What is inflation?
What causes inflation?
How can we measure inflation (what is CPI)?
What is the relationship between inflation and money supply (monetary policy)?
What is the role of the Saudi Central Bank (SAMA) about inflation?
Was the Saudi Central Bank (SAMA) effective at controlling interest rates in the past? What measures have been taken to ensure control?
What is the historical inflation trend in Saudi (2008 onwards)?
Research Methodology
The paper will make use of both qualitative and quantitative approaches to answer the research questions. The quantitative approach will make use of numbers, charts, and other statistical approaches such as regression. On the other hand, the qualitative approach will focus on interpreting the data and other numerical figures through objective and subjective analysis.
Literature Review
Inflation is a scenario where the price level of commodities and services in an economy persistently goes up over a specific period. When a country is experiencing inflation, the purchasing power goes down because a unit of currency buys fewer goods and services. This creates a loss in the value of a medium of exchange. Economies across the globe always try to maintain a stable and low rate instead of negative or zero inflation (Baumann & McAllister, 2015).
Inflation is measured by calculating the inflation rate. It is the rate of change in the price index over time. The most commonly used one is the consumer price index. The consumer price index is a statistical estimate that is built using the prices of a sample of items. The prices of this sample are gathered from time to time. In Saudi Arabia, the consumer price index is majorly made up of food, beverages, renovation, rent, fuel, water, transport, and telecommunication (Bernholz, 2015).
The causes of inflation can be analyzed by looking at the type of inflation. The two types are demand-pull and cost-push inflation. Demand-pull inflation occurs when the economy is near full employment. During this period, a swell in aggregate demand results in a rise in the price level when all other factors are held constant. Some causes of demand-pull inflation are monetary stimulus, high demand for fiscal stimulus, depreciation of the exchange rate, and rapid growth that is experienced in other economies.
On the other hand, cost-push inflation occurs when firms shift the rising costs by increasing prices to protect their bottom lines. Some of the causes of this type of inflation are an increase in the price of raw materials, labor costs, monopoly employers, and increased taxes. In Saudi Arabia, the key factors that affect inflation are external factors such as inflation in trading partners, exchange rate, and high oil prices (Bernholz, 2015).
The price level depends on the money supply in the economy. Thus, there is a direct connection between the rate of inflation and the rate of growth of the money supply. The relationship between inflation and money supply can be explained by the quantity theory of money (Bernholz, 2015). This theory holds that the money supply is equal to the value of all transactions.
MV = PY
M = dollars required to make transactions
V = velocity of money
P = gross domestic product deflator index
Y = real gross domestic product
The theory is based on the assumption that the velocity of money (V) is constant. Thus, changes in M are affected by changes in PY. Another assumption is that M does not affect real output (Y). This assumption is because the real output is affected by variables such as the state of the labor market and production function. This implies that a change in M results in a change in P only. This theory suggests that alterations in the money stock (M) would result in a comparative adjustment in P. This implies that if money grows at a high rate, then it will cause higher inflation levels in the economy. Based on this theory, expansionary monetary policies such as borrowing (external and internal) and printing of money cause inflation.
The central bank of the Kingdom of Saudi Arabia is known as the Saudi Arabian Monetary Authority (SAMA) (Saudi Arabian Monetary Authority, 2017). The authority is tasked with performing many functions. Some of the key roles of this agency are managing the monetary policy to retain the stability of exchange rate and prices, printing the national currency, strengthening of the currency, and ensuring that the currency maintains its value (Alkahtani, 2013).
The key drivers of inflation in Saudi Arabia are growth in money supply and government spending. Thus, the monetary policy supports fiscal policy by maintaining price stability. In the past, bank credit had a dismal effect on inflation. Therefore, SAMA did not see the need to regulate bank credit. In recent years, there has been significant growth in bank assets which is a strong indication of financial deepening. This implies that future causes of inflation are likely to be excess credit.
Therefore, SAMA came up with prudential and macro-prudential policies to regulate the availability of credit. In 2008, the country experienced an increase in the inflation rate. The rate was 7.1%. The rate further rose to 11.2% in 2009. Between 2010 and 2016, the inflation rate ranged between 2.19% in 2015 and 4.02% in 2016.
