Over the last century many countries throughout the world have experienced
inflation as their major economic problem.
Expensive wars have traditionally been
recognized as the sources of inflation. Governments, in effort to squeeze more production
out of an economy, have often resorted to printing or releasing more money to finance the
purchase of arms and soldiers1. In an economy already producing at full capacity, the
issuing of additional money serves to bid up the prices of the output of the economy,
resulting in inflation. It was generally assumed from past experience, that once the
economy returned to its normal state, the persistent tendency for overall prices to rise
would disappear, bringing inflation rates back to normal.
World War II brought the
persistent inflation that economists came to expect. In the 50’s and early 60’s inflation
resumed to very low rates concomitant with large growth increases and low
unemployment. But, from 1967 to 1974 the rates of inflation reached alarming proportions
in many countries, such as Japan and Britain, for no apparent reason. This acceleration in
inflation has forced many economists to reevaluate their views, and often align themselves
with a specific school of thought regarding the causes and cures for inflation.
There are two opposite theories regarding inflation. Monetarism indicates that
inflation is due to increases in the supply of money. The classic example of this
relationship is the inflation that followed an inflow of gold and silver into Europe, resulting
from the Spanish conquest of the Americas. According to monetarists, the only way to
cure inflation is by government action to reduce growth of the money supply.
At the other end is the cost-push theory. Cost-pushers believe that the source of
inflation is the rate of wage increases. They believe that wage increases are independent of
all economic factors, and generally are determined by workers and trade unions. More
specifically, inflation occurs when the wages demanded by trade unions and workers add
up to more than the economy is capable of producing.
Cost- pushers advocate limiting the
power of trade unions and using income policies to help fight off inflation.
In between the cost-push and monetarism theory is Keynesianism. Keynesians
recognize the importance of both the money supply and wage rates in determining
inflation. They sometimes advise using monetary and incomes policies as complimentary
measures to reduce inflation, but most often rely on fiscal policy as the cure.
Before we can understand the policies suggested by these different schools of
thought, we must look at the historical development of our understanding of inflation.
For approximately 200 years before John Maynard Keynes wrote the General
Theory of Employment, Interest , and Money, there was a broad agreement among
economists as to the sources of inflationary pressure, known as the quantity theory of
money2. The Quantity theory of money is easily understood through fisher’s equation
MV=PY( money supply times velocity of circulation of money equals price
times real income)
Quantity theorists believe that over an extended period of time the size of M, the
money supply, cannot affect the overall economic output, Y. They also assume that for all
practical purposes V was constant because short term variations in the circulations of
money are short lived, and long term changes in the velocity of circulation are so small as
to be inconsequential .
Lastly, this theory rests on the belief that the supply of money is in
no way determined by the economic output or the demand for money itself.
The central prediction that can now be made is that changes in the money supply
will lead to equiproportionate changes in prices. If the money supply goes up then
individuals initially find themselves with more money. Normally individuals will tend to
spend most of their excess money.
The attempt of people to buy more than they normally
do must result in the bidding up of prices because of the competitive nature of the market,
Also essential to the quantity theory is the belief that in a competitive market,
where wages and prices are free to fluctuate, there would be an automatic tendency for
the market to correct itself and full employment to be established.
In figure 1, w stands for the real wage rate (the amount of goods and services that
an individuals money income can buy), L d for the demand for labor and L s for the supply
for labor. Suppose now that the economic system inherited a real wage rate w 1, The