High Inflation in South Africa: Causes of Inflation - Research Proposal Example

The South African central bank governor, Tito Mboweni, has hiked the interest rates when inflation is already high “to tighten monetary policy in an effort to stem rising inflation”. 1 Since the cost of petrol is unceasingly increasing, it is creating additional pressure on food prices and adding to the current domestic inflation and bringing corresponding changes to the exchange rate, though the governor claimed that they were primary but not the only factors for the trend. “Together these two categories accounted for over half of the increase in the CPIX. Broad based pressures are also intensifying. If food and energy were excluded, CPIX inflation would have measured 6.1%”.2 Mboweni said the 50-basis-point hike was in “light of further deterioration in the inflation outlook, but mindful that the economy is responding to a less accommodative monetary policy stance.” 3 The increase was the 10th in two years, and took the prime lending rates set by the commercial banks to 15,5% - their highest in five years. 4Governor Tito Mboweni signaled repeatedly in the past month that lending rates were set to rise again as underlying inflation become “more generalized”, while stricter lending rules had so far failed to dent robust consumer spending and credit demand. 5 For the current business cycle, however, the hikes that were made to the country’s interest rates recently are generally being considered to be the last. Causes of high inflation The causes of high inflation in South Africa primarily are two external causes; “The current price drivers are rising oil and international food prices, simply because demand outstrips supply in the international market for these products. The two are linked because the immediate effect of increased fuel prices is that it becomes more expensive to produce food, but this on its own does not necessarily lead to a general price rise.” 6 Besides the policies of the South African government are not above contempt, and in fact these populist policies to appease some sections of the countrymen without concern or acknowledging the external causes in plunging the economy into despair. “Increased interest rates will have a direct effect on tax collections and therefore a direct effect on subsidizing the poor. This will lead to a rapid depletion of budget surplus, and to fill this gap the government has no option but to print money to fill in the gap.” 7 This is leading South Africa towards hyperinflation. Impact of high oil prices on South African economy The high oil prices have severely affected oil importing countries like South Africa, whose capacity to generate electricity has been affected and which has “forced them to ration electricity”. 8 Adding further, “The high price of oil impacts directly on firms, consumers and the government. First, it increases the domestic price of petroleum products, raises the cost of many immediate inputs, and as a result leads to higher production costs. Consequently firms may reduce their labor demand, investment and output. Second, as the short-run demand for oil is highly inelastic, consumers are forced to reduce their consumption of other goods and services to pay for higher energy bills.” 9 Moreover, the rising oil prices will also affect South Africa’s balance of payments, as exchange rates will work against them in international trade, this will reduce their level of economic activity since the amount of affordable oil that South Africa will be able to purchase shall be dramatically reduced under present conditions. “Consumers and firms could decide to reduce their oil consumption but since the demand for oil is highly inelastic in the short-term, they may be compelled to reduce their consumption of other imported goods. Doing so could undermine economic growth especially if capital goods imports are affected.” 10. Poverty is another issue facing the South African economy, since the current policy will lead to more widespread poverty as lack of adequate fuel will drive up the cost, with the cost of transportation of goods and services rising sharply and inadequate supplies of basic essential fuel for cooking purposes. Recession will set in which will further erode employable opportunities available and cut backs will lead to reduction in the employable work force, that will further hinder productivity and will break South Africa’s institutional measure to prevent it from spiraling down into the deep recesses leading to a great depression. “Previous oil price shocks have produced significant increases in real interest rates which undermined domestic investment, pushed the country deeper into recession and produced stagflation. Furthermore, a rising fiscal deficit, combined with increasing public expenditures due to petrol consumption by public entities, can prompt the authorities to use monetary creation to finance the additional expenditures. As the increase in the price of oil is akin to a supply shock, an accommodating monetary policy would contribute to inflation. It is advisable to adopt a non-inflationary policy to avoid hyperinflation and to maintain monetary credibility”. 