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.
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It was generally assumed from past experience, that once the conomy 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 ith 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 nflation 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 nflation. 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 o 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, inflation. Also essential to the quantity theory is the belief that in a competitive market, here 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 supply of labor is L s1 while the demand for labor is only L d1. At this point there is substantial unemployment because labor is costly for employers to buy. According to Classicalists, The existence of an excess supply of labor will lead to a competitive struggle between the unemployed and employed for the available jobs.
This struggle will lead to a reduction of real wages, thus employers will begin hiring more workers. Eventually competition will drive down wages to an equilibrium called labor- market clearance, where the demand and supply for labor is equal; this is We Le. Classicalists define Labor market clearance as the point of full employment. Thus, persistent unemployment can only be explained by a mechanism which interferes with a ompetitive market. They specifically blame monopolistic trade unions for preventing the wage rate from falling to We. Unions may use many threatening tactics to fight wage cuts.
Those most effective mentioned in the textbooks are collective bargaining and strikes. The Great depression, as experienced by the US and the countries of western Europe, cast a shadow over the Classical approach to economics3. The self-righting properties of classical economics were clearly not working when wages and unemployment failed to decrease. Blaming trade unions for these massive increases in nemployment seemed far fetched. John Maynard Keynes was the first writer to produce a non-classical, coherent, and convincing explanation of the inter-war depression.
He traced the sources of unemployment to a deficiency of effective demand. Put simply, unemployment occurred when total spending on output was not enough to fully employ the available workforce. Effective demand, called expenditures, was split into two groups by Keynes, consumption and investment. Consumption, the purchase of goods and services, far outweighed investment as the major component of effective demand. At the theories” core lay Keynes’ belief that an economies” total production, Y, will eventually adapt itself to changes expenditures.
Moreover Keynes argued that the equilibrium of wages exist when the output of producers is equal to the amount that consumers and investors are willing to spend on their output. Consider figure 2 Total expenditure, that is the sum of consumption and investment , is measured on the vertical and real income on the horizontal. For practical purposes investment will remain a constant in the graph and be represented by line I. If we dd the consumption function and the investment line, we get the the sum total expenditures, line E (E = C+I).
For any given amount of expenditures, Y can be located anywhere for a short time. If Y is above E, then producers are simply accumulating unsold stocks of goods. Eventually they will be forced to cut back on production until they can sell their existing stocks, earning capital enough capital to restart production. Conversely, If Y is below E, producers will be selling out of goods. Normally they will increase production as soon as possible to catch up to the demand and make the most profit. This is where, the 45 line comes into use.
Y, according to Keynes, will shift to the point where E intersects the 45 line. When Y intersects E at the 45 line, there is an equilibrium between expenditures and total output, and wages are stable. In order to illustrate how Keynes’ principle of effective demand accounts for unemployment, let us assume that the economy starts off at full employment where Ld (demand for labor) equals Ls (supply). The label of the output necessary to sustain full employment is Yf, f denoting full employment. If expenditures were smaller than Yf, than
Yf would adjust itself to the left on the graph to accommodate for this. Because the level of total output has shrunk, the demand for labor also has, and unemployment has risen correspondingly . If one accepts the Keynesian model, there are generally two things that can be done to raise the level of aggregate demand to a point where Y adjusts to full employment. Raising government expenditures, G, stimulating private investment, or lowering taxes, raising consumption because people will have more money to spend, will both raise the level of aggregate demand.
Both these policies come under the heading of iscal policy, which is deliberate manipulation of the government budget deficit in order to achieve an economic objective. During the great depression, many people rejected Keynes’ ideas on unemployment because they were scared to be different. The contemporary orthodox view was that cuts in the money wages would automatically be accompanied by cuts in the real wages, thus raising employment. Classicalists prescribed the government a remedy for unemployment based on implementing money wage reductions.
Keynes rejected this idea on both theoretical and empirical grounds. After the first World War, collective bargaining rendered the downward flexibility of wages highly improbable. Any attempts at cutting money wages would be fiercely resisted, as seen as the 1926 General Strike in Britain painfully demonstrated. Keynes regarded the trade unions’ resistance to wage cuts as a product of the rigid structure of wage differentials. This is actually just the relative position of the wages of a particular type of labor to all others, F. E. mechanics get paid 1$,Electricians get 2$, plumbers get 3$.
If any one group received generally higher wages, other groups would surely demand igher wages to preserve the structure. On the other hand, if a single group wantonly decided to accept a wage cut, other groups would likely not follow. Therefore labor groups vehemently resisted wage cuts. Theoretically, Keynes believed that drops in the money wages would eventually be accompanied by a drops in prices. This balanced deflation would bring real wages, the amount of goods that could be bought, to their original amount. Employers would not take on more workers because their real revenue, amount of goods they sell, would remain unchanged.