20

Theories of inflation

INTRODUCTION

One of the key economic questions that economists are concerned with are the causes of inflation. It is only after understanding the causes that attempts can be made to control it and keep it under acceptable limits. Hence, this chapter discusses the various theories of inflation. The theories explain the sources of inflation and thus, act, as a guiding factor in suggesting the different ways in which inflation can be controlled.

The theories can be broadly grouped under two approaches: the monetarist approach and the Keynesian approach.

The proponents of the monetarist approach take the Quantity Theory of Money (QTM) as their basis and propose that the changes in the price level can be explained mainly in terms of the changes in the money supply.

The Keynesian approach argues that an increase in the money supply will lead to only a modest increase in the price level if an economy is operating below full employment. In fact, it will lead to an increase in output and employment. However, when only once a situation of full employment is reached an increase in the money supply will lead to a considerable increase in the price level.

MONETARIST APPROACH TO INFLATION

Fisher’s Approach to the Quantity Theory of Money

Though the QTM is associated with Fisher, economists like Jean Bodin and David Hume had formulated the theory much earlier. They all had emphasized that changes in the supply of money affects the general price level. Later, other quantity theorists like J. S. Mill had stressed that change in the supply of money leads to proportional changes in the general price level. This proportionality was later put forward by Fisher in his QTM.

In Chapter 13, Fisher’s approach was discussed in the context of the demand for money. Some of the aspects of the theory are being repeated here to emphasize the relationship between money and prices.

Fisher’s famous equation of exchange is

where,                  M = total quantity of money in circulation
VT =	transactions velocity of money or the average number of times a unit of money changes hands to perform transactions during a given period of time
PT =	average price of all kinds of market transactions
T =	aggregate of all transactions of goods and services during a given time period

The equation of exchange is a truism because each side of the equation depicts the value (in terms of money) of the total transactions during a given time period. Fisher’s QTM is a tautology and does not make any assertions about the relationships between the variables in the real world. To develop the theory, certain assumptions are necessary; they are:

• Transactions, T: It is assumed that the total volume of transactions is a function of the basic physical and operational characteristics of the economy, namely capital, labour, the factors of production and technology, which are all independent of M, V_T and P_T
• Money, M: It is assumed that the stock of money is determined by the monetary system.
• Velocity of circulation, V_T: V_T is assumed to be constant because payment practices (including the frequency with which people are paid and the irregularity in payments, etc.) change quite slowly.
• Prices, P_T: In the QTM, P_T is the only variable that is influenced by the changes in M. Hence, we get from Eq. (1),
  

From the above analysis, with V_T and T as constants, and P_T as a passive variable, it is implied that P_T changes equiproportionately in response to changes in M.

It is important to note that this equiproportionate relationship between M and P_T will not hold true if there is a change in either V_T or T.

Cambridge Cash Balance Approach

The Cambridge economists Marshall and Pigou presented an alternative formulation of the QTM. In Chapter 13, the Cambridge approach was discussed in the context of demand for money as a function of money income. Here, we emphasize it as a theory of price.

In this neoclassical theory, the demand for money function is:

where,	Md = money demanded
	K = a constant
	Y = the national income in money terms

We have

where,	y = the real national income
	P = general price level

Combining Eqs. (3) and (4), we get

The equilibrium condition in the money market is

Thus, we get from Eqs. (5) and (6),

 

M = KPy

Hence,

In the above equation, P is determined from the QTM.

The Cambridge approach is considered to be advancement over Fisher’s approach in many ways:

1. In the Fisher’s approach, money is treated as a flow variable whereas in the Cambridge approach money refers to the stock of cash balances at a particular point in time and is thus a stock variable.
2. Fisher’s approach emphasizes the strategic role of the supply of money in influencing the price level whereas the Cambridge approach lays emphasis on the demand for money or, in other words, the demand for cash balances.
3. Fisher’s approach lays emphasis on the medium of exchange function of money whereas the Cambridge approach lays stress on the store of value function of money. Hence, the Cambridge approach is consistent with the broader definition of money that includes not only currency and demand deposits but also time deposits in the definition of money.