11 South Africa is currently printing more money which will alter the relationship of its monetary policy to the fiscal policy that is generally aligned to economic growth, since South Africa is a developing economy. The income distribution model will be affected severely because of the recent oil prices, as there will be no trickle down effect, and if these conditions continue, the majority of South Africans will be plunged into poverty with the fragile middle class descending down and the few layers of top benefiting most from this re-distribution of wealth. In the long haul, South Africa needs external help, probably from oil rich countries to act as a benefactor and bail them out. Currently, given the policies of the South African government, it seems unlikely that South Africa will manage to run its economic course on its own. Answer 2. 1: In Fig 1 i axis represents interest rate and Y the output – income in the economy and in Fig 2, P for price level and Y for output-spending. The equilibrium point is at E, the interest rate is io and the output is Yo, thus at Po the goods are in equilibrium at the income level of Yo. If the interest rates fall from io to i1, the output and the income increases because low inflation leads to increased borrowing from the firm because the aggregate demand increases shifting its equilibrium from E to E1 in fig 2, this leads to increased spending. This cycle creates more employment, higher spending power leads to increased aggregate demand that facilitates production, for which the need for increased labor force leads to more employment in the economy. Conversely if the inflation rises, the interest rates increases leading to higher prices of goods. Since high inflation erodes value of money, the spending power falls from Y1 to Yo in Fig 2 and the correspondingly so does the output, leading to production being greater than the aggregate demand. This leads to increased goods and services not being able to find a market and downsizing of the workforce which is underemployment. Hence, inflation and unemployment are inversely proportionate to each other. Answer 2. 2: If I could participate in the economic policy-making in South Africa, I would prioritize inflation over unemployment because unemployment is the aftermath of inflation in this context. Higher oil imports are heading the economy towards hyperinflation which affects the supplies of the basic utilities. Inflation induced by rising interest rates and expensive oil based activities hampers productivity which leads to lower productions in firms, imbalances in international trade, a weak Rand in the international exchange market. This leads to unemployment, with skilled labor out of work, the economy grows weaker as resources cannot be deployed to meet either internal aggregate demands of those of the foreign market. This will trigger a high debt condition which will additionally burden the South African economy that is currently struggling with high interest rates. Inflation and unemployment are like the strands of DNA intertwined into one another. Inflation leads to downsizing, which creates mass unemployment, ultimately resulting in low output that eradicates gains by economic growth. Lack of economic growth destroys economic development, the tool that fights inflation. In South Africa’s policy, inflation is top priority as that is what leads to the domino effect, if inflation is curbed the problem of unemployment can be solved. Answer 3: The difference between economic growth and economic development can be stated in the following manner. “Economy growth can be defined as the increase in the economy’s output over time”. 12 This means that the economy has reached the ability, whereby, it can produce both more goods and services. “Economic development is defined as a process of economic transition involving the structural transformation of an economy through industrialization and a raising of the Gross National Product and per capita income. Economy development also involves a change in social attitudes, cultural set-up and institutional framework.” 13 Some of the things that can make a nation to become more productive and wealthier are: (a) Adopting a systematic and comprehensive planning system to increase employment opportunities and income levels. (b) Remove institutional obstacles and structural barriers that hinder economic growth. (c) Transfer of labor to market-oriented industry from subsistence agriculture. (d) Implementing programs that curb the rate of population growth. (e) Emphasis on savings and investments rather than focusing on consumer debt. (f) Gains through international trade by linking different sectors of an economy and by progressive foreign policy related to foreign direct investments. Section B Answer 4: “The costs depend on the extent to which a country is a net importer of commodities and the benefits relate to the extent to which a country is an exporter of commodities”. 14 In the South African context, the commodities boom has benefited the non-commodity sectors “because they have managed to expand non-traditional manufacturing exports and diversify export market destinations.” 