Welfare Effects Of Inflation

Welfare Analysis of Food and Energy Inflation: A Representative Agent Approach with the Lesotho Working Class

P.L. Mohapi & R.I. Thamae NUL Economics Department

Introduction • While inflation is part of life, everyone would agree that 2008 was a really bad year for the consumer. • The Inflation Concept – Headline Inflation – Core Inflation – Components Inflation

• Focus on Components Inflation – Food and Energy

Introduction (cont.)  What does the study actually investigates?  Two things: 4. The impact of 2008 components inflation on the representative/average worker’s standard of living. 

This is measured by the worker’s proportion of income spent on discretionary items.

5. The necessary adjustment in income to immunize the workers from the effects of components inflation. 

This is measured by the Compensating Variation.

Presentation Outline 1. Recent Inflation Developments 2. The Working Class in Lesotho 3. The Representative Worker 4. Analytical Framework 5. Input Data 6. Results 7. Conclusion

Recent Inflation Developments  In the OECD countries Food inflation has tracked Headline inflation between 2.4 – 3.7% between 2001 and 2005.  From 2006 Food inflation has jumped above Headline and rising at a faster rate and diverging further away from Headline inflation.  Energy inflation in the OECD countries has been above Headline inflation by an average of 6 percentage points between 2001 and 2008.

Recent Inflation Developments (cont.) In South Africa:  Food prices “at factory gate” jumped up by an average 18 % in 2008, compared to 13.8 % in 2007.  Petrol and food price increases accounted for more than a half of the increase in CPIX inflation, which was measured at 10.4 percent in April 2008

Recent Inflation Developments (cont.) The drivers of these developments include:  Global increased demand for major commodities –  E.g.s of continental growth SSA 6%, Asia 9%  E.g. Over 50% of the increase in demand for oil was accounted for by India, China & Mid-East  Biofuels – Demand for grains needed for ethanol production

 Credit crunch-induced commodity bubble of 2008

Working Class in Lesotho Formally employed labor force in Lesotho - 2006 Formal Employment by Sector

# Employed

Percentage

Basotho mine workers

51,341

30.2

Textile and clothing

40,044

23.6

Government

38,144

22.4

Tourism

22,500

13.2

Construction

6,000

3.5

Wholesale, retail & services

12,000

7.1

Total

170,000

100

The Representative Worker  By representative we mean average and the defining characteristic is income.  First we recognize that it is difficult to get a truly representative worker given income disparities.  Constructed the following representative workers:    

Low income Lower -Middle Income Higher-Middle Income High Income

The Representative Worker (cont.) Table 2: Gross Monthly Income of Respective Representative Workers Income Classification

Gross Monthly Band

GoL Civil Servants in the Band

Representative Gross Monthly Income

M660 – M2,999

8,644 (54.3%)

M1,569.34

Lower-Middle Income

M3,000 – M7,999

5,734 (36.1%)

M5,033.40

Higher-Middle Income

M8,000 – M15,999

1,423 (9%)

M10,048.00

M16,000 +

93 (0.6%)

M18,846.16

Low Income

High Income

Source: Authors’ computations for GoL civil service payroll data of September 2008

Analytical Framework Representative worker’s problem is: n

max  x x1K xn

i 1

i i

subject to

where   0 and

n

 i 1

n

px i 1

i

i

m

i

1

Analytical Framework (cont.)

Resulting (Marshallian) demand functions is:

m x  i  pi * i

Rearranging it show that is the proportion of the worker’s income that goes to commodity i:

pi xi* i  m

Analytical Framework (cont.) Welfare is measured by the following Indirect Utility Function: i

 i  w  V (p, m)  m    i 1  pi  n

Analysis is confined to three commodity baskets – Food, Energy and Composite baskets. Therefore: F

E

 F   E  w  m      pF   pE 

C

 C     pC 

Analytical Framework (cont.) Impact of inflation on Worker’s Standard of Living:

  1 n C



i F , E



i 1 

i 100



Income adjustment required (measured by CV):

 p    p  CV  m       1   p    p  n E o E

E

n F o F

F

Input Data  To implement the two formulas above the following variables and parameters are needed as inputs: 1. Disposable income 2. Workers’ allocation of disposable income to respective baskets 3. Reported inflation of respective baskets and the resulting price ratios.

 Table 3 contains data inputs on 1. and 2. while Table 4 contains data inputs on 3.

Input Data (cont.) Table 3: Representative Worker Expenditure Allocations and Disposable Income Alpha F Alpha E Alpha C M08:1 M08:2-4 Low Income Lower-Middle Income

0.510

0.156

0.334

1,426.67

1,569.34

0.443

0.131

0.426

3,558.16

4,051.64

Higher-Middle Income

0.346

0.119

0.535

6,521.33

7,311.13

0.206 0.120 0.674 Source: Authors’ inferences and computations

11,720.24

13,029.93

High Income

Input Data (cont.)

Table 4: Quarterly Food and Energy Inflation and Corresponding Price Ratios

2008:1 2008:2 2008:3 2008:4

Food Inflation

Energy Inflation

Food Price Ratio

Energy Price Ratio

1.723 3.606 6.092 2.221

0.986 8.664 7.859 -1.234

1.0172 1.0361 1.0609 1.0222

1.0099 1.0866 1.0786 0.9877

Source: Authors’ computations

Results Table 5: Change in Representative Worker’s Standard of Living

2008:1 2008:2 2008:3 2008:4 Total

Low -0.010 -0.032 -0.046 -0.010 -0.099

LowerMiddle -0.009 -0.028 -0.040 -0.009 -0.085

Source: Computations by the authors

HigherMiddle -0.007 -0.023 -0.032 -0.007 -0.070

High -0.005 -0.018 -0.024 -0.003 -0.050

Results (cont.)  Across income groups, it can be seen that the second and third quarters of 2008 were the most difficult, with the third quarter inflation being more severe.  The first and fourth quarter inflation had similar impact across all groups except the high income group. The fourth quarter inflation impact was milder for this group.  Over the entire course of 2008, the low income suffered most with their std of living declining by almost 10% while the high income group suffered least with their std of living declining by only 5%.

Results (cont.) Table 6: Compensating Variation against Food and Energy Price Changes of 2008

2008:1 2008:2 2008:3 2008:4 Total % Increase

Low

LowerMiddle

HigherMiddle

High

14.93 53.09 76.66 16.63 161.31 10.28

32.16 117.07 169.68 37.53 356.44 8.80

47.07 175.87 249.35 51.06 523.35 7.16

56.03 245.07 321.41 44.78 667.29 5.12

Source: Computations by the authors

Results (cont.)  Once again, across income groups, it can be seen that the second and third quarters of 2008 were the most difficult, with the third quarter inflation being more severe in terms of the required income adjustment.  Over the entire course of 2008, the low income should have secured a 10.28% increase in disposable income in order to cope with food and energy price increases.  The high income group should have ‘scored’ a 5.12% raise just to cope.  Makes loads of sense, doesn’t it?

Summary Results

% Loss in Std of Living % Increase in Net Income

Low

LowerMiddle

HigherMiddle

High

9.9

8.5

7.0

5.0

10.28

8.80

7.16

5.12

Conclusion  Inflation hits low income earners more severely than high income earners and corresponding income adjustments should take cognizance of this.  As long as (net) income growth is slower than inflation, workers standard of living is bound to decline.  The reported required increases in disposable income are for food & energy price increases only.  Would have probably been higher had inflation on all other goods in the composite basket been taken into account.