Inflation can be defined as the average price level increase as an economy increases over time (Stanford 2008). Inflation refers to an annual persistent increase in the general level of prices of goods and services. However, a nation may experience a deflation situation when the overall average level of prices declines over time. In extreme cases, a nation may experience hyperinflation when commodity prices rise rapidly over time, such that inflation reaches 100 percent or more per year. Often, nations experience hyperinflation due to economic or political breakdown, as in Uganda during the 1970s. Inflation affects developing countries in two main ways. First, output affects economic growth through production of goods and services. Second, inflation affects a nation through consumption, by the price of consumer
goods and services, and factor inputs. These two broad sources of inflation establish the platform for modelling the impact of inflation on a nation, based on monetarist and neoclassical theories.
The Monetarist Theory, also called the quantity theory, is presented as the theory of the demand for money (Brunner & Meltzer 1972). Although the Monetarist Theory explains the role of inflation on economic growth, employment and poverty, it has some shortcomings. It explains more the need for government role in the economy than the role of macroeconomic variables in a nation (Espinosa-Vega & Russell 1997; Palley 2014). Macroeconomic variables—such as interest rates, wages and technology—play a role in economic growth, employment and poverty reduction due to inflation. The neoclassical theory was developed on the foundations of the Monetarist Theory, to explain the impact of inflation on a nation (Palley 2014). The theory explains the relationship between inflation and macroeconomic variables, which in turn affect economic growth, employment and poverty.
Since this study is concerned with inflation and macroeconomic variables, the neoclassical theory is employed in modelling the impact of inflation on economic growth, employment and poverty in Uganda.
6.8.1The Neoclassical Theory and the Impact of Inflation on Economic Growth, Employment and Poverty
The neoclassical theory was based on the earlier foundations of monetary theory. This study begins by modelling the impact of inflation on a nation, based on theoretical monetarism through the Fisher equation of exchange (Friedman 1970; Meltzer, AH 1976; Palley 2014). According to theoretical monetarism, the quantity equation indicated that aggregate spending money velocity (MV) is equal to nominal output (py), and is also equivalent to real output. This relationship sets the basic foundation for neoclassical theory, expressed as follows:
= = ( . . )
: M = ; = ; = ; =
Following the Production Function Equation (5.2.2), output depends on technology, capital and labour. Based on the equation, Gylfason and Herbertsson (2001) have indicated that inflation affects economic growth, employment and poverty through other variables that
affect money and price. The augmented production function can be specified to indicate the relationship among the variables:
= ( . . )
: = ; = ; = ℎ ;
L = Labour
, , 1 − − = , ,
The causes of inflation have been identified as international, fiscal and monetary; food and transport; and cost and demand factors. The main cause of inflation in developing countries is monetary expansion, related to seigniorage, which is defined as the ability of a government to print money (Quartey 2010). This is because developing countries are characterised by low tax revenue, yet there is the need for service delivery and infrastructure development. Accordingly, government income sources become seigniorage for balancing the budget to finance government subsidies and poverty alleviation schemes. However, as GE deficit increases relative to gross national product, so does inflation equivalent to the seigniorage rate. In turn, when money expansion exceeds the equilibrium, a nation starts to experience a spiral of effects, due to the need to finance government programs summarised by Figure 6.8.
Figure 6.8: Demonstration of the relationship between GE, seigniorage, tax and inflation on a least-developed nation
However, similar to effects of widening the tax base, the expending the seigniorage rate increases inflation but reduces economic growth. This is demonstrated by the Laffer curve Figure 6.9 where seigniorage revenue is a proportion to GDP and inflation rate( ). The optimal seigniorage level correspondents with the optimal inflation rate government keeps increasing to maintain optimal tax revenue deficit.
Increasing price for factor inputs/Marginal
Cost Reducing Firm Profitability,
Productivity (Efficiency), Output
Reducing economic Growth, Employment
Need for Increasing Government Expenditure
Increasing Seigniorage tax and Tax Base Increasing
Figure 6.9: Laffer curve implications of seigniorage revenue and inflation on economic growth
Source: Based on Quartey 2010
At any level between to , the seigniorage tax keeps economic growth increasing. Hence though money expansion has caused inflation, as long as the economy is equilibrium, a nation continues to experience economic growth. , However, any seigniorage tax increases from to leads to declining economic growth. To this extent the effects of seigniorage on a nation vary across nations (Chowdhury, Anis 2002).
In view of the effects of seigniorage in Uganda, other causes of inflation can be regarded as factors that reinforce and exacerbate the effects of inflation in the country. Other factors, such as world food and energy prices and domestic food shortages, increase in velocity ( ) or reduction in financial depth, increasing inflation. As inflation increases, the marginal cost increases, which in turn reduces a firm’s profitability. Economic growth and employment reduce, while poverty increases. The cause and impact of inflation differs, and the next step in this study is the explanation of the manner in which inflation is measured, so as to measure the impact that inflation has on Uganda’s economic growth, employment and poverty.
6.8.2Measuring Inflation
A number of approaches can be employed to measure inflation, including the consumer surplus and equivalent variation, as well as CPI and the Fisher Index. The consumer surplus and equivalent variation are suitable measures of welfare when examining the impact of a tariff on a nation. In Uganda, UBOS employs CPI as a two-stage approach using Laspeyres Price Index (LI). CPI reflects the percentage change in the cost to consumers of acquiring
Increasing
Economic Growth Declining
Growth Rate Tax Revenue Seigniorage/ EconomicGrowth Laffer curve High Optimal Seigniorage Inflation Rate ( ) High Low
goods and services. Also in Uganda, UBOS employs the Fisher Index as a combination of the LI and Paasche Index, to report price statistics in four categories: headline, core, energy and food inflation.
According to UBOS, headline inflation is reported on overall items for price changes in the consumption of goods prone to price volatility due to unpredictable/irregular factors. Meanwhile, core inflation (underlying inflation) is reported on all items, excluding food crops, fuel, electricity and metred water. Due to commodity sensitivities, UBOS reports food and energy inflation separately.
This section is concerned with modelling the impact of inflation on economic growth, employment and poverty, and examines the impact of inflation on the welfare and wellbeing of poor communities. Accordingly, this study employs CPI annual statistical data, published by UBOS, as a proxy for inflation, because CPI as a measure indicates the impact of inflation on welfare. The next step is to explain the manner in which CPI is measured.
6.8.2.1The Consumer Price Index Measurement for Inflation
CPI is the most commonly used approach by UBOS for measuring the impact of inflation on the cost of living.42 The CPI attempts to measure the average income required to purchase
goods due to inflation change. In this respect, CPI indicates that the average prices of goods and services purchased by measuring the overall average price that can enable a household to purchase a basket of goods. CPI reflects headline inflation, as the measure of the relative changes in the price of all goods and services.