The interest rate decisions are taken by SAMA in Saudi Arabia. The official interest rate is the Official Repo Rate (ORR). In 2008, the benchmark repo rate interest rate was high at 5.5%. However, the country reached a high of 7% in 2000. In the recent past, the interest rate has been at a constant level of 2% (International Monetary Fund, 2017). This shows SAMA has been effective in controlling the interest rates.
Data Collection
Inflation Rate
Table 1: Monthly inflation rate.
Month
Inflation Rate
2008-01-01
7.00%
2008-02-01
8.70%
2008-03-01
9.60%
2008-04-01
10.50%
2008-05-01
10.40%
2008-06-01
10.60%
2008-07-01
11.10%
2008-08-01
10.90%
2008-09-01
10.40%
2008-10-01
10.90%
2008-11-01
9.50%
2008-12-01
9.00%
2009-01-01
7.90%
2009-02-01
6.90%
2009-03-01
6.00%
2009-04-01
5.20%
2009-05-01
5.50%
2009-06-01
5.20%
2009-07-01
4.20%
2009-08-01
4.10%
2009-09-01
4.40%
2009-10-01
3.50%
2009-11-01
4.00%
2009-12-01
4.30%
2010-01-01
4.20%
2010-02-01
4.60%
2010-03-01
4.70%
2010-04-01
4.90%
2010-05-01
5.40%
2010-06-01
5.50%
2010-07-01
6.00%
2010-08-01
6.10%
2010-09-01
5.90%
2010-10-01
5.80%
2010-11-01
5.80%
2010-12-01
5.40%
2011-01-01
5.30%
2011-02-01
4.90%
2011-03-01
4.70%
2011-04-01
4.80%
2011-05-01
4.60%
2011-06-01
4.70%
2011-07-01
4.90%
2011-08-01
4.80%
2011-09-01
5.30%
2011-10-01
5.30%
2011-11-01
5.20%
2011-12-01
5.30%
2012-01-01
5.30%
2012-02-01
5.40%
2012-03-01
5.40%
2012-04-01
5.30%
2012-05-01
5.10%
2012-06-01
4.90%
2012-07-01
4.00%
2012-08-01
3.80%
2012-09-01
3.60%
2012-10-01
3.80%
2012-11-01
3.90%
2012-12-01
3.90%
2013-01-01
4.20%
2013-02-01
3.90%
2013-03-01
3.90%
2013-04-01
4.00%
2013-05-01
3.80%
2013-06-01
3.52%
2013-07-01
3.70%
2013-08-01
3.50%
2013-09-01
3.20%
2013-10-01
3.00%
2013-11-01
3.10%
2013-12-01
2.97%
2014-01-01
2.88%
2014-02-01
2.79%
2014-03-01
2.62%
2014-04-01
2.70%
2014-05-01
2.70%
2014-06-01
2.69%
2014-07-01
2.60%
2014-08-01
2.83%
2014-09-01
2.83%
2014-10-01
2.58%
2014-11-01
2.50%
2014-12-01
2.41%
2015-01-01
2.18%
2015-02-01
2.10%
2015-03-01
2.02%
2015-04-01
2.01%
2015-05-01
2.08%
2015-06-01
2.16%
2015-07-01
2.15%
2015-08-01
2.07%
2015-09-01
2.30%
2015-10-01
2.44%
2015-11-01
2.28%
2015-12-01
2.28%
2016-01-01
4.26%
2016-02-01
4.18%
2016-03-01
4.27%
2016-04-01
4.20%
2016-05-01
4.08%
2016-06-01
4.07%
2016-07-01
3.83%
2016-08-01
3.30%
2016-09-01
3.00%
2016-10-01
2.61%
2016-11-01
2.31%
2016-12-01
1.71%
2017-01-01
-0.44%
2017-02-01
-0.07%
2017-03-01
-0.45%
Chart 1: Trend of inflation rate.
Inflation Forecasts
Table 2: Inflation rate forecasts.
Year
Annual inflation rate
2017
1.98%
2018
4.7%
2019
2.04%
2020
2.04%
Chart 2: Graphical display of forecasted annual inflation rate.
Interest Rates
Table 3: Data on interest rate.
