Download CHAPTER IX THEORIES OP INFLATION There are seven important

CHAPTER
IX
THEORIES OP INFLATION
There are seven important theories of inflations
1, The cost-push theory of inflation
2« The demand-pull theory of inflation
3. Keynesian theory of inflation
4. Bent Hansen's dynamic'model of demand inflation
5. Schultze's sectoral demand-shift theory of inflation
6. The markup theory of inflation
7« The money-stock theory of inflation
I shall try to show that there are only two basic
theories of inflation - (l) One is the institutional theory
of inflation and the other (2) one is the money stock
theory of inflation.
Money stock theory of inflation
considers the Government and the Central Bank to be the
generators of inflation while the institutional theories
consider this or that section of the people to be respon­
sible for inflation.
Let us first get familiar with these
theories so that our task is henceforth eased.
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1. THE COST-PUSH THEORY O P INFLATIONS
The cost-push theory of inflation is the wage push
or the pr o f i t - p u s h theory of inflation.
of inflations
In every process
wages and prices rise and they reinforce the
rise in each other, whatever the cause of inflation.
if the cost-push theory is valid,
But
then they b o t h should
no t be the common result of some t hird force w hich may be
a rise in total demand or money supply or what not and the
initiation of inflation should have been made by an auto­
n o m o u s rise in wages or profits.
Wage - P u s h I n f l a t ion
I n r i c h capitalist economies,
the trade-unions are
well organized and strong and if the Government is p u r s u ­
ing the full-employment policy,
the labourers can succeed
in getting higher money wages than what their productivity
warrants.
If the employers are not prepared to grant
these higher money-wages,
then unemployment will be created,
but full-employment b e i n g the policy goal of the Govern­
ment,
the Government will increa.se money
fiscal and monetary m e a n s and thereby
demand so that ultimately,
supply through
create additional
all the unemployed, pers o n s get
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absorbed into the economy.
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W h e n the employers observe
that the Government is taking steps to increase total
demand,
it becomes easy for them to pass off the burden of
highei' money wages on to the
customers by increasing the
prices of goods that they produce.
I n the context of
r i s i n g demand, rise in prices does n o t r'educe demand.
whe n the wage-earners demand higher money-wages,
So,
they
grant it, as they kno w that in the context of r i s i n g demand,
the burden is to be borne by the customers in the form of
higher prices.
As a result, u n e m p loyment is no t created
though m o n e y -wages rise.
But when prices rise,
the real
wages are r e d u c e d and they resume their original position
and so n o w still higher money- w a g e s will be demanded which
will result into still higher prices of goods an d the
vicious circle of higher wages and higher prices will
ensue.
Thus the full-employment policy becomes the cause
of the w a g e - p u s h inflation.
V/ages and prices b o t h rise,
but the m i s c h i e f was done in the beg i n n i n g by w ages which
is the part of the cost of production and so it is known
as the w a g e - p u s h or the cost-push theory of inflation.
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lt<Z£>3
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P r o f i t - P u s h Inflation
W h e n the economy gets dominated by the oligopolists,
they can f i x higher pr i c e s for their respective commodi­
ties thus exploiting their m o n o p olistic p o s ition to earn
abnormal profits.
W h e n the prices of goods all around
rise, l a bourers also de m a n d higher wages,
firstly to
restore real wages to their original posit i o n and secondly
in order to share in the higher profits.
wages are increased,
But w h e n money-
the oligopolists increase the prices
still further, because w h e n costs all around rise,
all
oligopolists can increase the prices of their goods wit h ­
out compromising wit h their mutual conscious or implicit
understanding.
Thus a vici o u s circle of higher prices
and higher wages is set in, but the b e ginning was done by
the profit-push.
inflation.
So,
it is the profit - p u s h theory of
But the pr o f i t - p u s h is the cost-push,
the price is not perfectly market-determined,
because
but partly
monopolistically determined and so h igh profit is as if
the part of the m o n o p olistic cost and so, in a way,
the
profit - p u s h is the cost-push w hich is responsible for the
rise in prices r e s u i t i n g into the wage-price
I f it is the wag e - p u s h inflation,
spiral.
then it is on
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account of the institutional factors like the fullemployment policy of the Governments strong trade unions
etc.
If it is the profit-push inflation, then it is on
account of the monopolistic position of the oligopolists
which again indicates the institutional factor of monopoly
•i.e. Oligopoly.
Thus we conclude that the cost-push theory
of inflation is, in reality, an institutional theory of
inflation that finds fault with the wage-earners or the
oligopolists or both.
2. DEMAND-PULL THEORY OP INFLATION;
Wow let us discuss the demand-pull theory of
inflation.
According to this theory, it is not the push
of cost from behind, but the pull of demand from the fore
that causes inflation i.e. the wage-rise and the pricerise - both are the results of rising total demand.
Total
demand for goods in the economy can rise either on account
of the increase in the money stock or increase in the
velocity of money.
In the modern econony, liabilities
of the non-bank financial intermediaries work as neai
moneys or near money substitutes and thereby reduce the
demand for money that increases its velocity.
This is
also the thesis of Gurley and Shaw in their famous book -
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"Money in a Theory of Finance."
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Nov/ the rise in the
velocity of money can be understood in two ways - (1)
firstly, the growth of near money substitutes can lessen
the demand for money and thereby can increase the velocity
of money and secondly (2) money held up on account of
pervasive controls, as for example, during war times, may
begin to be spent when controls are relaxed or removed,
thereby increasing the turnover of money or the velocity
of money.
Between 1943 and 1958 in U.K., gross national
product in money terms rose by 93.5 per cent and nominal
money increased by only 30 per cent.
In the United Sta/tes,
the corresponding figures were 71.4 per cent and 38,6 per
cent.
So, the turnover of money in U.IC. and U.S.A. had
increased during that period.
The first view regarding
the velocity of money takes stock of the change in the
financial organization and the second one keeps in view,
the removal or relaxation of controls and wrongly thinks
that the case of the use of the loreviously created money
that was artificially held up, is the case of increased
velocity of money.
If there are no controls and no undue
increase in money stock and if the velocity of money
increases, then alone it is the genuine case of increased
velocity of money.
Above case, in reality, is the case
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of the increase in money stock rather than that of
enhanced velocity of money.
Money-stock was tremendously
increased during war times, but the entire amount was not
allowed to be spent due to controls and thus its velocity
was artificially reduced and money stock was forced to be
accumul £l*t6 Cl 9
Now when controls are relaxed, reduced velocity of
money gets increased and accumulated money begins to be
V
spent.
That is why in U.S.A., so-called increase in the
velocity of money was less, because in U. 3.A . ,controls
were less pervasive.
is not charity.
Giving back of the stolen property
The first view implied an institutional
change and the second one indicates an attempt to resume
or restore the normal velocity of money from which it was
desisted on account
of controls.
So, it is no
genuine increase in the velocity of money, just as the
slow rise in the price-level when the economy comes out
of depression and registers a revival, is not the case of
inflation, but simply moving forward to the normal pricelevel.
3. KEYNESIAN THEORY ON INFLATION %
Keynesian theory of inflation works through the
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investment-saving mechanism.
It is little surprising to
note that there are two Keynesian theories of inflation ■
one is demand-pull theory and the other is the cost-push
theory.
It may be said that the demand-pull theory was
/
Jy
jC q n
<1.
1 x 4" > /
*
(A -
expressed in the form of an ’inflationary gap* by Keynes
in his book "How to Pay for War1’ (J .Pi.Keynes, 1940) and
the cost-push theory was contained in his "General
Theory." (iKe\)'5n-e>S, J*- M v t33&)
First let us discuss the inflationary gap theory
of Keynes as developed in his book "How to Pay for War."
Keynesian Theory of the Inflationary Gap
Keynesians and believers in the quantity theory of
money (implicitly or explicitly) are one in the belief that
the immediate cause of inflation is excess demand, though
they may disagree regarding the proximate and the ulti­
mate causes of excess demand itself.
Keynes did not emphasize the excess money supply
as the cause of excess demand, because in U.S.A. during
Great Depression, it was widely believed that the
Federal Reserve System was expanding the money supply
through the activation
of monetary policy and still
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the economy w a s not r e s p o n d i n g and the effective demand
was no t reviving.
So he felt that the monetary policy
cannot deliver the goods and hence he advocated that the
fiscal policy
should he a c tivated and the Government should
increase p u b l i c expenditure an d reduce taxes thereby
u s h e r i n g into budget deficits.
expansion of m o n e y supply,
growth in m o n e y
Budget deficit implied the
but he did n o t emphasize the
supply ?/hich ma y take the place of hoarded
inactive m o n e y and thus may help in r e v i v i n g demand.
He
forced money an d the m o n etary policy to take a backseat
an d put the fiscal policy in the forefront.
He ar g u e d that
the b a l a n c i n g o f the economy was more important than the
b a l a n c i n g of the budget.
B a l a n c i n g of the economy may
require sometimes u n b a l a n c e d budgets.
Increase in money
supply to take the place of inactive money may come into
o p eration t h r o u g h the activation .
of the monetary policy,
but he h a d no faith in m o n e t a r y policy,
as acc o r d i n g to
him, the m o n e t a r y policy was d i s c r edited during Great
Depression.
But, b e i n g a monetary economist throughout
h i s life, by advocating deficit budget,
he, in fact, was
a d v o c a t i n g the policy of the expansion of money
course,
t h r o u g h the a c t i v a t i o n
supply,
of fiscal policy
n o w it is no secret that du r i n g Great Depression,
!
the
of
But,
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Federal Reserve System was actually following the policy
of contraction of money supply and not expansion of money
supply.
So "Great Depression" was actually "Great
Contraction" and was a sound testimony to the efficacy of
the monetary policy, of course, here for the worse,
But,
it is interesting to know how Keynes explains inflation
with the help of excess demand without openly bringing
into focus the expansion of money supply and shows the
development of the sinflationary gap.’
According to Keynes, excess of investment over sav­
ing gives rise to an inflationary gap which results into
inflation.
Thus, it is inflation through which saving is
increased and made equal to investment.
Thus an inflation­
ary gap means shortage of saving to support investment.
_
Saving is the release of consumer goods which can be utili­
zed hy the persons who are busy with capital formation i.e.
investment.
But when investment is in excess of saving,
it means that some persons who are producing capital goods
will not get consumer goods.
Thus the demand for consumer
goods will be more than the supply of consumer goods and
an inflationary gap will develop.
This gap will not dis­
appear unless rise in the price level depresses real incomes
of wage earners whose propensity to consume is higher and
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transfers this difference in income to profit earners whose
propensity to save is higher and thus saving is equivalently
augmented.
