July 25th, 2008 by Hafiz Noor Shams
It is fashionable these days to reminisce about the days when a penny could buy a fancy candy. I have no recollection of such times and I strongly suspect they are but a myth, especially when the not so old retell a story that should only be in the vague memory of the dead. I cannot help but roll my eyes whenever a conversation which touches on once-upon-a-time-a-penny-could-buy-a-fancy-candy slowly turns into a lament against inflation. Talk of inflation in the public sphere almost always takes a pessimistic tone but the inflation that we suffer is really misunderstood possibly due the lag that exists while wages and prices chase each other.
It is typical for many modern economies to see a rise in the general level of prices over time since the 1970s. There were some cases of deflation but we mostly live in an inflationary world. In Malaysia where inflation has been around for the longest time, many in the public complain about how inflation reduces individual purchasing power.
What many do not realize is that the general rise of price levels is as much as about the general rise of wage levels. As both factors try to catch up with each other, inflation really matters little in the long run.
Due to this, it really does not matter if a penny could buy a fancy candy in a time long forgotten but not now. We can still afford to consume that candy anyway. In fact, it is very likely that with all the real improvements we have seen in our standards of living, we can afford to buy more candies than we ever could when candy was priced at only a penny.
But however many candies we can afford nowadays, what makes inflation hurt in the short run is the lag between price increases and upward adjustments to wages. This lag is usually associated with a phenomenon known as price stickiness: individuals and entities take time to change prices. Sometimes, the act of changing prices itself incurs cost and further forces prices and wages to be inflexible.
For instance, one transportation company that I am familiar with took two weeks to revise its prices upwards after the June 5 price hike. Why two weeks? Internal approvals, negotiations with customers, costing modeling, simulation, etc. The company was adversely affected by the lag but after that, higher fuel expenditure is met with higher service prices while the service level remains the same.
This is the actual meaning of inflation. It is not about erosion of a person’s real purchasing power per se but rather, it is about erosion of purchasing power of a unit of a currency.
It is important to note that the phenomenon does not exclusively happen to businesses. Individuals too undergo the same path. In the long run, the wages and prices tend to approximately equalize each other. And just like what happened to the transportation company, it is the lag of wages vis-à-vis prices that hurts individuals. Inflation adversely affect real wages by depressing temporarily, until nominal wages catch up with higher level of nominal prices.
So, how do we reduce the pain?
There are a number of things but my favorite revolves around management of expectation.
The idea is that if individuals or entities successfully anticipate a rise in prices, wages would quickly match the other. That would come close to eliminating any lag that might exist otherwise.
To do that, wages have to be defined in real terms, i.e. having wages adjusted to inflation. In employment contracts especially, an escalator clause is a must if preservation of real wages is a goal. At the moment, too many people out there have their wages defined in nominal terms, i.e. unadjusted to inflation. For businesses, well, they could just increase their prices and pay their own wages.
If we manage to considerably eliminate this lag, then perhaps it would finally dawn on many that inflation really does not matter as much as many make it out to. More importantly, the story of a penny candy would finally be buried and forgotten.
A version of this article was first published in The Malaysian Insider.