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The impact of inflation on rural poverty in Indonesia: An econometrics approach

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International Research Journal of Finance and Economics
ISSN 1450-2887 Issue 58 (2010)
© EuroJournals Publishing, Inc. 2010
http://www.eurojournals.com/finance.htm

The Impact of Inflation on Rural Poverty in

Indonesia:an Econometrics Approach

Iman Sugema
Department of Economics, Bogor Agricultural University (IPB), Bogor, Indonesia
International Center for Applied Finance and Economics
Bogor Agricultural University (IPB), Bogor, Indonesia

Toni Irawan
Department of Economics, Bogor Agricultural University (IPB), Bogor, Indonesia
International Center for Applied Finance and Economics
Bogor Agricultural University (IPB), Bogor, Indonesia

Deniey Adipurwanto
Department of Economics, Bogor Agricultural University (IPB), Bogor, Indonesia
International Center for Applied Finance and Economics
Bogor Agricultural University (IPB), Bogor, Indonesia

Ade Holis
International Center for Applied Finance and Economics
Bogor Agricultural University (IPB), Bogor, Indonesia

Toni Bakhtiar
International Center for Applied Finance and Economics, Bogor Agricultural University (IPB)
Bogor, Indonesia, Department of Mathematics, Bogor Agricultural University (IPB)
Kampus IPB Darmaga, Jl. Meranti, Bogor 16880, Indonesia
Tel/Fax: +62 251 8625276
E-mail: tbakhtiar@ipb.ac.id

Abstract

This research aims to analyze the impact of inflation on poverty in national level,
urban and rural levels. Moreover, the research also measures the contribution of each group
of commodity inflation to poverty level and the magnitude of its impact on urban and rural
poverty levels. We employ consumer demand theory to measure the elasticity and so-called
price index for the poor (PIP). The elasticity is measured from Indonesian National
Household Survey (SUSENAS) and then we use consumer price index for 7 groups of
commodity (foods; processed foods, beverages and tobacco; housing; water, gas, electricity
and fuel; cloths and wearing apparel; health, education, sport and recreation; and
transportation, communication and financial services) to estimate PIP. The results suggest
that rural poor households are more vulnerable to economic shocks, especially inflation. In
more detailed analysis, price fluctuation on foods and its products has larger impact on
poverty relative to non-food commodity. Again, rural poor households will experience
more severe impact due to price fluctuation on foods. Furthermore, the magnitude of PIP
International Research Journal of Finance and Economics - Issue 58 (2010) 51

shows that in the last three years, the inflation has larger impact on poor households both in
rural and urban area relative to non-poor household.

Keywords: Price index for the poor, rural poverty, pro-poor.

JEL Classification Codes: E31, I32, I38

1. Introduction
Economic development still leaves a number of issues that should receive serious attention. One of the
main problems that arises as a result of the implementation of inconsistent and impartiality national
development programs is the widening inequality and chronic poverty. In the case of Indonesia, this
condition is exacerbated by the existence of urban bias which further marginalizing the rural
communities.
Rural become the least developed area in terms of economy. The majority of poor people live
in rural area, so that the rural becomes a prime pocket of poverty. In 2007, 63.52 percent of total poor
people in Indonesia live in rural area which is much higher than urban area.
Similar condition occurred to inflation rate. In period 2005 to 2008, rural area experienced
persistently higher inflation rate relative to urban area. These all show that price changes will have
higher pressure on rural economic performance relative to urban. Therefore, important question that
might arise is whether the inflation rate will affect poverty level in rural area.
Number of empirical studies by Keidel (2007), Azzoni et al (2004), Nouve dan Wodon (2008),
Singh et.al (1986), Deaton (1989; 1997), Demombynes et.al (2008), Tsimpo and Wodon (2008),
Vedder and Gallaway (2001), Epaulard (2003), James et.al (2008), Easterly and Fisher (2001; 2004),
Son and Kakwani (2006) and Akande, et all (2003) found that fluctuation on macroeconomic
indicators, one of them is inflation rate, do have significant impact on poverty level. This issue is really
important in terms of poverty alleviation program. If inflation rate has substantial effect on rural
poverty, thus government should control rural inflation rate along with poverty alleviation program
since most poor people lives in rural area. Up to now, there are only few studies that focus on inflation
rate and poverty in rural area. A study by Asra (1999) demonstrates the importance of urban-rural price
differences and inflation figures in poverty analysis in Indonesia. The study presents different
methodology to estimate poverty incidence by using both ratios of urban to rural food prices and
observed inflation rates. However the impact of inflation rates on poverty level still not being
observed. Therefore the objectives of this paper are to analyze the impact of inflation rate on poverty
level in national level, urban and rural level. Moreover, the research also measures the contribution of
each group of commodity inflation to poverty level and the magnitude of its impact on urban and rural
poverty level.
The paper is organized as follows. Section 1 outlines the importance of study. Section 2
describes the methodology to estimate elasticity and price index for the poor (PIP). Section 3 presents
the results and conclusion finally drawn in Section 4.