This is done by the rise in the price level.
Price level will continue to rise and thereby saving
increased and the inflationary gap reduced until the saving
reaches the level of investment.
When saving matches
investment, the inflationary gap is reduced to nill and the
price level ceases to grow.
When we say that investment is
more than salving, it means that the demand for consumer
goods, is more than the supply of consumer goods, because
the function of saving is to release consumer goods for
consumption by persons who are producing investment goods.
Without this sort of release of consumer goods through
saving, production of capital goods is not possible, as
producers of capital goods produce only capital goods, but
require consumer goods in order to survive and produce
investment goods.
When saving is increased to match
investment, consumption is reduced and made equal to its
supply.
So, Keynes has described the inflationary gap in
this very (the following) fashion in his famous book "How
to Pay for War", published in 1940 during the Second. World
War times.
Suppose the value of real national output is given
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by y, -that of Government expenditure by G and investment by
1 9 then y-G-I or y-(G+l) will give us the value of consumer
goods left for individuals to consume.
of constiraei’ goods.
for consumer goods.
This is the supply
Nov/ let us take into account the demand
If Y represents national income in
money terms and T represents tax revenue for the Government
and S, the savings of individuals, then the demand for '
consumer goods will be given by Y-T-S or Y-(T+S).
Now due
to the waging of war or for any other reason, if the Gover­
nment expenditure is higher and thus investment (which
includes Government expenditure, as in Keynesian termino­
logy, every autonomous expenditure is deemed as investment
and all investment is depicted as autonomous) is in excess
of saving and thus the demand for consumer goods is larger
than the supply of consumer goods, the situation can be
depicted symbolically, as Y-(T+S)^> y~(G+l) which is
indicative of an inflationary gap.
Here G and I, conceived
in real terms, are assumed to be bearing a constant ratio
to real output y, and hence the money value of the supply
of consumer goods represented by Y - (G+I) is increased by
the rise in the price level and thereby the demand for
consumer goods and the supply of consumer goods are made
equal to each other and there is created an equilibrium
-
in the commodity market.
the cup and the lip.
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But,
-
there is many a slip between
So, this should be -understood in
greater detail.
W hen prices rise and money incomes of the wageearners do n o t rise at all or rise less than proportionately
(as inflation may be unexpected),
consumption of the wage-
earners is redu c e d and their real income is shrunk.
This
loss in r eal income on the part cf the wage earners becomes
a gai n for the profit earners who produce those goods whose
prices have risen.
consumption,
will n o t be
If the profit earners increase their
then the e quilibrium in the commodity market
created.
But,
if the profit earners save this
excess profit and do not spend it for consumption,
growth
in saving will imply r e d u c t i o n in consumption w h i c h is
actually r e q u i r e d for the elimination of the inflationary
gap.
I f swelling of prof i t s does n o t lead to enhancement
of saving,
this excess profit may be taxed by the Go v e r n ­
m e n t or the general pu b l i c ma y be m o derately t a x e d so that
total saving in the economy matc h e s w i t h total investment
and the p r o c e s s of i n flation whose function is to achieve
this goal,
is halted, otherwise inflation will continue
to perform its dirty job of r e d u c i n g the real incomes of
the wage earners and transferring this loss to profit-
-
earners as their gains.
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I f the inflationary gap is not
allo w e d or m ade to disappear by the increase in saving,
inflation w ill continue to operate,
as the m e t h o d in the
madn e s s of inflation is to attempt to increase savings by
the r e d i s t r i b u t i o n of n a t i o n a l income among different
classes in the society.
This is more likely to happen,
because wage-earners cannot be expected to sit silent when
their real incomes are b e i n g cut.
They will demand higher
money wages in order to protect their real wages, because
it is real w a g e s that matter,
p u r c h a s i n g power,
and money,
devoid of its
is mere pieces of paper.
E n t r epreneurs
may be p r e p a r e d to finance higher money wages out of excess
profits thereby r e d u c i n g them if the excess prof i t s are
b e i n g taxed heavily by the Government.
In this situation,
r e q u i r e d saving to m a t c h excessive investment w i l l fail
to materialize and the wage-price inflationary
come into being.
Fo r m a i n t a i n i n g the initial r e d i s t r i b u ­
tion of income so that real wages may
depressed,
spiral will
and enhanced saving may
continue to be
continue to survive,
prices and wages will have to continuously rise at a.
constant rate in this K e y n e s i a n model.
Let u s examine this
K e y n e s i a n income-expenditure m odel of inflation as described
by Trevithick and Mulvey
(Trevithick,
1975).
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Suppose national income in money terms is given by
Y, the equilibrium share of wages in national income
represented by b, that of profits by 1-b and the marginal
propensity to consume of the wage earners by Cw and that
of profit-earners by C_ and autonomous expenditure (G+I)
as a fraction of national income to be represented by g.
In that case,
symbolically equilibrium equation for income-
expenditure will be Y = Cw bY + Cp (l»b)Y+gY.
This is the
situation of full-employment equilibrium income.
Now, Y = Cw bY + C fY - 0 bY + gY.
F
F
. .
t
(1)
^
=
t
(0, b + C - C b + g)
A ' w
p
p
b(C.
Y ** g
P
1-g-C
G )
P
_
, ,
ss
Sf
w
p
b (equilibrium situation of no inflationary
gap)
Here we observe that if g which represents the ratio
of autonomous expenditure (G-+I) to national income is
increased, b which represents the share of wages to national
income, will be reduced.
In a non-equilibrium situation created initially by an
1-g-C
increase in g, b ^
and 1:118 inflationary gap exists.
w
p
-
Gap is removed by inflation.
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Keynes, as an illustration,
showed that the prices will have to increase by 15 per
cent in order to depress real wages so that saving may be
enhanced to match high investment (G+l).
If money wages
increase proportionately after one year lag, and if prices
react without almost any time lag, then
^
and
P
= (1+0,15)
, . e , . . . o o o o . « o » . « (
X)
..... .(ii)
Putting the value of
from the (i) equation into
the (ii) equation, we get
Pt * (1+0.15) Pt _ !
According to this model, as prices are ahead of
wages by 15 per cent and as wages adjust to prices after
one yeax’ lag, every year, prices will have to increase by
15 per cent, as money wages would have fully adjusted to
the 15 per cent price rise within a year.
So this chasing
of prices and money wages to each other will have to
continue at a constant 15 per cent rate in order to main­
tain the initial lagging behind of money wages to pricerise by 15 per cent.
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Thus,
-
the proportional rate of change of prices
#
ti
if the inflationary
j
t-1
gap is to disappear or no t to reappear.
all periods excopt the initial period.
This is true for
So i n flation at a
constant rate m a intains the l a g of wages to prices and
hence i n flation does n o t get out of control and continues
to operate at a constant proportionate rate.
of some rea s o n or the other,
I f o n account
this time l a g is reduced,
inflation becomes r apid a nd the rate of inflation gets
increased.
Tak i n g an extreme situation of highly antici­
p a t e d inflation, when instead of a time lag,
there may be
a time m a r c h of money wages over price-rise and they
increase in the present,
anticipating future price rise
within the contract period,
rapid,
then inflation becomes highly
as it lends speed to mutually reinfo r c i n g price-wage
rise spiral.
I n the K e y n e s i a n m o d e l of inflation,
time l a g p lays a very important role,
the
because it is this
l a g of money wa,ges to prices that m a k e s increase in savings
possible and thereby l imit the price rise by l i m i t i n g
the inflationary gap.
The part of the r e s u l t i n g extra
profit that is n o t saved should be t a x e d by the Govern­
men t and thus enhanced saving maintained.
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This is the K e y n e s i a n theory of inflation as
pre s e n t e d in his hook " H o w to Pay for <7ar."
’General Theory®
Prof.
But his
supports another version.
S. Weintraub,
in his famous article - "The
K e y n e s i a n Theory of Inf l a t i o n - The Two Paces of J a n u s ?"
p u b l i s h e d in International Economic R e v i e w (Sidney W e i n ­
traub,
I960)
shows that the K e y n e s i a n theory of inflation
can only be the cost-push theory of inflation,
though
generally it is considered to be the demand-pull theory.
Let u s see hows
Many
times,
the K e y n e s i a n Eq u i l i b r i u m Gross is
u t i l i z e d to explain the K e y n e s i a n demand-pull theory
y
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O n the horizontal axis, real income is shorn while
the total expenditure for consumption and investment has
b e e n expressed on the v e r t i c a l axis and C, I and Y have
b e e n m e a s u r e d in constant dollars or rupees.
I n this way,
the changing price- l e v e l ha s been excluded and only real
forces r e i g n supreme in this K e y n e s i a n model.
H o w can it
explain the change in the price- l e v e l i.e. inf l a t i o n ?
It
is excluded by its very m a n n e r of presentation,
The consumption curve C embodies the consumption
function.
To this, a definite m a g n i t u d e of investment is
o
added and thereby the G + I curve is drawn.
45 line carries
all those poi n t s w hich are equi-distant from Y,
tal axis (representing total output)
the h o r i z o n ­
and 0 + I the vertical
axis (representing total expenditure)
and hence it shows the
equality b e t w e e n real income and expenditure.
N o w suppose Y ^ indicates full-employment incooe.
I f 0 + I repr e s e n t s total expenditure,
in the figure,
then the C + I curve
gives only Y income w h i c h is less than Y^. -
the full-employment income.
At this level of income Y,
income and expenditure are equal, but there is u n e m p l o y ­
ment,
as Y is less than Y f *
I f w ages fall, then employ­
m e n t can increase and the economy
can r e a c h Y^*
Bu'k
a c c o r d i n g to-Keynes, m oney wages w i l l not fall and even
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if, suppose they fall, then prices will be reduced to the
equivalent extent, not allowing real wages to fall thus
failing to increase employment.
There will be underemploy­
ment equilibrium (or underemployment disequilibrium
ala
Patinkin) at Y which can be modified in favour of
only
by the fiscal and monetary measures consciously undertaken
by the State for this avowed purpose.
According to Keynes,
solution is not in the labour market, but in the rise in
total demand i.e. it is in the commodity market.
If suppose some-how, real income is at a stand-still
at Y^ where total demand for goods D^Y^ is more than the
total production of goods OY^, will the gap between demand
t
and supply i.e. D^Y-^, prove to be the inflationary gap
leading to a rise in the price-level so that at Y^, the
gap is removed and the equilibrium is established ?
Demand
being more than production, but there being excess capacity
(as it is a situation of less than full-employment), demand
will meet increasing production rather than the rising
prices and rising wage-rates.
