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Unit 4 - Inflation
Unit 4 - Inflation
UNIT 4 : INFLATION
DEPARTMENT OF ECONOMICS
STELLA MARIS COLLEGE (AUTONOMOUS), CHENNAI
• Keynes- Departure from traditional analysis- explanation of war time inflationary situation | Flow of national exp.- main determinant of price
level.
• Given full emp. o/p - ↑ exp. → inflationary gap widens → ↑ prices.
• Kurihara: “The excess of anticipated expenditure over the available output at base prices or at the pre-inflation prices.”
• Keynes- War time rise in Govt. exp.→ inflationary gap. The gap analysis can be done if there is ↑ in investment exp or a ↑ in consumption
spending.
• Inflationary gap – excess of expected exp over available ss of o/p . Expenditure – determined by current income & expectations of future
income. SS of o/p – conditioned by level of employment & state of technology. Flow of real o/p – fixed at full emp. – expectation of ( flow of
expenditure > o/p) → Price rise → widens gap → inflations gains momentum. If tax & savings measures adopted – can do away with the gap.
o FACTORS AFFECTING INFLATIONARY GAP: Some affect speed of inflation, others strengthen the
inflation process, while others weaken it.
1. Rate of ↑ of money stock : ↑ in money stock in same proportion to an ↑ in price level or in
greater proportion → expansion of C or I spending → widen inflationary gap. However, if stock of
money remains constant or ↑ in smaller proportion than prices → rate of interest ↑ → fall in agg.
DD for goods & services → inflationary process gets checked. Monetary factor will have
dampening effect when : 1. Income-elasticity of transactions DD for money is high ; 2. Interest-
elasticity of the DD for money is low ; 3. Interest-elasticity of marginal efficiency of investment is
low.
2. Income redistribution : Inflation → redistributes real Y against fixed Y groups. Marginal Prop. To
spend is higher – agg C function shifts down. If Y is redistributed to those with high MPC – agg C
function increases → inflation ↑.
3. Pigou Effect : Inflations → reduces real value of cash balances. To the extent that Pigou effect is
present → C spending will fall → Inflation curtailed.
4. Nature of expectations : Expectations towards rising prices → accelerated/checks inflation
If price rise is expected → purchase of consumer goods, inventories and fixed capital will be accelerated → gather
requirements before price rise. Expectations towards temporary rise and then falling prices → purchases will be
postponed → eventually reduce inflationary gap →rise in prices will be dampened.
5. Lag b/w expenditure & income: Emphasis on lag in adjustment of exp to increasing incomes. If people want to hurriedly
spend incomes as soon as they receive it to avoid hit to purchasing power → Inflationary gap widens & inflation is
accelerated. If average lag b/w income & spending is long → inflation will be slow.
6. Rate of interest: When monetary authority → more money ss → lowers rate of interest → Inflation gains impetus →
Increase I, C & G spending → widens inflation gap. Initial impetus can come even through an autonomous upward shift in
C, I or G Exp. Functions.
7. Adjustment of wages to prices: Rapidity of wage adjustment → Impacts speed & strength of Inflation. If adjustment is
incomplete → profits rise relative to wages. MPC out of wage Y > MPC out of profits →C spending falls. Propensity to
spend on investment is high for profit Y → Rise in investment. Thus, net effect of incomplete adjustment is difficult to
gauge.
8. Rate of change of tax collections: If tax collection ↑ faster than prices (in a progressive tax system) → C function will
shift downwards → reduced inflationary pressure.
9. Changes in foreign trade: Inflation – affects foreign trade of a country → Rising prices internally →discourage exports &
encourages imports → Payment deficits | Drain of gold or Forex reserves → Can also relieve inflationary strains by ↑ ss of
goods (as a result of ↑ imports & ↓ exports)
BENT HANSEN’S DEMAND INFLATION THEORY
• Post-war theory – 1951 – Criticised Keynes’ inflation analysis → wage rates tied to prices or autonomously determined – not
realistic ➔ confusion b/w cost inflation and demand inflation | Misdirected criticism
• Hansen – wage rates in a pure model of DD inflation to be determined by SS of & DD for labour.
• Keynes: considers excess DD in the goods market | Hansen: Inflationary pressures - even from services (factors) market
• Hansen’s theory → towards disaggregation → Goods markets ≠ Factor/services market
• Applicability of Hansen’s theory : Suppressed inflation | Structural unemployment & unemployment inflation
• For full inflation – positive excess DD for goods & factors – goods gap as well as factor gap
• X axis – Reciprocal of real wage rate (P/W) | Y axis – real income (Yr)
• D – Agg. DD curve which is downward sloping due to MPS of wage-earners > MPS of
profit-receivers.
