The interaction of inflation, interest rates, and GDP

An excise tax not only raises the price of the product directly and make the poor to suffer more; it also lowers output and create more joblessness among the poor.

The government is lowering its real GDP or output growth target this year from 7 to 8 percent down to 6.5 to 6.9 percent.

This came after seeing the 6.6 percent GDP growth in the first quarter going down to only 6.0 percent in the second quarter and the inflation rate rising to 6.7 percent in September from only 6.4 percent in August and 0.5 percent from September last year.

To fight inflation, the BSP has increased its policy rate, the rate at which all the other type of interests are based, to 4.5 percent by September from only 3.0 percent at the start of the year.

Despite the increase in the policy rate, however, the government now concedes that inflation may still reach its peak this month or next month which may again require the BSP to raise the interest rate further.

If high interest rates is supposed to curtail inflation rate, why has the latter not been abated?

The answer lies in the fact that monetary policy, whether done by way of a direct change in money supply or interest rate, has a time lag before its full impact is felt.

At the height of high inflation rate of about 9 to 11 percent in the US in the late 1970s, Fed Chairman Volcker cut the money supply down which resulted in higher interest rates that went up to more than 21 percent for prime rates.

But this also caused the economy to go into a recession immediately.

After two years though in 1981, inflation finally went down to 9 percent, then to 6 percent and 4 percent.

Why the time lag?

The answer lies in the fact that monetary policy, while easy and faster to execute by the monetary board, than fiscal policy that requires congressional action, has to wait for the reaction of investors who may take more time to decide to cut their investments with the increase in interest rates.

When making an investment, an investor has to compare the cost of money with the expected return of investments.

As long as the expected return is higher than the cost of money, investments will continue to grow.

Otherwise, it will be restricted or go down.

Many other factors also affects the decision of investors to invest, some of which may negate the impact of an increase in interest rates.

If the prospect of business is really good, for example, high interest rates may not deter investments.

Another thing to consider is that interest rates will also impact on the cost of doing business.

When the cost of doing business is high, output will be lower. Lower business output also means lower overall national output or GDP.

And that in fact was the reason why the US went into a recession when Volcker tightened money supply which caused the interest rates to rise.

In our present case in the country, the problem is even more complicated because the cause of our inflation this time is not so much of the demand pull type, aggregate demand greater than aggregate supply but more of the cost push in origin as occasioned by the Train Act which raised the excise tax of oil, sugar, and other products which is also aggravated by the global rise in the price of oil and the failure of the NFA and DA to maintain stable supply of staple goods.

An excise tax not only raises the price of the product directly and make the poor to suffer more; it also lowers output and create more joblessness among the poor.