Inflation which is, in fact,
reflation here, can be expressed only through the decumu­
lation of inventory
holdings rather than through the
change in the price-level, as in this model, real forces
alone are depicted and the changes fn the general price?
,
!
'■
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42
level, have logically "been r u l e d out.
At Y 2 total demand is DgYg while total produ c t i o n
is OYg*
Thus demand is less than the production of goods
by Y 2 * D 2
will l e a d to the accumulation of inventories
of ^ 2*^2
But ultimately,
these stocks will be
sold at lower prices and the income will recede to Y from
y
2.
If the total expenditure curve is 0^ + If,
then the
economy will r e a c h the full employment equilibrium level
Yf.
But if the total expenditure curve is 0
+ lx,
then
the economy cannot r e a c h the point Y x where income and
expenditure are equal, because full-employment income is
at Y ^ and h ence output cannot increase beyond Y^.
the light of C + I
curve, at Y
So, in
, total demand for goods
is A Y ^ while the p r o d u c t i o n of goods is OY-p w h i c h shows
demand to be more than the production by ADf amount which
is the inflationary gap*
This will l e a d to the decumula­
tio n of the inventory holdings, but it will not be express­
ed here by the rise in the general price-level,
because
only real forces have b e e n depicted here and at Y ^ y Y, Y ^
etc., the price-level is the same,
as they have bee n
expressed in terms of constant purc h a s i n g power.
the technical position.
This is
I n reality, Ke y n e s hims e l f asserts
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and we all k n o w that w h e n the full-employment level is
reached,
any further rise in total demand will be infla­
tionary a n d will enhance the general price-level.
But
what Prof. Wei n t r a u b w a n t s to emphasize is the technical
inability of this K e y n e s i a n m odel to include an d explain
the change in the general price-level,
whatever the cause
or causes.
But as we know, p rice-level changes are to be r uled
out from this model and hence excess demand is to be shown
to be inflationary indirectly ty p o i n t i n g out to the
decumulation of inventory holdings.
Inflationary gap does
n o t h elp to explain the price level changes i.e,
inflation
here.
H i c k s ’s Summary of K e y n e s i a n General Theory
Prof. J.B. Hicks su mmarised the K e y n e s i a n economics
in this r e s p e c t by d r a w i n g a single figure d e p i c t i n g IS and
L M curves (J.B, Hicks,
1936).
This figure also is u t i l i z e d
to explain the Ke y n e s i a n demand-pull theory of inflation.
-
44
-
horizontal one indicates real income.
The IS curve shows
the effects of the changes in the rate of interest on real
income via changes in investment,
It assumes a certain
consumption function and the marginal efficiency of capital
and the identity between total expenditure and total income
in the economy*
The LM curve expresses the effects of the
changes in real income on the interest rate when the money
supply and the liquidity preference of the people are given.
Increase in real income will lead to the rise in the
interest rate, as it increases the transaction demand for
money to he satisfied at the cost of the speculative demand
for money which requires a rise in the interest rate,
IS
and LM curves intersect at the point P where the interest
-
45
-
rate and the level of income - bot h are simultaneously
determined.
N o w if OY'
equilibrium income is not full-employment
income and if full-employment income is OY^,
then it
requires the shifting of IS curve or LM curve or both so
that the full-employment
income can be reached.
IS curve
embodies the effects of changes in the rate of interest
on real income and the L M curve emboldens the effects of
changes in the level of real income on the rate of interest.
So, in this figure,
only real forces have been depicted
and price-level changes have been totally r u l e d out.
the point that the full-employment is reached,
Opto
it is real
output that responds to the changes of the IS and/or LI
curves.
After r e a ching the full-employment level,
prices
can rise on account of the wag e - p u s h or the pr o f i t - p u s h
i.e, the cost-push or due to the rise in total demand i.e.
the demand-pull, but the p r i c e-changes have b e e n excluded
by the very technique of this model that deals only with
the real forces.
S.Weintraub,
I n the light of these arguments of Prof.
it is very amaz i n g h o w the above discussed
m o d e l s a n d techniques have been,
time and again, u s e d to
explain the K e y n e s i a n excess demand theory of inflations
W i t h the aid of the
’General Theory',
some economists
-
46
~
explain inflation in a different way which "brings forward
chiefly the cost-push theory of inflation.
Prof. Weintraub
Money expenditure (actual or expected) is measured
vertically and employment is measured horizontally,
Keynesian analysis being the short-period analysis, it is
assumed that the stock of capital is given and also the
money wage rate.
Z curve represents the aggregate supply
~
47
-
function i.e. it embodies the minimum amount of expenditure
that the people should make after the goods produced if
the corresponding volume of employment is to he maintained,
though higher expenditure will be surely welcome.
It may
be surprising how the Z curve slopes upward even when the
money wage rate is assumed to be constant.
But the reason
is obvious that it turns upward because of diminishing
returns taking place due to rising employment.
If the
money-wage rate changes, then Z curve and D curve both will
shift.
If the actual expenditure is less than this minimum
or expected expenditure, corresponding to a certain employ­
ment level, then employment will suffer and will get redu­
ced.
D curve represents actual expenditure by the people
on the goods produced which may be more or iess than the
minimum required expected expenditure as represented by
the Z curve.
Z and D curves will shift with the change in the
capital stock or the technique of production or the change
in the money wage rate.
As it is shown in the figure, if
ON-j^ is the volume of employment, then the minimum required
expenditure by the people after the goods produced is
measured by Z^N-^ while the actual expenditure is
In this situation, it is encouraging for employers to
-
48
-
produce more and employ more people.
So, the employment
point moves from N^to N throtigh If2 etc.
increased,
As employment is
the difference between the D curve and the Z
curve is n a r r o w e d and excess demand is reduced.
We should
b ear in m i n d the fact that this excess demand has been
conceived here in the W a l r a s i a n sense of m i c r oeconomic
markets rather than in the K e y n e s i a n sense of m a c r o economic variables.
At the point P,
excess de m a n d dis­
appears and the m i n i m u m necessary expenditure and the
actual expenditure become equal and so n o w there is no
more scope for increasing total profits for employers and
so no scope for further employment too,
b r i u m point.
At this level,
P is the equili­
employment will be OK.
Figures 2 and 3 depicted only real forces and so
they excluded all price-level changes and hence were
incapable of dealing w i t h inflation - demand-pull or costpush, while the figure 4 above k eeps the price changes
always in the fore-front and that also mainly due to the
money - w a g e changes w h i c h can explain if pr o v e d right, the
cost-push inflation.
If the technique of p r o d u c t i o n and
the vol ume of the capital-stock do n o t change, the n the
change in the money wage rate will shift p o sitions of Z
a n d D curves, because the change in the money wage rate
-
49
UU3
-
will change the expenditure of the employers in producing
a certain level of output and so the m i n i m u m necessary
expenditure hy the people o n the goods produced as expected
hy the employers will a.lter too and so will change the
actual expenditure hy the people.
is constant,
I f the m o n e y wa,ge rate
price-level cannot change except on account
of d iminishing returns w h e n employment gets a u g m e n t e d or
o n account of the p r o f i t - p u s h administered hy the oligopo­
lists.
D i m i n i s h i n g r e t u r n s will n o t change the position
of Z curve, hut only the point o n the same u p w a r d sloping
Z curve while the price-rise due to the profit - p u s h of the
m o n o p olists
phenomenon.
should he a very m i n o r one,
a,s a continuing
So, this figure explains very well the wage-
p u s h inflation.
Hence it was concluded hy Prof. Weintrauh that the
K e y n e s i a n theory explains cost-push inflation while it is
n o t capable, hy the very
definition of its technique, of
explaining demand-pull inflation.
theory of inflation,
V/e have
Thus the K e y n e s i a n
is J a n u s w h i c h ha s two faces,
concluded earlier that the cost-push
inflation depends on institutional factors like the fullemployment policy of the Government,
etc.
strong trade unions
Here, K e y n e s i a n theory of inflation,
at the most,
-
50
-
is p r o v e d to be the w a g e - p u s h theory of inflation w hich
heavily relies on institutional factors as m e n t i o n e d earlier.
Thus the K e y n e s i a n theory is another variant of the insti­
tutional theory of inflation.
But the majority of the
Keyne s i a n s do not accept Prof. W e i n t r a u b ’s interpretation
and they consider K e y n e s i a n theory to be demand-pull
theory of inflation.
Here we should also examine the Marxist variant of
the K e y n e s i a n cost p u s h theory of i n f lation w h i c h explains
inflation as a consequence of the efforts of different
classes in increasing their respective
shares o f national
income,
Theory of S t r a t o -Inflation - A V a r i a n t of Co s t - P u s h Theory
of Inf l a t i o n
H o s t of the K e y n e s i a n s and moneta r i s t s ■are agreed ftaabifc is
n o t cost-push,
inflation.
but demand-pull that is responsible for
But according to monetarists,
m oney-pull which,
it is ultimately
in the context of stable demand for
money, is responsible for demand pull while a c c o r d i n g to
Keynesians,
it is change in autonomous expenditure that
causes alterations
in money national income,
and the money
-
51
supply passively adjusts to it,
-
Therefore, Keynesians
advocate increase in tax revenue or borrowing to slash
budget deficits with a complementary income-price policy
in support.
Monetarists on the other hand, recommend
reduction in public expenditure and taxes so that the
budget deficits are removed,
They are opposed to the
application of any income-price policy, as it would
misallocate national resources, without being successful
in curbing inflation.
Money wages rising more than the prices is not a
proof of cost-push inflation, as it may happen due to an
attempt to protect the erosion of the real wages from the
future anticipated rise in prices,
Anticipated rise in
prices is due to actual persistent rise in prices.
Begin­
ning of the wage-price rise spiral being made by wage-rise
first, is also no sign of cost-push inflation.
Because
the excess demand in the economy may reflect itself first
in the labour market and then in the commodity market.
Profit push which is also a variant of cost push and which
purports to mean oligopolistic determination of high prices,
cannot be responsible for inflation, as inflation being
persistent rise in prices, it requires constantly increas­
ing oligopolistic power to explain inflation.
This cannot
-
52
-
also explain international transmission of inflation.
Still however,
there have b een stern b e lievers in
cost-push theory of inflation.
A c c o r d i n g to them (Ja.ckson, 1975; Trevithick,
and
Curwen,
1976),
1975
the cause of i n flation is of socio­
political o rgin and it is the result of the different
cla.sses in the society attempting to get a greater share
of national income.
I n developed capitalist economies,
there are two m a i n classes - wage earners and profit
Suppose in a situation of price stability,
earners get
earners get
wage
g(_X part of Y t national income and the profi
°C2 ■of Y t income.
err
earners.
