Inflation Essay, Research Paper

Sarah Steward

Inflation

The value of money can be defined at the amount of goods and services that a certain amount of money can buy in an economy. The amount that can be bought depends (ceteris paribus) on the amount of inflation that exists in an economy. Inflation is a sustained general rise in prices or how much the general price level changes over time. There are various methods that can be used to measure inflation in an economy. The main reason for this is that the government may have different reasons for wanting to manage inflation. It is generally assumed from past experience that once the economy returned to its normal state, the persistent tendency for overall prices to rise would disappear; bringing inflation rates back to normal. World War II brought the persistent inflation that economists came to expect. In the 50 s and early 60 s, inflation resumed to very low rates concurrent with large growth increases and low unemployment. But, from 1967 to 1974, the rates of inflation reached alarming proportions in many countries, such as Japan and Britain, for no apparent reason. This acceleration in inflation has forced many economists to reevaluate their views, and often align themselves with a specific school of thought regarding the causes and cures for inflation.

There are two opposite theories regarding inflation. Monetarism indicates that inflation is due to increases in the supply of money. The classic example of this relationship is the inflation that followed a flow of gold and silver into Europe, resulting from the Spanish conquest of the Americas. According to the monetarists, the only way to cure inflation is by government action to reduce growth of the money supply.

At the other end is the cost-push theory. Cost-pushers believe that the source of inflation is the rate of wage increases. They believe that wage increases are independent of all economic factors, and generally are determined by workers and trade unions. More specifically, inflation occurs when the wages demanded by trade unions and workers add up to more than the economy is capable of producing. Cost-pushers advocate limiting the power of trade unions and using income policies to help fight off inflation.

In between the cost-push and monetarism theory are Keynesians Keynesians recognize the importance of both the money supply and wage rates in determining inflation. They sometimes advise using monetary and income policies as complimentary measures to reduce inflation, but most often rely on fiscal policy as the cure. For approximately 200 years before John Maynard Keynes wrote the General Theory of Employment, Interest, and Money, there was a broad agreement among economists as to the sources of inflationary pressure, known as the Quantity Theory of Money. The Quantity Theory of Money is easily understood through Fisher s equation:

MV = PT

(money supply times velocity of circulation of money equals price times real income)

M is the money supply, V is the velocity of money, P is the price level and T is the number of transactions over a given period. In the short-run, increases in M will feed through to increases in T (national income will rise and unemployment is likely to fall), and a fall in V. However, in the long run, increases in M over and above the growth rate of the economy will lead to an increase in prices (inflation). Also essential to the quantity theory is the belief that in a competitive market, where wages and prices are free to fluctuate, there would be an automatic tendency for the market to correct itself and full employment to be established.

An increase in the money supply will shift the aggregate demand curve. After an initial rise in output, but with increased prices and over-full employment, wages will rise and the economy will return to long-run equilibrium. Prices have risen but output remains unchanged.

The central prediction that can now be made is that changes in the money supply will lead to equiproportionate changes in prices. If the money supply goes up then individuals initially find themselves with more money. Normally individuals will tend to spend most of their excess money. The attempt of people to buy more than they normally do must result in the bidding up of prices because of the competitive nature of the market, inflation.

The short-run link between money supply and output is known as the monetary transmission mechanism. If an increase in the money supply pushes the money market into disequilibria, the supply of money will be greater than its demand. Therefore, money will be converted into goods, or non-monetary financial assets such as shares or bonds. Increased demand for bonds will reduce the interest rate. This fall in interest rates will increase the level of consumption and investment in the economy. Thus, an increase in the money supply leads to a short-run increase in the level of aggregate demand in the economy.

The Great Depression, as experienced by the United States and the countries of western Europe, cast a shadow over the Classical approach to economics. The self-righting properties of classical economics were clearly not working when wages and unemployment failed to decrease. Blaming trade unions for these massive increases in unemployment seemed far-fetched. John Maynard Keynes was the first writer to produce a non-classical, coherent, and convincing explanation of the inter-war depression. He traced the sources of unemployment to a deficiency of effective demand. Put simply, unemployment occurred when total spending on output was not enough to fully employ the available workforce. Keynes split effective demand, called expenditures, into two groups, consumption and demand. Consumption, the purchase of goods and services, far outweighed investment as the major component of effective demand.