Interest rate
The interest rate on government securities
3.00
0.330000
3.00
0.260000
2.25
0.270000
2.25
0.330000
2.25
0.390000
2.00
0.450000
2.00
0.470000
2.00
0.430000
2.00
0.410000
2.00
0.360000
2.00
0.350000
1.50
0.338200
0.75
0.351300
0.75
0.354000
0.75
0.355000
0.50
0.362500
0.50
0.419300
0.25
0.431000
0.25
0.260000
0.25
0.270000
0.25
0.330000
0.25
0.390000
0.25
0.450000
0.25
0.470000
0.25
0.430000
0.25
0.410000
0.25
0.360000
0.25
0.350000
0.25
0.338200
0.25
0.351300
0.25
0.354000
0.25
0.355000
0.25
0.362500
0.25
0.419300
0.25
0.431000
0.25
0.433700
0.25
0.390800
0.25
0.396300
0.25
0.391800
0.25
0.390000
0.25
0.385000
0.25
0.330000
0.25
0.290800
0.25
0.272800
0.25
0.262000
0.25
0.286800
0.25
0.307700
0.25
0.282300
0.25
0.329000
0.25
0.339800
0.25
0.354800
0.25
0.365800
0.25
0.375800
0.25
0.381300
0.25
0.368300
0.25
0.376400
0.25
0.384000
0.25
0.413900
0.25
0.443000
0.25
0.496500
0.25
0.498000
0.25
0.492000
0.25
0.455000
0.25
0.490900
0.25
0.488000
0.25
0.499000
0.25
0.503990
0.25
0.465340
0.25
0.489010
0.25
0.497010
0.25
0.472410
0.25
0.527980
0.25
0.574340
0.25
0.528000
0.25
0.528000
0.25
0.528000
0.25
0.528000
0.25
0.528000
0.25
0.526660
0.25
0.526660
0.25
0.526660
0.25
0.502660
0.25
0.473660
0.25
0.418660
0.25
0.412700
0.25
0.405300
0.25
0.400300
0.25
0.398900
0.25
0.397700
0.25
0.391000
0.25
0.395000
0.25
0.431300
0.25
0.470000
0.25
0.520000
0.25
0.560000
0.25
0.813330
0.25
1.033100
0.25
1.126700
0.25
1.167500
0.25
1.249700
0.25
1.438300
0.25
1.435700
0.25
1.029990
0.25
1.054000
0.25
1.066000
0.25
1.046200
0.25
0.940160
0.25
0.868340
0.25
0.849338
0.25
0.805938
Chart 3: Trend of interest rate.
Money Supply
Table 4: Data for money supply.
M1
M2
M3
398194000000.00
689018000000.00
815137000000.00
399126000000.00
692136000000.00
827353000000.00
411706000000.00
705839000000.00
834041000000.00
408384000000.00
699199000000.00
826210000000.00
418872000000.00
702851000000.00
844404000000.00
429150000000.00
711926000000.00
860697000000.00
427709000000.00
732064000000.00
877050000000.00
419178000000.00
737560000000.00
885771000000.00
417909000000.00
744411000000.00
888453000000.00
417647000000.00
745558000000.00
901087000000.00
426605000000.00
772557000000.00
919324000000.00
425494000000.00
793118000000.00
929125000000.00
436250000000.00
787978000000.00
928427000000.00
448362000000.00
799681000000.00
956589000000.00
459795000000.00
816198000000.00
965601000000.00
470015000000.00
818373000000.00
977604000000.00
471762000000.00
816407000000.00
986847000000.00
476054000000.00
824203000000.00
1001903000000.00
488641000000.00
836038000000.00
1011391000000.00
489446000000.00
825061000000.00
994725000000.00
492679000000.00
823313000000.00
999925000000.00
495722000000.00
826140000000.00
1003903000000.00
506234000000.00
848240000000.00
1023234000000.00
521558000000.00
844935000000.00
1028944000000.00
531692000000.00
839519000000.00
1005570000000.00
531781000000.00
849545000000.00
1009850000000.00
542010000000.00
855717000000.00
1010511000000.00
549389000000.00
856979000000.00
1002953000000.00
555609000000.00
863592000000.00
1012323000000.00
576928000000.00
880975000000.00
1035582000000.00
589134000000.00
878816000000.00
1034820000000.00
589122000000.00
876285000000.00
1023425000000.00
591279000000.00
889453000000.00
1050936000000.00
595171000000.00
878756000000.00
1040839000000.00
609087000000.00
899487000000.00
1061277000000.00
625592000000.00
923874000000.00
1080370000000.00
638858000000.00
927948000000.00
1087031000000.00
641042000000.00
933632000000.00
1096716000000.00
685779000000.00
983598000000.00
1149654000000.00
722624000000.00