So in a situation of Zero
inflation,
Y t = °^lY t +t^ 2 Y t
+ ^ 2
=
= ^ 1
Y t where
1 which m eans Y ^ = Y ^ expost.
There we have assumed rea l income to be constant.
N o w if suppose the wage earners try to get a larger
share of n a t ional income
say
c/jf
e arnor Ss
in order to continue to get their share of income at the
original level,
increase the prices,
aC
be
greater than one and m oney n a t ional income will increase
due to rise in prices w h e n real income is constant.
If
-
53
-
profit earners adjust to change in money wages (that took
place in period t - 1) immediately in the very next period
(t), then Y. = i.’C'.Y. _ +
.
i.e.
.
Yt
Y t (1
-
*C 2
2)
Yt
«
/-Y,
=
-1
0C 3. Y t - 1
' Y
t~l
i.e. Y . - ° k L _ Y . .
t
«i
r
t-1
“ c^2
Profit earners get
P ar^ of national income and they
wish to allow (1 - ^ g )
P ar'fc of national income to be
earned by the wage-earners.
So in that ca.se profit earners
will not increase prices if
aC-^.
~ 1
~ c*C2 011a ilGnce
*
=
1
But if, as we have seen,
^
c?C ■
the profit earners will increase prices in order to maintain
their original share of income.
of change of prices
**1
1
^
dP
When
1
= 1, the rate
or P will be Zero, but if
1, P will be positive, as real income is con­
vC
stant and nominal income changes only due to change in
prices.
P
= -Bll---- 1 ^ 0
1 -JLz
But we know that the profit-earners cannot increase prices,
54
-
if demand for goods is g oing to falter on account of higher
prices and in that case,
which will force
equal to
oCq
1 -
policy of m oney
there will emerge unemployment
to he equal to
w h i c h is again
0nly w *ien the Government adopts
the
supply expansion or the demand expansionary
policy that the prices can be increased, without demand
b e i n g curtailed.
So cost -push can function only i n the
excess demand situation.
But if there cannot be any cost-
p u s h inflation without excess demand,
it is better to
consider excess demand to be the cause of inflation and
cost-push to be a mere vehicle of inflation.
money inflation is turned,
through wage inflation.
into
I n fact,
price inflation
Wage rise is not the cause, but
in reality the carrier of inflation.
But Jackson, Turner and W i l k i n s o n have a d v anced a
theory of strato-Inflatio n as distinguished from normal
or equilibrium inflation.
They have t aken into account
the two types of groups of countries that suffer from
inflation.
One
group of countries is ha v i n g an annual
3 to 4 per cent rise in the general price level and there
is another group of countries (they h a d L a t i n A m e rican
countries in mind)
that are h a v i n g inflation rates
exceeding 30 fo a year.
They did n o t find a single country
-
55
-
that was h a v i n g the inflation rate betw e e n 9.6
and
21*6 °/o over the period 1948 - s71 and hence they concluded
that there was a difference in kind betw e e n normal infla­
tion and strato-inflation.
I n the normal inflation types,
the money wages in some key industries where productivity
is i ncreasing rapidly, may increase accordingly,
but in
other industries where productivity may not be increasing
so rapidly, proportionate rise in m o n e y wages may get
generalised through institutional factors in o rder to
m a i n t a i n the initial wage differentials though productivity
differentials might not have bee n maintained,
thus result­
i n g into inflation at a certain normal rate.
I n strato-
inflation type,
after an i n f lation of a higher rate than
normal has set in due to soiiie r e a s o n and is e x p e c t e d to
continue,
social conflict o n the basis of distribution of
national income comes out in the open w i t h immense ferocity
w h i c h resu l t s into very h i g h rates of inflation,
This
k ind of basic social conflict was there, but in an infla­
tionary situation,
it is compelled to come out in the open
w i t h all its ferocity w h i c h again imparts rapidity
inflation.
regard.
to
Example of Chile is especially given in this
Case of Britain at that time,
of normal inflation.
was cited as a case
I n a no r m a l i n f lation case,
Social
-
56
-
conflict is as regards the distribution of only yearly
addition of national output and not r e g a r d i n g the basic
distribution of n a t ional income (as it may h a p p e n in
strato-inflation countries).
But n o w Britain is ha v i n g a
25 per cent annual rate of inflation and J a p a n more than
20 per cent.
These were previously no r m a l or equilibrium
inflation countries.
They all Of a sudden became strato-
inflation countries or very near to that description.
All
of a sudden, ho w is it that a basic social conflict regard­
ing the distribution of national income developed in these
countries ?
I f this conflict is always there in every
capitalist society,
then why
say that there is a difference
of kin d b e t w e e n normal inflation and strato-inflation ?
T hen ho w do y o u also explain the difference in the
aeteology of these two types of inflation ?
The causes of
normal inflation and s t r a t o - inflation are different.
Inb e t w e e n h o w is it that normal inflation is r e p l a c e d by
strato-inflation ?
There is an international transmission
of inflation w hich takes place whe n some country
(e.g.
U.S.A.) or countries are h a v i n g chronic balance of p a y ­
ments deficits w h i c h correspondingly
create balance of
payments surpluses for other trade partners which,
by
giving rise to expansion of money supply, produce infla-
-
tion.
57
-
West Germany and J a p a n (barring their unusual
experiences of the last three years)
are clear examples.
H o w can this international transmission of inf l a t i o n he
explained in the light of the theory of strato-inflation ?
Does it m e a n that the b asic class conflict is also exported
to another country w h e n classes can not be so e x p orted ?
Recent a ccelerated inflationary development in Britain,
West Germany and other West E u r o p e a n countries and J a p a n
have u n d e r m i n e d the so-called difference in k i n d between
normal i n f lation countries and strato-inflation countries
and have p r o v e d the difference to be of mere degree and
have shown that the argument of social conflict to be
c a n n e d to far fetched limits whe n considered in the
context of Zero excess demand or Zero excess money
supply,
is mere abomination.
There is not a single case of excessive m o n e y
supply w h i c h has not r e s u l t e d into inflation or a case of
inflation where excessive money supply is not found,
irrespective of the m o n e t a r y
of history.
grant money
system,
country or the period
So, wise K e y n e s i a n s though not p r e p a r e d to
supply an exogenous or autonomous role in the
aeteology of inflation,
instantaneously accept the
necessity of at least the passive adjustment of money
58
supply to excess demand.
-
But the uph o l d e r s of cost-push
inflation and of social conflict do not see even this
necessity except some who
concede that the money
supply
variat ions can be brought in to explain the enhancement of
the rate of inflation (if not inflation itself),
the v ariations of money
though
supply themselves may be the result
of the pressure of class conflict for the larger share of
national income.
Actual inflation,
a c c ording to them,
is
the result of social conflict and can be explained without
the excess of money supply over the real demand for money.
But this is r a s h indeed o n their part.
ba d lawyers of a weak case.
They are definitely
That is why the role of on
institution like trade u n i o n s in e x plaining (inflation or)
the rate inflation can be studied only in the context of
excess demand (which is, of course,
excess money
supply).
In the previous discussions,
u n i o n s was presumed.
where the two
the direct result of
the role of trade
I n a developed capitalist economy
classes of wage earners and the profit
earners attempt to get a larger share of national income,
the b a r g a i n i n g activities of the wage earxiers cannot be
thought of without b r i n g i n g trade u n i o n s into the picture.So indirectly we have already taken into account the
-
59
-
implicit role of trade u n i o n s as rega r d s inflation*
Bow
le t u s discuss the role of trade u n i o n s perta i n i n g to
inflation a r o lici%
(P.J.
Curwen,
H . A. Turner; Prank Wilkinson,
1976; Dudley Jackson;
1975).
We have presumed that there is excess demand (due
to excess money
supply)
w h i c h mainfests itself in the
commodity m a r k e t and the labour market.
Excess demand for
labour will l e a d to rise in money wages, but the question
that we are examining is whether trade un i o n s add some­
thing of their own to these money wages in a d d i t i o n to
rise due to excess demand.
Excess demand for labour can be p r e s e n t e d as
Rate of change of money wage rate
=
~
~
E =
Nd — Ns
—
= w.
I. In the context of no role of trade unions W = aE ...
There is no positive or negative role of trade unions
and tbe increase in the money wage rate w is due to
only excess demand for labour.
2. There is a positive role of trade -unions and it
accelerates the rise in the money wage rate and hence
W = aE + X where X
y
0
3. The trade un i o n s play a m i x e d role
certain level of excess demand,
so that upt o a
the trade u n i o n s play
-
60
a positive role, but after a certain stage, they begin to
play a sort of negative role#
described as
f = bB +
Z
This situation can be
where b c a
and x
0.
4. Trade unions have got a negative role and hence they
retract, to some extent, from the rise in money wages
brought about by excess demand.
where c < a.
In this situation, W = cE
All these four possibilities regarding the
role of trade unions pertaining to wage inflation can be
more concretely depicted with the help of the following
that the OB line representing it, is just like the 45° line
and the change in the money wage rate is explained, bit by
61
bit by excess demand.
-
So, the existence of trade unions
here has got neutral effect on w.
2.
ZD line representing the 2nd case, is parallel to
OB line and ZD moves at a higher level than OB by a constant distance Z.
Z depicts the role of trade unions in
accelerating wage inflation.
3.
ZG line which depicts the 3rd case, moves higher
than the OB line upto Y (which measures OE
excess demand),
but after the point Y, ZG moves at a lower level than OB.
So upto excess demand OB-^, i.e, upto the point Y, trade
unions play the role over and above that of excess demand
in securing money wage rate rise, but after that point,
trade unions become a hindrance to instantaneous money wage
rate rise, as the trade union bargaining takes its own
required, time while the tight labour market can give swift
money wage rises.
4.
OH line represents the 4th case where, throughout,
money wage rate-rise is kept at al. lower level than it
would have been due to excess demand without trade unions.
OH line is below OB line throughout.
This is the result
of the universal character of the trade unions which have
to undergo time consuming processes of collective bargain-
-
62
ing and thereby slacken the swiftness of the money wage
rate rise w h i c h was b e c o m i n g possible due to excess demand.
Prof. M i l t o n F r i e d m a n has been considered to be the
propounder of this case.
interpreted.
