Causes and Effects of Inflation
In the post-WWII period all major economies have experienced inflation, although the rate of inflation has varied widely both between nations and between time periods for a given nation. The persistence of inflation and the tendency for the rate of inflation to rise for substantial periods has resulted in a situation where great weight is given to the prevention of inflation, even at the expense of allowing a high rate of unemployment. Inflation is undesirable for two main reasons:
· Inflation impairs the efficiency of the price mechanism and raises transaction costs because money becomes less reliable as a standard of value. In the presence of inflation it is difficult to know if a price increase on a given good represents an increase in the general price level, or an increase in the price of that good relative to other goods. In order to answer this question, it would be necessary to collect information on the current prices of many other goods. Similarly, the seller will have difficulty determining the relevant prices of factor inputs, substitute goods, etc.
· Unanticipated inflation redistributes income and resources in a largely capricious manner. Inflation penalizes those with incomes that are fixed in money terms, and favors those whose money income reacts quickly to changes in the price level. The former group includes most pensioners, students, and many salary earners, while the latter group includes most wage and profit earners. Where household incomes include transfer payments from the government, it is possible to index payments to keep pace with inflation, but the more successfully this is done, the greater the inflationary bias in the economy. Unanticipated inflation also favors borrowers and penalizes lenders, because if the loan amount and interest payments are fixed in money terms, inflation results in the lender receiving less real value than expected—if the inflation continues, lenders will respond by charging higher interest rates to compensate. Finally, if tax brackets are assigned based on nonindexed money values, inflation can shift the boundary real income between tax brackets, which can result in a major unplanned reallocation of income from households to the government. Indexing taxes will prevent this outcome, but again, the more successfully taxes are indexed, the greater the inflationary bias in the economy.
· A continued higher rate of domestic inflation than that which prevails in other nations will increase imports, reduce exports, and create problems for continued stable currency exchange rates.
In the presence of unanticipated inflation, the above effects are often capricious and unintended. Continued inflation will lead to an adjustment in behavior patterns which can mitigate the effects, but inflation can never be fully anticipated. Full anticipation would require not only full information on the aggregate rate of inflation, but also requires that every economic agent have information on all the relative price movements which affect their decisions.
Up to WWII most industrialized nations experienced periods of inflation cycling with periods of stable or falling prices. Occasional examples of high, sustained inflation can be found as a result of things like the Spanish gold discoveries of the fifteenth century and the German hyper-inflation of 1923, but these were isolated events with an easily identifiable cause. The sustained and near-continuous inflation experienced by all major economies subsequent to WWII has no historical precedent. The emergence of persistent, widespread inflation has led to a major re-examination of the theory of price determination. At the most basic level the proposed theories can be classified into ‘demand-pull’ and ‘cost-push’ models.
The demand-pull model, favored by Keynes, sees price increases as a consequence of excess demand for goods and services which exceed the capacity output of the economy. As real output cannot increase significantly beyond capacity output, excess demand ‘pulls up’ the prices of final goods and services. At the same time, as firms bid up the prices of factors of producion, money incomes rise. This approach has some problems. It cannot explain monetary factors which are clearly observed to be capable of causing inflation (eg, the Spanish gold discoveries), nor does it deal with the possibility that monetary factors could be used to combat inflation. It also regards wage and salary earners as passively reacting to changes in the price level by bargaining up their incomes. However, in the 1950s and 1960s, more centralized wage and salary bargaining became a feature of the major economies, and as a result a new school of thinking developed which elevated labor markets to a primary, causative role in the determination of the price level.
This new, ‘cost-push’ model sees price increases as a consequence of bargains struck in the factor (primarily labor) markets, which raise the production costs of employers, who then pass on higher costs in the form of higher prices. Most cost-push models incorporate the following elements:
- Prices and costs are ‘administered’ rather than responsive to the market forces of demand and supply. With the exception of a few truly competitive markets (agricultural commodities, for example), most markets for final products have some strong anti-competitive elements, meaning that one or a small number of producers have an influential role in setting prices.
