THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Causes of Inflation

<< THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….)

THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):BALANCE OF PAYMENTS >>

Introduction to Economics ECO401

Lesson 11.3

THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS

(CONTINUED.......)

Causes of Inflation:

There are three views here:

a. The Traditional Keynesian View.

b. The cost push inflation

c. The monetarist view.

a. The traditional Keynesian view which sees inflation and unemployment as opposite

sides of the same coin, so is merely a result of excessive aggregate demand (demand-

pull inflation). Assuming that increases in aggregate demand in a Keynesian world do

have some output and employment impact, one can think of plotting the relationship

between inflation and unemployment as trade-off: a downward sloping curve in

inflation-unemployment space. This curve is called the Phillips curve names after the

economist who first quantitatively documented this trade-off in the context of the UK

economy in the 1950s and 60s. The Phillips curve tradeoff can be summarized as

follows: Lower unemployment can be achieved only at the cost of higher inflation. The

policy prescription flowing from this particular diagnosis of inflation was simple: reduce

aggregate demand by contractionary fiscal and/or monetary policies.

b. Cost-push inflation: This view came to fore in the 1970s when the world was

confronted with a situation of rising prices but high unemployment (stagflation),

something that demand-pull theories could not explain. It was observed that the two oil

price shocks in the 1970s, which were essentially supply side shocks (because they

increased the cost of production), were capable of producing such a situation. In AD-

AS space, such a supply shock would be shown by shifting the AS curve to the left

(and up) causing prices to rise and output (and employment) to fall. In the context of

the Phillips curve, the supply shock would be shown by shifting the Phillips curve out to

the right, reflecting a structural shift in the inflation-unemployment trade-off. The name

given to the resulting higher inflation (at any level of unemployment) was cost-push

inflation. The policy prescription appropriate for dealing with it, included supply-side

measures such as developing alternative energy sources, fuel efficient technologies,

production cost reduction methods, and reducing tax distortions (that reduce the

incentive to produce), increasing competition (in search of productivity gains), removing

price floors etc. Keynesian demand management policies were obviously not seen as

relevant in this context. It is important to note that sometimes what appears as cost-

push inflation is actually driven by higher demand. For e.g., let's say demand for

property increases in an economy; this causes housing prices to rise, causing rents to

rise, causing workers to demand higher wages. Higher wages cause firms' production

costs to increase prompting them to raise goods prices which in turn causes retail

prices to rise. At every point of the who chain, it is the costs that are rising (rental costs,

production costs, purchase costs of retailers), but the cause of these rising costs is

higher demand for property. This situation is often branded cost-push illusion.

c. The Monetarists View: Monetarists located the causes of inflation in the Quantity

Theory of Money (QTM), which provided an explanation for inflation totally independent

from that for unemployment. QTM states: MV = PQ, where M is the real money supply,

V is the velocity of money (the no. of times money is circulated in the economy in a

year), P is the price level and Q is the real output. Assuming a constant V and a stable

(natural rate) output Q*, changes in P could be explained totally by changes in M. A

stable M would imply a stable P. Thus the Monetarist key to solving the inflation

problem was a stable money supply set to grow at the rate of growth of natural rate

output (Q*). For Monetarists, the concern was not the government's expansionary

114

Introduction to Economics ECO401

fiscal policy per se, but the manner in which the fiscal deficit was financed. If the

government financed its deficit by borrowing from the central bank (i.e. printing money,

and thus expanding money supply), this would be tantamount to inflationary finance of

the budget. If, however the government financed the deficit by borrowing from banks or

the retail savers, then there would be little inflationary consequences.

It is also instructive to see how Monetarist's viewed the Phillips curve, and the inflation-

unemployment tradeoff. Monetarists believed that the economy generally gravitated around a

full-employment or natural rate level, and any positive output or employment impact of

inflationary demand policies would have be limited. The duration and extent of this limited

impact would depend on how much money illusion private agents suffered from. Money

illusion is when agents base their decisions on their expectations about inflation (set in period

t-1), so that when government driven actual inflation (increase in prices and wages) in period t

exceeds expected inflation, agents view the increase as real rather than nominal, and

therefore erroneously spend more than they should. In setting expectations for period t+1,

however, they learn from the previous period, raising their inflationary expectations based on

the outcome in period t. Only an inflation rate higher than this new expected rate can convince

them to spend more. The net effect of learn and error process is that inflation rises very

steeply in response to continued demand-injections by government until the effect on spending

and employment is virtually zero a vertical Phillips curve. This is how Monetarists

characterized the long-term tradeoff between output and inflation, i.e. that there was no trade-

off and that expansionary demand policies (i.e. expansionary monetary policy) translated fully

into higher inflation with no impact on employment whatsoever.

115

Table of Contents: