Theories Of Inflation

Because we differ with Minister Konneh assertion that there is no textbook solution or user’s manual to solve the economic distress the Country is currently experiencing I have presented formidable models of economic to analyze and recommend solutions that may bring about inflationary relief to us. As I set out to write many questions have come to my mind as an economist myself.

* Single digit inflation is acceptable why macroeconomic managers in the Country nervous with 7% rate of inflation?

* Why will an economy with low employment (3.7%) have high inflation?

*Why are consumers agitating?

* Do we have the right reports on inflation and unemployment?

Now, in respect to the determinants of inflation, there are various theories proposed by variouseconomists to explain the occurrence of inflationary situations. The varioustheories of inflation are grouped basically into two broad theories, the excess–demandtheories under the umbrella of expectations-augmented Phillips curve (which comprises themonetarist and the Keynesians theories of inflation) and the cost-push theories which arecurrently termed structuralists/institutional theories of inflation.

Excess-demand theories of inflation

The excess-demand theories argued that excess demand for goods and services over supply inan economy is the main source of inflation. This view that was implicitly reflected in thePhillips empirical study in the late 1950s, which showed a trade-off between unemploymentand inflation (the Phillips curve), led the monetarists to search for a theory that can explainthe existence of excess–demand to propagate inflationary conditions. In their search for thecauses of excess-demand in an economy, the monetarists adopted the quantity theory ofmoney as their point of departure. The original quantity theory is expressed by fisher’sequation of exchange as ;( Curwen, 1976)

MV = PT

Where (M) is the money stock in the economy, (V) represents the velocity of moneycirculation, (P) is the average price level and (T) represents the number of transactions in theeconomy. The classical economists assumed that (V) is constant over time and that theeconomy is at its full employment level, meaning that (T) is also constant. Under theserestrictions, it implies that changes in the money stock (?M) directly affect changes in theprice level. Also, the monetarists with Milton Friedman (1956) as its chief advocate followedthe same line of argument as their predecessors (the classical economists). They only differ inrespect to the assumptions on (V) and (T). Friedman, consider that money demand is one ofthe five main forms of holding wealth (other forms of holding wealth are; equities, bonds,physical goods and human capital) and that any significant change in any of the other formsof wealth would cause velocity of circulation to vary, but only in the long-run.

Based on the fact that velocity of circulation does not change in the short-run but does in thelong-run in a steady manner, Friedman concluded that, money supply and velocity ofcirculation could be treated as existing independently of one another. Considering this as thecase, he concluded that, money national income (Y = T in the original quantity theory) couldbe traced almost exclusively to changes in the money supply. This argument by themonetarists therefore suggests that in the long-run, growth in the money national incomecould only be achieved through adherence to steady long-term growth in the money supply.

Based on this, since velocity of circulation is constant in the short-run, it implies that changesin money national income (Y) must be equal to and move in the same direction as moneysupply changes, if the price level is to remain steady. This implies that any increases in moneysupply beyond the increases in money national income will lead to increases in the generalprice level. Hence when the rate of growth in money supply is greater than that of grossdomestic product in the long run, inflation is the ultimate result. Friedman concluded bysaying that “inflation is always and everywhere a monetary phenomenon”.

Liberia GDP growth rate is 8.7% and Money Supply growth rate is 34.6%[(www.tradingeconomic.com)(World Bank Indicators Report)]. Note that in addition to the LD supply theis a sizable amount of USD in circulation not measured by our monetary authority.

Johnson (1971) also introduces international aspect of inflation into the monetarist theory ofinflation. He when a country expands itsdomestic demand via increases in the domestic money supply, the excess demand generatedwill not only be on domestic products but also on imports. Due to this kind of spillover ofexcess demand, it means that inflationary pressure generated by increases in money supplywill be shared between the domestic sector and the foreign sector. However, He pointed outthat the extent of the spillover effects depends on the size and the marginal propensity toimport by the domestic country where the excess demand originated. This re-enforcesFriedman’s statement that inflation is always a monetary phenomenon.

Liberia recorded a trade deficit of 63.80 USD Million in June of 2013 (CBL report)

Liberia recorded a trade deficit of USD458.75 million in 2012. 20% of imports were for food and live animals and 47% for capital equipment and petroleum products. (MOCI 2012 report)

The other excess-demand theory of inflation is the Keynesians theory of inflation. Their ideasevolved from Keynes-Smithies ideas on inflation, basically the inflation gap model. TheKeynesians argued that, excess demand for goods and services result in inflation which is inline with the monetarist theory, but they differ in respect to what generate the excess demandin the economy. For the Keynesian, excess-demand is the result of increases in aggregatedemand in the economy rather than just increases inmoney supply. They argued that, moneysupply is only one of the components of aggregate demand and therefore cannot solely beresponsible for increases in the general price level; rather it is aggregate demand that entirelyinfluences inflationary situations in a country. Keynesians believe that, factors that influenceaggregate demand in the economy (money supply inclusive) are responsible for the persistentrise in price levels in an economy.

Have we establish what else besides changes in money supply that could influence demand and by so doing contribute to excess demand and if no can we do a study to find out?

Structuralism/ cost-push theory of inflation

The cost-push theory of inflation is a generic term for Marxists, Structuralists and Keynesians theories of inflation that are not based on excess-demand influences in the economy. In thisgroup of theories of inflation, a host of non-monetary supply oriented factors influencing theprice level in the economy are considered. Thus cost-push causes of inflation result when costin production increases independently on aggregate demand.

