What causes inflation in China - Essay Example

? What causes inflation in China? Introduction Inflation is an economic phenomenon in which prices of goods and services increase gradually over a period of time. It is one of the most important economic problems facing by majority of the countries at present. Even developed countries and rapidly emerging countries are not free from the problems generated by inflation. China is the most rapidly developing country in the world at present. Yet, “China's inflation rate hit a 10-month high in February, as Lunar New Year festivities drove up food prices. Consumer prices rose 3.2% from a year earlier, with food prices up by 6% (China inflation rate hits 10-month high in February, 2013). This paper analyses the reasons of inflation in China. Causes of inflation in China Even economists are not unique in their opinions about the reasons of inflation. In other words, there are plenty of reasons for inflation in a country. However, two economic theories; Demand pull and cost push inflation theories explain the reasons of inflation comprehensively. Demand-pull inflation occurs when demand for a good or service increases so much that it outstrips supply. As demand increases, sellers start selling out of the product, and frustrate potential customers. Their next step would be to produce more. However, if supply is constrained, their next step would be to raise prices, creating inflation (Amadeo, 2013). Demand pull inflation is illustrated in the figure given below. Demand pull inflation is a case in which too much money available in the market whereas the availability of goods or services is less. In other words, in economies with demand pull inflation, demand for goods and services will be increased whereas the supply decreased. As a result of that price will be increased. (Monetary Policy - Inflation – Causes, 2012) Demand pull inflation occurs mainly in growing economies. Since China is one of the most rapidly growing economies, demand pull inflation occurs quite frequently. “China’s broad money supply more than doubled in four years, reaching 97.42 trillion yuan (US$15.66 trillion) by the end of 2012, according to central bank figures. Economists blame the unprecedented growth in credit for the inflation and asset bubbles” (Zitan, 2013). Centran bank of China is printing excessive currencies in recent times in order to pump more money into the market and to increase the economic activities. As a result of that asset bubbles are creating major industrial sectors, like real estate industry in China. Asset bubble is an economic phenomenon in which the prices of assets increase sharply. In other words, asset bubble increases the prices of commodities beyond its actual or realistic price. When prices of a commodity increases beyond its actually value, the possibility of sudden collapse of its value cannot be ruled out. In short, when the government pumps more money into the market the value of the commodities increases beyond its actual prices and thereby causing inflation. Credit or money supply is essential for a country’s economic growth. It has direct relationships with the gross domestic product (GDP) of a country. Economic activities in a country can be sustained only with the help of adequate money supply. However, excessive money supply brings more harm than good. Money supply is usually keeps a ratio of 1 to 1.5 with GDP in developed countries. However, in China’s case, this ratio reached an all-time high 1.88 in 2012 (Zitan, 2013). In terms of credit creation, no country seems to be anywhere near to China. As a result of that asset bubbles or economic bubbles are common in China. Loans made by Chinese banks in recent times are extremely higher compared to that in the past. Thus, Chinese people are getting plenty of money in their hands for purchasing goods and services. When the purchasing abilities of the people increase, economic activities will also be increased. At the same time, price hikes will also take place as a result of the pumping of more money in to the market. Cost push inflation is “A phenomenon in which the general price levels rise (inflation) due to increases in the cost of wages and raw materials” (Cost push inflation, 2012). When wages and raw material costs increase, companies will increase the prices of their products and services to maintain an adequate level of profit. It should be noted that the primary motive of all the companies is to increase the profit as much as possible. They will always put the liabilities of increased raw material price and wages on the shoulder of the consumers. Cost push inflation is partly responsible for the increased inflation rates in China. Cost push inflation affects China same way like it affects all the other countries in the world since current markets are extremely globalized. According to Yunqi (1989), there are two reasons for inflation increase in China. “The first is price reform and changes in economic structure associated with economic reforms (ie reform inflation). The second is the mistakes made in the process of formulating and implementing economic policy, specifically the expansion of excess aggregate demand (ie excess demand inflation)” (p.655). It should be noted that Chinese economy has changed from a command to market economy because of the economic reformation. Chinese economic activities were under the tight control of the government until couple of decades before. In the 80’s and 90’s Chinese government led by Deng, made lot of economic reforms in the country. As a result of that private capital started to accumulate in China. Chinese authorities realized that internal resources alone may not help China to achieve its economic objectives. They started to accept foreign capital as much as possible from 80s onwards. When China was under command economic system, prices were fixed for longer periods and hence inflation was not at all a problem. However, the transition from command to market economy forced the government to allow the private firms to set prices of their products and services. When aggregate demand for goods and services exceeds aggregate supply of output which is produced by fully employing the given resources of an economy, excess demand is said to occur. This excess demand leads to the rise in general price level i.e. inflation in the economy. Before full employment of resource is reached, any rise in aggregate demand will cause aggregate supply of output to rise (Varun, 2012). When demand increases, prices will also increase unless the supply is not adequate. In China, because of the excessive money flow to the market, demand for goods and commodities are increasing. At the same time, Chinese manufacturers are incapable of producing goods sufficient enough to meet the domestic demand. It should be noted that a substantial portion of the goods produced in China are exported to earn more foreign money. As a result of that scarcity of goods and commodities is taking place in Chinese market. In short, China’s