Nils Kwarciak (21377227)

ECW3143

Assignment 1

The objective of this essay is to analyze adverse effects of a moderate inflation rate between the boundaries of 5% to 10% and discuss the impact of current interest rates in China on consumers and businesses. Milton Friedman claimed that inflation is always and everywhere a monetary phenomenon that is a result of increases in money supply within an economy (Fitzgerald, 1999). Consumer Price Index (CPI) data is a common measure of the rate of inflation in an economy (Mishkin, 2009). China has made low inflation a major macroeconomic policy; to reverse rapid and sustained price increases (Yao, Fullick, & Rabinovitch, China Jan inflation may keep policy tightening on track, 2011). Escalating food prices are particularly highlighted as they make up 30% of CPI basket of goods. In a country where poverty still prevails despite rapid increases in Gross Domestic Product (GDP) in the last decade, the government is feeling the pressure to satisfy its citizens as a result of food inflationary riots in the Arab world in early 2011 (Yongding, 2011). Chinas official forecast for year on year inflation in 2011 was 4% (Branigan, 2011). A moderate rate of expected inflation will affect the allocation of resources in Chinas economy. Inflation results in Chinas Yuan to lose real value, because it acts as a tax on real money balances when those balances pay less than the market rate of interest (Hubbard, 2008). Consequently; the purchasing power parity (PPP) of Chinese citizens will decrease. Analysis estimated fruit prices to have increased by 35%, vegetables by 2%, and grains by 15% in the last year, with current wheat crops facing drought (Wheeler, 2011). While the relative seriousness of inflation is up to debate, there are undoubtedly economic and social costs associated with persistent inflation in goods and services. Moderate inflation creates wage-price spiral problems within an economy. As prices for goods and services rise, workers demand higher wages to maintain their real standard of living (Hubbard, 2008). Businesses in China are directly affected; as pressure on wages to rise, increases manufacturing costs. Rising inflation increases inflationary expectations as reflected by the level of wage bargaining that occur within the economy. For example; Hon Hai Precision Industry Co (Foxconn) raised wages by 30% as a result of increasing suicides in their labor force. Consequently many Chinese businesses increased their wages, supported by the central government with the aim of reducing labor unrest (Oster, 2011).
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Nils Kwarciak (21377227)

ECW3143

Assignment 1

Higher wages would result in an increase in domestic consumption and reduce reliance on exports to expand the Chinese economy. However, rising wages result in businesses increasing prices to maintain profit margins. Rising standards of living will keep prices of natural resources high as demand outpaces supply (Oster, 2011). Cost-push inflation is applicable in China. When workers push for higher wages either to catch their real wages (wages adjusted for changes in PPP) or to catch up to inflation expectations, the consequences are lower profit margins harming investment decisions (Hubbard, 2008). As the worlds most populous nation China has a large abundance of labor. Consequently, Chinese businesses attracted labor from rural farms into manufacturing jobs in urban areas. However, the wage-price spiral is facing increasing pressure from a shrinking labor force that needs to sustain a growing elderly population, resulting in even higher wages and a further reduction in PPP (Ma, 2011). Rural areas in western China are at the focus of mitigation because of increasing wage costs, as suggested by Foxconn, among other Chinese organizations, announcing expansion operations to inland China. Analysts suggest that mitigation is challenged by increased logistics and transportation costs of moving inland, and that any productivity gains are outpaced by wage increases, as such increasing unit labor costs (Oster, 2011). A sustainable and moderate inflation rate has a negative impact on consumers and businesses on fixed incomes. Pensioners for example would see their real value of income depreciate year on year unless the central government adjusts their pensions relative to the rate of inflation. However, the problem lies in the fact that pensioners are unlikely to have spending patterns relative to CPI weights (Leicester, O'Dea, & Oldfield, 2008). Inflation leads to uncertainty, disrupting business planning with an adverse effect on the level of planned capital investment. Budgeting becomes a complex issue as businesses are tentative about future levels of operating costs. The current volatility of inflation leads to firms demanding higher nominal rates of return on planned investment projects prior to capital spending. Certain projects may potentially be cancelled or postponed until economic