- Similarly, labor markets are ‘administered’ in that wages and salaries are largely determined by bargains struck between employers and trade unions, rather than by market forces.
- Final product prices are also ‘administered’ on the basis that firms set prices on a cost-plus basis, with prices reflecting the full cost of production plus some mark-up for profit. As a result, if costs rise, firms will attempt to pass on the higher costs to consumers, in the form of higher prices—so the whole economy is essentially on a cost-plus basis.
- The purpose of trade unions is to bargain better pay for their members.
- Labor represents the single largest factor market, by a wide margin.
Under such a system, bargaining over money wages and salaries is considered the primary ‘motor’ of inflation. Trade unions continually attempt to bargain for better wages and salaries. Sometimes, they are successful. When this happens, the factor costs of labor (the largest cost of production) increase, so firms pass this increase on to consumers in the form of higher prices. The increase in prices will erode the real value of the money increase in wages, which may then lead to further demands for wage increases. ‘Cost-push’ inflation originates with higher wage costs which then push up prices. Cost-push inflation is likely to occur in economies where wages and salaries are not flexible downwards, a feature of most modern economies. It has long been recognized that workers, trade unions, etc., will particularly resist any cut in money wages. That being so, firms, faced with lower demand for their products, may be reluctant to lower prices, because the ‘stickiness’ of wages would mean that the price cuts would mainly be at the expense of profits. Instead, the firms will lower output and therefore employment.
Where deficient demand may not cause prices to fall, excess demand will be reflected in higher wages and prices. In other words, the reaction of wages and prices is asymmetrical. If this is so, then a change in the distribution of demand, even given the same aggregate demand, could cause prices to rise. Inflation does not occur as a result of excess aggregate demand, but rather as the result of excess demand in particular markets and the failure of prices to fall in particular demand-deficient markets. In addition, price increases in particular markets are likely to trigger ‘spill-over’ or ‘linkage’ effects in other markets. For exampe, if wage agreements are interlinked so that trade unions negotiate similar wage increases for everyone they represent, then ‘bidding up’ of wages in one sector will encourage workers in other sectors to demand raises as well.
Cost-push inflation can only occur in the presence of a permissive monetary policy which allows the continued expansion of the money supply. Higher wages which result in higher prices must raise the money value of output, unless offset by an accompanying reduction in output and employment. If the money supply is fixed, it would be necessary for the velocity of circulation of money to rise to generate the higher level of monetary demand consistent with the higher money value of output. To sustain a continuing inflation, the velocity of circulation of money would have to increase continuously. As the velocity of circulation is heavily influenced by institutional arrangements and existing habits, it is unlikely to be able to change quickly enough to sustain much inflation.
In short, if faced with an increase in money wages, the monetary authorities can either hold the money supply constant or allow it to increase but at a rate lower than the rate of increase of money wages, with the result of a fall in output and employment but stable prices, or they can allow the money supply to increase to allow a sufficient level of monetary demand to sustain the same output at higher prices.
There are two additional possible sources for cost-push inflation: Imports and expectations. Imported inflation occurs when trade or other factors cause the prices of imported goods to rise, particularly when demand for those goods is relatively price inelastic; not only do consumers pay mor directly for the imported goods, but because imported factor inputs are now more expensive, inflation will accelerate through the entire economy, as in the 1970s oil crisis. Expectations-based inflation is a relatively recent concept. Economic models generally treat expectations one of three ways:
· Expectations are static – people always expect the current situation to continue;
· Expectations are adaptive – people’s expectations change over time to adjust to the situation;
· Expectations are rational – people base their expectations on the same information as is available to policy makers.