The Cambridge approach is also superior in that it is in accordance with the demand supply analysis of the money market.

Modern Quantity Theory of Money

In 1956, Milton Friedman had presented his well-known article ‘Quantity Theory of Money—A Restatement’. The modern QTM is a reformulation of the earlier QTM of Friedman. The modern theory is an attempt by Friedman to present the QTM as a theory of demand for money. The earlier versions of the QTM were suffering from the onslaught of the Keynesians who did not give much importance to money supply. Friedman’s theory was an endeavour to save the QTM.

In Chapter 15, Friedman’s theory was discussed in the context of the demand for money. It is sufficient to mention here, as emphasized by Friedman also, that this is clearly a theory of demand for money and not a theory of income or prices. Friedman rejects the view that the QTM is essentially a theory of prices. Friedman has expressed the demand for money in terms of the QTM.

Friedman’s reformulation of the demand for money and, thus, of the QTM has been strongly influenced by Keynes and his liquidity preference theory. Hence, it lays more importance on money as an asset as compared to the earlier versions of the QTM that lay more emphasis on money as a medium of exchange.

Although it is possible to differentiate between the simple QTM and the Keynesian theory without much difficulty, the same cannot be said for the modern QTM. While Friedman sees the modern QTM as simply a statement of the old QTM, others agree that it is more close to the Keynesian theory.

• Fisher’s famous equation of exchange is MV_T = P_TT.
• In Fisher’s approach, the equiproportionate relationship between M and P_T will not hold true if there is a change in either V_T or T.
• The Cambridge approach is considered to be advancement over Fisher’s approach.
• Friedman’s theory lays more importance on money as an asset as compared to the earlier versions of the QTM, which lay more emphasis on money as a medium of exchange.

KEYNESIAN APPROACH TO INFLATION

The classical economists had put forward the importance of the supply of money as the cause of inflation whereas Keynes had argued that inflation occurs due to an increase in the aggregate demand. An increase in the aggregate demand, given the full employment output, leads to an excess demand.

Keynes’ analysis of excess demand was presented in terms of the ‘inflationary gap’ in his book, How to Pay for the War in 1940. It is, in fact, an application of his aggregate demand model to an inflationary situation.

Figure 20.1 depicts an inflationary gap with the help of a Keynesian cross. Initially, the aggregate demand represented by C + I + G equals the aggregate supply at point B. The equilibrium output is Y_f, which is also the full employment output. Suppose there is an increase in the aggregate demand depicted by an upwards shift of the aggregate demand curve to C + I + G + ∆G. This will create an excess demand equal to the amount AB. AB is the inflationary gap, which is actually the excess demand at the full employment output. The inflationary gap is the amount by which the aggregate demand exceeds the aggregate output at the full employment level.

If an economy is in the inflationary gap, then it is obvious that since the output level cannot be increased beyond the full employment level, the prices will increase leading to demand pull inflation.

 

Keynes had argued that for inflation to be controlled it is necessary that the aggregate demand curve must be shifted downwards such that it intersects the 45 degree line at point B. This can be achieved through appropriate policy measures like increasing taxes or reducing government expenditure.

Figure 20.1 Inflationary Gap

It is important to note that Keynes’ theory of inflation is a non-monetary theory as the increases in the money supply do not play any role in the theory.

• An economy can come out of an inflationary gap through appropriate policy measures like increasing taxes or reducing government expenditure.
• Keynes’ theory of inflation is a non-monetary theory as the increases in the money supply do not play any role in the theory.

MODERN APPROACH TO INFLATION

As is obvious from the theories of inflation discussed so far, the prime concern of the economists is to identify the causes of inflation. The modern approach focuses on the fact that the price level is determined by the aggregate demand and the aggregate supply. Thus, changes in the price level can be related to changes in the aggregate demand and the aggregate supply.

 

In Chapter 18, we had analysed the determination of the price level through the aggregate demand and aggregate supply analysis and it will form the analytical basis of our discussion in the present chapter. However, the theories of inflation will be explained in terms of the IS-LM framework.

