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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. - 23 - 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 - absorbed into the economy. 24 - 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. - 25 lt<Z£>3 - 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 - 26 - 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 - - 27 "Money in a Theory of Finance." - 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 - 28 - 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 29 - 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 - 30 - 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, - 31 - 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 - 32 - 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 - 33 - 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. 34 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. 35 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). 36 - - 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. 37 - 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. 38 - 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. - 39 - 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 - 40 - 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 41 - - 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? , ! '■ - 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 - 43 - 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, - 87 - 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. - 88 PHILLIPS - 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 - 89 - 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 - 90 - 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 - 92 - 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 - 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 - 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 - 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. - 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 - 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 - 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.