Nils Kwarciak (21377227)

ECW3143

Assignment 1

conditions improve. A low rate of new capital investment clearly diminishes long-run economic growth and productivity (Fama & Gibbons, 1982). Inflation distorts the operation of price mechanisms, resulting in an inefficient allocation of resources. Volatile inflation disrupts information relative to price levels; hence consumers and businesses can make ill-informed decisions to the supply and purchase of goods and services. For example, price volatility has caused reluctance among pork suppliers to increase output in China. Pork is a major component of Chinese food expenditure yet prices rose 57% year on year in June 2011 to record highs (Yongding, 2011). The central government reacted by arranging a release of reserves onto the market to reduce prices. Such a measure is only a short-term solution and focus must lie in maintaining inflation. Chinas Ministry of Commerce also notes that the rising cost of feed and rural labor has put further upward pressure on prices (Yao J. , 2011). Inflation reduces public demand for real money balance resulting in shoe leather costs; whereby consumers and businesses incur the cost of making more trips to the bank to avoid holding large amounts of currency and transfer funds from interest-bearing assets into money. If public shoe leather costs exceed government revenue gains from inflation tax, inflation generates an excess burden, or social loss (Hubbard, 2008). Another cost of expected inflation according to Keynesian theory arises from so called menu costs or costs to firms of changing prices (reprinting, informing customers). Faced with different menu costs, not all firms change prices at the same time therefore price changes are not synchronized throughout the economy (Hubbard, 2008). Inflation distorts taxes that individuals and firms pay on their income. Income tax rates usually apply to nominal income, and progressive; where tax rates increase as income increases. Bracket creeps occur when tax brackets are not indexed for inflation, as income rises with inflation; thus individuals are subject to higher tax rates, even though they might not gain PPP from increasing income. Tax code also fail to adjust inventory values and the value of depreciation allowances for inflation; raising corporate tax burden and depressing business investment during inflationary periods (Hubbard, 2008).

Nils Kwarciak (21377227)

ECW3143

Assignment 1

Figure 1 (source: www.tradingeconomics.com, China Economic Information Net)

Figure 1 above indicates that inflation was has been rising steadily since 2009 following a slowdown after heavy inflation in 2008. In December 2010 the figure stood at 5.9%.Since February 2010 when CPI climbed 2.7%, and Chinas official one-year deposit rate was 2.25% real interest rates have been negative as indicated by the calculation below. These figures are worrying for Chinas major trading partners due to its largely untapped consumer market and cheap supply of export labor, threatening economic growth in China (Vlad, Hurduzeu, Josan, & Vlasceanu, 2011). The real interest rate is defined as the nominal interest rate minus the expected rate of inflation. The distinction between real and nominal interest rates is important because real interest rates reflect the real cost of borrowing, giving better indications towards market conditions (Mishkin, 2009). In July 2011 the Peoples Bank of China (PBOC) released year on year Chinese CPI results at 6.50%, with nominal interest rates increasing 25 base points to 3.50%, with the aim of a deflationary effect on GDP (NBS, 2011). Application of the data to the Fischer equation;

Where is the nominal interest rate and

is the expected rate of inflation (Mishkin, 2009),

allows an estimate of real interest rates on savings to stand at -3.00%. The nominal rate of interest on loans stands at 6.56%, as such the real rate of interest on loans stands at 0.06%

Nils Kwarciak (21377227)