1009170000000.00
1175390000000.00
722480000000.00
1013890000000.00
1174710000000.00
716633000000.00
1014937000000.00
1171004000000.00
727600000000.00
1014000000000.00
1170070000000.00
736120000000.00
1018570000000.00
1175330000000.00
726460000000.00
1016000000000.00
1175850000000.00
735228000000.00
1017408000000.00
1190954000000.00
745475000000.00
1028908000000.00
1193299000000.00
760985000000.00
1066427000000.00
1223563000000.00
781501000000.00
1077978000000.00
1234616000000.00
790140000000.00
1094716000000.00
1248265000000.00
800183000000.00
1107197000000.00
1270619000000.00
809610000000.00
1101552000000.00
1269921000000.00
809828000000.00
1106675000000.00
1265419000000.00
811618000000.00
1120594000000.00
1286147000000.00
819708000000.00
1113188000000.00
1281531000000.00
833396000000.00
1116893000000.00
1288775000000.00
823114000000.00
1116970000000.00
1310056000000.00
847205000000.00
1172235000000.00
1346285000000.00
837667000000.00
1147458000000.00
1329558000000.00
887115000000.00
1221543000000.00
1393754000000.00
896761820000.00
1220167820000.00
1400172635000.00
905143176000.00
1229755861000.00
1398211935000.00
940948093000.00
1253034790000.00
1427173882000.00
956512157000.00
1268046140000.00
1448943918000.00
960760590000.00
1279273894000.00
1469842834000.00
961968431000.00
1281349171000.00
1466359722000.00
978649497000.00
1289993445000.00
1474025312000.00
975185365000.00
1290523582000.00
1467102946000.00
964875794000.00
1290516121000.00
1485258501000.00
969947544000.00
1296227110000.00
1486336925000.00
993149700000.00
1323840800000.00
1509362000000.00
1000449300000.00
1345484675000.00
1545149127000.00
1039982242000.00
1380577264000.00
1579656895000.00
1036490745000.00
1384959153000.00
1583429910000.00
1061853209000.00
1409864489000.00
1620689393000.00
1086948943000.00
1434554479000.00
1641366921000.00
1090182399000.00
1450754205000.00
1647539268000.00
1090586076000.00
1450785369000.00
1646991237000.00
1084864530000.00
1473364164000.00
1669317776000.00
1101004574000.00
1491287381000.00
1679834915000.00
1098919521000.00
1500506920000.00
1684223727000.00
1096572472000.00
1493904632000.00
1705354045000.00
1108079168000.00
1500548269000.00
1694805729000.00
1142950803000.00
1541694084000.00
1729355579000.00
1142906056000.00
1525126448000.00
1700949639000.00
1210852300000.00
1595330900000.00
1768421900000.00
1217562600000.00
1602256700000.00
1785279100000.00
1243716000000.00
1602257000000.00
1795381000000.00
1258350000000.00
1631460000000.00
1819443000000.00
1257089261000.00
1630105405000.00
1820159457000.00
1247372623000.00
1624372797000.00
1807743111000.00
1232986295000.00
1613621158000.00
1797093179000.00
1232986295000.00
1613621158000.00
1797093179000.00
1232986295000.00
1613621158000.00
1797093179000.00
1232986295000.00
1613621158000.00
1797093179000.00
1145559000000.00
1580060000000.00
1774095000000.00
1152485458000.00
1572000505000.00
1764393044000.00
1149178712092.09
1561291421092.09
1752725051409.52
1154645031563.36
1567083367486.85
1778362389166.07
1152594051000.00
1558684195000.00
1769009751000.00
1159588471705.67
1568842659101.95
1761909960620.63
1145714221037.00
1589235766660.95
1773626337535.28
1139529789291.04
1570162905645.44
1753382132219.63
1120543200264.41
1575750925041.26
1752329149680.89
1115957800000.00
1591061000000.00
1755933400000.00
1128865932506.13
1626889889554.54
1778879078466.05
1146904393812.69
1635687616257.01
1793751874003.17
1144435059177.08
1636030205985.34
1787351585660.29
1149844080218.16
1619670884348.89
1769582062820.19
1140480000000.00
1609250000000.00
1753860000000.00
Chart 4: Trend for money supply.
