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[Note for bibliographic reference: Melberg, Hans O. (1992), Inflation: An overview of theories and solutions, http://www.oocities.org/hmelberg/papers/921201.htm]
[Comments: This paper is best suited for undergraduates who want a short, non-technical overview of theories of and solutions to inflation.]



Inflation: An overview of theories and solutions

This essay will discuss how one could defeat inflation. It would be a lie to say that the answers presented are scientifically correct, because the fact is that inflation is a complex phenomena which is not yet fully understood. Hence, the answers presented can only be a part of a larger unknown picture.

What is inflation?
First of all: What is inflation? The definition of inflation is a general rise in the price level in an area over a certain period of time. The usual approximate measure of this is the Consumer Price Index which weigh the prices of different goods according to importance in a typical budget and then see how much the prices of these goods have increased. This immediately raises some problems. For example the weighting must change over time. The importance of computers was not measured in the price index 100 years ago. Another problem is the failure of the price index to capture changes in quality. Has the price of a good risen by 10% if the quality at the same time has improved by 20%. The consumer price index says so, but many would disagree. Hence, inflation is not easy to define in practice. This should be kept in mind when discussing how to defeat inflation.

Why do we want to reduce it?
The second question one must ask, before one discusses the methods for defeating inflation, is why one would want to reduce inflation. The answer is that inflation has distortionary effects because if make planning more difficult. It also changes the income distribution in society in favour of those with much capital and against people with relatively fixed nominal wages. Finally there is a psychological cost. People simply do not like inflation and price increases. So, given that inflation is costly - how should it be defeated.

The structure of this essay
The structure of this essay in answering this question is to present and evaluate different theories of inflation. The theories are important because when one tries to defeat inflation one must first clarify the causes of inflation. The theories present hypothesises about these causes. The basic microeconomic question is why a firm would rise its price. Costs of input, such as labour (wage), is clearly one part of the answer, but the theories present different models for explaining the phenomena and hence different ways of fighting inflation.

The Classical theory: The money supply
One way of defeating inflation, according to the early classical economists, is to reduce the money supply. The prescription arises from their belief that the economy always operates in equilibrium. The result of this belief is that when the money supply increases, this will simply result in more money chasing the same amount of goods. The excess demand will then increase the price level back to equilibrium (fast or immediately) and nothing in the "real" sector of the economy has changed. The only difference is an increase in the price level. Clearly there are some problems with this model. The main problem is that it ignores the possible rigidities in the economy. For example the adjustment processes might work at different speeds. Another problem is that it does not account for the real affects of changes in the monetary sector to the goods sector.

Keynes's theory I: Fixed-price models: Rigidities
In response to the deficiencies of the Classical theory, Keynes developed a new theory of inflation. This theory stressed rigidities in the economy, most importantly in the labour market. These source of these rigidities was that workers were reluctant to reduce their nominal wages. Another rigidity was that firms did not always change their prices as a response to changes in demand, often increasing output instead. Putting these rigidities (and others) together one gets what is called a fixed-price model. In this model there are several ways of defeating inflation. The basic cause of inflation is excess aggregate demand and hence the most obvious cure is to reduce aggregate demand. The policy instruments available to do this could be tax increases or cuts in public spending. Another possibility in this model is to reduce the rigidities. For example one rigidity in the labour market was the reluctance of workers to cut nominal wages because it changed the relative wages. In other words they were afraid of cutting earlier than others, or more than others, and consequently loose relatively to others in the adjustment process towards a real wage level that is compatible with the output level. So, instead they preferred inflation which affected most incomes equally i.e. they did not lose their relative status position. One way of reducing this rigidity would be to use income policies. Highly centralised unions, employer organisations and the government would sit down and negotiate a deal that would reduce the rate of wage increase while at the same time keep most of the relative wage differences stable. Alternatively the government could impose a wage/price law saying that no one could increase prices more than eg. 0%.

What are the problems with the original Keynesian model of inflation? One argument has been that it cannot explain stagflation (simultaneous inflation and rise in the unemployment level). This is so, the argument goes, because inflation indicates excess demand, while rising unemployment signals deficient demand. This argument against the Keynesian model is false. The reason is that Keynes clearly recognised that the supply side was also important. A change in the aggregate supply curve caused by for example the oil-shock in 1973, means that the economy has to adjust to a higher price level and a lower level of output. This adjustment process implies both inflation and rising unemployment. Hence stagflation does not refute the Keynesian model.