According to the modern theory, as the price level is determined by aggregate demand and aggregate supply, any change in the price level is caused by a change in either aggregate demand or aggregate supply or both. When the increase in the price level is due to an increase in the aggregate demand, it is called demand pull inflation and when it is due to an increase in the aggregate supply it is called cost push inflation.

 

Inflation: Demand Side

One explanation of inflation is in terms of a generalized excess demand or, in other words, when too much of money is chasing too little of goods. Thus, at the existing price level the demand for goods and services exceeds the supply of goods (or the potential or full employment output) leading to an increase in the general price level.

 We assume that

1. The aggregate supply curve slopes upwards to the right and then becomes perfectly inelastic at the full employment output level.
2. The economy is operating at full employment. Thus, a rightwards shift in the aggregate demand curve influences only the price level. In other words, it leads to a situation of pure inflation, without influencing the output level in any way.

 In terms of the IS-LM analysis, excess demand that further leads to an increase in the price may occur due to

1. a shift in the IS curve to the right due to a change in the real factors, including fiscal actions like a change in government expenditure and taxation;
2. a shift in the LM curve to the right due to a change in the monetary factors like a change in the money supply.

An excess demand (which occurs due to the forces, which are operating only on the demand side of the commodity market) leads to demand pull inflation since the inflation occurs as the aggregate demand is pulled above what the economy’s potential output is in the short run.

Demand Pull Inflation Arising From Real Factors

As already mentioned, demand pull inflation occurs due to a change in the real factors. A change in the real factors leads to a rightward shift of the IS curve. A change in the real factors includes:

1. An increase in government expenditure with no change in tax revenue.
2. A decrease in tax revenue with no change in government expenditure.
3. An upward shift of the investment function.
4. A downward shift of the saving function.
5. An upward shift of the export function.
6. A downward shift of the import function

Figure 20.2 illustrates the process by which demand pull inflation occurs due to a change in the real factors. The intersection of IS₁ and LM curves determines the initial equilibrium at point E₁, with the rate of interest at r₁ and the income level at Y₁, which represents the full employment real output. The aggregate demand curve, which corresponds to IS₁ and LM, is given by AD₁. The curves AD₁ and AS intersect to determine the equilibrium at E₁ with the income level at Y₁ and the price level at P₁.

An increase in investment expenditure shifts the IS curve rightwards from IS ₁ to IS₂. The curve IS₂ intersects the LM curve at point E₂. The new equilibrium is at point E₂, with the rate of interest at r₂ and the income level at Y₂.

Figure 20.2 Demand Pull Inflation Arising from Real Factors

The aggregate demand curve, which corresponds to LM and IS₂, is AD₂. The intersection of curves AD₂ and AS determines the price level at P₂. The increase in the price level from P₁ to P₂ is required to eliminate the excess demand, equal to Y₂ – Y₁ that exists at the price level P₁. This excess demand is a result of a rightward shift in the IS curve. The increase in the price to P₂ eliminates the excess demand to re-establish equilibrium at the full employment income Y₁ and the price level P₂.

The analysis would be the same with any of the other factors discussed above, which lead to a rightward shift of the IS curve.

Demand Pull Inflation Arising From Monetary Factors

Demand pull inflation also occurs due to a change in the monetary factors. A change in the monetary factors leads to a rightward shift of the LM curve. A change in the monetary factors includes

1. an increase in the money supply, and
2. a decrease in the demand for money.

In general, the increase in the money supply plays a more important role as far as the shift in the LM curve is concerned. Figure 20.3 illustrates the process by which demand pull inflation occurs due to a change in the monetary factors. The intersection of IS and LM₁ curves determines the initial equilibrium at point E₁ with the rate of interest at r₁ and the income level at Y₁. The income Y₁ represents the full employment real output. The aggregate demand curve, which corresponds to IS and LM₁ is given by AD₁. The intersection of the curves AD₁ and AS determines the equilibrium at E₁ with the income level at Y₁ and the price level at P₁.

An increase in the money supply shifts the LM curve rightwards from LM₁ to LM₂. The curve LM₂ intersects the IS curve at point E₂. The new equilibrium is at point E₂ with the rate of interest at a lower level of r₂ and the income level at Y₂.

