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New budget to fuel inflation.

A Disturbing feature of the budget 2008-09 is the double-digit target of 12 percent set for inflation. Although inflation has emerged as a risk to the economy since 2004-05, such a high level of inflation has not been targeted in the budget or experienced in recent history. The hike in the prices of petroleum products and CNG has further fuelled inflationary expectations.

What are the causes of high level of inflation? Economic theory provides three possibilities of higher inflation described by Robert J. Gordon as the "triangle model":

(a) aggregate demand outstrips the aggregate supply of goods (demand pulled inflation),or

(b) costs increase due to any supply side effects which increase the cost of production (cost-pushed inflation) or

(c) inflation induced by adaptive expectations (builtin inflation). Any or all types of inflation can be generated by fiscal measures.

The government can adopt expansionary fiscal and monetary policies, which may cause demand pull inflation; simultaneously it has the power to impose indirect taxes or increase tax rate that may result in cost push inflation and finally it can generate "price/wage spiral" which trigger a process in which workers trying to keep their wages up with rise in prices and employers passing higher costs on to consumers.

The important question is: what explains the recent inflationary trend since 2004-05, and why government has set a high target of 12 percent for 2008-09?

Since 2002-03, the monetary policy stance has been expansionary. There was lack of sterilization of foreign exchange inflows since 9/11. The initial impact was, of course, growth in output in 2003-04 and 2004-05, which peaked at nine percent. Thereafter, monetary expansion has increasingly spilled over into higher inflation, due to limits of capacity. The initial boom was basically a release of 'repressed growth'.

The precipitous fall in interest rates sparked off an explosion in private sector credit and raised aggregate demand in the economy. Expansionary monetary policy also helped in creating 'fiscal space' due to the sharp fall in interest payments. As a result, aggregate demand outstripped the aggregate supply of goods and translated in relatively higher inflation till 2006-07.

In 2007-08, inflation was also fuelled by "external shocks" of rising oil and food prices. However, the impact had not been felt directly till recently because of limited pass through into domestic prices. An indirect effect has come via the sharp jump in the subsidy bill that has raised the fiscal deficit, financed largely by borrowings from the central bank.

It is clear that the expansionary fiscal policy is impacting on monetary policy. Also the high single digit inflation in the last three years and the soaring inflation this year have built-in inflationary expectations. Consequent behavioral changes along with soaring prices of energy and food and rupee depreciation have resulted in spiralling inflation. Thus the economy has been experiencing an inflation of 11 per cent rather than the target of 6.5 per cent for 2007-08.

The government resource mobilisation efforts are largely concentrated on taxes like custom, federal excise duty and sales tax. In this year's budget, the rate of sales tax has been increased from 15 to 16 per cent. Due to a plethora of excise duties, sales taxes and various customs duties, business and industry would have no option but to pass on most of the taxes to the consumer. In this sense, it is a budget, which cuts at the roots of supply side economies by enacting direct cost increasing policies which are quite inflationary in nature.


The government plans to cut current expenditure both in nominal as well as in real terms.

Given the size of budget deficit, this is a positive move if successfully implemented. While the current expenditure is expected to decline marginally by only Rs23 billion, subsidies are expected to drop from Rs407 billion to Rs295 billion. These subsidies are largely used to stabilise energy and food prices. The cut in subsidies will not only increase the fuel and electricity prices, but will affect every sector of the economy, by increasing the transportation and production costs. This will fuel the cost push inflation.

The impact of the budget deficit on inflation depends on its mode of financing. The current deficit for 2008-09 is being largely financed by non-bank borrowing (44.5 percent) followed by both external resources and bank borrowing (25.6 percent each) and only 4.3 per cent through privatisation. Of these four measures, bank borrowing or monetization of deficits is highly inflationary. The projected financing through bank borrowing is more than one per cent of the GDP and may lead to a high inflation.

It is obvious from the new taxation proposals and expenditure reduction strategy that the budget would promote cost-push inflation. The previous inflations have been largely "demand-pulled", but this one clearly shifts the focus to " cost-pushed". The cost-pushed inflation is worse than demand-pulled inflation, because costs when increased are built into prices and these price increases are very hard to undo.
Rate of inflation

 CPI Food prices

1999-2000 3.6 3.8
200-01 4.4 3.6
2001-02 2.5 2.5
2002-03 3.1 2.8
2003-04 4.6 6.0
2004-05 9.3 12.5
2005-06 7.9 6.9
2006-07 7.8 10.3
2007-08 * 11.0 -
2008-09 ** 12.0 -

Sources: PES and budget speech 2008-09
* Revised estimate
** Target
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Author:Sabir, Muhammad
Publication:Economic Review
Geographic Code:4EUUK
Date:Jun 1, 2008
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