The new pay scale: Unfounded fear of inflation?

WHO does not like a pay increase? The new pay scale - the proposed increase in the salary of government employees - is likely to be implemented in the upcoming fiscal year beginning from next July. This is good news for government employees as the pay increase will enable them to increase their consumption and help them meet some of their unmet demands. 

At the same time, there is widespread fear that the pay scale is likely to increase inflation which will reduce the purchasing power of money. Depending on the magnitude of the increase of inflation, the government employees may or may not sustain their current living standards by using the augmented income received under the new pay scale. 

Against the above backdrop, the most important question is how inevitable high inflation is as an outcome of the implementation of the new pay scale. Honestly speaking, there is no clear economic reason for the new pay scale to push up the inflation. But in developing countries, many economic consequences arise out of non-economic factors. 

Many experts on economy argue that the new pay scale will increase the money supply and hence fuel inflation. This will be the case only and only if the central bank finances the pay scale, which has never been the case in any country of the world, and should not be the case in Bangladesh either. The Government will finance the new pay scale either by collecting additional revenue from citizens or by borrowing from commercial banks and non-bank financial institutions. 

In case of the first form of financing, money simply changes hands, flows from the tax payers to the government employees. Even in case of the second form of financing, money simply changes hands, from lender to the government first and eventually to the government employees. In both cases, financing of the new pay scale would not increase the money supply, thus fueling inflation. 

The total money supply of the country will not increase even if the government finances it through external borrowing. The government borrows from external sources in foreign currency and spends it in the domestic economy in local currency. Let's say that the government borrows $1 from abroad – the central bank then pays the government a certain amount of taka against this dollar depending on the dollar-taka exchange rates. At the same time, the central bank withdraws the same amount of taka from the local money market to keep the overall money supply unchanged. This is why external borrowing will not increase the money supply in the local money market.  

However, the increase in demand when it does not match a similar increase in supply, is a reason for an increase in inflation. In fact, this has been the main reason for inflation in Bangladesh in the recent years. The implementation of the new pay scale will increase the purchasing power of the government employees and as a result their demand for goods and services is likely to increase. From a simple point of view, this may increase inflation if our supply and marketing chain fails to meet this enhanced demand. But one has to be more analytical and take note of two things in analysing the nexus between the new pay scale and demand-induced inflation. 

First, while the new pay scale increases the disposable income of government employees, it would at the same time reduce the disposable income of others, i.e. the taxpayers or lenders to the government. Therefore, in terms of disposable income, the new pay scale will result in a zero-sum game in the economy; an increase of disposable income of some citizens (i.e. the government employees) and a concomitant decrease of disposable income of some other economic entities (lenders to the government). 

Second, not everybody in a country has the same pattern of consumption. In plain words, not everyone spends the same amount of money when their disposable income increases by a certain amount. People vary in their taste, attitude towards life, and above all, in terms of the present situation they are exposed to. These differences, in turn, impact their consumption decision. 

If those who experience an increase in disposable income and those who experience a decrease in disposable income have an equal propensity to consume, the new pay scale would not result in any increase of consumption at the aggregate level. For argument's sake, let us assume that the beneficiaries of the new pay scale have relatively high propensity to consume. In such a case, the overall demand for consumption would increase and if the supply and marketing chain of the country fails to meet this augmented demand, the new pay scale will fuel inflation. 

The most important question in this context is how significant this inflationary pressure exerted by the new pay scale would be. According to media reports, the implementation of the new pay scale would require about Tk 150 billion. How significant is this amount when juxtaposed to our total national consumption?

Our GDP (in current price) in the last fiscal year was about Tk 13, 509 billion. Total consumption accounted for about 77 percent of the GDP amounting to about Tk 10, 344 billion. According to the preliminary estimates, the GDP will grow by about 6.5 percent suggesting that total consumption in the current fiscal year would be about Tk 11, 078 billion. An augmented demand of Tk 150 billion, when compared to the country's overall consumption does not seem to really impact the inflation of the country significantly. 

Unfortunately, inflation may still increase in July with the implementation of the new pay scale. But lack of proper management of a market-oriented economic system, as currently pursued in Bangladesh, will be the main reason for that. While this reflects a structural problem in our economic system, this also points to the responsibility of the government to properly monitor the market to prevent unjustified price hikes. True, people run business for profit. But profit should be an economic outcome, not the result of taking advantage of economic mismanagement. 

The new pay scale will increase the living standard of the citizens of the country only if the government ensures that economic mismanagement is prevented. Otherwise, the intended benefit of the new pay scale will be dissipated and a large segment of the country will suffer an absolute decline in their living standards.

The writer is Researcher at Bangladesh Institute of Development Studies (BIDS), former economist, World Bank, and former faculty, Willamette University, USA. Email: cccg67@yahoo.com