Figure 20.3 Demand Pull Inflation Arising from Monetary Factors

The aggregate demand curve, which corresponds to IS and LM₂ is given as AD₂; the curves AD₂ and AS intersect to determine the price level at P₂. Once again, the increase in the price level from P₁ to P₂ is required to eliminate the excess demand equal to Y₂ – Y₁ that exists at the price level P₁. This excess demand is a result of a rightward shift in the LM curve. The increase in the price to P₂ eliminates the excess demand to re-establish equilibrium at the full employment income Y₁ and the price level P₂.

For a persistent increase in the price level, there should be a persistent increase in the money supply. The analysis would be the same with any of the other factors discussed above, which lead to a rightward shift in the LM curve.

There is a disagreement among economists regarding the importance of the factors that cause inflation. Friedman is of the view that inflation is caused by monetary factors whereas Hicks is of the opinion that money plays only a supportive role as far as inflation is concerned. Thus, economists differ in their opinion as to the role performed by the real and monetary factors in the modern demand pull inflation.

Inflation: Supply Side

Another explanation of inflation is in terms of the supply side, called supply or cost push inflation.

Cost Push Inflation

The theories of cost push, also called mark up or seller’s, inflation came in the 1950s. They appeared to refute the demand pull theories of inflation. These theories lay emphasis on an autonomous increase in some component of cost as the source of inflation and which leads to an upward shift in the supply curve. Three ingredients that are common to these theories are:

1. The upward push in costs is independent of the demand conditions prevailing in the relevant market.
2. The push forces work through some important component of cost like wage and profits.
3. The increase in the costs is not absorbed by the firms, which are producing the good but are passed on to the consumers of the good.

There are three main kinds of cost push inflation:

(1) Wage push inflation: This is caused by an increase in the money wage rate, which is in excess of the increases in the labour productivity. The reason behind this increase in the money wage may be the monopoly power of the trade union in the imperfectly competitive labour markets, which may pressurize the employers for a wage increase. As this increase does not match an increase in the labour productivity, it will lead to an increase in the cost of production and thus to an upward shift in the supply curve. This will further lead to an increase in the price level.

To analyse as to how an increase in the money wage rate leads to a shift in the supply curve, the four quadrant diagram used in Chapter 18 to derive the upward sloping aggregate supply curve is being repeated here.

It is assumed that the marginal productivity of labour is diminishing. Figure 20.4 depicts cost push inflation arising from an autonomous increase in the wage rate.

Assume that the existing money wage rate is W₁ as depicted by the curve W₁ in Quadrant C. Corresponding to W₁, the AS₁ has been derived in Quadrant D. The AD and AS₁ curves intersect to determine the initial equilibrium at point E₁ with the income at Y₁ and the price level at P₁.

Figure 20.4 Cost Push Inflation Arising from an Autonomous Increase in the Wage Rate

Next suppose that there is an increase in the wage rate to W₂, which is entirely due to the monopoly power of the labour union and is in no way linked to increases in the labour productivity or any increase in the demand for labour. This leads to a shift in the money wage curve to W₂ in Quadrant C. With there being no shifts in the curves in Quadrant A and Quadrant B, the AS curve in Quadrant D will now shift to AS₂. At the price P₁ the aggregate demand exceeds the aggregate supply by Y₂ Y₁. Hence, there is an increase in the price level till a new equilibrium is established at point E₂. Thus, the AD and AS₂ curves intersect to determine the new equilibrium at point E₂ with the income at Y₂ and the price level at P₂.

It is to be noted from the above analysis that an increase in the money wage rate leads to

1. a decrease in the income or output;
2. an increase in the price level; and
3. a decrease in the employment.

Wage inflation cannot occur in an economy where the labour markets are competitive. In such a market, the money wage rate will increase or decrease only in response to variation in the supply or demand for labour.

For a wage push inflation to occur, it is not necessary that the labour market is completely unionized. It is sufficient that a small segment of the labour market is unionized because then the effect of a wage push in the unionized industries may spread to the non-unionized industries. This is because the non-union wages are closely linked to the union wages.