But here,, he has been wrongly
Perhaps what he was tr y i n g to p r o p o u n d was
that the trade unions have not succeeded in securing and
sometimes to a small extents, they have even h i n d e r e d the
rise in real wages in a normal situation, as the rise in
real wages is possible only due to increase in the marginal
productivity of labour w h i c h depends on capital,
management etc.
along w i t h labour.
technology,
But in a situation of
inflation w h i c h has settled itself and thus has become
expected or anticipated inflation,
money wages will surely take place,
the necessaiy rise in
according to Friedman*
Only anticipation of price rise does not help,
labour
should have the capacity to rise to the occasion of
anticipated price ris$,
otherwise mere psychological anti­
cipation is of no use in economic literature,
the capacity
to adjust to anticipated price rise is also i n c luded in
the wider import of the w o r d 'a n t i c i p a t i o n ' «
M i l t o n F r i e d m a n believes excess of money
W h e n Prof.
supply to be
responsible for inflation and also propounds the theory of
anticipated inflation where money wages adjust perfectly
63
-
to price rise and when it is also conceded that determina­
tion of money wages is through collective 'bargaining of
trade unions, how can Friedman make such an -implausible
statement that in the context of excess demand situation,
trade unions play a decelerating role ?
This model of the
role of trade unions conceived in a situation bf price
stability and evolved for a different purpose of examining
their role in increasing real wages, cannot be mechanica­
lly applied to a situation of excess demand to explain
the movement of money wages,
4.
BENT HANSEN’S DYNAMIC MODEL OF DEMAND INFLATION;
Danish economist Bent Hansen rightly complains that
the Keynesian theory of inflation is not a pure case of
demand inflation#
His special contribution in this respect
is his emphasis on the dynamic role of the factor gap.
So, in order xo explain inflation, he lays stress on the
inflationary gap in the labour market and their mutual
interaction (Bent Hansen, i957).
Tlie vertical axis represents the pi^ice-wage ratio
which is the inverse of the real wage and the horizontal
axis indicates the supply of and demand for output.
The
S curve expresses the amounts of output that are supplied
at each price-wage ration
As employment increases, outiJut
increases, Tout at the full-employment level, output is
constant*
That is why, 3^H is the vertical line.
S curve
indicates the supply of labour indirectly through the
supply of varying output and the D curve also indirectly
expresses the demand for labour through the demand for
goods that the corresponding supply of labour can produce.
Thus in a pure case of demand inflation, the wage rate is
determined by supply and demand understood in the macro­
sense and not in the classical sense.
I
-
65
-
The horizontal difference between D and
lines
shows the inflationary gap in the goods market and the
horizontal difference between S and Sj lines, expresses
the inflationary gap in the factor (labour) market,
So,
Hansen asumes that
(1)
4i
(2)
=
f„ (D ~ Si)
x
i,e* the time rate of change in
the price-level is the function
of the magnitude of the infla­
tionary gap in the goods market.
=
fp (S - Si)
i.e, the time rate of change of
the wage rate is the function of
the magnitude of the inflationary
gap in the factor (labour) market.
P
At all price-wage ratios below (^)^, the goods gap
exists..
At all price-wage ratios above' (^)^? "^e factor
gap exists.
At (■§)]_!> there is no goods gap, but there is
a big factor gap.
So, as the demand for labour is high,
wage rate W will increase.
But as W is the denominator in the price-wage ratio
|
, rise in
W
will lead to a fall in |.
Pall in
moving vertically in the downward direction.
| means
p
As -jj moves
in the downward direction, the magnitude of the factor
(labour) gap is reduced and the goods gap commences to
p
resume shape. Rise in P increases ^ and hence moves it in
-
66
-
the upward direction, while the rise in W lowers ^ and so
carries it in the downward direction.
When these two
forces, moving £ in the opposite directions, are equal,
p
P
^
^ reaches (^)2 5
goods gap AB produces a certain rate
of price increase while the factor gap AO produces a
definite rate of wage increase and they may be in quasip
equilibrium,
But
at (f)2»
small goods gap gives
2*ise to only a slow increase in prices while the big
factor gap at that point, produces a higher rate of wagerise and thus they are not equal, The wage-rate rise being
P
more than the price-rise,
still moves downwards. As
P
Y
] moves downwards, the factor gap is narrowed and the goods
gap is widened.
At
^ , the factor gap is narrowed to DE
and the goods gap is increased to BP giving rise to a rapid
P
price rise and a slower wage rate rise. At (f)^* f^e factor
gap is closed and so the wage rate is stable, but the goods
gap is very wide here which increases
the price level
p
rapidly thus m o v i n g ^ in the upward direction.
p
So, between
p
and
somewhere there should be quasi-equilibrium
where the push of the wage rise and the pull of the pricerise are equal and hence prices and wages move together.
P
The quasi-equilibrium point will be at a higher ^ if the
wage rate is sluggish and prices are agile while it will
-
p
be at a l ower ^
67
-
if it is otherwise.
This m u c h reg a r d i n g
the p o s ition of the quasi-e q u i l i b r i u m point.
N o w at the
quasi-e q u i l i b r i u m point, what will determine the speed of
inflation ?
The absolute sensitivity of the wage rate
change and the price change to the magnitude of the factor
gap and the goods gap respectively will determine the speed
of inflation in the qua s i - e q u i l i b r i u m condition.
I f both
are agile,
inflation will be running, but if they are less
sensitive,
inflation will be slowly m o v i n g indeed.
But what determines the sensitivity of the wage rate
change or that of the price change ?
Here,
again,
we have
to b r i n g in the factors of the full-employment policy of
the Government,
strong trade unions, oligopolies etc. H i g h
prices and h i g h wages do no t constitute inflation.
It is
r i s i n g prices and r i s i n g money wages that indicate inflation
and the r ates of price
change and wage change depend on
institutional factors.
So H a n s e n attempts an impossible task of p r o v i n g
the validity of demand inflation, without b r i n g i n g into the
picture, the institutional factors like the trade u n i o n
pressures,
employment policy,
money supply variations.
administered prices etc.
H i s complaint against the
K e y n e s i a n theory of inf l a t i o n falls to the ground,
as he
hims e l f b e c o m e s a prey to the same forces against w hich
or
he revolted
5.
CHARLES 3CHULTZE'S SECTORAL DEMAND™SHIRT THEORY OP
INFLATION
Prof* Sehultze could not find any excess demand in
the economy in U.S.A, in the early fifties though the
prices were found to be rising.
cost-push theory of inflation.
He did not accept the
So, in his efforts to
reconcile the demand-pull theory with the fact of the
rising price level without any general apparent excess
demand, he developed this theory.
He showed that in a dyn
mic economy, demand is shrinking in some sectors and shift
ing to other sectors and so the sector or the industry in
whose favour, demand has shifted will register a rise in
the price of that commodity produced in that sector which
will also enable the employers to grant the rise in money
wages to the employees working in that sector, but the
sectors in which, demand has fallen, will fail to register
a fall in prices and money-wages, on account of the down­
ward rigidity of money wages and hence the general pricelevel will rise (Charles L. Sehultze, 1959).
In a dynamic
economy, this will constantly happen and the story will
be repeated many times, giving rise to an inflationary
-
wage-price spiral.
69
~
Thus the rising price-level is not
explained "by an overall excessive demand, but rather by
the sectoral rise in demand in conjunction with the refusal
by the declining demand sectors to register a price-fall
and the wage-fall.
inflation.
In a way, it is mixed demand-cost
•
We may say that it is a hybrid variety of
inflation - sectoral demand-pull and sectoral cost-push.
It wanted to explain inflation, not by emphasizing/ excess
demand nor by any autonomous wage rises, but by laying
stress on the fact that the sectoral shift in demand which
should bring about a change in relative wages and relative
prices, results into a general rise in wages and a general
rise in prices.
Demand factor is responsible for increas­
ing the prices and wages in only those sectors where demand
has gone; up, but the cost factor becomes relevant when
prices and wages refuse to fall in the declining sectors.
This cost factor which is of strategic importance, is an
institutional factor which is responsible for turning the
relative price and wage-change into a general price-wage
level change.
So, in a way, Schultze’s theory is a case
of cost theory of inflation rather than the mixed demandcost theory of inflation.
Every cost theory of inflation
is based on some institutional factor or factors.
In the
-
70
-
industries where demand is fallings
output may "be fallings
but the wages and prices may not fall on account of two
m a i n reasons - first (l)
is the trade u n i o n - pressure and
the full-employment policy of the Government and second
(2) is the h i g h percentage of o v e rhead cost in total cost
of p r oduction w hich m akes it difficult to reduce
output declines,
Schultze has specifically emphasized the
second factor in this respect,
So,
it enumerates simply one
case of a wider institutional theory.
This theory was in
h i g h vogue w h e n it was first presented by Prof.
Schultze in 1959>
cost when
Charles
but its popularity 3ms been short-lived,
as it failed to observe general excess demand that was
actually p r e valent w h i c h enabled the sectoral demand-pull
and the sectoral cost-push to transform the relative price
a n d wage-changes into the general price and wage-level
changes.
We may
say that it describes the px-ocess of
inflation, but does not explain the cause of inflation.
6.
MARKUP THEORY OP INFLATION:
I f all firms add u p a certain m a r k up
(by way of
overhead costs and profits)
to the costs of direct
material a n d direct labour,
in order to fix up the prices
of their respective commodities and if the l a b ourers also
-
71
price their services by adding a certain definite mark up
to their cost of living and if these two do not tally, then
inflation m a y result.
Mr, Gardner Ackley gives a very apt
example to explain the phenomenon of mark-up inflation.
The mark up pattern followed by firms may he such that the
ws.ge rate of ^ 2 leads to a price-index of 104 and the mark
up pattern pursued hy the labourers may he such that the
price-index of 104 leads them to demand and succeed in
getting the wage-rate of
$
2.08 which again, from the point
of view of the firms, requires the pi ice-index of
which necessitates the wage-rate of
so forth.
0
108.2
2.164 and so on and
The respective markups followed hy firms and
labourers do not give rise to such prices and wages which
have got harmonious relationships and so prices and wages
continue to rise due to this inconsistency.
This is
markup inflation^AcKlc.^;6:a-'vdTi£V) US'!).
We are given to understand that even the markups
change.
When the total demand in the economy is rising,
firms increase their markups and when a high level of
employment is reached, the labourers enhance their markups
and vice versa.
Thus the markup theory of inflation
a.ttempts to explain inflation hy emphasizing the institu­
tional factor of the markup resulting from the attempts
-
72
of trade u n i o n s and oligopolists.
The m o d i f i e d markup
theory of inflation shows ho w markup inflation may become
rapid i n the circumstances of ri s i n g total demand and
falling unemployment.
M a r k u p inflation is the result of attempts of the
firms and the labourers to m a i ntain certain ;,f a i r ” rel a ­
tionships between bu y i n g prices (which include the cost
of living)
and selling pr i c e s (which include wage rates).
These classes not only want to m a i n t a i n the 53f a i r ” rel a ­
tionships, but they sometimes attempt to increase their
share in the name of fairness when the productivity is
r i s i n g or otherwise.
