Economy Basic Concepts Part 7 – Food Inflation

Food Inflation

  1. When food prices rise in the developed world it is an inconvenience, something to grumble about. But, when food prices rise in the developing world it can make difference between going hungry and getting enough to eat.
  2. Food inflation is volatile. Agricultural prices tend to fluctuate because demand and supply are both inelastic and supply can vary due to the weather.
  3. . However, despite the usual volatility, food prices seem to be showing a strong upward movement, reaching record highs in recent years.
  4. For example, in India, a booming economy has GDP expanding at 9% a year. Official inflation is around 7%, but, headline food inflation is more than double at 17.8%.

Causes of food Inflation

15.1

  1. There have been short-term supply constraints such as bad weather. However, there is also evidence of increasing long-term supply constraints such as loss of farming land due to global warming.
  2. Increased use of biofuels. Growing crops for energy rather than food production.
  3. Rising Demand. Rapid economic growth in China and India is increasing demand for more resource intensive foods.
  4. As incomes rise, people tend to spend a higher % of income on meat and dairy products.
  5. These require more intensive land cultivation. e.g. crops are used to feed cattle, therefore the supply of crops for food has decreased.

Implications of Food Inflation

  1. It is important to bear in mind food price spikes tend to be temporary and often the result of local bottleneck shortages.
  2. Whilst rising food prices tend to make headlines, later falls in prices tend to make less news.
  3. However, even temporary periods of rising prices can cause widespread hardship to those on the breadline.
  4. Agriculture is a market when relying on free market forces can cause much hardship. Though often difficult to implement.
  5. There is a necessity for guaranteeing supply and minimum prices of at least the basic foodstuffs such as rice and wheat.
  6. Also, the rise in food prices cannot just be put down to short-term factors. A growing population and growing affluence will inevitably place a greater demand on agriculture.
  7. If environmental pressures continue to grow the pressures on both supply and demand could lead to food prices becoming more common.
  8. It is true that we gloomy Malthusian prophecies have often proved false. But, that doesn’t mean we can always count on increasing food supply to meet demand.
  9. There are diminishing returns to green technology, especially when the weather erodes away our fertile land.
  10. Whilst we worry about Space travel, quantitative easing and marvel at the growth of electronic technology, it is rather humbling that the greatest problem of mankind still seems to revolve around food and water.

Measures to cut down inflation 

Monetary Policy Measures

  1. With the growth of 3.8%, demand in the economy could be growing faster than capacity can grow to meet it.
  2. This leads to inflationary pressures. We can term this demand-pull inflation. Therefore, reducing the growth of Aggregate demand should reduce inflationary pressures.
  3. The Central bank could increase interest rates. Higher rates make borrowing more expensive and saving more attractive. This should lead to lower growth in consumer spending and investment.
  4. A higher interest rate should also lead to a higher exchange rate, which helps to reduce inflationary pressure by
  • Making imports cheaper.
  • Reducing demand for exports and
  • Increasing incentive for exporters to cut costs.

Fiscal Policy

  1. The government can increase taxes (such as income tax and VAT) and cut spending.
  2. This improves the budget situation and helps to reduce demand in the economy.
  3. Both these policies reduce inflation by reducing the growth of Aggregate Demand. In Nigeria’s case, the economy seems to be growing reasonably strongly.
  4. Therefore, we can reduce inflationary pressures without causing a recession. If Nigeria had high inflation and negative growth, then reduce aggregate demand would be more unpalatable
  5. As reducing inflation would lead to lower output and higher unemployment. They could still reduce inflation, but, it would be much more damaging to the economy.

Other Policies to Reduce Inflation

Wage Control

  1. If inflation is caused by wage inflation (e.g. powerful unions bargaining for higher real wages), then limiting wage growth can help to moderate inflation. Lower wage growth helps to reduce cost-push inflation and helps to moderate demand-pull inflation.
  2. However, as the UK discovered in the 1970s, it can be difficult to control inflation through incomes policies, especially if the unions are powerful.

Monetarism.

  1. Monetarism seeks to control inflation by controlling the money supply. Monetarists believe there is a strong link between the money supply and inflation.
  2. If you can control the growth of the money supply, then you should be able to bring inflation under control. Monetarists would stress policies such as:
  • Higher interest rates (tightening monetary policy)
  • Reducing budget deficit (deflationary fiscal policy)
  • Control of money being created by the government
  1. However, in practice, the link between money supply and inflation is less strong

Supply Side Policies

  1. Often inflation is caused by persistent uncompetitiveness and rising costs. Supply-side policies may enable the economy to become more competitive and help to moderate inflationary pressures.
  2. For example, more flexible labour markets may help reduce inflationary pressure.
  3. However, supply-side policies can take a long time, and cannot deal with inflation caused by rising demand

High and volatile inflation has economic and social costs.

Anticipated inflation:

  1. When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects.
  2. Trade unions might use their bargaining power to negotiate for increases in money wages to protect the real wages of union members.
  3. Households may switch savings into accounts offering a higher rate of interest or into other financial assets where capital gains might outstrip price inflation.
  4. Businesses can adjust prices and lenders can adjust interest rates. Businesses may also seek to hedge against future price movements by transacting in “forward markets”. For example, many airlines buy their fuel months in advance as a protection or ‘hedge’ against fluctuations in world oil prices.

Unanticipated inflation:

  1. When inflation is volatile, it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future.
  2. Unanticipated inflation occurs when people, businesses and governments make errors in their inflation forecasts. Actual inflation may end up below or above expectations causing losses in real incomes and a redistribution of income and wealth from one group to another

Money Illusion

  1. People often confuse nominal and real values because they are misled by the effects of inflation.
  2. For example, a worker might experience a 6 per cent rise in his money wages – giving the impression that he or she is better off in real terms. However, if inflation is also rising at 6 per cent, in real terms there has been no growth in income.
  3. Money illusion is most likely to occur when inflation is unanticipated so that people’s expectations of inflation turn out to be some distance from the correct level.

The Economic Costs of Inflation

We must be careful to distinguish between different degrees of inflation since low and stable inflation is less damaging than hyperinflation where prices are out of control.

  1. Impact of Inflation on Savers: When inflation is high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if interest rates are lower than inflation – leading to negative real interest rates. This has certainly happened in the UK during 2009-2011.
  2. Inflation Expectations and Wage Demands: Price increases lead to higher wage demands as people try to maintain their real living standards. This process is known as a ‘wage-price spiral’.
  3. Arbitrary Re-Distributions of Income: Inflation tends to hurt people in jobs with poor bargaining positions in the labour market – for example, people in low paid jobs with little or no trade union protection may see the real value of their pay fall. Inflation can also favour borrowers at the expense of savers as inflation erodes the real value of existing debts.
  4. Business Planning and Investment: Inflation can disrupt business planning. Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs – and this may reduce planned investment spending.
  5. Competitiveness and Unemployment: Inflation is a possible cause of higher unemployment in the medium term if one country experiences a much higher rate of inflation than another, leading to a loss of international competitiveness and a subsequent worsening of their trade performance.

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