It is not necessary that every increase in the money wage rate leads to a wage push inflation. An increase in the money wage rate does not lead to a wage push under certain conditions:

1. When the increase in the money wage rate is matched by increases in the labour productivity.
2. When an increase in the money wage rate results from an excess demand for labour, derived from the upward shift in the aggregate demand for goods (and not due to the monopoly power of the labour union).

(2) Profit push inflation: This is caused by the exercise of the monopoly power of the oligopolistic and monopolistic industries to enhance their profit margin. Thus, the monopolists and oligopolists may often go in for a price rise which is more than any increase in the costs.

We have observed that for a wage push inflation to occur, the existence of a unionized labour is necessary. Similarly for a profit push inflation to occur, the existence of imperfect competition in the sale of goods is a necessary condition. It is in such imperfect markets that the seller is successful in administering prices such that they increase at a rate much greater than the costs.

The process is the same as that described in Figure 20.4, which depicts wage push inflation. The aggregate supply curve shifts upwards from AS₁ to AS₂ in Quadrant D resulting in profit push inflation.

Some economists are of the opinion that a monopolist will not increase his price randomly. He has to take into consideration factors like demand for the good, sales and unit costs before he sets the price. It is often argued that the responsibility for supply side inflation rests more with the labour unions who are more concerned with increases in the wage rates than with other considerations.

(3) Supply-Shock inflation: This is caused by occurrences like the increase in the prices by the OPEC and even crop failures.

The process here again is the same as that described in Figure 20.4, which depicts wage push inflation and also profit push inflation. The aggregate supply curve shifts upwards from AS₁ to AS₂ in Quadrant D resulting in supply-shock inflation. The difference is in the driving force that leads to the inflation.

The monopolists and oligopolists on the one hand and the labour unions on the other hand exercise some kind of power that is different from the powers exercised by organizations like the OPEC. Unlike the monopolists and the labour unions, which are subject to the control of the authorities, the OPEC is a foreign organization which is outside the control of any authorities.

Similarly, crop failures and crop shortages are again subject to the vagaries of nature and thus beyond the control of any government. It is also important to note that supply shocks are unanticipated and unexpected.

Relationship Between Demand Side Inflation and Supply Side Inflation

Till now we have focused individually on the demand side and supply side inflation; however, some economists are of the view that any inflationary process contains some aspects of both demand side and supply side inflation.

It cannot be denied that there is an asymmetry between the two sides of inflation as depicted in Figure 20.5. Suppose, initially, the equilibrium is at point E with the output at Y₁, the full employment output and the price level at P₁. Two situations are possible:

1. An inflationary process may begin with an excess demand and may continue as long as the excess demand persists. In the figure, this is depicted by the shifts in the aggregate demand curve from AD₁ to AD₂ and further to AD₃. The aggregate supply curve will remain unchanged at AS₁. Cost push factors are not playing any role whatsoever in the inflation process. As a result, the equilibrium shifts from point E to A to C. While the output will remain at Y₁, the prices will increase from P₁ to P₄ and so on. It is quite possible that in the extreme case there may occur a situation of hyperinflation.

   It is quite possible that due to the rise in the aggregate demand, in a situation of full employment, the wage rates may increase. The increase in the money wage rate shifts the AS₁ curve to AS₂, which intersects AD₂ at point A. However, it is quite possible that the increase in the prices leads to a situation where the producers find their profits lower. Thus, they increase the administered prices. This creates a situation of a wage-price spiral where the general price level and the money wage rates follow each other in an upward spiral.

2. An inflationary process may begin on the supply side but it will not continue unless there is an excess demand. In the figure, this is depicted by the shifts in the aggregate supply curve from AS₁ to AS₂ and further to AS₃. The aggregate demand curve will remain unchanged at AD₁. Demand pull factors are not playing any role whatsoever in this inflation process. As a result, the equilibrium shifts from point E to F to G. While the output (and thus the employment level) will decrease from Y₁ to Y₂ to Y₃, the prices will increase from P₁ to P₂ to P₃ and so on. The successive decreases in the output level and the growing unemployment levels will ultimately put an end to the inflation process.