Liberia presently has high cost of electricity, bad roads and other poor infrastructure.

The Keynesians argued thatwage mark-up via trade unions lead to increases in the cost of production. For the affectedfirms in this regard to maintain their profit margins, they will have to increase prices of theirproducts. The increases in the prices will further put pressure on the trade unions to press forhigher wages which will ultimately lead to further increases in prices and the process continuein that circular manner, known as the price-wage spiral.

The extent to which price-wage spiralaffect the increases in the general price level (inflation) depends on the power of trade-unionsrelative to employers association. The Keynesians went on to point out that when firms gainmore market power, they will be able to push up prices independently in order to make profit.

Simply, firms will increase prices to yield profit; the high prices will cost people/ labor to demand higher wages to match their demand to procure goods and services. Their demand for higher salary will cause firms to increase price: elasticity consider. This may not be the case in Liberia with 3.7% unemployment.

Structuralist ideas on cost-push causes of inflation can be summarised by J. LaurenceLaughlin views in his article in the 1909 journal of political economy (12, P.178). He startedby rejecting the monetarist explanation of inflation. Instead, he proposed that the causes ofinflation “must be sought in the (real) forces settling particular prices” Structuralists believe that, conflicts over the distribution of income between capital and labour, between landownersand peasants, between different producers in different sectors, is the main cause of inflation.This is due to the fact that demand for higher income by one of the following groups (labour,landowners and different producers in different sectors) in excess of their productivity canonly be achieved by each of the other groups (firms, peasants and different producers indifferent sectors) via increases in prices of their products.

Additionally, said here is that if people are producing less than the income they are receiving, the higher income paid to them will come as a result of increases in price and the increase in prices will cause laborers to bid for higher prices. Can we determine if there is a correlation in the case of our Economy?

The Structuralists also consider currency depreciation as an essential part in explaininginflationary situations. This is due to the fact that, in the structuralists’ production process, emphasis is placed on capital input. This implies that in countries were there is lack of foreignreserves; currency depreciation becomes a serious problem with or without foreign exchangecontrol. The currency depreciation leads to high cost of imported raw materials forproduction, which are ultimately passed onto higher prices for goods and services. Besides, Structuralists such as Pazos (1972), Arida and Andre (1985) also pointed out that inflation isgenerally caused by inertia. Inflation inertia is a process where the current inflation rate isdetermined by its past history. This is generally caused by inflationary expectations, relativeprice adjustments, institutional adjustments that support the indexation of wages, financialcontracts, monetary and exchange rate policy frameworks.

From the Keynesian and the structuralist theories of cost–push causes of inflation, the following general factors can be identified as the agents of inflation; wage increases by trade unions, profit motives of firms that gain market power, increase in the prices of raw materialsimported from abroad through currency depreciation and price increase in the worldcommodity market, structure of landownership, inertia, taxes such as value added tax (VAT)and the presence of external shocks such as a dramatic change in oil prices, crop failure andwar.

Quite frankly here we can find synergies of cost-push inflation causes as stated above in the case of Liberia and maybe more.

Conclusion

It remains true that variables in economic models may vary based upon the economic environment but the model/ assumptions remain constant almost always ceteris paribus. Therefore we can only conduct successful macroeconomic management planning, programming and implementation strategies based upon existing assumptions. They have been tested and widely proven to be true.

Now inflation according to the monetarist every and anywhere is a monetary issue. However, studies have shown in the sub-region and elsewhere in South Sahara Africa that changes in price has been cause by more than just changes in the monetary variable. GDP growth has also contributed to price changes therefore price change/ inflation is a macroeconomic management team issue involving both fiscal and monetary agents. Further to this the Central Bank of Liberia is responsible for the cause of inflation in the Country whether by omission or commission and must take the lead to stabilize it. If we must hinge on the fact that we have achieve our inflationary target so be it but the reality remains that consumers are pained by the present price condition. Further to this, without a study I frankly agree that the Central Bank has performed correctly using the appropriate monetary tools. However, the question will be have they used them correctly considering the local economic reality if so can we think outside of the box for new tools/ models and best practice?

On the other hand the imbalance or high price may have been caused by faulty fiscal regime also by omission/ commission on the part of fiscal players. Noteworthy here is that a fiscal regime (borrowing, raising and spending government income) is one that supports output, income/ jobs, etc.

Recommendation

Moving forward to find a solution the Macroeconomic Management (monetary and fiscal) Authorities should commission an empirical study to understand the currency and exchange rate regime, usage of monetary tools and prudency of fiscal regime in Liberia. The terms of reference for such study must be to understand the drivers of the parallel market exchange rate, outline the strengths and weaknesses of alternative possible exchange rate regimes, and how the existing regime may be open to abuse, improvement or changed.This should also includehow prudent monetary tools used by the Central Bank have been effective in meeting Macroeconomic stability targets. For example, the exposure giving to SME and the informal sector by the Central Bank has reported 100% returns but have we considered what has been the impact on demand owing to the transition mechanism networking in a faulty fiscal regime and also how has fiscal policy been effectiveto influence the pattern of economic activities and also the level and growth of aggregate demand, output and employment affect price stability government spending, taxation and borrowing?

George B. GOULD

Economist

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