Literature Review Focusing on Income Disparity Issues

Income disparity is a widespread phenomenon in not only the developing economies, but the developed world as well. Shift towards the studies relating to income inequality occurred in 1990s, thus conducting a study under a time period from 1990 to 2009 will be quite relevant under current situation. Unequal income distribution is an economic issue that links its roots with other important and complex economic problems; such as, increasing poverty, corruption, petty thefts, increasing crimes etc. this issue can create a total political deadlock if we take a wider perspective. According to many economists, such as; Romer and Romer, 1998 Bulir, 2001;Easterly and Fischer,2001 inflation, yet another economic problem highly positively correlates with income disparity, and this correlation is the subject matter of this paper as well. Rubens P. Cysne, Wilfredo L. Maldonado, Paulo Klinger Monteiro (2005), link the income disparity with the inflation under the shopping time approach, the welfare cost of the inflation. According to them; “Our main conclusion is that under such assumptions, a formal link between inflation and the Gini coefficient of income distribution can be theoretically proved. For transacting technologies in which the productivity of the interest-bearing asset is high enough, an increase of the inflation rate unequivocally leads to a deterioration of the income distribution.” [Rubens P. Cysne, Wilfredo L. Maldonado, Paulo Klinger Monteiro (2005)]. Under the assumption taken by the above mentioned article, the role of interest bearing assets in linking inflation with income inequality becomes important. Economists have linked inflation with inequality using other economic variables as well. This article is a good example of that.

The employment paper “Is inflation bad for income inequality: The importance of the initial rate of inflation” by Rossana Galli and Rolph Van Der Hoeven explores theoretically and empirically the effects of monetary policy and inflation on the income inequality, but in the developed economies. It basically tries to solve the inflation inequality puzzle, that is, that both the variables have mixed correlations, this paper suggests a U-shaped relationship between both the variables with inequality decreasing as inflation first rises and then lowers down and inequality increasing as inflation is further reduced. The paper has basically focused on the developed economies, unlike that of Pakistan. In Pakistan’s case, we may assume for now a curve which shows a direct relationship between the inflation and income inequality that is as the inflation increases, the income gap between rich and poor enlarges.

Moreover, “Income inequality: does inflation matter” by Ales Bluir, contributes to the income inequality literature. This paper is based on the traditional Kuznets model. This paper improves upon the Kuznets model by incorporating inflation in the model, a variable, which was not initially considered important by the older economists. According to this article, reduction in inflation from hyperinflationary levels to very low level seems to bring slight added gains in the income inequality, the GINI coefficient. Incorporating inflation in Kuznets model is the main focus of this mentioned article. Again, we may negate the findings of this model as it relates to the developed world and since the economic settings of developed country differ quite a lot from a developing one, there is a high probability that results obtained there are inconsistent in Pakistan.

In addition to this, the paper written by Roel M.W.J Beetsma and Frederick Van Der Ploeg; provides cross country evidence on a positive link between inflation and income inequality for the democratic countries. We may relate the findings of this paper with our paper as Pakistan is taken to have a democratic ruling party since 1990s, excluding the Musharaff’s era, the martial law period. The paper provides a positive relationship between the income inequality and inflation, which is what exactly presupposed in our working paper.

Developed world has been successful to an extent in resolving their income disparity concern, but the developing nation needs to really work upon it. This unequal distribution of income is also the main root cause of poverty in these countries, destroying the financial health of all such nations. Developing economies are expected to have the social indicators in the favor of the upper class compared to the lower class, that is, the development works in the economies like that of Pakistan, help the richer population and not the poor ones, thus, increasing the income disparity.

Income disparity, alone can impact various economic indicators directly or indirectly. For instance, income inequality can impact poverty and the growth rate of a country. “Low inequality can, therefore, benefit the poor in two ways: by increasing overall growth and average incomes, and by letting them share more in that growth.” [Haroon Jamal (2006)]. Since it can be seen that the income inequality impacts poverty in a manner that may be enough to cater to that issue, resolving the income disparity issue becomes important. In other words, one economic issue can be the cause of several others, thus catering to one may help resolve the rests of the problems as well.

There are many reasons for income inequality to be high in Pakistan, such as market imperfections, poor governance, lack of transparency in economic policies, high level of corruption, burden of debts and interest rate payments on debts, worsening situation of law and inappropriate implementation of economic policies, lack of proper strategy plans etc.