   The increase in the money wage rates leads to an increase in the prices. However, this increase in the prices will not be sustained unless it is followed by appropriate changes in the aggregate demand.

   

   Figure 20.5 Relationship Between Demand Side Inflation and Supply Side Inflation

• Friedman is of the view that inflation is caused by monetary factors whereas Hicks is of the opinion that money plays only a supportive role as far as inflation is concerned.
• For a wage push inflation to occur, it is not necessary that the labour market is completely unionized. It is sufficient that a small segment of the labour market is unionized.
• For a profit push inflation to occur, the existence of imperfect competition in the sale of goods is a necessary condition.
• It is often argued that the responsibility for supply side inflation rests more with the labour unions who are more concerned with increases in the wage rates than with other considerations.
• An inflationary process may begin with an excess demand and may continue as long as the excess demand persists.
• An inflationary process may begin on the supply side but it will not continue unless there is an excess demand.

CONTROL OF INFLATION

As far as the demand side inflation is concerned, restrictive monetary and fiscal policies are commonly used to control the inflation. Any increases in investment, government expenditure or foreign expenditures that lead to a rightward shift of the aggregate demand curve leading to an increase in the price level can be counteracted by restrictive monetary and fiscal policies. This is because such policies have an immediate impact on the level of the aggregate demand.

As far as the supply side inflation is concerned, restrictive monetary and fiscal policies are not appropriate for controlling inflation. This is because supply side inflation is accompanied by rising prices and an output below the full employment level.

In Figure 20.6, the intersection of the curves AS₁ and AD₂ at point E determines the full employment output at Y₁ and the price level at P₁. Assume an increase in the money wage rates, which leads to a shift of the AS₁ curve to AS₂. The intersection of the curves AS₂ and AD₂ at point F depicts a decrease in the output to Y₂ while the price level rises to the P₂.

An attempt at using restrictive monetary and fiscal policies to prevent the price rise will lead to a shift of the aggregate demand curve to AD₁. The intersection of the curves AS₂ and AD₁ at point G depicts a further decrease in the output to Y₃ while the price level remains unchanged at P₁. Hence, it is apparent that an attempt at controlling a supply side inflation through restrictive monetary and fiscal policies can be achieved only at the cost of a reduction in the output and hence in the employment level. Such an increase in the unemployment may not be socially acceptable and may, in fact, result in an economic slowdown. Thus in such cases, price stability can be achieved only at the cost of an increase in the unemployment rate.

Figure 20.6 Supply Side Inflation and Restrictive Monetary and Fiscal Policies

Indexation

Indexation is a method by which there is an automatic adjustment of wages and prices according to the rate of inflation. Indexation reduces the reaction of people to inflation.

 

There are two kinds of contracts, which are especially affected by inflation. These are as follows.

1. Long-term loan contracts, which are for a period of 25 to 30 years with a fixed nominal interest rate for the entire period like housing loan. For the long-term lenders and borrowers, the rate of inflation is of great importance for the next 25 or 30 years. Thus in countries where the inflation rates are not only high but also uncertain, the long-term nominal loans turn out to be very risky. The lenders are not certain about the real value of the repayments that they expect to receive. Hence to tackle such situations, the governments in such countries may issue what is called indexed debt. Indexed debt is a debt where the interest payments are adjusted upwards every year to account for inflation.
2. Wage contract: Often, the labour contracts incorporate automatic cost-of-living adjustment (COLA) provisions. These provisions index the wage to the inflation rate. Hence, they make it possible for the workers to recover the purchasing power that they have lost due to the increase in the prices. Wage indexation is more widespread in the countries with high inflation rates.

• An attempt at controlling a supply side inflation through restrictive monetary and fiscal policies can be achieved only at the cost of a reduction in the output and, hence, in the employment level.
• Cost-of-living adjustment provisions index the wage to the inflation rate making it possible for the workers to recover the purchasing power that they have lost due to the increase in the prices.

INTRODUCTION

1. This chapter discusses the various theories of inflation. The theories explain the sources of inflation and, thus, act as a guiding factor in suggesting the different ways in which inflation can be controlled.
2. The theories can be broadly grouped under two approaches: the monetarist approach and the Keynesian approach.

