Political economy of inflation

January 23, 2022

The current government’s policies, formulated within the framework of IMF conditionalities, have exacerbated inflation

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The attempt to control inflation in Pakistan falls within the rubric of responsibility of the State Bank. This organisation, now autonomous from the government, believes that inflation in Pakistan, as in developed countries, can be controlled exclusively through monetary policy, i.e., control of the money supply. In recent years, following this view assiduously, the State Bank has sharply raised interest rates, restricted borrowing by the government and manipulated the reserve ratio of commercial banks to further constrict credit. These drastic measures have failed to quell inflation. They have, however, served to slow down GDP growth, increase unemployment and poverty.

It could be argued that the limitations of monetary policy as an exclusive instrument of inflation control in underdeveloped countries like Pakistan may lie in two factors. First, inflation in Pakistan is a structural, not a monetary phenomenon that can be addressed entirely through control of the money supply. The evidence shows that there are three features of structural inflation: (a) Rapidly rising food prices pull up the average inflation rate (b) Devaluation, in so far as it increases the rupee cost of imported inputs that go into both industrial and agriculture production. This results in cost-push inflation (c) Prices of electricity, gas and fuel, which induce an across-the-board inflation because these are key inputs in the production of almost all goods and services. None of these structural features can be addressed through monetary policy.

The second factor that limits the effectiveness of monetary policy as an instrument of inflation control, is that at least half the economy is in the “informal” sector. The value of goods and services produced as well as the changes over time in these values remain unknown to both the government and the State Bank. Apart from this, producers and consumers of goods and services in the informal or undocumented sector do not borrow loans from commercial banks. So, half the economy of the country is simply not susceptible to monetary policy.

The conventional view of the factors underlying inflation even in the developed countries has recently been questioned. The traditional belief of central bankers in the West was that expectations are the key determinant of inflation. For example, if workers believe that prices will rise in the future, they will get wages pushed up through trade union action, hence induce cost-push inflation. Similarly, if businesses expect higher costs in future, they will set higher prices today. Thus, inflation becomes a self-fulfilling expectation, induced by future projections. So central banks have historically aimed to control expectations by achieving stability in the system.

If the government is to prevent an explosive political situation, it must set aside the idea that the market necessarily delivers efficient outcomes. When millions are facing hunger because of the way the market is functioning, then the government must step in. It should show a modicum of empathy for the people it represents.

Jeremy Rudd, the author of over a dozen papers on inflation, wrote a discussion paper recently, challenging the conventional view of inflation, which the US Federal Reserve has posted on its website. The Economist, London, has discussed Rudd’s paper. The Economist refers to him as saying that a preoccupation with the view that expectations determine inflation is “useless and dangerous”. Useless because what matters are observed prices today, not future prices. Dangerous, because central bankers might harbour an unjustifiable confidence in their “powers of mind control”.

Rudd’s view has been contested by Ricardo Reis, a distinguished economist at the London School of Economics. However, Rudd’s argument that casts doubt on the conventional determinants of inflation, such as expectations, money supply and interest rates, is part of a more fundamental questioning of the economics orthodoxy. In a footnote he says, “…mainstream economics may serve as an apologetics for a criminally oppressive, unsustainable and unjust social order.”

The current government’s policies, formulated within the framework of IMF conditionalities, arise out of the political economy of the existing social order. These policies of contracting the economy through monetary and fiscal policy, far from controlling inflation have exacerbated it. They have placed the people of Pakistan into a double bind. High inflation together with increasing unemployment. Consequently, for almost half the citizens, articles of daily use are going out of reach. So desperate is their economic plight, that some are committing suicide. The market has failed them. If the government is to prevent an explosive political situation, it must set aside the ideology that the market necessarily delivers efficient outcomes. When millions are facing hunger because of the way the market is functioning, then the government must step in. It should show a modicum of empathy for the people it represents.

Given rising food prices and falling family incomes of the people, the logic of compassion rather than the market has to be followed. This requires food to be taken out of the market system, and supplied free, initially to the bottom 45 percent of the people. This action should be supported by legislation that declares food a fundamental human right.


The writer is a professor and dean at the School of Humanities and Social Sciences, Information Technology University, Lahore



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