2. Data and Methodology

This paper use National Socio-Economic Survey (SUSENAS) 2005 covering 277.202 households in all
provinces in Indonesia. The survey is collecting a detail income and expenditure data periodically,
usually every 3 years. Moreover, the paper also uses Consumer Price Index (CPI) that is published by
Central Agency of Statistic (BPS) for the period 2002-2009, where the 2002-2006 survey involves 45
cities and the 2007-2009 survey includes 67 cities in Indonesia. Inflation rate is calculated as
percentage changes of CPI year on year. Household consumption data from SUSENAS is covering 20
types of commodities both foods and non-foods. Then, we aggregated those 20 types of commodities
into 8 groups of consumer goods.
52 International Research Journal of Finance and Economics - Issue 58 (2010)

We employ consumer demand theory approach to estimate the elasticity and price index for the
poor (PIP). In terms of poverty indicators, we use Foster et al. (1984) method by calculating Poverty
Head-Count Index, Poverty Gap Index, and Severity of Poverty Index, hence
‫ݖ‬
‫ݖ‬−‫ߙ ݔ‬
ߠ≔න ቀ ቁ ݂ሺ‫ݔ‬ሻ݀‫ݔ‬,
0 ‫ݖ‬
where θ is poverty rate, α is inequality aversion parameter; z is poverty line, x is individual income, and
f(x) is density function of income for each individual. If α = 0, we will have Poverty Head-Count Index
in which we give the same weight for all people who have income less than poverty line. If α = 1, each
individual will have weight as much as the difference between its income and the poverty line, which is
called as Poverty Gap Index. If α = 2, each individual will have weight as much as square of difference
between its income and the poverty line, which is called as Severity of Poverty Index. Elasticity for
each poverty indicator is measured as
݉ ‫݂ݖ‬ሺ‫ݖ‬ሻ
ߟ‫ = ܪ‬෍ ߟ‫= ݅ܪ‬ , for ߙ = 0,
݅=1 ‫ܪ‬
݉ ߙ
ߟߙ = ෍ ߟߙ ݅ = ሺߠߙ−1 − ߠߙ ሻ, for ߙ ≠ 0,
݅=1 ߠߙ
where ηH stands for elasticity of head count ratio H, ηα is elasticity of poverty gap index if α = 1 and
that of severity of poverty index if α = 2.
If price change from ‫ ݅݌‬to ‫ ∗݅݌‬, poverty rate is expected to change as much as λ, which is known
as price index for the poor (PIP), hence
݉
‫݅ ߠߟ ∗݅݌‬
ߣ=෍ .
‫ߠߟ ݅݌‬
݅=1
Since inflation rate in Indonesia is calculated using Laspeyres index, hence
݉
‫∗݅݌‬
‫=ܮ‬෍ ‫ݓ‬ ഥ
‫݅ ݅݌‬
݅=1
and pro-poor price index (ϕi) as
ߟߠ
߮݅ =
‫ݓ‬
ഥ ݅ ߟߠ ݅
where is the average share of expenditure on commodity i, then we can rearrange PIP formula as
݉
‫∗݅݌‬
ߣ=‫ܮ‬+෍ ‫ݓ‬ ഥ ሺ߮ − 1ሻ.
‫݅ ݅ ݅݌‬
݅=1
We can see from the above formula that if λ is less than L, inflation rate can be categorized as
pro-poor and otherwise anti-poor.