Muhammad Shahbaz and Naveed Aamir (2008), well stated in their article that as generally the developing countries have a high rate of population growth and lower investment rate, it results in lower economic growth, thereby adding more people in the poverty bracket or making income distribution worsen. It can be widely agreed that the development factors, such as FDI, the trade openness benefit the upper class more than the lower class, thus worsening the income equality. Same article states; “in empirical psychology, results reveal that increased FDI in Pakistan worsens income distribution because it is focused towards capital intensive industrial and services sectors of urban localities. Economic growth also makes income distribution more unequal following upper echelon trend. Relation between income distribution and trade-openness according to Leontief paradox i.e. more trade promotes rich class more. Government size is associated negatively with income distribution showing exploitation of poor segments through elite class.” [Muhammad Shahbaz and Naveed Aamir (2008)], this statement clearly depicts the situation of this country. Policies employed work for the betterment of the already better lot of the country. The poor population, that is the major portion of population of Pakistan is well ignored, thus, the main lot is left under the poverty line, increasing the income disparity. Catering to the poor population will help solve this problem. Thus it can be concluded that focusing on the ways richer get to accumulate wealth is creating the whole problem.

Dollar and Kray (2001), also mention in their paper that “social spending in developing countries often benefits the rich and middle classes more than the poor”, [Dollar and Kray (2001)], again contributing to the fact that development expenditures done in the developing economies increase the income disparity. Similar is the case with the Pakistan, where policies need to change and focus more upon the lower class than upper class. In Pakistan, the rich are accumulating the wealth; the poor are left at their mercy and in the end suffer. Developing economies have a rich population which is a very small % of the total population. Thus, if the poor lot, that is the major one isn’t made better off, disparity would keep rising.

Inflation in Developing Countries

It has been unanimously agreed by the policy makers that every country should be able to achieve a stable price level or a small, steady inflation rate. There are varied determinants of inflation in a developing economy, such as; the purchasing power parity, increase in money demand, increase in labor cost or rising costs of factors of production, when there is an excess demand for goods, expectations about future inflation rates also determine the inflation, political decisions and institutional factors also play a role in the determination of inflation, certain structural factors also affect the CPI, growth rate, exchange rate and level of imports also impact the inflation.

Inflation affects the economic growth of the country to a very large extent; it actually deters the condition of the country. There is clear agreement that even moderate levels of inflation damage real growth [Cecchetti (2000)]. Considering such unfavorable impacts of inflation on the economy, there is a consent among the worlds’ leadinby the economists and central banks that the price stability is the main purpose of monetary policy [King (1999); Blejer, etal. (2000)] and the central banks are working diligently to the low inflation rates [Goodfriend (2000)].

Inflation may be a cause of demand side or supply side factors. Either way it is harmful for a developing country. Such is the reason; the central banks of the developing economies try to target a stable inflation rate, for price stability purposes. According to an article; “The possible sources of inflation include rising costs such as wages, profits, imported inflation—exchange rate, commodity prices, external shocks, exhaustion of natural resources and taxes.” [Abdul Qayyum (2006)]. Thus, we see that inflation can be a cause of both, the demand side and supply side factors. Both side factors need to be catered for to achieve price stability.

Rising inflation can create enormous amount of problems for the developing as well as developing economies. For instance; take an example, if process keep on rising, such as a state of hyperinflation is reached, the worth of the incomes will keep on falling that is the purchasing power of income would decrease. Fixed income earners might want to find a job somewhere else; this would increase the rate of search unemployment. During such a phase the depression faced by the citizens, the crime rates and other such problems might keep on increasing. Thus, we see that a problem like inflation can have huge direct, indirect and after effects.

Catering to inflation is important, especially in developing economies where the monetary policy applied has not yet been able to achieve a constant CPI rate.

Inflation in Pakistan

Price stability and low inflation should be the goal of every country’s macroeconomic policies. A target inflation approach can be adopted to make sure that factors affecting inflation act in a way that they do not cause the inflation rate to go above a certain limit; 3% to 6% can be taken as a good range for the CPI rate. Inflation in Pakistan is one of the most complex issues which require being resolved. Persistent increase in prices is something extremely bothering to every citizen of this country. Wages, incomes are constant, but prices keep on increasing, reducing the real income of a normal Pakistani.

The determinants of inflation as identified by Khan, Abdul Aleem; Ahmed, Qazi Masood and Hyder, Kalim (2007) include; “First, increased domestic demand due to remittances from abroad and liberal demand-management policies outpaced the domestic production, creating a positive output gap, which in turn put upward pressure on prices. Second, the growing gap between domestic demand and domestic production was filled by a sharp increase in net imports, which grew by over 40 percent in FY05 and by 24 percent in FY06. Third, fiscal policy has remained expansionary in the last few years. Expansionary fiscal policy fuels domestic demand and puts pressure on the current account deficit. In other words, it widens the investment-saving gap, which has to be financed externally. Fourth, the expansionary monetary policy through high growth in money supply and loose credit policy was also believed to be contributing to high inflation” [Khan, Abdul Aleem; Ahmed, Qazi Masood and Hyder, Kalim (2007)]. The determinants of inflation pointed out in this article basically sum up to be the demand related factors, either it be demand for goods or demand for money. All these factors highly imapct the inflation.

Inflation can make growth detrimental and erode the rich poor gap. For around 11 years of the past 32 years, inflation in Pakistan has been more than 11%. Fiscal factors or monetary shocks,