W h e n the 51f a i r 53 shares of all the
classes add up to more than 100 per cent of the total
n a t ional output,
inflation results.
But this is not
possible u n l e s s m o n e y - s t o c k is augmented.
Total demand for
goods cannot be more than the total supply of goods, -unless
demand is ba c k e d by increased money-stock.
I n reality,
m a r k u p theory is simply the description of the process
of inflation.
A certain mar k u p i,e. inconsistency between
the markup of employers and employees here is n o t the
cause of inflation.
As we have already
seen that the
markup u n d e r g o e s change when demand conditions and cost
conditions (employment conditions)
alter and r i s i n g
-
73
-
employment is due to rising demand which again is on
account of the rising money supply.
We have also
observed that the markup theory lays stress, on the
institutional factor of certain markup as fixed by firms
and labourers.
It is their markup policy, an institutional
element which-is the villain of the piece, the level of
which depends on general demand and cost conditions which
again
as we have already shown in the beginning, either
stress institutional factors or rely on the increasing
money-stock,
Thus we see that all the theories except the moneystock theory emphasize the institutional factor or factors
of some kind or another.
We earlier observed how the wage-
push or profit-push relied on the institutional factors of
the full-employment policy of the Government, strong trade
unions, monopolistic power of the oligopolists etc.
We also
observed that the demand-pull depended on the rise in the .
velocity of money (or the nise in the money-stock which
again substantiates the stand we have taken) which depended
on near money sub-stitutes which again are the liabilities
of the non-bank financial intermediaries.
Thus, here the
financial structure, which is an instahtional factor, is again
relied upon.
We have also shown that the Keynesian
-
74
-
theory of inflation is the cost-push theory of inflation
and we have enumerated, time and again, these institu­
tional factors which are responsible for the cost-push.
Bent Hansen’s theory of inflation relies heavily on
institutional factors to establish the functional rela­
tionship between the rate of inflation and the ”goods
gap” and the "factor gap” .
The essenoe of inflation is
not the high prices, but the rising prices .
of inflation
ohe rate
depends on institutional factors
which are simply assumed away in the equation given by
Hansen thus making a mockery of his theory and lending
credence to the belief that the institutiona factors are rea­
lly at the core of his theory.
Prof. Charles 1.
Schultze's sectoral demand-shift theory of inflation is
considered to be the mixed demand-cost theory of infla­
tion, as it emphasizes the sectoral demand rise to
explain the rise in some prices and relies on cost
factors (increasing overhead costs) to show how this
leads to rise in the general price level.
Markup
theory of inflation which emphasizes the policy of
markup followed by the employers and employees, rests
on the respective bargaining capacity of these classes
which again depends on the employment policy of the
-
Government,
75
-
strength of the trade-unions and the m o n o ­
polistic p o w e r enjoyed Icy the oligopolists w h i c h are
all institutional factors.
Changing general demand
conditions and employment conditions influence the m a r k ­
up polic i e s of the employers and employees.
These demand
and employment conditions emphasize the demand-pull and
cost-push factors and we have already shown that they
depend on institutional factors.
7.
M O N E Y - S T O C K THEORY 03? I N F L A T I O N i
So,
we
first
reduce all theories of inflation
to demand-pull or cost-push theories, then we show that
the demand-pull and c o s t-push theories are, in fact,
institutional theories.
Hence,
in the field, only two
m a j o r theories - (1) M o n e y - s t o c k theory and (2) the
institutional theory - r e m a i n to vie and compete w i t h
each other.
Insti t u t i o n a l theories of inflation describe the
process of inflation r a t h e r than explain the cause of
inflation.
Some institutional factors carry f o r w a r d the
impact of the r i s i n g m o n e y - s t o c k and some institutional
factors b r i n g pressure for the increase in m o n e y stock
and in the circumstances of the incr e a s i n g money-stock,
76
-
they
create pressure
for
-
further rise
I f this pressurized further rise
al l o w e d to
take place,
are h e l p l e s s
and no
Institutional
they
all
inflation
factors
do n o t
explain the p r e ssures
stock.
stock is not
are not
itself the
identical*
the I n s t i t u t i o n a l
fallacies
increase
stock,
that
f o r the
has been
tional
(2)
already
of
the
increase
take placq
rather
in moneythe
fact of
for increasing moneyin money-stock,
they
equate
they
at the m o st,
they
a n d the
and thirdly
in money-
c a n e x p l a i n the
inflation theory
(3)
they
fail
which
to r e a l i z e
f a c t o r s b e g i n to b r i n g p r e s s u r e
a u g m e n t e d due
the full
Government
the
f o r the
confuse b e t w e e n the
in money-stock only
and
So,
three
the pressure
actual rise
to
employment
or the
price
when money-stock
other
cpocihl
or the
Contra! Bank
a n e x p e c t a t i o n that- the. f u r t h e r
will
being*
increase
Pressure
they,
theory
factors like
policies
is
(1)
institutional
increase
into
explained by
s t o c k w i t h the
indentical
the
come
explain inflation,
he
in the m o n e y - s t o c k hut
are n o t
can
factors
theories of inflation commit
in money
money-stock rise
institutional
2his pressure may he resisted.
- firstly
secondly
in m o n e y - s t o c k is not
for the
Inflation can only
the r i s i n g money-stock.
rise
the
in money-stock.
level
rise
will
institu­
growth
and thore
in n o n c y - c t o e k
continue
to rise.
-
77
-
Prof. Milton Friedman points out that the demand
function for money is a stable and predictable entity
which depends on other
variables in the economy.
According to him, the quantity theory of money is the
demand for real money theory rather than the money
supply theory.
People want to maintain a certain defi­
nite part of real output in the form of liquid money.
In the Cambridge equation
M
= KPY, where K indicates
such real demand for money as a definite percentage of
annual national output.
But, the classical or neo-class
cal economists assumed the value of K (which depends on
institutional factors) to be constant - the position
which was not tenable in the m o d e m world when other'
\
near money substitutes had cropped up and money was to
be studied as wealth or capital, earning zero income,
which provides real facilities in consumption as well
as production processes thus serving as an alternative
among many other real alternative variables like shares,
bonds, human capacity, non-human wealth etc.
Thus the
value of K was not constant and it could change with
the change in the returns on other alternative real
variables and the expected change in the general pricelevel, but to go to the other extreme, as the theory
-
o f Ra d c l i f f i s m does,
78
-
and to claim any possible increase
in the v e l o c i t y of m o n e y without limit,
were,
in fact,
was spurious.
They
deceived by the monetary experience of U.K,
a n d U.S.A. betw e e n 1 9 4 8
a n d 1 9 5 9 w h e n the r e s u m p t i o n of the
no r m a l v e l ocity of m o n e y o n account of the r e l a x a t i o n of
controls w a s m i s c o n s t r u e d to be the rise in the velocity of
money,
thus incr e a s i n g the price-level without the increase
in the m o n e y - s t o c k or increase in it in lower amounts.
F r i edman took a middle a n d compromising p o s i t i o n and pointed
out that the velocity of m o n e y is n o t constant as the classi­
cal and neo-cl a s s i c a l economists thought and it is also not
instable as R a d c l iffism claims, but the demand f u n ction for
real- money
money)
(which indirectly gives u s the v e l ocity of
is predictably stable which depends on the r e u t m s
on other real variables in the economy,
income and subjective preferences.
on per capita
real
What is e mphasized here
is the demand for the r eal quantity of money rather than
n o m i n a l money.
Nominal quantity of m oney m eans the
quantity of money expressed in terms of rupees,
dollars
etc. and the real quantity of money m e a n s the quantity
of money r e p r e s e n t i n g a certain definite general
purch a s i n g power or rep r e s e n t i n g the income of a certain
n u m b e r of weeks with w h i c h it is equal.
demand for m o n e y
(here,
currency)
I n India,
is equal to seven
the
79
-
w e e k s ’ income.
India,
time,
and
spend
it
It means
all the
will
services pro d u c e d by
This
currency,
but
in Greece
U.S.A.
people
in U.S.A.
it
to 1 . 7 5
in the
the
within
every
is
is
equal
to
in India.
the
is
This
in
is
income
the
wide-spread
in U.S.A.
Greece
less.
a n d in
of
is
40
stability
countries.
that
income Y
i n the
is roughly
expressive
out
In
demand for
the r atio
of money
same.
in India,
different
and the money
amount
the
In
currency,
comparatively
capita income
demand for money
changed,
is
in
seven w e e k s ’ income
4 w e e k s ’ income,
which prices P
it
in
their
liquid money.
extent,
and Israel
though per
that
that
weeks’
f o r m of
b anking is more
than what
to
7
i n the
a
goods
individual
h o l d 4 weeks*
Deposit
in
at
of I ndia keep
form of
Milton Friedman points
is
to b u y
6 l/4 w e e k s ’ income
people
So,
in U.S.A.
I n I n d i a it
times
hold
and Israel
or Yugoslavia,
U.S.A.
that
they h o l d
also'f t h e p r o p o r t i o n i s r o u g h l y
currency.
currency
able
people
i n the
the people
that
the people
o n average,
and Israel,
form of
all
seven w e e k s ’ income
seven w e e k s ’ income
Jugoslavia,
if
be
does n o t m e a n
India keeps his
1
that
cash money
(cash money)
period.
-
if the u n i t
are
demanded
in
expressed,
should
change
-
p ro p o rtio n a te ly ,
80
-
So t e c h n i c a l l y s p e a k in g , F rie d m a n ’ s
e q u a t io n r e p r e s e n t i n g t h e demand f u n c t i o n f o r money m ust
"be c o n s id e r e d t o be hom ogeneous o f t h e f i r s t d e g re e i n
P an d Y so t h a t
Md = f (P , Y, r
1
' r
to f (
r " r
XY,
dr 1
d t' P
dP . \ ,
dt* **) becom es e q u a l
H i ’ T ■§!♦
w here P = price
le v e l
Y = n a t i o n a incom e
1 dr
r -r£
= N et i n t e r e s t incom e
^
|ji| = e x p e c te d r a t e o f
change o f t h e p r i c e
le v e l.
h = r a t i o o f human w e a lth a n d
non-hum an w e a lth
. . Md = y t ( P , Y, r
Now l e t
Then Md
!
r
dr
at*
i
P
dP
dt*
nj
1
\
ldr
f (£ l
'P ’ p ’
rSf'
T h is e q u a tio n g i v e s th e demand f o r r e a l money a s
a f u n c t i o n o f a few v a r i a b l e s .