FISHER’S APPROACH TO THE QUANTITY THEORY OF MONEY

1. Though the Quantity Theory of Money (QTM) is associated with Fisher, economists like Jean Bodin and David Hume had formulated the theory much earlier.
2. Later, other quantity theorists like J. S. Mill had stressed that change in the supply of money leads to proportional changes in the general price level. This proportionality was later put forward by Fisher in his QTM.
3. Fisher’s famous equation of exchange is MV_T = P_TT.
4. Fisher’s QTM is a tautology and does not make any assertions about the relationships between the variables in the real world. To develop the theory, certain assumptions are necessary.

CAMBRIDGE CASH BALANCE APPROACH

1. The Cambridge economists Marshall and Pigou presented an alternative formulation of the QTM.
2. In this neoclassical theory, the demand for money function is M_d = KY.
   Also, M = KPy where, P is determined from the QTM as
3. The Cambridge approach is considered to be an advance over Fisher’s approach in many ways; for example, while Fisher’s approach lays emphasis on the medium of exchange function of money the Cambridge approach lays stress on the store of value function of money. The Cambridge approach is also superior in that it is in accordance with the demand supply analysis of the money market.

MODERN QUANTITY THEORY OF MONEY

1. The modern theory is an attempt by Friedman to present the QTM as a theory of demand for money.
2. Friedman’s reformulation of the demand for money lays more importance on money as an asset as compared to the earlier versions of the QTM, which lay more emphasis on money as a medium of exchange.

KEYNESIAN APPROACH TO INFLATION

1. Keynes had argued that inflation occurs due to an increase in the aggregate demand.
2. The inflationary gap is the amount by which the aggregate demand exceeds the aggregate output at the full employment level.
3. Keynes had argued that inflation can be controlled through appropriate policy measures, like increasing taxes or reducing government expenditure.
4. It is important to note that Keynes’ theory of inflation is a non-monetary theory as the increases in the money supply do not play any role in the theory.

MODERN APPROACH TO INFLATION

1. The modern approach focuses on the fact that the price level is determined by the aggregate demand and the aggregate supply. Thus, changes in the price level can be related to changes in aggregate demand and the aggregate supply.
2. When the increase in the price level is due to an increase in the aggregate demand, it is called demand pull inflation and when it is due to an increase in the aggregate supply it is called cost push inflation.

INFLATION: DEMAND SIDE

1. One explanation of inflation is in terms of a generalized excess demand or, in other words, when too much of money is chasing too little of goods.
2. In terms of the IS-LM analysis, excess demand that leads to an excess demand inflation may occur due to a shift in the IS curve to the right due to a change in the real factors, or a shift in the LM curve to the right due to a change in the monetary factors.
3. Demand pull inflation occurs due to a change in the real factors. A change in the real factors leads to a rightward shift of the IS curve. For example, an increase in investment expenditure shifts the IS curve rightwards leading to a shift in aggregate demand. There occurs an excess demand, which leads to an increase in the price level. The increase in the price level eliminates the excess demand to re-establish equilibrium at the full employment income level but with a higher price level.
4. Demand pull inflation also occurs due to a change in the monetary factors. A change in the monetary factors leads to a rightward shift of the LM curve. In general, an increase in the supply of money shifts the LM curve rightwards leading to a shift in aggregate demand. There occurs an excess demand, which leads to an increase in the price level. The increase in the price level eliminates the excess demand to re-establish equilibrium at the full employment income level but with a higher price level.

INFLATION: SUPPLY SIDE

1. Another explanation of inflation is in terms of the supply side, called supply or cost push inflation.
2. The theories of cost push lay emphasis on an autonomous increase in some component of cost as the source of inflation and which leads to an upward shift in the supply curve.
3. There are three main kinds of cost push inflation.
4. Wage push inflation is caused by an increase in the money wage rate which is in excess of the increases in the labour productivity. For a wage push inflation to occur, it is not necessary that the labour market is completely unionized. It is sufficient that a small segment of the labour market is unionized.
5. Profit push inflation is caused by the exercise of the monopoly power of the oligopolistic and monopolistic industries to enhance their profit margin. For a profit push inflation to occur, the existence of imperfect competition in the sale of goods is a necessary condition.
6. Supply shock inflation is caused by occurrences like the increase in the prices by the OPEC and even crop failures. It is also important to note that supply shocks are unanticipated and unexpected.

