A little inflation is good for the economy

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

15 June 2008

When the Nation Bureau of statistics announced that the inflation rate for the month of May stood at 31.5 percent, many people stopped and took notice. However, there were other figures quoted in the report that seem to have caused confusion in the public. Richard Kamau, for example, wants to know “how they calculate inflation and the difference between inflation and the consumer price index (CPI)”.

The two quantities are actually related to one another. The CPI is a value derived from the prices of goods within a period, say one month. It monitors the average movement of the cost of goods. But it is not just a simple average: it takes into account the fact that different people apply different proportions of their income on different items depending on their income and where they live.

For example, everybody buys food but richer people spend a smaller portion of their income on this than poorer people. In addition, Nairobi residents pay more for food than rural folk. For this reason, the inflation values are different for different people.

The change in the CPI expressed as a percentage gives the inflation rate. But there are several ways of doing that: one may compare the movement between two consecutive months, or over three months, or one year.

The inflation values obtained from first method (“month-on-month”) can vary by wide margins from one month to the next. For example, the value in January was 105.6 percent per year; then it dropped to 25.2 in February; and now it was 42 percent in May.

The one year inflation value is more reliable. It compares the CPI today to it value in the same month last year. This is was the 31.5 percent quoted press reports. It has been increasing gradually from 18.2 percent in January to 19.1 in February and 21.8 in March.

Nevertheless, a little inflation is good for the nation. Economists say that if inflation was kept at zero then we’d get economic stagnation. This is how:

Suppose you have a cow and I keep chickens. We come to an agreement that I shall give you two eggs for every litre of milk. If all our other needs are met, then that price will remain and we will never have reason to increase our production of milk and eggs. Our “economy” will stagnate.

If one day you insist on three eggs for a litre of milk, I will be forced to figure out a way of increasing the out put from my chickens. I could skip milk for one day and let one chicken sit on the saved eggs. When they hatch, I will have more chickens to produce enough eggs to pay for the milk! As a result, “our” economy would grow.

But if you asked for four eggs, I might decide to reduce my milk intake instead of increasing my egg production. The result would be a reduced economy. This has started happening in Kenya.