Macroeconomic as Significant Impact on a Nations Economic Development - Research Paper Example

Introduction Inflation is generally considered as a macroeconomic variable having positive as well as negative impacts on financial markets and economies. In simple words, inflation can be described as an increase in the price level of goods and services in an economy over a particular period of time. According to one popular definition, “inflation can be defined as a rise in prices or a devaluating of money, resulting in decreased buying power for consumers”1. When there is a rise in the general level of price, each unit of currency can buy fewer goods and services. Therefore, inflation directly leads to the weakening of purchasing power of money. Consumer Price Index and Product Price Index are the major tools employed to measure the inflation rate. Today, rising commodity prices are turning out to be a threat to the UK economy because commodity prices can have a direct impact on inflation rate. This paper will evaluate the impacts of rising commodity prices on inflation. In addition, the paper will also discuss why inflation is becoming a key issue for financial markets. Rising Commodity Prices Today, rise in commodity prices is a ubiquitous issue across global markets despite huge efforts taken by national governments to address the situation. As per reports, food prices and fuel costs have been going up globally, particularly in the United Kingdom2. Referring to an Oxfam study, the report adds that this trend would continue over the next 20 years; and again, according to the UN’s Food and Agriculture Organization, the whole prices of food reached its highest monthly figure on record in February 20113. 4 The chart given illustrates the rise in food prices over the period between 1990 and 2010. From the chart, it is obvious that food prices rose dramatically after mid 2000s. Floods, droughts, and fires have devastated harvests largely in many parts of the globe such as Canada and Australia over the last decade. In addition, the lagging production behind growing demand also contributed to food cost rises. 5 The diagram given above indicates that rise in commodity prices over a time period of 12 months. The diagram clearly reflects that prices of different commodities including meat, diary, oils, cereals, and sugar soared during this period. Clearly, sugar price increased very much over this period whereas the price of meat rose slightly. The prices of cereals, oils, and diary also showed a notable increase over these 12 months. In addition to factors like natural contingencies and lagging demand, speculators also played a major role in increasing commodity prices. Speculators who trade commodities on the financial markets utilised this favourable market environment as an investment opportunity and significantly contributed to exaggerating commodity prices. In addition, there is a notable rise in the price of oils. As per reports, the price of a barrel of oil reached a three year high ($125) on the London market in April 20116. Economists opine that growing uncertainty is the major factor contributing to rising demand for oil. Some other people including US President Barack Obama are of the view that increased energy consumption of emerging economies like China and India causes oil price increase. The key issue of growing oil prices is that it would raise prices of other goods by increasing the cost of production and transportation. Another report points out that rising commodity prices has lifted the cost of living in the United Kingdom. Janez Potocnik, the European Commissioner for the Environment, warns that commodity prices may continue to rise over the next years. In order to justify his argument, Potocnik particularly tells that demand for food, feed, and fibre is expected to increase by 70 percent by 20507. However, 60 percent of the world’s major ecosystems that serve this demand have been degraded already or utilised improperly. Hence, supply can never meet demand and the situation may eventually end up in further rise in commodity prices. He anticipates that drastically growing commodity prices would notably affect economic and social stability in the coming decades8. Referring to Potocnik’s opinions, it can be assumed that that rising commodity price is turning out to be a potential impediment to the economic as well as social developmental efforts taken by national governments. Effects of rising commodity prices on inflation Referring to the International Financial Statistics published by the International Monetary Fund, currently global consumer inflation is running at a pace of approximately 5.5 percent annually whereas it was under 4 percent in recent years9. According to this opinion, rising commodity prices evidently contribute to high inflation rates. Many others hold the same view and strongly believe that significant rise in the prices of key commodities like oil is the major driving force behind the recent strong increases in the prices of goods and services. They say that an immediate monetary policy development is necessary to address this economic problem. In contrast to this view, some economists argue that commodity price increases have little impact on inflation in the long run10. To justify their view, they try to make a link between theory and evidence. Theoretically, supply and demand of various goods determine the relative prices in an economy. Therefore, relative prices are subjected to change in accordance with a change in demand or supply. However, relative prices tend to stabilize once they reach the equilibrium level. In other words, the relative prices do not rise forever. It must be noted that many commodities like oil are used as raw materials (input) for the production of other goods. As a result, an oil price hike is likely to result in an increase the cost of other goods which in turn may raise their prices too. Since prices of all other goods eventually adjust to the rise in the oil price in the short run, “both total and possibly core inflation will increase”11. “once the price levels adjust, inflation should settle back down to its original rate”12. Further assumptions are required to gain a permanent increase in inflation rate as a result of a rise in the price of commodities. According to this view, one of the major assumptions is that “those relative price changes might get embedded in people’s expectations of the inflation of non-energy goods”13. In order to illustrate the real relationship between rising commodity prices and inflation, Tootell analysed the real food price hikes and core inflation rates over the 1991-2010 