export oriented economic policies are causing insufficient supply of goods in the domestic market and thereby causing inflation. Another reason for China’s inflation rate increase is the increased attachment of Yuan with US dollar. In other words, economic problems in America are causing inflation problems in China in one way or another. There are experts who say China cannot escape the inflationary spiral as long as it keeps it currency, yuan, pegged to the U.S. dollar. The more strength the Chinese economy gains with each passing day, which it does, the weaker the American economy becomes, making it ever more impossible for China to keep the cost of pegging the currency to dollar at a comfortable level. As China’s economy gains strength, and the American economy weakens, the cost and difficulty of maintaining the peg become ever greater, and eventually outweigh the benefits that the policy supposedly delivers to China, Peter Schiff wrote in Daily (Jacob, 2011). China has the habit of purchasing US dollars from open market since US dollar is believed to be one of the strongest currencies in the world. China knows very well that America is the wealthiest country in the world at present and its economy will be back in the growing phase sooner rather than later. China believes that the current economic problems in America are temporary and American economic growth will be back on track in near future itself. These assumptions are encouraging China to purchase as much US dollars possible from the open market. In fact China does so to protect its interests in future. However, the present scenario is such that American economy is getting weakened as time goes on and China forced to purchase more and more US dollars. In order to purchase more U.S. dollar, China is printing more Yuan. It should be noted that Chinese goods are currently very much popular in American market because of its cheaper prices. As a result of that, imports of Chinese goods to America have been increased a lot in recent past. When America imports more Chinese goods, newly printed US dollars are exported to China. At the same time, newly printed Yuan is getting accumulated in China itself. In short, Chinese market is getting accumulated with newly printed dollars and Yuans and the outcome would be inflation. It should be noted that when newly printed currencies are getting exported, inflation may not take place. At the same time, when such currencies are getting accumulated in the domestic market, inflation would be the result. According to Yi Gang, vice governor of the People's Bank of China, “China's large external imbalances, combined with its interventions in the foreign -exchange market, are the "root cause" of the country's current inflation problem”(Back, 2013). As mentioned earlier, China is currently trying to boost the exports at any cost and discourages the imports. Thus foreign money is getting accumulated in China. In fact foreigners are seeking benefits from yuan by pumping foreign money into Chinese market. “Many in China argue that inflows of "hot money," short-term capital that seeks to benefit from yuan appreciation and interest-rate arbitrage, are also a main factor behind China's foreign reserve accumulation and a source of imported inflation pressures”(Back, 2013). Foreign exchange rate of Yuan is considerably depreciated because of the governmental policies. It is a fact that cheaper Yuan would definitely help the manufacturing and exporting sector. However, cheaper yuan would definitely make imported goods more expensive. Consumerism is increasing in China along with the population growth. Manufacturing sector is struggling to meet the demand in the domestic market. All these factors are contributing to the higher inflation rates in China. For China, urbanization is not only the core content of transitional development but also the primary way to achieve modernization. During this course, the market-driven price mechanism plays a dominant role in distributing resources, and investment and consumption demands need to be satisfied by marketization transactions. As the demand for marketization continues to grow, the phenomenon of inflation expectations will inevitably appear (Xianzhong, 2011). Over urbanization is another cited reason by economists for China’s growing inflation rates. It should be noted that urbanization increases the purchasing abilities of the consumers. It is a fact that rural people consume less compared to urban people. Over urbanization increases consumption and thereby it increases the demand for goods and services. Conclusions Economic reforms in 80’s and 90’s have transformed Chinese economy from a command economy to market economy. As a result of that, control of the government on prices of goods and commodities started to decrease. Moreover, China is printing more Yuan as a measure to increase economic activities in the domestic market. Thus the purchasing abilities of the people of China are increasing. At the same time, supply of goods and services is not adequate in domestic market. China is giving more emphasize to exports rather than imports. In short, accumulation of foreign as well as local currencies is taking place in China. As a result of that, inflation is occurring beyond the acceptable limits in China. Over urbanization is another reason for the higher inflation rates in China. References Amadeo, K. 2013. What Is Demand-Pull Inflation? [Online] Available at: http://useconomy.about.com/od/inflationfaq/f/demand-pull-inflation.htm [Accessed 14 March 2013] Back A. 2013. External Surpluses Root Cause of China's Inflation Problem. The Wall Street Journal. February 26, 2011. China inflation rate hits 10-month high in February. 2013. BBC News. [Online] Available at: http://www.bbc.co.uk/news/business-21737871[Accessed 14 March 2013] Cost push inflation, 2012. [Online] Available at: http://www.investopedia.com/terms/c/costpushinflation.asp#axzz2NTNIX3Qu [Accessed 14 March 2013] Jacob J. 2011. What is the real reason behind Chinese inflation? [Online] Available at: http://www.ibtimes.com/what-real-reason-behind-chinese-inflation-263693[Accessed 14 March 2013] Monetary Policy - Inflation – Causes, 2012. [Online] Available at: http://www.bized.co.uk/virtual/bank/economics/mpol/inflation/causes/theories1.htm [Accessed 14 March 2013] Varun, 2012. How does Excess demand cause demand-pull inflation? [Online] Available at: http://www.preservearticles.com/201106188234/how-does-excess-demand-cause-demand-pull-inflation.html [Accessed 14 March 2013] Xianzhong, Y. 2011. Is over-urbanization causing China's inflation?. [Online] Available at: http://english.people.com.cn/90780/7580352.html[Accessed 14 March 2013] Yunqi L, 1989. China’s inflation causes, effects and solution, Asian Survey. Vol. 29, No. 7, Jul., 1989. Zitan, G. 2013. Printing Money Is Cause of Inflation in China [Online] Available at: http://www.theepochtimes.com/n2/china-news/printing-money-is-cause-of-inflation-in-china-355279.html[Accessed 14 March 2013] Read More