Data Analysis
Analysis of Trend
A review of table 1 and chart 1 show that there was an increase in the inflation rate between January and November 2008. The rise in the inflation rate necessitated SAMA to put in place several measures that were aimed at reducing the rate. The major cause of inflation during this period was the inflationary pressure in other countries due to the global financial crisis. The country experiences a decline in the rate until January 2009.
Between 2009 and December 2015, the country has experienced low levels of inflation. There has also been a general decline in inflation during the same period. However, there was a slight increase in January 2016. Between January and March 2017, Saudi Arabia had negative values of inflation. This implies that the country is experiencing a decline in price levels. Table 2 and chart 2 shows the expected annual inflation rate. A low of 1.98% is expected in 2017 followed by a sharp increase in 2018. A constant rate of 2.04 % is expected in both 2019 and 2020.
Table 3 and chart 3 displays the trend of both the repo rate and the deposit rate. Since May 2009, SAMA has maintained the repo rate at a constant rate. The deposit interest rate was also low with a slight increase between September 2015 and May 2016. Table 4 and chart 4 shows that there has been a continuous increase in money supply in the economy as measured by M1, M2, and M3. Based on the quantity theory of money, it is expected that as the money supply increases, then the rate of inflation should also go up. However, this is not the case as can be seen in the trend of the inflation rate.
Descriptive Statistics
Table 4: Summary of descriptive statistics.
Inflation rate
Interest rate (Repo rate)
Deposed interest rate
M1
M2
M3
Mean
0.046
0.480
0.498
829568730633
1173049073101
1343910580650
Standard Deviation
0.023
0.622
0.247
283375396993
320856073893
334262543237
Kurtosis
1.480
6.229
4.256
-1.45
-1.49
-1.50
Skewness
1.170
2.712
2.158
-0.08
0.10
0.06
Range
0.1154
2.75
1.178
860156000000
947012205985
1005022457000
Minimum
-0.0044
0.25
0.260
398194000000
689018000000
815137000000
Maximum
0.111
3
1.438
1258350000000
1636030205985
1820159457000
Correlation
Table 5: Correlation results.
Inflation rate
Interest rate (Repo)
Interest rate (government securities)
M1
M2
M3
inflation rate
1
interest rate (Repo)
0.7878
1
Interest rate (government securities)
-0.3249
-0.2098
1
M1
-0.8000
-0.5412
0.5528
1
M2
-0.7945
-0.5163
0.6143
0.9918
1
M3
-0.8006
-0.5296
0.6113
0.9928
0.9990
1
The correlation results show that there is a strong positive relationship between the repo rate and the inflation rate. Also, there is a negative relationship between inflation and other variables.
Regression Analysis
A multiple regression analysis will be carried out to analyze the association between the three variables. The regression result will take the form presented below.
Y = X1I1 + X2I2 + X3M1 + X4M2 + X5M3
Where;
Y = inflation rate;
X1 (I1) = Repo rate;
X2 (I2) = Interest rate on bonds;
X3 (M1) = Money stock /supply;
X4 (M2) = Money stock / supply;
X5 (M3) = money stock / supply.
Table 6: Regression results.
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.9272902
R Square
0.8598672
Adjusted R Square
0.8531300
Standard Error
0.0089393
Observations
110
ANOVA
Df
SS
MS
F
Significance F
Regression
5
0.05099
0.010199
127.6306
9.76223E-43
Residual
104
0.00831
7.99E-05
Total
109
0.05930
Coefficients
Standard Error
t Stat
P-value
Intercept
0.110705
0.0130623
8.4751
1.67E-13
I1
0.01904
0.0017558
10.845
8.69E-19
I2
0.0269
0.0053892
4.999
2.34E-06
M1
1.03161E-13
3.09267E-14
3.335
0.001181
M2
-8.26203E-14
6.52064E-14
-1.2670
0.207964
M3
-5.68613E-14
6.65078E-14
-0.8549
0.39454
Based, on the results above, the regression equation will take the form Y = 0.1107 + 0.01904 X1 + 0.0269 X2 + 1.03161E-13X3 – 8.26203E-14X4 – 5.68613E-14X5.
