Saturday, August 22, 2009

Inflation in Under Developed Countries

Developing countries sin their bid to raise the standard of living of their people through development plans have often found themselves in the grip of inflation. But the nature of inflation in under developed countries like Pakistan is quite different from that found, in advanced or developed countries. In advanced countries true inflation starts after the level of full employment is attained. But in under-developed countries like Pakistan huge unemployment and inflation exist side by side. In other words in underdeveloped countries serious inflation is in evidence long before the level of full employment is reached. This is so because the nature of unemployment in under-developed countries differs from that which prevails in developed countries during time of depression.
In order to get the economy out of depression governments in advanced countries take various steps to increase the level of investment. The additional investment expenditure leads to an increase in effective demand depending upon the magnitude of the multiplier. But his increase in investment and effective demand des not generate serious inflationary pressure because of the elastic nature of the supply curve of output. Instead increase in investment and effective demand helps a great deal in removing depression and unemployment. Which are caused by the lack of effective demand. This is the case of developed economics.
In advanced countries during depression there is a lot of excess capacity in the system so that an increase in output presents no difficult problems. Thus when the supply of output can be increased easily so as to match increase in effective demand, there need be no inflationary pressure.
The situation in under developed countries is however different. Here an increase in investment does create additional demand but a corresponding increase in the supply output cannot be taken for granted. Unemployment in under developed economies is not due to the lack of effective demand but due to the death of real capital.
In these countries level of national income can be increased and the unemployment can be removed accumulating more real capital. But increase in the rate of capital formation requires stepping up the level of investment. Now under-developed countries, under their development plans, are making huge investment expenditure to increase the rate of capital formation and thus to obtain rapid economic growth. This huge investment expenditure leads to a sharp increase in aggregate demand for consumer goods, especially the agricultural products. Since in under-developed countries, there is no excess capacity in the system, the supply of consumer goods cannot be increased sufficiently and rapidly to match the increase in demand for them. This leads to inflationary rise in prices.
It is worth noting that it is the food prices which first start rising rapidly in the developing economy. Rise in food prices is followed by the rise in the prices of other consumer goods. This is so because a greater part of the increase in demand generated by the investment expenditure is spent on the food produces such as wheat and rice. But the supply of these food products cannot be sufficiently increased in the short run due to the tiny size of the farms, lack of irrigation fascilities of superior seeds, fertilizers and owing to inefficient techniques of cultivation. Income elasticity of demand for food is very high, because the vast majority of the people are under nourished. Thus as a result of huge investment expenditure there is a sharp rise in demand for food grains, leading to increase in food prices.
In under-developed countries like Pakistan, which are predominantly agricultural countries, the prices of agricultural commodities, especially of food crops, hold the key position in the price structure of the country. Any distortion in agricultural prices leads to a distortion in the whole price structure.
A steep rise in food prices increases the cost of living of the people. Consumers are hit hard, as their income do not increase so easily to offset the increase in prices. Workers whose cost of living rises, press for higher wages. When wage increased are conceded, the cost of production of manufactures articles rises and this in turn increases their prices and soon.
More over some agricultural producers are raw material for industries and increase in their prices will directly increase the cost of production of industrial goods. Hoarding of, and speculation in, both agricultural and industrial products add fuel to the inflationary fire. Thus once the prices of agriculture (goods rise) they are likely to cause an inflationary spiral in the economy. A factor which deserves special mention in this connection is the mode of financing development plans. The developing countries are not in position to finance their plans fully from voluntary savings of the people and taxes by the government. They have often to resort to deficit financing (i.e. the creation of new money) as a method of financing their development plans. Deficit financing to some extent is good and can be absorbed by the economy without experiencing inflation. This is so because, as the economy grows its monetary sector expands and also there is an increase in production for which extra money is needed. But owing to acute shortage of finance, the under-developed countries have often indulged in deficit financing to an excessive degree. Sharp increase in the money supply with the public as a result of excessive deficit financing adds greatly to the level of aggregate demand for consumer’s goods, on the other hand the supply of consumer’s goods, especially of food products, can not be increased rapidly and sufficiently. The pressure of demand therefore leads to an inflationary rise in prices.
It may however be pointed out that investment expenditure made by the government under the development plans do not only generates he additional demand for goods, it also increases the productive capacity. Investment has a duel effect. On the one hand it generates demand or income on the other it increases the productive capacity. As a result of increase in productive capacity more output of goods can be obtained, which will counter act inflationary tendencies. But in the earlier stages of development, investment expenditure is largely made on huge dams, steel plants and other heavy and basic industries. In other words the long term projects can help in increasing the supply of consumer’s goods only in the long run. In the short run prices generally shoot up under the pressure of excessive demand for goods. And one inflationary spiral starts operating, it is difficult to control it.


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