15 These have led to strong foreign direct investments and participation of private portfolio investors with the Johannesburg Stock Exchange making gains due to firm resources stocks as increases in bio-fuel production in the world based on maize augurs well for South African exports. The consistency in the high amount maintained by Gold and other metals provides the stability in international trade especially against a weak dollar. The cost that will be paid by South Africa is in its import of oil, since the Rand is weak, it will have to pay high dollar for the same amount of imports as “demand from China, India and the Middle East accounted for more than 56% of the growth in oil consumption between 2001 and 2007.” 16 Food production for the domestic market may be inadequate and will need to be imported since locally produced food will be instrumental in keeping the economy going, due for exports, as supplying the needs for bio-fuel is more viable because of current high prices. Electricity will be a problem since the prices of alternative sources of energy like coal is on the rise because of switching and the oil option and its dependence across sectors shall create a great deficit in the long run. Concluding, “Econometrix economist Azar Jammine says people complaining about high fuel and food prices often don't realise the very factors driving those prices higher are driving South Africa's export prices higher. He's conducted an analysis of the balance of payments (BoP) for 2007 and found South Africa was a net beneficiary of commodity prices”. 17 Answer 5: “The monetary policy is required to facilitate the fulfillment of the basic objectives of planning and is also required to play the difficult role of countervailing force. The monetary policy of any economy operates through three important instruments, viz., the regulation of money supply, control over aggregate credit and interest rate policy. A restrictive monetary policy can limit the secondary expansion of money supply through multiplier effect and thereby prevent fluctuations in domestic price level.” 18 In the South African economy context, the governor is trying to push the interest rate higher that leads to the citizens having to accumulate more Rand to keep at the current standard. The strategy being utilized is to increase the opportunity cost of holding money which will change the nature of the aggregate demand in the long term. Since the current international trends have a deep influence on the economy, South Africa will not be able to meet an increasing aggregate supply, to prevent this, the availability of credit is being made unattractive and inelastic. However, what needs to be determined is the time period between the current increase in interest rates and the corresponding results that are hoped to be achieved by taking such a stance by the governor. If overdone, a persistent increase in interest rates, given South Africa’s unstable foreign exchange rate may eventually retard its economic growth, if correct checks and balances have not been institutionalized or a correct timing to manifest the necessary changes is missed. Answer 6: The economic impact of increased expenditure is both favorable and unfavorable. The benefits are in the business sector as expected sales rise, increasing the level of investment and employment opportunities generated. This brings about technological changes which deploy current resources more efficiently and provides favorably exchange rates in foreign trade. The pattern of income also changes considerably providing an increase in the standard of living, facilitating better government fiscal and monetary policy that operates from strength. The disadvantages are that increased expenditure may alter the dynamic on the availability of raw materials and their optimum utilization in the correct sectors, focusing on consumption rather than utility. This may bring in a shock effect, disturbing the economy and leading it to inflation and increasing interest rates with dependence on imports, removing any gains made in the balance of payments ratio. Increased consumption periods may also change the mindset from savings to debt, depleting the reserves that the economy can depend upon and creating more liability. Answer 7: The relationship that exists between interest rate and financial paper is inversely proportionate. Money market instruments move in the opposite direction of the change in interest rates. “The most commonly used measure of interest rate risk is duration” 19and “The key to measuring interest-rate risk is the accuracy of the estimate of the value of the position after an adverse rate change.” 20If the interest rate rises over a long period, the value of financial paper decreases and vice versa. We can calculate the stated relationship in terms of duration as: “∆y = change in yield in decimal VO = initial price V_ = price if yields decline by ∆y V+ = price if yields increase by ∆y The duration can be expressed as Duration = V_ - V+ / 2 (VO) (∆y)” 21 BIBLIOGRAPHY Citations 1. Lesova, Polya. (2008) Emerging Markets Report: South Africa hikes interest rates to fight inflation. 12 June 2008. Available from: http://www.marketwatch.com/news/story/south-africa-hikes-rates-not/story.aspx?guid=%7BE5571756-5205-4080-8EE5-93289F570DD0%7D [Accessed 15 August 2008] 2. Mboweni, Tito. (2008) South Africa: Reserve Bank – Statement of the Monetary Policy Committee (Pretoria). 