At the theory s core lay Keynes belief that an economy s total production will eventually adapt itself to changes in expenditures. Moreover, Keynes argued that the equilibrium of waged exist when the output of producers is equal to the amount that consumers and investors are willing to spend on their output. Keynesians argue that increases in the money supply are more likely to reduce the velocity of money in circulation than to increase prices. Further, they argue that the monetary transmission mechanism is weak, since goods are a poor substitute for money. Also, they argue that investment and consumption are relatively interest rate inelastic. For these reasons, Keynesians do not see a problem with increases in the money supply of a moderate level. They do accept that a vast increase in the money supply will lead to hyperinflation, however. The demand-pull theory of inflation says that inflation is caused by an increase in spending in the economy. This increase in demand pulls up prices. A rise in aggregate demand when the economy is at less than full employment will result in an increase in both prices and output. If the economy is at full employment, increases in aggregate demand simply lead to increases in inflation. A second Keynesian theory of inflation is the cost-push theory, which states that inflation is caused by increases in costs of production. These increases are caused mainly through increased wages, imports, profits, or taxes. An unexpected or unjustified increase in costs of production will not just result in a one-off increase in prices, it is argued. Instead, it leads to a wage-price spiral, where increased prices lead to higher wage demands, which must be financed through higher prices. This then leads to higher wage demands the following year. Prices then spiral upwards. An initial rise in costs leads to a chain of wage increases and increases in demand, which feed back to increases in costs. Therefore, the short-run equilibrium level of prices in the economy is constantly moving upwards.

Cost-push inflation can be avoided by reducing expected inflation, it is argued. This can be achieved in three ways. Firstly, indirect taxes could be frozen in money terms. This will reduce the real price of many goods, thus inducing workers to moderate their pay demands. Nationalized industries could freeze or lower their prices, achieving the same effect. Thirdly, reducing employers National Insurance contributions, or lowering corporation tax will lower industry s costs, also bringing inflation down. However, these tax breaks or price reductions must be met with a reduction in government expenditure to reflect their reduced income. Otherwise, the extra government spending would simply create more inflationary pressure. Demand-pull inflation can be checked with the use of fiscal policy. If the government raises taxes, households and firms will have less disposable income, and the aggregate demand curve will shift to the left, lowering inflation. If government expenditure is cut, revenues and wages to those undertaking government contracts will fall, leading to a fall in aggregate demand. The multiplier will exaggerate the effect of these strategies. Monetarists would argue that both of these solutions are futile. Playing with indirect tax rates or altering government spending will not address the real cause of inflation, namely an excess supply of money. A restrictive money supply will result in firms and households holding less money than they desire. Through the monetary transmission mechanism, inflation will fall. However, Keynesians would argue that the money supply is an exogenous function, dependent upon the banking system. As such, control of inflation by this means is not possible.

Exchange rates can also be used in the fight against inflation. Devaluation or depreciation will raise the price of imports, leading to cost-push inflation. Maintaining the value of the currency may then play an important role in controlling inflation. Monetarists who resort to raising interest rates as a substitute for direct control of the money supply are also concerned with the exchange rate. Higher interest rates will curb domestic spending and reduce inflationary pressures. They will also attract inflows of foreign capital, pushing up the exchange rate. This in turn makes imports cheaper and exports more expensive, forcing firms to cut costs. Thus inflationary pressures will be reduced again.

Many of these counter-inflation policies are mutually exclusive. For instance, to combat cost-push inflation, it is suggested that taxes should fall. However, the remedy for demand-pull inflation is an increase in taxes. Therefore, if taxes are increased, cost-push inflation will be increased. If they fall, demand-pull inflation will be fueled. The effectiveness of fiscal policy as a weapon against demand-pull inflation is dependent upon where the AD curve intersects with the Keynesian AS curve. If the intersection lies on the horizontal part of the curve, measures to reduce aggregate demand will simply reduce output and leave prices unchanged. If the AD curve is on the vertical section, however, a leftward shift in the AD curve will result in a large fall in inflation with a small corresponding drop in output.

Many individuals have some sort of debt. Most of the time, this is likely to be in the form of mortgages secured on houses. If interest rates for mortgage repayments increase, this is likely to mean less disposable income for mortgage holders. Similarly, nominal interest rates are the opportunity costs of holding money. This would make it more attractive to save money instead of spending it. The net affect would be lower levels of consumption and cause a shift on the aggregate demand curve, and a reduction of inflationary pressures. An increase in the official interest rate will increase the costs for firms to borrow money. This means that firms will be less willing to borrow money and invest in new projects and are more likely to reduce employment. The multiplier effect will mean that the change in the amount of investment carried out by the firms will then affect the other firms and individuals in the economy, even those not affected by a change in the interest rate. The overall result will, once again, be a decrease in the levels of aggregate demand in the economy and less inflationary pressures. It is difficult to say exactly how interest rates affect inflation, because of the complexity of the economy and the particular circumstances of the time. But it is generally accepted that any increases in interest rates will, ceteris paribus, reduce inflationary pressures, while lowering the interest rate will eventually result in increased inflation.

Using the Keynesian, monetarist, and cost-push viewpoints, the government tries to control inflation. Using only one theory may not be best; a combination of theories may work better. Although there can be attempts made to get rid of inflation, as long as there are expenditures and consumption, inflation will exist.

Bibliography

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