3. Result and Discussion

3.1. The Impact of Price Changes on Poverty in National Level
In this sub chapter we will analyze the impact of inflation rates on poverty by using national level data.
Table 3.1 shows elasticity for three poverty indicators along with pro poor price index for each
indicator. In general, price elasticity of poverty for foods commodities is much higher than non foods
commodities. In terms of head count ratio, price elasticity of poverty for foods commodities is 1.99
which is much higher than non foods commodities that only accounted as much as 0.90. These means
that an increase of food price by 1 percent increase head count ratio by 1.99 percent whereas an
increase of non food price by 1 percent is only cause head count ratio to rise by 0.90 percent.
International Research Journal of Finance and Economics - Issue 58 (2010) 53
Table 1: Price Elasticity of Poverty in National Level

No Commodity Head Count Ratio Poverty Gap Ratio Severity of Poverty

Elasticity PPI Elasticity PPI Elasticity PPI
Level 1
a Foods (1,2) 1.99 1.18 2.77 1.20 3.23 1.19
b Non Foods (3,4,5,6,7) 0.90 0.77 1.20 0.75 1.42 0.75
c Others (8) 0.03 0.59 0.03 0.33 0.04 0.40
Total 2.93 1.00 3.99 1.00 4.69 1.00
Level 2
1 Food 1.65 1.26 2.21 1.24 2.62 1.25
2 Processed food, beverages and tobacco 0.37 0.95 0.50 0.94 0.57 0.92
3 Housing, Water, Electricity, Gas and 0.64 0.89 0.99 1.01 1.12 0.97
Fuel
4 Clothing 0.05 0.72 0.02 0.22 0.05 0.40
5 Health 0.05 0.79 0.03 0.32 0.05 0.48
6 Education, Recreation and Sport 0.07 0.58 0.08 0.48 0.10 0.52
7 Transportation, Communication and 0.07 0.36 0.15 0.52 0.16 0.47
Financial Services
8 Others 0.03 0.58 0.03 0.34 0.04 0.41
Total 2.93 1.00 3.99 1.00 4.69 1.00

In the food category, price of food product have higher impact on poverty level relative to
Processed Food, Beverages and Tobacco. This result is confirming press release of Central Agency of
Statistic (BPS) No. 38/07/Th. X, 2 July 2007. Table 1 suggests that elasticity is getting bigger as we
used higher level of poverty indicator. Total elasticity for head count ratio, poverty gap ratio and
severity of poverty are 2.93. 3.99, and 4.69, respectively. These imply that the impact of higher price
on an extremely poor individual is much higher than that on poor people.
Another important indicator in Table 1 is pro-poor price index. This indicator measure how
price changes on each consumer products can distort income distribution. Based on our calculation,
two groups of consumer product have pro-poor price index higher than 1, namely food and housing,
water, electricity, gas and fuel. These imply that if price of those two groups of consumer product
increase, the impact on poor people will be more severe that non-poor people. In other words, an
increase on price of those products will widen the income gap between poor and non-poor people or
anti-poor. These results are substantially important in the formulation of price regulation policy or
other policies that could affect price level.

Table 2: Percentage Changes of Poverty as an Impact of Price Changes in National Level