• Thus, total L income varies directly with the real-wage rate.
• S – Agg. o/p of firms at each price-wage ratio for unlimited L ss → upward sloping
(WHY?) - Real wage rate falls → workers at higher real wages enjoy leisure & more
goods → S1 first rises and then bends backward → Indicates that L ss sets a threshold
upon economic capacity to produce at full emp.
• D-S1 : Goods Gap – Responsible for ↑ in price level| S-S1 : Factor Gap – Responsible for ↑
in money wages - Both these gaps are +ve b/w (P/W)4 and (P/W)2. At (P/W)4 and (P/W)2
points – one gap will be +ve and other will be 0.
• The time rates of the change in price level and wages are given by these conditions :
(given by Samuelson)
𝑑𝑝
• = f1 (D-S1)
𝑑𝑡
𝑑𝑤
• = f2 (S- S1)
𝑑𝑡
• At (P/W)2 - Goods gap =0 , Factor gap – Large → Money wages rise rapidly however, no
change in price level → The real wage rate rises and P/W declines → Factor gap is
reduced → But goods gap widens
• At (P/W)1 – Goods gap < Factor gap → Here, due to a rapid rise in money wages and
slower rise in price level → real wage will tend to rise.
• When P/W falls below (P/W)0 → Goods gap > Factor gap → Rapid rise in price level but
slower rise in money wages → Real wage rate falls → This condition exists at both
(P/W)4 and (P/W)3
• The real wage rates will thus fluctuate b/w (P/W)2 and (P/W)4.
• The actual speed of inflation → depends on absolute sensitivity of wages and price
changes relevant to size of gaps ➔ Both gaps volatile – Rapid Inflation | Both gaps
slower – Slower Inflation.
COST INFLATION OR COST-PUSH INFLATION
THEORIES
Cost or SS theories of inflation → attributed to inflation due to push of wages, mark-up pricing policies and profit push.
WAGE PUSH:-
- Cost inflation – contrast to DD pull inflation → Main cause of rising prices – on SS side
- Recall: Initial stage - Autonomous ↑ in DD (given full employment capacity) → ↑ in prices → Excess DD conditions cause prices to
shoot up more.
- Here, money wages too ↑ - Consequence of inflation but not a cause for it.
- However, cost push inflation theories reverse the causal sequence. Here – Initial stage – Autonomous ↑ in money wages or price of other
inputs → Producers will try to defend themselves → ↑ prices of final G & S to cover rising costs → Prices ↑ but real wages get eroded.
Workers – want to keep the wage they take home unharmed → want to neutralise prices by an ↑ in wages → HOW will they do this? →
Action by trade unions → ↑ money wages ➔ ↑ prices → INFLATION → continues with push of wages & costs (domino effect on price
level when no excess DD is there)
- Here, strong role to trade unions is assumed → Emphasise on compensatory ↑ in money wages (when prices are ↑) to avoid hit on
workers’ take home real wages. Nevertheless, money wage ↑ is not merely through trade unions.
- Labour contracts may have clauses that ask for wage rates to be ↑ with an ↑ in cost of living index.
- Money wages will ↑ even with increased productivity of labour → This might not cause inflation to occur.
- ↑ in production → some moderating effect on prices.
- ↑ in money wages could be due to : scarcity of labour services | competition among
employers | motive to preserve industrial peace | to justify actions concerning product price
increases (in case of monopolistic markets and oligopoly) | to maintain wage parities in
various industries |
- Initial impetus for price ↑ could come from ↑ in cost of imported inputs → cost of inputs ↑
leads to ↑ in price of final goods → ↑ in money wages → bid up prices further →
INFLATIONARY CONDITIONS
• As price increase of imported inputs and wage rates tend to shift the agg. SS
function to the left, prices increase and so does unemployment.
• Control of stagflation : Keynesian economics – Depression economics – all tools
formulated were to deal with depression, stagnation & unemployment in
advanced countries. If we follow Keynesian recommendations like progressive
taxing, increasing public expenditure , deficit financing and cheap money
policies, etc. → Aggravate inflation and deepen unemployment more when
stagflation is already prevailing. MON POL & FIS POL → not effective in
curtailing stagflation.