A lso l e t
Then
Md
Y
r
1
r
dr
d tf
1
f
dP
d tf
h\
'
81
-
Demand for money is the inverse of the velocity of money
ana hence ^
can he expressed in the form of
1
1
V(i
r
dr 1
* dt* 5
dP
If*
h )
p
f-
Y
/Here ^ has heen inversed into ^
because it is brought
1
into theQ cienominator. V is incono-vclo city of money
and so
is the income-demand for money]
Md
—p —
V ( |,
r -
1 dr 1
r dt* f
dt*
h)
Demand for and supply of money being equal, in place of
Md, Ms can be written as well .
Cross multiplying we get
Ms. v(
Y
r
f *
1
r
dr 1
dt* P
dP
dt*
h) = Y = Py
where y is real
income and Y is
money income.
This is in the Fisherian form of W f = PT, as T is a
definite fraction of Y.CPrCe^-ma.'i'i, Miltcm*, 18 £3
.
So, in these circumstances, if the money stock is
increased, the price-level will rise if there is full
employment output.
Prof. Friedman puts it very well
that "'the relationship between changes in the stock of
money and changes in prices, while close, is not of
course precise or mechanically rigid.
Two major factors
-
82
-
produce discrepancies - changes in output and changes
in the amount of money that the public desires to hold
relative to its income,” (Friedman Milton, 1969s 174)
So, only by knowing the growth in money-stock, we cannot
say anything regarding the change in the price-level or
output or employment level| we have to take into account
other variables also along with the growth in money
supply before we can say anything about the price-level or
the level of output or employment.
Without the stable
demand function for money, the change in the moneystock will fail to affect the price-level, output or
employment level in a predictable and definite way.
So, the stable demand function for money is the h e a r t .
of the quantity theory of money,
In the light of the
stable demand function of money, inflation can only be
explained by changes in the stock of money and by no
other factor or factors.
Other factors become effective
only in the context of rising-stock of money.
If the
stock of money is not rising more than the rise in the
demand for money, despite other factors,, inflation will
not take place.
That is why Friedman very rightly says!
”To the best of my knowledge there is no
instance in which a substantial change in the stock of
83
-
money per unit of output has occurred without a sub­
stantial change in the level of prices in the same
directions conversely, I know no instance in which
there has been a substantial change in the level of
prices without a substantial change in the stock of
money per unit of output in the same direction.
And
instances in which prices and the stock of money have
moved together are recorded for many centuries of history,
for countries on every part of the globe, and for a wide
variety of monetary arrangemen1&.li,(Friedman Milton, 1969s 172,173)
The general rise in prices can be explained ly mriaiiansiii
the supply of money and the demand for money.
Demand
for money depends on output in a stable fashion.
Hence
real demand for money increases proportionately or more
than proportionately, but in a stable way to the rise in
real output.
Increase in money supply through the
interest rate mechanism is passive and hence money
supply through this channel, increases only to the extent
of the increase in the demand for money based on increase
in output.
But increase in money supply due to budget
deficit or due to the control of the exchange rate when
the balance of payments is in surplus and foreign
exchange reserves are accumulating, is autonomous and
-
84
-
exogeneous and is likely to be inflationary if pres s e d
beyond a limit.
I f inflation has t a k e n place,
there is no
sense in
try i n g to contract e x i s t i n g money supply or reduce effective
demand by a p p lying monetary and fiscal means.
Because it
will reduce output and curtail employment.
Once money supply is increased,
it gets absorbed
into the economy and so it is suicidal to attempt to
w i t h d r a w the spent money.
being,
Once inflation has come into
it should be allo w e d to be an open one a n d i n the
present, only that m u c h m oney supply should be augmented
w h i c h is n e c e s s i t a t e d by the rise in the demand for money
consequent u p o n growth in output so that the already h igh
price-level may not rise further.
I n this regard, we can
take only preventive m e a s u r e s and n o t curative measures,
curative m e a s u r e s are to be left to the m a r k e t forces.
This applies only to the inflationary
situation and not
n e c e s sarily to the situation of depression.
We should
simply be careful to see that money provides a neutral
general f r a mework and money
serves only as a healthy m eans
an d does n o t create any problems of its own.
problems w h e n real p r o blem s of growth, output,
Money
creates
employment
etc. are e ndeavoured to be solved w i t h the help of only
-
changes i n money-stock.
the economy increases,
85
-
So, w hen the productivity in
we should a l l o w the respective
prices to fall, because then alone prices can continue to
perform their function of a llocating resources efficiently.
But when the output r ises due to growth in labour supply,
money- s t o c k to that m u c h extent,
should be increased.
Besides, p e r capita rise in real income,
increases the
demand for m o n e y absolutely and relatively, because incomeelasticity of demand for money is generally f o u n d to be
more than u nity and hence in that case, m o n e y - s t o c k should
be equivalently augmented.
Stability should n o t be con­
fused w i t h constancy \ an d monetary
stability is consistent
w i t h the price-fall if it is due to the rise in productivity.
N e u t r a l m oney and stable currency can help in
achieving the goals of full-employment,
growth,
stability and balance of payments equilibrium.
priceBut now-a-
days, they are wrongly v i e w e d as conflicting goals and so
the problem of trade o f f betw e e n them, has arisen.
This
problem, we have e x a mined in the n e x t section u n d e r the
title of P h i l l i p s curve.
We have observed that the institutional theories
of inflation are real theories of inflation in the sense
that they emphasize the institutional factors that are
86
-
real and non-monetary in nature.
But there are other real
theories of inflation of lower theoretical status, which
are not institutional in nature e.g. the theories of black
money, black markets, smuggling etc., which vainly claim
to explain inflation.
The distinction between the insti­
tutional theories and the non-institutional real theories
is that the institutions emphasized by the institutional
theories give rise to pressure for the expansion in money
supply or increase the velocity of money in the long run
(though it remains stable in the short run) while the noninstitutional real theories have been never claimed to
have given vogue to any pressure for the growth in money
supply.
Without growth in money supply per unit of output,
inflation is not possible.
So non-institutional real
theories are no systematic and scientific theories of
inflation, though they are politically popular.
All non-monetary theories of inflation are either
institutional real theories or non-institutional real
theories.
But the institutional theories give rise to
pressure for the expansion of money supply and hence these
theories become more complex.
When we submit that infla­
tion, in most of the countries, is due to budget deficits
which are again on account of mounting public expenditures,
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87
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though here we refer to the institutional factor of the
overactivity of the Government, the institution of the
Government is different from other institutions in the
society in the sense that the Government alone has got also
the power to print money or to get it printed by the
Central Bank while other institutions at most
can increase
only the velocity of money by providing close substitutes
of money in the long period.
Change in the salary period
also can affect the demand for money, but such changes
take place only in the long-period and are passive and no
longer inflationary.
In the short-period, it is only
budget deficits or the rigidity in the exchange rate or
lack of response of the Central Bank to the market condi­
tions which are the true causes of the excessive increase
in money supply and hence of inflation.
So the Government
as .
and the Central Bank^institutions
area category apart, becau­
se they themselves togewhile other institutions can only enhance the pressure for
the expansion of money supply and cannot increase money
supply by themselves.
Now let us address ourselves to the study of the
problem
of trade off between employment and price stabi­
lity, which is attempted in the next section.
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88
PHILLIPS
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CURVE
(Trade-off between price stability and full employment)
Mr, A.W. Phillips studied the relationship between
money wages and unemployment over a period of 72 years
from i860 to 1931 for U.K. and he discovered that there
was a trade off between the percentage of unemployment and
percentage rate of change of money wages i.e. there is an
inverse relationship between the level of unemployment and
the rate of change of money wages (A.W. Phillips, 1958,
1962).
When unemployment is less, money wages are higher
and when it is more, money wages are comparatively lower.
This is commonsensical also, because lower proportion of
unemployment is a consequence of a very high demand for
labour which may be a derived demand from the overfull
demand for goods and hence the bargaining power of labour
being more due to its intense scarcity, labour succeeds
in eliciting higher money wages from the employers. But
o
when the supply of labour is overfull and the demand for
it faltering due to shortage of demand for goods, price of
labour-power i.e, money wages may be low, though on account of
the downward rigidity of money wages, they may not fall too
much corresponding to a fall in their demand.
Thus a
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89
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curve showing the relationship between the percentage of
unemployment U and the percentage rate of change in money
When the percentage of unemployment is "of” , change
I
in the money wage rate is zero and hence in the terminology
t
of Milton Friedman, it may he deemed as the 'natural rate
of unemployment' like the Wicksellian concept of 'the
natural rate of interest.'
Any endeavour to reduce the
percentage of unemployment below this natural rate "of” ,
will result into higher money wages to be granted.
It
should be clear here that this rise in money wages is in
excess of growth in the productivity of labour, which
increases the price-level.
I
But then how to show the rise
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in money wages (when prices are stable) which is a result
of growth in the productivity of labour and not due to
excess demand for labour and hence which does not result
into the rise in the price level ?
In order to distinguish between inflationary and
non-inflationary wage-rise (irrespective of whether wagerise is the cause of price-rise otf vice versa), we shall
have to draw a separate figure for it, as the prices are
not represented on any axis and hence the vertical axis
represents percentage change in the money wage rate irre­
spective of .whether it is warranted by growth in producti**
vity of labour and hence is non-inflationary or it is the
91
-
The point f
-
in the figure 8 is not the same as
the point f in the figure 7 .
The point f in the
7th
figure indicates the natural rate of unemployment and
that natural rate of unemployment is expressed by the
*
point Uo in the 8th figure,
OWo is the percentage incre­
ase in the money wage rate due to growth in the producti­
vity of labour.
But if suppose that the Government finds
OUo level of unemployment to be unacceptable and wishes
to reduce it to OU^ and in pursuance of this objective if
the Government adopts such fiscal and monetary measures
which result into excess demand for goods and then to
excess demand for labour, money wages will rise due to
greater scarcity of labour and the employers will shift
the burden of higher money wages on to the consumers byincreasing the prices of the products.
money wages is 4 per cent.
Say, the rise in
Here because the Government
itself is following the excess demand and more employmentoriented policy, employers will not find any difficulty
in shifting the burden of high money wages by way of
increase in prices, to the buyers of the goods.
Thus
when prices rise, the benefit in real wages secured byrise in money wages is eroded.
prices is 4 per cent.
Suppose, the rise in
Also suppose 4 per cent actual
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inflation produces the same rate of expected inflation.
So now employees will demand increase in wages "by 8 per
cent (4 + 4) and not 4 per cent only.
When they succeed
in securing 8 per cent rise in money wages, prices will
rise by 12 per cent.
So the wage-earners will demand
the increase in money wages by 16 per cent and a vicious
wage-price spiral will come into being, making inflation
rapid.