The favorite example of rational expectations is the stock market. If you read in the newspaper that IBM is going to have a good year, there is no point rushing to buy the stock as a result, because everyone else has already read the newspaper article and market trading has already adjusted the price of IBM stock to account for the news. Nor is there any point taking advice from your stockbroker, as anything the stockbroker knows is already accounted for by the market prices of stocks. The only information which has not already been accounted for in the stock prices is insider information, but trading based on insider information is illegal. The theory incorporating rational expectations is called the Efficient Market Hypothesis. Expectations affect the inflation rate to the extent that firms and individuals do business in the expectation of future benefits or costs. If you agree to purchase goods for future delivery, you must agree on a price today. The price which you are willing to pay will depend on your expectations of the future value of the goods to be delivered, which depends on your expectations regarding inflation. If you have agreed to a deal at some specified price and date in the future, you have in effect established a part of what the price level will be on that future date.
Anti-Inflationary Policies
The distinction between demand-pull and cost-push inflation is very important for regulatory purposes. If inflation is considered cost-push in origin, arising from institutional labor agreements, then the only way to change the rate of inflation is to change the institutional framework within which these agreements are made. If expectations are the cause of inflation, then in the long run those expectations must be changed if inflation is to be curbed. Both Keynesian and monetarist approacues suggest that inflation should be combated by reducing demand, but they disagree on how: Keynesians would reduce demand through fiscal policy (increase taxes / decrease government expenditure), monetarists through monetary policy (restrict the money supply). This having been said, it is in practice quite difficult to determine the cause of inflation.
Worker productivity (and hence potential output) increases with time. If produtivity is increasing by 2% per year, then a 2% money wage increase per year will be consistent with price stability. In other words, price stability results when D(Money Wages)+D(Worker Productivity)= D(Price Level). As a result, the Phillips Curve, which is normally shown as inflation vs. unemployment, can also be shown as change in money wages vs. unemployment.
One weakness of the Phillips Curve is that it is possible to interpret the empirical results as showing either a demand-pull or a cost-push explanation of inflation. As a demand-pull explanation: As unemployment decreases, excess demand for labor increases, and vice versa, in a stable and predictable fashion. The higher the excess demand for labor, the greater the rate of increase of money wages, and vice versa, again in a stable and predictable fashion. As a result, there is a stable and predictable inverse relationship between unemployment and the rate of change of money wages. As a cost-push explanation: At high levels of unemployment, trade unions and employee groups would be less likely to demand money wage increases because the reality of layoffs and unemployment would be more visible. As unemployment decreases, these same groups would become steadily more militant, and at the same time firms would be more willing to allow costs to rise and to pass on these additional costs in the form of prices, since at low unemployment (in a ‘hot’ economy) their sales are less likely to suffer as a result of the price increases.
While empirical evidence confirms the validity of the Phillips Curve in the short run, it is not at all clear if it is valid in the long run. It has been suggested that the trade-off between unemployment and the rate of change of money wages is a transitory phenomenon resulting from the failure of expectations to adjust immediately to price changes. Once expectations adjust to the new price level, according to this theory, the trade-off effect between inflation and unemployment disappears entirely. This analysis has gained credibility in recent years because of the evident breakdown in the historical relationship between the price level and the unemployment rate. The 1970s and early 1980s witnessed ‘stagflation’ – a sustained simultaneous increase in both the rate of inflation and the rate of unemployment. Advocates of the Phillips Curve argued that the curve had simply shifted upwards on an ongoing basis because of expectations and exogenous events.
Monetarists have a more fundamental objection to the Phillips Curve. They argue that labor is concerned with the rate of change of real wages, rather than money wages. If this is so, a tradeoff between unemployment and the rate of change of money wages will only exist when labor expectations are that the rate of inflation should be zero or close to it. As soon as labor expects to see a noteworthy rate of inflation, the short run relationship between unemployment and money wages will shift to the right, with the magnitude of the shift depending on how high the inflation rate is expected to be. In the long run, therefore, there is no tradeoff between unemployment and inflation. By this analysis, policy makers are not able to select combinations of unemployment and inflation rates; in fact, macroeconomic policy is unable to affect the long run rate of employment at all. In the long run, only the rate of inflation can be controlled and therefore the policy maker should choose a zero rate of inflation.