period. From the study, he found that notable increases in food prices occurred over this period had little impact on core inflation. It is observed that the core inflation level was not actually affected even in the midst of the recent food crisis. Based on this analysis, he justified the notion that there is an adjustment to the aggregate price level along with the relative price change; and the change occurred in the aggregate price level settles back down after this adjustment. The author also conducted an energy price inflation Vs core inflation study to strengthen his arguments. In this study, he examined the effect of energy price inflation on core inflation during the period 1971-2010. Unlike the first study, this study provided some evidence that commodity price variations can influence the trend inflation rate. The author identified that a strong correlation between oil price fluctuations and core inflation over the 1970s and the first half of the 1980s. However, the trend was not consistent and the correlation level has been poor since the early 1990s. Tootell gives a thoughtful explanation for the trend observed. He says that the temporary inflation rise during 1970s in response to a relative oil price increase “embedded in inflation expectations”14. Campbell, et al also conducted some statistical analysis of previous data to explore the relationship between growing commodity prices and core inflation. From the study, they empirically proved that increase in commodity prices does not really affect inflation. Based on such evidences, many people claim that rising commodity prices have little effect on inflation in the long term. There is a third group holding the view that rise in commodity prices moderately affects inflation rate. In order to defend their views, they claim that most of the commodities except items like precious metals are used as inputs so as to produce finished goods. Hence, manufactures simply pass the increases in commodity trading prices to the prices of consumer goods and this practice directly leads to a situation where market prices are high. However, they also tell that such practices have only a slight impact on core inflation because only a small percent of rise in commodity prices are passed to prices of consumer goods. The rest goes to taxes, marketing, labour, transport, and energy. It is estimated that one dollar increase in the price of wheat causes a thirty cent rise in flour and only a one thin dime of rise in the price of loaf of bread. Frank Shostak simply explains the relationship between commodity prices increases and inflation levels. He says that if the oil price goes up and people do not cut down the amount of oil they use, probably people will be compelled to raise more money for buying oil. If people’s money stock remains to be the same, less money would be available for them to spend on other goods and services. In this situation, people want average price of other goods, and services has to come down so that they can meet their day to day requirements. In fact, it does not happen always. It must be noted that the overall money spent on goods and services remains the same but the spending composition is altered when there is an increase in oil price. More precisely, the spending pattern is changed in a way that more money is spent on oil whereas less on other commodities. As a result, average price of goods or more clearly money per unit of good is not changed. The level of rise in the price of goods and services may be regulated by the level of increase in money supply but not by the level of increase in the oil price15. “It is not possible for increases in the price of oil to set in motion a general increase in the prices of goods and services without corresponding support from the money supply”16. Importance of inflation in financial markets Inflation plays a significant role in regulating the way financial markets operate and in determining nations’ economic performance. Therefore, policymakers give particular focus to managing inflation. Accelerated inflation rate would pose challenges to economic stability and efforts taken by policymakers to restore the combination of solid growth and low level inflation that prevailed in the beginning of this last decade17. Economists have identified that inflation affects all levels of economy, ranging from consumer spending and business investment to government programmes and tax policies. It is particularly important for investors to learn more about inflation because this macroeconomic variable may influence the returns on investment. Unlike debt market which monitors inflation data closely, stock market reacts only when there is a notable change in inflation level over a period of time. Many studies disclosed a notable negative correlation between inflation and economies’ growth performance. Those studies also suggest that evidenced negative correlation is experienced by economies that have a relatively high inflation rate. Some economists claim that inflation and real activity are negatively related at high rate of inflation. According to Boyd, et al., economies that maintain average rates of inflation exceeding particular thresholds have weaker financial systems than economies having inflation rates below these thresholds18. It seems that inflation can have a direct impact on gas prices and this situation causes difficulties in financial planning because gas price increases would lead to home value losses. At high rates of inflation, people need to spend more on goods and services and therefore they cannot have much savings. This situation is likely to affect the financial market performance negatively. In addition, fluctuating inflation rates will increase the level of uncertainty regarding the future. When future market environment is more uncertain, investors are less likely to risk their money by making huge investments. As a result, this situation would also impede the growth of financial market. Another importance of inflation in financial markets is that people’s inflation expectations may lead to core inflation. To illustrate, when people expect that commodity prices are going to increase in the near future, they would spend more, and such a particular economic environment may cause inflation. Moreover, when people plan their financial future in the short term, the resulting economic condition would dreadfully affect the financial market growth. Under such circumstances, inflation may go out of control and hence it is called spiralling inflation. In another article titled ‘The impact of inflation on financial sector performance’, Boyd et al illustrate another effect