This is the result of attempting to peg the un­
employment rate below its natural rate.
The natural rate
of unemployment, in the words of Hilton Priedman, is the
level that would be ground out by the Walrasian system of
general equilibrium equations provided there is imbedded
in them, the actual structural characteristics of the
labour and commodity markets, including market imperfect­
ions, stochastic variability in demands and supplies,
the cost of gathering information about job vacancies and
labour availabilities, the costs of mobility and so on.
It is a full-employment level of unemployment or the
unemployment level of full-employment, full employment
understood in the Keynesian sense.
So this kind of
frictional unemployment which is not due to shortage of
demand, but on account of real factors as described above
-
by Friedman,
93
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cannot be l e s s e n e d by demand-oriented m e a s u ­
rers, but by taking the real steps of m a k i n g the mobility
of labour m o r e r a p i d by providing training,
housing,
educational and other facilities to temporarily displaced
labour.
Due to rise in money wages,
prices are no t shown on any axis,
prices rise,
but as
it can be depicted only
by the shifting of the P h i l l i p s curve.
So the P h i l l i p s
curve will shift to the right and in order to m a i n t a i n the
lower OU-j_ unemployment rate,
the Government will have to
constantly m a i n t a i n the excess demand Ina d and hence
consequently inflation will assume rapidity as the time
elapses.
The P h i llips curve will go o n shifting to the
right - h a n d side.
For m a i n t a i n i n g the artificial lower
level of u n e m p loyment at U - p h i g h e r and higher doses of
price-rise an d wage-rise will be required.
As m oney wages
rise, prices rise and as prices rise, money wages also
grow.
Rate of change of money wages depends o n excess
demand for labour and excess demand for labour* is expressed
through the proportion of u n e m p l o y e d labour.
E x c e s s demand
for labour is not observable also and so the p roportion
of u n e m p l o y m e n t was taken as a proxy variable and a
»
r e l a t ionship was found b e t w e e n W and U.
But as we have
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94
-
observed that excess de m a n d for la b o u r that r e s u l t s into
rise in money wages, resu l t s into rise in p r i c e s also.
But the excess demand for labour depends on what ?
Demand
for the factors of p r o d u c t i o n is a derived demand deduced
fro m the demand for goods.
ces,
So in m o s t of the circumstan­
the excess demand for labour has emanated f rom excess
demand for goods and excess demand for goods results into
rise in prices of goods w h i c h again force labour to demand
higher m oney wages in self-protection.
So when we analyse
the P h i l l i p s curve and show that the rise in m o n e y wages
results into rise in prices and a gain that brings about
further rise in prices and thus a vici o u s circle sets in,
we do not advocate the cost-push theory of inflation,
P h i llips h i m s e l f had,
inflation.
in mind,
the demand-pull theory of
As Dr. Lipsey has correctly shown,
the
P h i l l i p s curve can be studied irrespective of one's
belief in cost-push theory of inflation or the demand-pull
theory of inflation,
as the P h i l l i p s curve is a functional
relationship of limited range and is to be u s e d as a tool
for the enumeration of d a t a and ver i f i c a t i o n of a theory.
E v e n the degree of non-linearity an d the slope of the
P h i l l i p s curve have no t b e e n specified and only r e l a t i o n ­
ship b e t w e e n the prop o r t i o n of u n e m ployment an d the rate
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95
-
of change money wage-rise has b e e n depicted.
As there is
very
close relationship betw e e n wages
an d prices and as the P h i l l i p s curve takes into account
money wages an d not real wages,
appear on the scene.
the price factor has to
It is possible that in the long-run,
there may no t be m u c h of
trade off between unemployment
and the change in the real wage rate and the P h i l l i p s
curve may be only a short-run phen o m e n o n found to be
broadly true r e g a r d i n g the relationship between rate of
change of money wages and the p r o p o r t i o n of u n e m p loyment
in the context of u n a n t i c i p a t e d or less than fully-anti­
cipated inflation.
So in the figure given below,
we
depict the rate of change of prices p in place of the rate
of change o f the money wage rate W on the v e r tical axis
a n d keep the percentage
une m p l o y m e n t U on the horizontal
axis as usuali
P = P e rcentage rate of
change of the price
level.
P e = $age expected rate
of change of prices.
U o = 3 per cent.
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96
W h e n m o n e y wages rise to the extent w a r r a n t e d "by
growth in the productivity of labour, prices will not
rise.
So w h e n we show price-change rather than money
wage-change o n the v e r t i c a l axis,
figure
f' point as in previous
is not r e q u i r e d a n d U o directly gives u s the
percentage of natural unemployment w h i c h is consistent
w i t h price stability.
Any effort to reduce unemployment
b e l o w it by demand manag e m e n t methods, will u s h e r into
inflation a n d m ost probably into the ri s i n g crescendo of
inflation due to the o n - s e t t i n g of the price-wage
spiral.
I n the above figure, w h e n on effort is made by the Govern­
m e n t to re d u c e unemployment to U-^ fro m Uo,
there is a 4
per cent rise in prices due to 4 per cent rise in money
wages.
But in order to u n d e r s t a n d further development,
consequent u p o n it, the P h i l l i p s curve is to be shifted to
the right.
A n t i c ipated or expected price rise becomes one
of the important determinants or the carriers of inflation.
W h e n 4 per cent rise in prices took place, a nticipated
price rise pe wa s zero.
But n o w w hen 4 per cent price)
rise has t aken place,
expected price rise will be positive
and it will not be equal to zero an d hence the nex t pe
curve w h i c h assume pe >
o, becomes relevant.
Actual
inflation becomes more r a p i d as the degree of expected
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97
-
inflation increases.
Whe n inflation is unanticipated*
price rise takes
wage earners "by surprise and their r eal wages fall due to
l a c k of prot e c t i o n of their real wages.
P r i c e s have r isen
and money wages have r e m a i n e d the same and hence the real
wages have fallen.
Pall in real wages makes la b o u r
cheaper and enhances the profits of the employers also
and hence more labour is employed and the degree of u n ­
employment is reduced.
I t is forced saving by inflation
w hich increases employment.
But after a certain time lag,
wage earners react to this fall in real wages by demand­
ing and u ltimately s u cceeding in eliciting hig h e r money
wages*
The moment this happens, u n e m p loyment again appea­
rs, because extra profit is w iped out by rise in money
wages and thus labour ceases to be cheaper.
But because
the Government has bee n following the policy of pegging
employment at a higher rate or unemployment at a lower
rate,
it will no t a llow this u n e m p loyment to appear and
hence it will take demand expanding measures so that the
employers will be enabled to shift the burden of higher
money wages to the consumers by way of higher prices of
goods.
Increase in prices of the commodities will no t
reduce demand,
as the Government is t a k i n g demand-
98
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swelling measures, and hence despite higher money wages,
unemployment will not appear.
But prices will rise fur­
ther so that the forced saving due to the fall in real
wages may he maintained and thereby higher level of
employment may he sustained.
Again the wage earners
react to this by demanding still higher money wages and
the price-wage spiral comes into operation.
Thus when
inflation becomes expected inflation and the money
illusion disappears, expected rate of inflation affects
money wage contracts between labotir and management,
how
as money wage contracts are meant for a period of time,
over that period of time, whatever degree of price-rise
is expected to take place, the compensation of it "by
proportionately higher money wages is embodied in the
present contracts and that is why we observe a very
unusual phenomenon of money wages rising faster than
prices in developed countries.
This is the effect of
expected inflation and it is the result of measures
taken in self-protection by labour which is large in
number and strongly united and which functions in a
democratic society.
This reduces profits also and hence
investment suffers and unemployment appears.
Thus there
arises a phenomenon of inflation and unemployment moving
-
together in a merry
's t a g f l a t i o n * .
99
-
company w hich we euphemistically call
There is accelerating inflation a long
w i t h r i s i n g r ates of unemployment.
Thus cost-push is the
result of anticipated inflation and anticipated inflation
is the consequence of actual inflation and actual infla­
tion emanates from the demand expanding measu r e s taken by
the Government to reduce u n e m p loyment b e l o w a natu r a l
level of it or for any other avowed purpose.
I f the
Government does not take the demand- expanding m e a s u r e s
in a normal situation and allows the natural rate of
u n e m p loyment to prevail or takes other real m e a s u r e s to
reduce frictional unemployment,
this price-wage
inflation will not come into being.
spiral of
So in the l o n g - r u n ,
P h i l l i p s curve will be a v e r tical line passing through
the point of natural rate of unemployment
zontal axis.
on
the h o r i ­
This also m e a n s that at this n a t u r a l rate
of unemployment,
i n f l a t i o n becomes perfectly anticipated
and there does not r e m a i n any difference between actual
inflation and anticipated inflation and hence the scope
for creating additional employment by creating forced
saving and m a k i n g labour comparatively cheaper by not
allowing m o n e y wages to rise proportionately to pricerise,
disappears and any price-rise becomes consistent
100
-
with this natural rate of unemployment.
That is why the
Phillips curve becomes vertical and the trade off between
unemployment and inflation disappears in the long-run.
Any price level is consistent with this natural rate of
unemployment.
As price-rise does not pay, the policy of
price-rise and the consequent real wage-fall is abandoned
by the Government and the workers succeed in serving the
nation by demanding higher money wages in self—protection
when prices rise due to the misconeived
and faulty though
well-intentioned policies of the Government.
In this study of the Phillips curve, not only the
effect of an attempt at reducing unemployment, on the
price situation was taken into account, but in the reverse
way, the effect of reducing inflation, on the employment
level was also threadbare discussed.
The strange import
of the Phillips curve was that there was a tra.de off
between unemployment and inflation i.e. between higher
employment and price stability.
If a very high level of
employment is required, we have to be ready to tolerate
some degree of inflation which is likely to become rapid
too and if price stability is thought to bo a desirable
goal, then we have to adjust to the existence of some
degree of unemployment.
We cannot have the best of both
-
the worlds.
101
-
The Phillips curve asks us to choose from
the different possible combinations of unemployment and
inflation and we can reduce one only by increasing the
other, we cannot do away with both altogether and usher
into a world of a very high employment and price stability.
We who believe that no good things are in conflict with
one
other and hence wonder at this trade off between
high level of employment and price stability, strongly
suspect, that it must be due to human folly.
We have
traced that folly and showed that the Phillips curve can
be vertical and then this trade off disappears as shown
-
102
-
.
In the above figure, aa curve is the short-run
Phillips curve, cc is the long-run fully anticipated
inflation curve which is vertical and hence devoid of
trade off.
This much about the Phillips curve.
Now if the monetary theory is more likely to be
correct, then let us evolve ,a methodology to study the
problem of inflation from that point of view.