13 June 2008. Available from: http://allafrica.com/stories/200806130142.html [Accessed 15 August 2008] 3. Isa, Mariam. (2008) South Africa: Tito to Tease Stun Markets. 13 June 2008. Available from: http://allafrica.com/stories/200806130452.html [Accessed 15 August 2008] 4. Isa, Mariam. (2008) South Africa: Tito to Tease Stun Markets. 13 June 2008. Available from: http://allafrica.com/stories/200806130452.html [Accessed 15 August 2008] 5. allafrica.com. (2007) 2008 South Africa: Bank Likely to Hike Repo Rate a Half-Percentage Point.Palapye.com News Blog. 13 August 2007.Available from: http://palapye.wordpress.com/2007/08/13/south-africa-bank-likely-to-hike-repo-rate-a-half-percentage-point/ [Accessed 15 August 2008] 6. Copeman, Philip. (2008) Reader Blog: What causes inflation? Available from: http://www.thoughtleader.co.za/readerblog/2008/06/04/what-causes-inflation/ Accessed 16 August 2008] 7. Copeman, Philip. (2008) Reader Blog: What causes inflation? Available from: http://www.thoughtleader.co.za/readerblog/2008/06/04/what-causes-inflation/ [Accessed 16 August 2008] 8. Ouagadougou, Burkina Faso. (2006) Introduction: High oil prices and the African Economy. Available from: http://www.afdb.org/pls/portal/url/ITEM/1356DCF9057CFFBCE040C00A0C3D2EF1. [Accessed 16 August 2008] 9. Ouagadougou, Burkina Faso. (2006) Oil importing countries: High oil prices and the African Economy. Available from: http://www.afdb.org/pls/portal/url/ITEM/1356DCF9057CFFBCE040C00A0C3D2EF1. [Accessed 16 August 2008] 10. Ouagadougou, Burkina Faso. (2006) Oil importing countries 2.2 Balance of payments: High oil prices and the African Economy. Available from: http://www.afdb.org/pls/portal/url/ITEM/1356DCF9057CFFBCE040C00A0C3D2EF1. [Accessed 16 August 2008] 11. Ouagadougou, Burkina Faso. (2006) Oil importing countries 2.7 monetary policy: High oil prices and the African Economy. Available from: http://www.afdb.org/pls/portal/url/ITEM/1356DCF9057CFFBCE040C00A0C3D2EF1. [Accessed 16 August 2008] 12. ICFAI. (2001) Economic Growth, Development and Planning. Economics – II, p. 189. Hyderabad. ICFAI University Press. 13. ICFAI. (2001) Economic Growth, Development and Planning. Economics – II, p. 190. Hyderabad. ICFAI University Press. 14. Steyn, Greta. (2008) Section/ Mining Finance: Doubt about the commodity benefit. Fri, 30 May 2008. Available from: http://www.miningmx.com/mining_fin/497978.htm [Accessed 19 August 2008] 15. Economist Intelligence Unit Views Wire. (2007) Africa's strong growth: Beyond commodities. Oct 19th 2007. Available from: http://www.economist.com/agenda/displaystory.cfm?story_id=10006712 [Accessed 19 August 2008] 16. Steyn, Greta. (2008) Section/ Mining Finance: Doubt about the commodity benefit. Fri, 30 May 2008. Available from: http://www.miningmx.com/mining_fin/497978.htm [Accessed 19 August 2008] 17. Steyn, Greta. (2008) Section/ Mining Finance: Doubt about the commodity benefit. Fri, 30 May 2008. Available from: http://www.miningmx.com/mining_fin/497978.htm [Accessed 19 August 2008] 18. ICFAI. (2001) Modern Macroeconomics: Monetary Policy and Interest Rate Structure. Economics – II, p. 174. Hyderabad. ICFAI University Press. 19. Fabozzi, Frank J. PH.D., CFA, CPA, Mann, Steven V. PH.D. (eds.) and Ferri, Michael G. PH.D. (2005) Overview of the Types and Features of Fixed Income Securities. The Handbook of Fixed Income Securities, p.22. New York: McGraw – Hill Companies, Inc. 20. Fabozzi, Frank J. PH.D., CFA, Mann, Steven V. PH.D. (eds.), Buetow, Jr. PH.D., CFA, Gerald W., PH.D., CFA and Johnson, Robert R. PH.D. (2005) Measuring Interest-Rate Risk. The Handbook of Fixed Income Securities, p.183. New York: McGraw – Hill Companies, Inc. 21. Fabozzi, Frank J. PH.D., CFA, Mann, Steven V. PH.D. (eds.), Buetow, Jr. PH.D., CFA, Gerald W., PH.D., CFA and Johnson, Robert R. PH.D. (2005) Measuring Interest-Rate Risk. The Handbook of Fixed Income Securities, p.197. New York: McGraw – Hill Companies, Inc. References (Answer 2 and 4) 1. ICFAI. (2001) Economics – II. Hyderabad. ICFAI University Press. 2. Motsoeneng, Tiisetso. (2008) South Africa: Market players bet it all on commodities. August 6, 2008. Available from: http://www.busrep.co.za/index.php?fSectionId=629&fArticleId=4545472 [Accessed 19 August 2008] 3. Motsoeneng, Tiisetso. (2008) South Africa: Commodities put spring back in JSE's step. August 18,2008.Available from: http://www.busrep.co.za/index.php?fSectionId=629&fArticleId=4564725 [Accessed 19 August 2008] 4. Mackenzie, Jacqueline. (2008) South Africa: Buzz in resources sector boosts JSE. June 30, 2008. Available from: http://www.busrep.co.za/index.php?fSectionId=629&fArticleId=4482057 [Accessed 19 August 2008] 5. Mackenzie, Jacqueline. (2008) South Africa: Relief rally lifts trade. June 30, 2008. Available from: http://www.busrep.co.za/index.php?fSectionId=629&fArticleId=4509886 [Accessed 19 August 2008] 6. Mackenzie, Jacqueline. (2008) South Africa: Recovery in resources brings a boost. August 14, 2008.Available from: http://www.busrep.co.za/index.php?fSectionId=629&fArticleId=4559063 [Accessed 19 August 2008] Read More