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February 23, 2019

Wage Increase Is Not Necessarily The Cure For Rising Inflation

Our money: Striking teachers stage demonstrations over their salary increment at Mwalimu Centre in Kakamega on September 15.
Our money: Striking teachers stage demonstrations over their salary increment at Mwalimu Centre in Kakamega on September 15.

ALONG with unemployment, inflation is one of the most serious concerns for any economy. Inflation occurs when the average price level of goods and services in the economy rises. This is quite familiar. The landlord raises the rent, the mortgage rates rise, the price of unga and other basic everyday items rise as well. This is inflation.

On a long term basis, increase in the price level of goods can be regarded as a basic monetary phenomenon. With time, both the amount of money available and the money required to buy something naturally increases. The prices of goods in 1980 are substantially different from today, but then, money was also in shorter supply.

The normal reaction of the household to inflation is to make budget adjustments, cutting first the items that may border on non-essentials. This may involve cutting on the lunch budget or holiday travel.

As inflation continues, further adjustments may then involve more fundamental changes that may be regarded as affecting the lifestyle. A lifestyle change may involve moving to a smaller house, or even changing from using private means to public transport.

The immediate cure for inflation is an increase in the wage levels. In the event that the increase in prices is matched by an equal increase in wages, then the impact of inflation on the household is neutralised.

Of course that sounds quite simple, until the question of where the money to increase wages is going to come from is put on the table. Before green growth and climate change issues came to the fore, the reminder that “money does not grow on trees” was often a popular response to demand for wage increases in the face of inflation.

Generally, inflation itself is not avoidable, and to some extent a little inflation is beneficial to the economy. Researchers have actually found an inverse relationship between inflation and unemployment. As unemployment reduces, inflation tends to rise. As more people work, more is produced causing wage increases, causing more people to have more money and to spend more. This results in consumers demanding more goods and services, finally causing the prices of goods and services to increase.

The challenge of keeping both unemployment and inflation low is a policy issue. The general approach is to set an acceptable range of inflation in order to balance both the positives and negatives.

For instance, the Central Bank has set an annual inflation target of five per cent with boundaries within 2.5 per cent. This means the minimum desirable inflation is 2.5 per cent and the highest tolerable rate is 7.5 per cent. This is part of the monetary policy.

Labour unrest is often one of the consequences of prolonged periods of high inflation that is not matched by wage increases. After all, wages are the most important financial resources of a person’s life, as they determine how much money the person has to spend and even how much they can save for retirement. Often times, labour unrest is resistance to budgetary and lifestyle adjustments that the labour market may regard as undesirable.

In the medium to short term, inflation may be caused by many factors including prices, wage rates and interest rates. It is interesting that wage increase is both a cure and a cause of inflation.

Let me explain in a hypothetical scenario. What would happen in the economy if everybody’s salary was doubled? There would be plenty of money chasing few goods and prices would rise. Faced with increased prices, lifestyles would remain the same because the extra money from the wage increase would be used to meet the same expenses at higher prices. In effect, a major increase in wages would actually be the cause of inflation.

Consequently, faced with increased inflation caused by the wage increase, there would be further demand for wage increase. And if unchecked, the situation has the potential to cause a wage-price spiral in a vicious cycle with possibly no answer to which came first and how to stop it altogether.

It is therefore understandable why the clamour for salary increment remains one of the main challenges currently facing the government, especially after devolution with its accompanying weak income policies. Whether the fears of a wage-inflation spiral are unfounded or real is another matter altogether. What is more certain however, is that considering the possibility of a spiral effect, salary increases are only a short term solution and more long term solutions are required to deal with the rising inflation and cost of living.

Regardless, there are also some benefits that accrue to the economy from wage increases, particularly public service wage increases.

One, at least 30 per cent of the wage increase will be recouped back as income tax and National Health Insurance Fund, thus increasing the tax collection. In the case of public service, the left hand takes part of what the right hand gives, thus minimising the net impact.

Two, the indirect taxes collected will increase considering part of the wage raises will be spent on goods and services that have indirect taxes such as VAT. If 50 per cent of the increase will be spent on goods and services that are subject to VAT at the general rate of 16 per cent, then an additional eight per cent will be recouped.

Lastly, there is a multiplier effect arising from stimulated demand as take-home increases. More disposable income is available to spend and demand for goods and services will rise in response. This has the potential to create jobs, especially in an economy with high unemployment rates.

Nevertheless, while wage increase may offer the immediate cure for inflation, more may need to be done to keep a tighter rein on inflation going forward.

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