Period Total Changes Income Effect Distribution Effect

% Changes in Head Count Ratio
2001-2002 45.49 44.70 0.79
2002-2003 19.33 21.83 -2.50
2003-2004 11.22 12.37 -1.15
2004-2005 22.43 21.94 0.49
2005-2006 43.08 45.75 -2.67
2006-2007 26.11 23.68 2.43
2007-2008 24.55 22.18 2.38
2008-2009 34.53 31.81 2.72
% Changes in Poverty Gap Ratio
2001-2002 62.98 60.93 2.05
2002-2003 27.78 29.76 -1.98
2003-2004 15.74 16.86 -1.11
2004-2005 30.99 29.90 1.09
2005-2006 60.84 62.36 -1.52
2006-2007 35.11 32.28 2.83
2007-2008 33.07 30.23 2.84
2008-2009 47.08 43.36 3.72
54 International Research Journal of Finance and Economics - Issue 58 (2010)
% Changes in Severity of Poverty
2001-2002 73.56 71.53 2.03
2002-2003 32.00 34.93 -2.93
2003-2004 18.28 19.79 -1.51
2004-2005 36.26 35.10 1.16
2005-2006 70.66 73.21 -2.55
2006-2007 41.47 37.90 3.57
2007-2008 39.03 35.49 3.54
2008-2009 55.29 50.90 4.39
Note: The calculation is based on year on year inflation rate in March.

Table 2 shows the impact of price changes on national poverty level. The magnitude measures
the pure effect of price changes when all variable is assumed to be constant or ceteris paribus.
Moreover, Table 2 also presents the decomposition of total effect into income effect and distribution
effect. By using income effect we can measure the changes of poverty if all prices are assumed to rise
uniformly. Distribution effect measures the relative impact of price changes on poor people to non-
poor people. In 2001-2002, price changes is expected to increase poverty level by 45.49 percent in
terms of head count ratio, 62.98 in terms of poverty gap ratio and 73.56 in terms of severity of poverty.
During the period given, we found that only three period has negative distribution effect which imply
that price changes has less severe impact on poor people relative to non-poor people, namely 2002-
2003, 2003-2004, and 2005-2006. Meanwhile, in the rest 5 periods, poor people received more severe
impact due to price changes.

Table 3: Inflation Rate based on Laspeyres Index and PIP Index

Period Laspeyres Index Price Index for the Poor (PIP)

Head-Count Ratio Poverty Gap Ratio Severity of Poverty
2001 10.62 9.35 8.12 8.04
2002 14.07 14.17 13.81 13.60
2003 7.17 5.78 4.61 4.38
2004 5.11 4.91 4.60 4.56
2005 8.81 8.33 7.84 7.74
2006 15.74 15.52 15.45 15.27
2007 6.95 8.22 9.55 9.72
2008 7.10 9.37 11.12 11.31
2009 7.92 9.41 10.56 10.61

Table 3 presents the inflation rate based on two different measurements, Laspeyres Index and
PIP index. Generally, before 2007 PIP index persistently lower than Laspeyres index except for head
count ratio in 2002. Meanwhile PIP index is persistently higher than Laspeyres Index in 2007 up to
2009. These results imply that price changes before 2007 are pro-poor whereas price changes in the last
three year relatively have more severe impact on poor people rather than non-poor people.

3.2. The Impact of Price Changes on Poverty in Rural and Urban Level
This sub chapter is the main focus of the paper. Here we will analyze the impact of inflation on rural
poverty level. Moreover, we also complete the result with the analysis of urban poverty level.
Important to note here that we use different poverty line for urban, rural and national level based on
poverty lines that are published by BPS.
In terms of elasticity, poverty in rural area is much more responsive to food price changes than
urban. Oppositely, in terms of non food price changes, rural poverty is much less responsive than urban
poverty, see Table 4. These results are rational since 65 percent of rural household expenditure is spent
on food products. Next, Table 5 presents pro-poor price index in rural and urban. Generally, the feature
is quite similar with national level in which poor people both in urban and rural will experience
substantially serious effect if food price increase relative to non-poor people.
International Research Journal of Finance and Economics - Issue 58 (2010) 55

The last analysis in this paper is PIP index in rural and urban which is shown in Figures 1 and
2. Results that are presented in those figures emphasize the findings in the national level. The last three
years is proven as hard period for poor people. Since 2006, PIP index is persistently higher than
Laspeyres Index in both urban and rural. Moreover, the difference between PIP and Laspeyres Index is
much larger in the rural relative to urban. These imply that poor people in rural area experience more
severe impact