Milton Friedman, the leading monetarist, postulates a ‘natural rate of unemployment’ which is similar to the previously-considered full employment rate of unemployment. Friedman suggests that the actual rate of unemployment can only be reduced below the ‘natural’ rate in the short term by the creation of inflation beyond expectations, and it can only be held below the ‘natural’ rate by continuing to accelerate inflation so that there is always a ‘gap’ between expected inflation and actual inflation. To combat unemployment in the long run, the ‘natural’ rate must be reduced, and this has nothing to do with macroeconomic policy. The ‘natural’ rate of unemployment depends on factors such as the efficiency of information flow in the job market, the rate of structural change in the economy, the costs of undertaking additional worker training, etc.
Monetarists consider that the demand for money is a stable function of a number of variables such as the level of income, the expected rate of return on investments, and the rate of change in prices. This implies that the velocity of circulation of money (V) will be quite stable. Keynesians believe that changes in V may offset and frustrate monetary policy; for example, in a depression, increases in the money supply will find themselves largely falling into precautionary and speculative balances, so that V falls and no overall change is seen to the level of aggregate demand.
Monetarists consider that the demand for and supply of money are largely independent of each other; the supply of money is determined exogenously by the regulatory authorities. It follows that given a stable demand function for money, exogenous changes to the money supply will result in predictable changes to aggregate demand and therefore inflation rates. Modern Keynesians believe that the money supply may be determined, at least in part, endogenously; it may be responsive to economic variables. For example, if the level of money wages rises due to union bargaining, the commercial banks and/or central money authority may expand the money supply to ‘underwrite’ these changes—in effect the money supply has responded to a change in the price level.
Keynesians further suggest that the central monetary authority may be unable to control the money supply effectively. The commercial banks may be able to frustrate the desires of the regulatory authority by finding effective substitutes for money (such as credit card balances), or by finding more efficient ways to use money (income tax deducted at source, for example, reduces the demand for money and therefore increases the ability to use what money exists).
When it all comes down, monetarists maintain that changes in the money supply have been the chief cause of substantial fluctuations in national income/output, causing both major inflations and major recessions. The monetarist view is that monetary policy can have a major impact on the level of real income and employment in the economy. Therefore, the monetarists maintain, monetary policy should follow an automatic rule, allowing an annual change in money supply to match the long-run growth rate of the economy. As a result, whenever the economy is operating at less than its potential, the overly-large money supply will fuel additional output and income; conversely, whenever excess demand exists beyond potential output, the overly-restricted money supply will ‘put on the brakes’ and return the economy to Q. Government attempts to expand or contract the money supply during the business cycle will simply result in heightened oscillations.
The following observations are from empirical evidence and would be acceptable to nearly all economists:
1. There has never been any major inflation occurring without an accompanying substantial increase in the money supply.
2. There has never been a substantial increase in the money supply which has not been accompanied by a major inflation.
3. Given 1 and 2, a high rate of inflation cannot be sustained unless the money supply is expanded.
In examples of major inflation, such as Germany in 1923, America
In terms of the circular flow of income, if a large trade union is successful in negotiating a wage increase, then the firms in that industry will charge higher prices to compensate and money national output will rise. However, all output eventually accrues as income to resource owners. As a result, the total money income of all resource owners will rise. Given that all resource owners have some marginal propensity to hold money for precautionary and transactional purposes, a net increase to the total demand for money will occur. If the money supply is held constant by the regulatory authorities, then the amount of money available for speculative purposes will fall. In order to ensure that households and businesses are content to hold this reduced amount of speculative money, interest rates must rise. However, this will discourage investment, resulting in a fall of aggregate demand. In short, unless there is an increase in the money supply, then the process of passing on higher costs in the form of higher prices cannot be sustained indefinitely without a serious adverse effect on aggregate demand and consequent unemployment. While it is true that sustained inflation is impossible in the face of a sustained and determined attempt to restrain the money supply, this attempt will also generate undesirable consequences for the economy.
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