New pay scale and fear of inflation

The new pay scale, which proposes to increase salary of government employees, is likely to be implemented in the upcoming fiscal year beginning from next July. Who does not like a pay increase? So quite understandably, the government employees are happy. Pay increase will enable them to increase their consumption and meet some of their unmet demand.
 At the same time, there is a 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 standard by using the augmented income received under the new pay scale. But definitely the others who are not employed by the government are going to suffer a loss of their living standard if the new pay scale really prompts high inflation. Since the most of the people of the country earn their living from the non-government sector, the new pay scale may become national welfare reducer in the end.  
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 the inflation up. But in developing countries, many economic things arise out of non-economic factors. In many cases the non-economic factors dominate over the economic factors resulting in outcomes which are nonsensical from economic point of view. Therefore, the apprehension of high inflation as an outcome of the implementation of the pay scale cannot be shrugged-off.
Many economic commentators argue in print and electronic media that the new pay scale will increase the money supply and hence fuel the inflation. This will be the case only and only if the central bank finances 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 the citizens of the country or 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. In case of the second form of financing as well, money simply change hands, from lender to the government first and eventually to the government employees. In neither case, financing of new pay scale would increase the money supply which, in turn, may increase inflation.
Total money supply of the country will not increase even if the government finances it through external borrowing. Government borrows from external sources in foreign currency and spends it in the domestic economy in local currency, i.e., taka. Whenever government borrows, say, 1.0 US dollar from abroad, the central bank pays the government a certain amount of taka against this dollar depending on the dollar-taka exchange rate. 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 the external borrowing will not increase the money supply in the local money market.  
Therefore, the new pay scale will not increase money supply as long as government does not borrow from the central bank. As a result, the apprehension of a money-induced inflation following the implementation of new pay scale in next July is not based on any economic reasoning.
However, when the increase in demand cannot be matched by similar increase in supply, there is a reason for increase of 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 fail to meet this enhanced demand. But one has to be more analytical and take note of two things while analysing the nexus between the new pay scale and demand-induced inflation.
First, while the new pay scale increases the disposable income of the government employee, it would reduce the disposable income of others, i.e., the taxpayers or lenders to the government, at the same time. Therefore, in terms of disposable income, 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 employee) 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 propensity to consume. In plain words, not everyone spends same amount of money if his/her disposable income increases by a certain amount. People vary in their taste, attitude towards life, above all, in terms of the situation they are exposed to. These differences, in turn, impact their consumption decision. Usually, people living at the lower echelon of the income strata, have a higher consumption tendency out of any additional disposable income compared to the relatively wealthier people.
If those who experience an increase of disposable income and those who experience a decrease in disposable income have equal propensity to consume, the new pay scale would not result in any increase of consumption at aggregate level. However, it is very unlikely that these two groups would have similar propensity to consume. For argument's sake, let us assume the beneficiaries of the new pay scale have relatively high propensity to consume. In such a case, overall demand for consumption would increase and if the supply and marketing chain of the country fail to meet this augmented demand, 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 150 billion taka. How significant is this amount when juxtaposed to our total national consumption?
Our GDP (in current price) in the last fiscal year was about 13509 billion taka. Total consumption accounted for about 77 per cent of GDP (Gross Domestic Product) amounting to about 10344 billion taka. According to the preliminary estimates, GDP will grow by about 6.5 per cent implying total consumption in the current fiscal year would be about 11078 billion taka. An augmented demand of 150 billion taka, when compared to country's overall consumption does not seem much to really impact the inflation of the country significantly. Therefore, the fear of an increase of inflation as a result of the new pay scale has no solid economic reason.
Unfortunately, inflation may still increase in July with the implementation of the new pay scale. The lack of proper management of market-oriented economic system as currently pursued in the country will be the main reason for that. While this reflects a structural problem of our economic system, at the same time, this points to a responsibility of the government as well to properly monitor the market to prevent the possible unjustified price hike. True, people run business for profit. But profit should be an economic outcome, not the result of taking advantage of economic mismanagement.
It is the responsibility of the government, even within the purview of market-oriented economic system, to prevent the second phenomenon happening. The new pay scale will increase the living standard of the citizens of the country only if the government can do this. Otherwise, the intended benefit of new pay scale will be dissipated and a big section of the citizens of the country will suffer an absolute decline of their living standard.       
Abul Basher, PhD is Researcher at the Bangladesh Institute of Development Studies (BIDS), former economist, World Bank, and former faculty, Willamette University, USA.
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