RELATIONSHIP BETWEEN DEMAND SIDE INFLATION AND SUPPLY SIDE INFLATION

1. Some economists are of the view that any inflationary process contains some aspects of both demand side and supply side inflation.
2. An inflationary process may begin with an excess demand and may continue as long as the excess demand persists.
3. An inflationary process may begin on the supply side but it will not continue unless there is an excess demand.

CONTROL OF INFLATION

1. As far as the demand side inflation is concerned, restrictive monetary and fiscal policies are commonly used to control the inflation.
2. As far as the supply side inflation is concerned, restrictive monetary and fiscal policies are not appropriate for controlling the inflation.
3. Any attempt at controlling a supply side inflation through restrictive monetary and fiscal policies can be achieved only at the cost of a reduction in the output and hence in the employment level.

INDEXATION

1. Indexation is a method by which there is an automatic adjustment of wages and prices according to the rate of inflation. Indexation reduces the reaction of people to inflation.
2. There are two kinds of contracts, which are especially affected by inflation.
3. Long-term loan contracts are for a period of 25 to 30 years. In countries where the inflation rates are not only high but also uncertain, the long-term nominal loans turn out to be very risky. To tackle such situations, the governments in such countries may issue what is called indexed debt. Indexed debt is a debt where the interest payments are adjusted upwards every year to account for inflation. Wage contracts: Often, the labour contracts incorporate automatic cost-of-living adjustment (COLA) provisions. These provisions index the wage to the inflation rate.

TRUE OR FALSE QUESTIONS

1. Fisher’s QTM is a tautology and does not make any assertions about the relationships between the variables in the real world.
2. Fisher’s approach lays emphasis on the store of value function of money whereas the Cambridge approach lays stress on the medium of exchange function of money.
3. Friedman’s theory is a theory of demand for money.
4. The inflationary gap is the amount by which the aggregate output exceeds the aggregate demand at the full employment level.
5. When the increase in the price level is due to an increase in the aggregate demand, it is called cost push inflation.

VERY SHORT-ANSWER QUESTIONS

1. What is an inflationary gap? Discuss.
2. How can an economy move out of an inflationary gap?

3. (a) What is demand pull inflation?

   (b) What is cost push inflation?

4. How can demand pull inflation occur due to a change in the real factors? Explain.
5. How can demand pull inflation occur due to a change in the monetary factors? Explain.

SHORT-ANSWER QUESTIONS

1. ‘The Cambridge approach is considered to be an advance over Fisher’s approach in many ways.’ Explain.
2. Write a short note on Friedman’s modern quantity theory of money.
3. What is the Keynesian approach to inflation? Discuss.
4. How can inflation be controlled? Discuss.
5. What is indexation? Discuss.

LONG-ANSWER QUESTIONS

1. Compare Fisher’s approach to the quantity theory of money with the Cambridge cash balance approach.
2. What is the monetarist approach to inflation? Explain.
3. What is demand pull inflation? Compare demand pull inflation arising from real factors with that arising from monetary factors.
4. What is cost push inflation? Which are the three main kinds of cost push inflation?

5. (a) Is there a difference between demand side and supply side inflation?

   (b) Analyse the relationship between demand side inflation and supply side inflation.

TRUE OR FALSE QUESTIONS

1. True. As Fisher’s QTM is a tautology and does not make any assertions about the relationships between the variables in the real world, to develop the theory certain assumptions are necessary.
2. False. Fisher’s approach lays emphasis on the medium of exchange function of money whereas the Cambridge approach lays stress on the store of value function of money.
3. True. Friedman’s theory is clearly a theory of demand for money and not a theory of income or prices.
4. False. The inflationary gap is the amount by which the aggregate demand exceeds the aggregate output at the full employment level.
5. False. When the increase in the price level is due to an increase in the aggregate demand, it is called demand pull inflation.