ECW3143

Assignment 1

using the above mentioned formula and CPI data. However, assuming that PBOC fund rates remain unchanged, rates are firmly negative. Thus, CPI inflation would have to drop to 3.00% just for the real rate to get back to 0.00%. If real interest rates are negative in relation to inflation there can also be a significant reduction in the real value of savings (Levi & Makin, 1979). This implies that the real rate of interest does not fully compensate for the increase in general price levels. As such borrowers will see their real value of debt decrease, at the expense of savers. Such data is worrying as Chinese households hold more than 5.2 trillion US dollars in savings (Trouillaud, 2011). The rate of return offered in the banking system is too low to compensate the loss of PPP due to inflation, which is also affected by the fact that savers pay tax on income earned through interest. Therefore, negative real interest rates result in lenders being reluctant to issue loans because of negative real interest earned, while borrowers will favor the condition. Consequently, nominal interest rates should be raised until inflation in China is under control as the above mentioned examples clearly indicate rising prices in China which in turn reduce consumers PPP. Inflationary volatility with negative real interest rates increase market speculation as investors seek higher returns to offset the loss PPP. Global trading partners pressure China to appreciate Yuan value (Kazer, 2011) , yet confidence in the Yuan as a store of value will decline, further depreciating Yuan value. Negative real interest rates also put upward pressure on commodity and precious metal prices as people tend to seek alternate stores of value (Nickell, 1998). To counteract adverse affects of the 2008 global financial crisis, Chinese financial institutions issued large amounts of credit. Rising liquidity created asset bubbles throughout industries increasing sustainable inflation. Chinas central government reacted by raising the ratio of reserves that banks are required to hold to a record 21.5 % for the biggest lenders (Lifei, 2011). With further expected inflation, at current interest rates bank depositors will withdraw their savings and invest elsewhere. As money leaves the banking system, increasing deposit ratios will not be effective in reducing excess liquidity. However, reluctance to interest rate increases is linked to potential hot money inflows and increased debt burdens for local governments which are estimated at 10.72 trillion Yuan (Jiayi, 2011).
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Nils Kwarciak (21377227)

ECW3143

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Banks have given credit preference to government enterprises at the expense of small and medium business enterprises forcing them to borrow at inflated rates of return (Yao K. , 2011). Administrative and quantative ratio measures are not enough and will not protect the interests of depositors who are heavily integrated by savings data in the system. Market reforms will help lower inflation expectations and allow price signals to work more effectively in capital markets. Thus, China must tackle inflation by basis of reducing money supply and increasing nominal interest rates by a minimum amount of 3.00% at a reasonable pace, to balance real interest rates out of negative territory. Yuan exchange rates have traditionally been kept low by the central government to support cheap exports. However, a stronger currency would make imports cheaper, and decrease increasing money supply that is causing the core problem of inflation. One must also bear in mind that in the context of a fast-growing and developing economy, inflationary problems are only natural, however if the problem is not tackled it could spiral out of control. WORD COUNT = 1,638

Nils Kwarciak (21377227)

ECW3143

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Bibliography
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http://www.google.com/hostednews/afp/article/ALeqM5hqlkbUC5nzvQOnziz1yX9Vn08dUA?docId= CNG.582de026b4a2bc17c19719d897de717b.301 Vlad, L. B., Hurduzeu, G., Josan, A., & Vlasceanu, G. (2011). The Rise of BRIC, the 21st Century Geopolitics and the Future of Consumer Society. Revista Romana de Geografie Politica , 48-62. Wheeler, C. (2011, February 15). Chinas food inflation leaving a bad taste. Retrieved August 24, 2011, from The Globe and Mail: (http://www.theglobeandmail.com/report-onbusiness/economy/chinas-food-inflation-leaving-a-bad-taste/article1907440/) Yao, J. (2011). Commercial Development of China from January to May. Ministry of Commerce People's Republic of China (MOFCOM) . Yao, K. (2011, July 12). Analysis: China may lean on rate rises to fight inflation. Retrieved from Fox Business: http://www.foxbusiness.com/markets/2011/07/12/analysis-china-may-lean-on-rate-risesto-fight-inflation/ Yao, K., Fullick, N., & Rabinovitch, S. (2011, February 14). China Jan inflation may keep policy tightening on track. Retrieved August 24, 2011, from Reuters: http://www.reuters.com/article/2011/02/14/china-economy-inflation-idUSTOE71D04720110214 Yongding, Y. (2011, August 8). China's inflation muddle . Retrieved August 19, 2011, from The Daily News Egypt: http://thedailynewsegypt.com/global-views/chinas-inflation-muddle.html