of inflation on financial market performance. They point out that an increase in the inflation rate negatively impacts the real rate of return on both money and assets in general19. The reduction experienced in real returns can add to the intensity of credit market frictions. As these market frictions may result in rationing of credit, credit rationing becomes more difficult once inflation increases. Consequently, the financial sector makes fewer provisions for loans, resource allocation becomes inefficient, and intermediary operations declines with negative implications for capital investment20. Evidently, reduction in capital investment severely affects both economic performance and equity market activity in the long term21. Findings of some other economists support this view. It is identified that credit market frictions may not be a problem at low level inflation. Therefore, inflation rate does not affect the flow of information or resource allocation and growth. However, if the inflation rate goes beyond the threshold level, credit market frictions will become binding and consequently there will be a noticeable fall in financial sector performance due to the high intensity of credit rationing. Based on the findings above, it can be claimed that high inflation rates may result in stock return variability and less financial activities in the long run. In economies where inflation rate is very high, intermediaries would not lend much and allocate capital effectively. In addition, equity markets will be relatively smaller and less liquid under those economic environments. Different inflation thresholds may change the relationship between inflation and financial sector performance. Most notably, if inflation rate goes beyond a critical level; incremental increases in the inflation rate in the long run can have no additional effect on financial sector performance. As already discussed, financial markets play a crucial role in an economy’s growth process. Hence, influence of inflation on stock market and other key market areas have a significant impact on long-run real activity and thereby an economy’s growth. Scholars identify that even permanent and predictable changes in inflation rate can affect the financial system through long run real activity. Smith, et al examined the influence of inflation on two indicators of stock market development: they are stock market trading volume and stock market capitalisation22. Through a series of evidence based studies and analyses, they found that inflation negatively affects stock market trading volume. In case stock market capitalisation, it was observed that modest levels of inflation increases can promote stock market development at an improved rate23. As compared to anticipated inflation, unanticipated inflation can have more notable effects on financial markets. To illustrate, when an increase in inflation rate is predictable, regulators can take potential measures to respond to such changes effectively. In contrast, when the unpredictability of inflation becomes high, people will be less interested to enter into contracts that clearly state nominal values in advance. Many market analysts believe that inflation rate can influence government decisions, which in turn can have a significant effect on financial market operations. For instance, when inflation goes up, governments (or regulators) may make necessary changes to other monetary tools like interest rates, and this situation ultimately impacts financial market performance. It has been identified that inflation adversely affects production volumes because marketers cannot predict actual demand for their products. Undoubtedly, decline in production levels may indirectly weaken the performance of financial markets. Inflation becomes a barrier to the effective integration of a nation’s financial institutions and markets with the rest of the world’s markets. In sum, inflation is of particular importance in a financial market performance. Conclusion From the above discussion, it is clear that inflation is a macroeconomic variable that can have significant impact on a nation’s economic development. There are two contrasting views about how growing commodity prices influence inflation in the long run. Many people argue that rising commodity prices have little effect on the core inflation rate despite a strong direct relationship observed in 1970s and early 1980s. In contrast to this view, some others claim that increasing commodity prices contribute to inflation rates. They add that rises in the price of oil greatly contributed to the recent increases in the price of goods and services. However, empirical evidences and studies by some reputed bodies show that rising commodity prices can little affect inflation rates in the long term. It seems that inflation has greater importance in financial markets as it directly impacts long run real activity. Inflation affects financial markets differently at different levels. Economists indicate that high rate of increases in inflation would pose more potential challenges to financial market performance than low level rise in inflation does. In addition, unanticipated inflation also raises severe threats to financial markets as this economic situation would adversely affect investors’ willingness to invest. Bibliography Boyd, J. H., et al., ‘Inflation and Financial Market Performance’, Working Paper, Federal Reserve Bank of Minneapolis Research Department, [online document] (1996) accessed 14 March 2013. Boyd, John H and Levine, Ross. ‘The Impact of Inflation on Financial Sector Performance’, JEL, [online] (2000) accessed 14 March 2013. Campbell, Jeffry R et al., ‘Macroeconomic Effects of FOMC Forward Guidance’, JEL, E5, [online] (2012) accessed 14 March 2013. Lipsky, J., Commodity Prices and Global Inflation, International Monetary Fund, (May 8, 2008) , accessed 14 March 2013. Tootell, G. M. B., ‘Do Commodity Price Spikes Cause Long-Term Inflation?’ Public Policy Brief, Federal Reserve Bank of Boston, [online document] (May 2011) accessed 14 March 2013. Shostak, F., Commodity Prices and Inflation: What's the Connection? Ludwig von Mises Institute [web page] (2008 July, 1) accessed 14 March 2013. Schwartz, J., Master the GED 2011 (w/CD) (US: Peterson's, 2010). Sanderson, P., Commodity prices to continue to rise: Says European Environment Commissioner, SCM [web page] http://www.scrap-ex.com/news/commodity_prices_continue_rise_says_european_environment_commissioner.html> , accessed 14 March 2013. Smith, B. D. Et al., ‘Inflation and Financial Depth’, Working Paper, International Monetary Fund 2001 [google books] accessed 14 March 2013. Read More