Table 4: Price Elasticity of Poverty in Urban and Rural Level

Consumption Elasticity
Head-count Ratio Poverty Gap Ratio Severity of Poverty
Urban Rural Urban Rural Urban Rural
Level 1
Foods 2.28 2.52 2.54 3.04 3.02 3.57
Non Foods 1.25 0.92 1.72 1.59 1.92 1.72
Others 0.03 0.03 0.12 0.03 0.10 0.04
Total 3.56 3.46 4.37 4.66 5.03 5.33
Level 2
Food 1.78 2.15 2.10 2.57 2.46 3.02
Processed food, beverages and 0.46 0.40 0.56 0.39 0.65 0.50
tobacco
Housing, Electricity, Gas and Fuel 0.88 0.69 1.03 1.17 1.23 1.27
Clothing 0.04 0.04 0.18 0.11 0.15 0.11
Health 0.06 0.04 0.14 0.11 0.13 0.11
Education, Recreation and Sport 0.11 0.05 0.18 0.17 0.19 0.16
Transportation, Communication and 0.19 0.07 0.05 0.11 0.12 0.13
Finance
Other 0.03 0.03 0.13 0.03 0.11 0.04
Total 3.56 3.46 4.37 4.66 5.03 5.33

Table 5: Pro-Poor Price Index in Rural and Urban

Consumption Pro-Poor Price Index

Head-count Ratio Poverty Gap Ratio Severity of Poverty
Urban Rural Urban Rural Urban Rural
Level 1
Foods 1.27 1.14 1.15 1.03 1.19 1.05
Non Foods 0.74 0.76 0.83 0.98 0.80 0.93
Others 0.42 0.45 1.21 0.38 0.90 0.44
Total 1.00 1.00 1.00 1.00 1.00 1.00
Level 2
Food 1.35 1.23 1.30 1.09 1.32 1.12
Processed food, beverages and tobacco 0.96 0.88 0.96 0.65 0.96 0.72
Housing, Electricity, Gas and Fuel 0.89 0.90 0.85 1.14 0.88 1.08
Clothing 0.51 0.44 1.89 0.91 1.37 0.81
Health 0.81 0.51 1.46 1.06 1.15 0.94
Education, Recreation and Sport 0.59 0.51 0.76 1.24 0.70 1.06
Transportation, Communication and 0.55 0.42 0.11 0.49 0.25 0.48
Finance
Other 0.41 0.45 1.33 0.39 0.95 0.44
Total 1.00 1.00 1.00 1.00 1.00 1.00
56 International Research Journal of Finance and Economics - Issue 58 (2010)
Figure 1: Inflation Rate in Urban Based on Laspeyres Index and PIP Index

20

15

10

0
2001 2002 2003 2004 2005 2006 2007 2008 2009

Laspeyres Index Head-Count Ratio

Poverty Gap Ratio Severity of Poverty

Figure 2: Inflation Rate in Rural Based on Laspeyres Index and PIP Index

18
16
14
12
10
8
6
4
2
0
2001 2002 2003 2004 2005 2006 2007 2008 2009

Laspeyres Index Head-Count Ratio

Poverty Gap Ratio Severity of Poverty

4. Conclusion
The impact of macroeconomic indicators fluctuation is one of the interesting issues in economics.
Moreover, the Millennium Development Goals (MDGs) that are signed by 100 countries have state
that one of the main objectives of MDGs is to reduce world poverty level in 2015. Many programs
have been implemented but economic instability has deteriorated all the positive impacts of the
programs. Therefore, it is important to understand the impact of inflation rate on poverty level
especially in more detail level such as urban and rural. Moreover, it is also important to understand the
contribution of each group of commodity inflation on poverty rural. These are the main focus of our
paper.
Important finding that should be our first concern is that the rural poor are relatively more
vulnerable to economic shock, especially inflation than urban poor which are reflected in the
magnitude of the elasticity. In more detail analysis we show that inflation on food price do have higher
impact on poverty level relative to non food commodity. The impact is much higher on rural poverty
than urban or national level. Moreover, the study also found that in the last three years, changes in the
inflation rate cause a relatively higher impact on poor people in national level, urban and rural level
relative to non-poor ones.
 International Research Journal of Finance and Economics - Issue 58 (2010) 57

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