Wednesday, August 31, 2011

Inflation And Its Effect On Real Income

Inflation is having a huge impact on everybody’s income. Inflation refers to a rise in the prices of goods and services over a period of time. In PNG it is measured by the Consumers’ Price Index, or CPI.

Inflation occurs for two main reasons. Firstly, when there is an increase in the cost of inputs which are used to produce goods and services. This is referred to as cost-push inflation. Secondly, when there is an increase in the demand for the goods and services (demand-pull). In this instance it is also referred to as “too much money chasing too few goods”.

When an economy grows, there is usually an increase of cash flow and liquidity, meaning that many people and entities such as private companies and the government have money to spend. This generates a demand for goods and services which are usually limited in supply. Excess demand forces prices upwards, leading to an increase in inflation.

This is our situation in PNG currently. It has been reported that inflation during the June quarter of this year was 9.6%. What this means is that prices have risen by that much over the March quarter of 2011.

Inflation affects different people in different ways and to different extents. But what it means for everyone is that real incomes fall when prices rise. This is so for the country as well as for individuals. Inflation reduces the Kina’s ‘purchasing power’, meaning that people need more money to buy the same basket of goods and services they had purchased prior to the rise in prices. So when the Bank of PNG reports that inflation was 9.6%, it is actually saying that incomes have fallen by 9.6% in real terms.

We have been hearing calls for employers to raise salaries and wages. We have also been hearing calls for a reduction in personal income taxes. These are all said to be measures which need to be taken to combat the effect of inflation on personal incomes, and hence the livelihoods of workers. But is raising wages or reducing income tax a solution to dealing with the impact of inflation?

The answer is no. While such measures may offer temporary relief, they cannot be long-term solutions, because there is a limit to how much salaries and wages can be raised, and how much taxes can be lowered.

What people can do to combat inflation is to start by cutting down on all unnecessary items of expense that they waste money on. Now when I say this, you may be thinking that you don’t waste money and that there are no unnecessary expenses. The truth is that most people waste a lot of money on unnecessary items. Four items which a lot of Papua New Guineans waste money on are cigarettes, betel nuts, alcohol and gambling. These are what I call expenses that add neither to your wealth nor your health. People spend thousands of Kina on these items without realizing it. Others may include mobile phone credits as a result of uncontrolled phone calls, giving to wantoks, customary obligations, etc.

The second way to combat inflation and maintain your lifestyle is to start a business. A business may not take off as you anticipate, and you may lose your investment, but it does give you the opportunity to realize returns which are higher than the rate of inflation. It also allows you to raise your prices as the prices of your inputs rise, such that some if not all of the rise in costs is passed on to consumers.

The way things are shaping up in PNG, inflation is going to be big headache for the majority of us. While the government and Central Bank use their different policy instruments to minimize inflation, we need to realize that rising prices is a necessary consequence of economic growth. As the economy grows, both the private sector and the government will spend money. This will generate a lot of demand for limited goods and services in the country, with the result that prices rise significantly, with a resultant negative impact on incomes.

My advice to readers is therefore that the time for throwing money around on unnecessary expense items is over. It is now time to tighten our belts, so to speak, and become more prudent in managing money.


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