The intercept is 0.1107. It has no significant statistical interpretation. It simply shows the variables that have not been included in the regression equation. The positive coefficient values for repo interest rate, the deposit interest rate, and M1 imply that their inflation and these three variables move in the same direction. If the variables change by one unit, then inflation will change by the value of the coefficient. On the other hand, M2 and M3 have a negative coefficient. It implies that there is an inverse relationship between these two variables and inflation. If M2 and M3 increase by one unit, then inflation will drop by the value of the coefficient.
The coefficient of determination (R-square) is 0.8599. The value shows that 85.99% of the variations in inflation is explained by the five variables. It is an indication of a strong explanatory variable. The value of an adjusted R-Square is also high at 0.8531.
Another area that can be analyzed in the regression results is the significance of the explanatory variable. This can be done by looking at the p-value and t-statistic. The t-statistics will be compared with the significance level of 5%. If the p-value is less than the level of significance, then the variables will be statistically significant at the 95% confidence level. From the table, the p-values for repo rates (8.69E-19), interest rate on government securities (2.34E-06), and M1 (0.001181) are less than the significance level.
This implies that they are statistically significant at the 95% confidence level. On the other hand, the p-values for M2 (0.20796) and M3 (0.3945) are greater than 0.05. Therefore, the two variables are not statistically significant at the 95% confidence level.
The final area that will be analyzed in the regression result is ANOVA. It is used to test the significance of the entire regression line. This can be achieved by evaluating the F-values. From the table, F-statistic is 127.63, while significance F is 9.76223E-43. This value is lower than the significance level of 0.05. This implies that the overall regression line is significant at the 95% confidence level.
Thus, the statistical analysis indicates that the regression is significant and can be relied upon. Thus, inflation is a strong determinant of GDP. However, M2 and M3 can be dropped from the regression equation because they not statistically significant. The results indicate that the interest rate and M1 affect inflation in Saudi Arabia. M1 comprises of physical money, checking accounts, negotiable order of withdrawal accounts, and demand deposits. Therefore, if SAMA wants to control inflation in the country, then they should come up with measures that target these variables.
Conclusion
The paper carried out an analysis of the past, present, and future inflation rates in Saudi Arabia. The objectives of the paper were to understand inflation, measures of inflation, the causes of inflation, the relationship between inflation and money supply, the role of SAMA, and the effectiveness of SAMA in controlling interest rates. The paper made use of both quantitative and qualitative approaches to answer the research objectives.
From the analysis, it can be deduced that inflation is a persistent rise in price levels in the economy that are caused by demand-pull and cost-push factors. Besides, it is measured using the consumer price index. Further, the quantity theory of money is used to explain the relationship between money supply and inflation. The theory suggests that there is a direct association between money supply and inflation. The discussion above also indicates that SAMA has successfully controlled the interest rate. The inflation rate was high in 2008. The values dropped between 2008 and 2015. Thereafter, the values rose again. In 2017, the inflation rates in the country were negative.
The regression results show that the repo rate, deposit interest rate, and M1 are the statistically significant variables that affect inflation. However, M2 and M3 are not significant determinants. Therefore, M2 and M3 can be dropped from the regression equation and other variables can be added. The positive relationship between inflation rate and M1 confirms the quantity theory of money, which states that there is a positive association between inflation and money supply. Also, the positive relationship between inflation and interest rate indicates that bank credit affects the inflation rate. Therefore, it is important for the regulatory authority to closely monitor bank credit.
Baumann, D. & McAllister, L. (2015). Inflation and string theory (1st ed.). Cambridge, UK: Cambridge University Press.
Bernholz, P. (2015). Monetary regimes and inflation: History, economic and political relationships (2nd ed.). Cheltenham, UK: Edward Elgar Publishing Limited.
International Monetary Fund. (2017). Data. Web.
Saudi Arabian Monetary Authority. (2017). Inflation rate. Web.
