Evangel's IB Economics Blog

Article: China’s inflation eases due to tightening measures

In May 2011, Chinese government eased inflation by intervening in economy. Previously, China experienced rapid economic growth under loose monetary policy, resulting in high inflation. This commentary will investigate causes of inflation and evaluate the government’s policy in terms of advantages and disadvantages among stake holders.

Inflation is a continuing rise in general price level. Theoretically, there are two types of inflation: demand-pull and cost-push. Demand-pull inflation occurs when aggregate demand (AD)—total of all planned expenditure in an economy at each level of prices—exceeds aggregate supply (AS)—total of all planned production at each level of prices. Cost-push inflation occurs when cost of production increases and firms put up prices to maintain profits.

It can be assumed that China’s inflation was demand-pull. The economic growth shifted AD rightward, as shown below:

(Figure 1) Demand-pull inflation in China

As AD shifted from AD₁ to AD₂, average price level—a measure of overall prices for goods and services in a given interval—has increased from PL₁ to PL₂. Along with price level increased real gross domestic product (GDP)—a measure of the level of economic activity adjusted for inflation—from Y₁ to Y₂.

Apparently, price level rose to the point that “rising food, fuel and housing prices have been identified as serious problems” (BBC, 2011). With this, cost of production has increased, bringing about cost-push inflation illustrated below:

(Figure 2) Cost-push inflation in China

When AS shifted leftward, average price level increased from PL₁ to PL₂ while real GDP decreased from Y₁ to Y₂. With two types of inflation working together, China suffered from high inflation.

Theoretically, there are two macroeconomic polices—polices designed to influence principal macroeconomic targets—that can alleviate inflation: fiscal and monetary policies. Fiscal policy is changes in level of taxation and government expenditure, while monetary policy is changes in supply of money and interest rates. In order to ease inflation, government can higher taxation and/or decrease government expenditure using fiscal policy or decrease money supply and/or increase interest rate using monetary policy.

China implemented only monetary policy, since it brings about result instantly and allows government to fine tune. According to the article, the government “raised the cost of borrowing four times” (BBC, 2011). With this government eased annual inflation rate by 0.1%, depicted below:

(Figure 3) Leftward shift of AD as a result of higher interest rate

With increase in interest rate, AD shifted to leftward from AD₁ to AD₂, bringing about decrease in average price level from PL₁ to PL₂ and in real GDP from Y₁ to Y₂. Because government increased interest rate, money leaked out of economy, slowing down money circulation and thus deflating inflation.

According to the article, “China’s central bank [will] continue to raise borrowing costs” (BBC, 2011). There are advantages and disadvantages to this among stake holders: savers and debtors, domestic firms, foreign investors, and the government.

For savers, a rise in interest rate is advantageous because it will increase the money received from interest-bearing bank. Nevertheless, an increase in interest rate is detrimental to debtors and people with mortgages, since they would have to pay higher interest rates.

As of domestic firms, they will suffer because with rising saving, consumption and investment will likely decrease. This means demand for firms’ products and their efficiency will decrease, resulting in decrease of profit, which leads to fall in value of stock.

Foreign investors, on the other hand, will benefit from a rise in interest rate. This is because as investors are attracted to the higher sterling rates of interest, foreigners are likely to increase the amount of funds into China. As the article mentioned, this will “allow the yuan currency to strengthen,” bringing down the cost of imported items.

Lastly, the Chinese government will likely be worried about increase in unemployment as a result of  increase in interest rate. Because inflation rate and unemployment rate have inverse relationship, as inflation rate decrease due to the monetary policy, unemployment rate might increase.

In general, the Chinese government has made a right choice: to tighten monetary policy. Unless rising inflation was dealt with, China might have experienced economic bubble: a phenomenon characterized by surges in asset prices to levels significantly above the fundamental value of that asset.