Monetarism I
The first wave of monetarism criticised the long term implications of Keynes theories. In their view demand management could not work because government "fine-tuning" was practically impossible. Income policies too were condemned as a means to reduce inflation because of the high administrative costs and the distortionary effects of preventing the market forces to allocate resources. The monetarist prescription for defeating inflation was to keep the money supply growing at a steady rate. This rate would be approximately the same as the growth of the productivity in the economy and hence the price level would remain stable. There are several problems attached to this theory. Firstly, the definition of money is not obvious. There is M1, M2, M3 etc. and there are money substitutes, available credit and different interest rates. Secondly, even if it could be defined it is not necessarily easy to measure or to control. The banking system cannot be forced to do what the government wants. For example the government may try to sell bonds to decrease the money supply, but the banks are not forced to buy the bonds. Another problem is the endogeneity of the money supply itself. It is perfectly possible that if the government tries to decrease the money supply, then different kinds of money substituted develop. The banks may lend out more money than the government wants. There are also institutions (eg. credit card organizations) that function as "money suppliers." Hence, the demand for money may influence the supply. Thus, the government may not be able to control the money supply to the extent that the monetarist theory require.

A final problem with this theory of inflation is that it may require a very deep recession to bring inflation down. The first effect of a reduced growth in the money supply (or an actual cut) is to reduce the aggregate demand (or reduce the growth of aggregate demand). As a result of the reduction in aggregate demand, output is lower and unemployment increases. This may (not necessarily) reduce wages and hence the adjustment process towards the long run equilibrium with even the labour market in equilibrium may be quick. But, more likely as people in the UK should know, the adjustment process towards the long run equilibrium is long. This implies a long period with high unemployment. This again, implies large social costs which might not be reversible i.e. there could be a hysteresis effect. The process of adjustment might make many of the unemployed "unemployable" and they consequently exert no downward pressure on the wages in the labour market. As a result Friedman's Natural Rate of unemployment may increase significantly as a result of his medicine. Added to this there is the problem that a lower money supply implies a higher interest rate which reduces investment. This, in the long run, reduces the productivity and the output capacity of the economy. If this happens then an even larger cut in the money supply is needed to defeat inflation. This is so because the adjustment process reduces the output and there is a situation of "equal amount of money chasing fewer goods" and the resulting inflation.

These criticisms do not mean that the money supply is insignificant in controlling inflation. One could easily agree that a large increase in the money supply will cause inflation. This is accepted easily even in the Keynesian model (a large increase in aggregate demand so the demand is larger than the production possobility creates inflation). What is not accepted however is that a 10% reduction in the money supply will simply reverse the consequences of previous 10% increase in the money supply. There is an asymmetry working through different rigidities and through hysteresis. These asymmetries and rigidities makes the defeat of inflation simply be monetary means very costly.

Supply Side theory
Another method of defeating inflation could be to work on the supply side. This theory side is ideologically related to monetarism, but it is not a necessary theoretical part of it. Simply put one could defeat inflation by encouraging the supply of more goods. The logic is that if too much money is chasing not enough goods then, instead of painfully reducing the amount of money in the economy, one could instead increase the amount of goods. This theory has been treated with contemp by many Keynesian economists because it is said to represent a right wing ideology of reducing consumer protection, ignoring environmental regulation, reduce the right of labour and reduce the taxes for the rich thus worsening the income distribution. Besides it only represents one-shot gains ie. once the de-regulation has taken place one cannot increase supply further. Viewed in this light the supply side solution for defeating inflation seems very unsympathetic. However, one could look upon supply side economic in a more favourable light. One should not deny that supply matters and government intervention to increase productivity for example by encouraging research and development, may well contribute to defeat inflation in the longer term.

Keynesian theory II: Imperfect competition
The monetarists theory provoked a new Keynesian theory. This is the theory of imperfect competition. One should start by realizing that the price level is exogenous for the individual worker in a wage negotiation, but endogenous for all the workers in a wage negotiation. Further on one should note that in the real world wage negotiations are unsynchronised and discrete (with different frequencies). Inflation in this theory is the result of a fight between workers to keep high wages and firms to keep high profits. If the workers get "too" high wages, the firm will increase the prices of its goods (mark-up pricing) and hence there is inflation. How could one defeat inflation in this theory?

Clearly one could try to increase the flexibility of the system. The "political incorrect" solution would be to make labour less powerful. For example by decreasing the power of unions, allowing short term contracts or contracts that give much power to the employer and little to the employee. However, there is a "political correct" side to the equation too. One could regulate the profit margins of firms by for example taxing profits heavily or make a legal rule regarding the size of the mark-up. (Though this could lead to over-capitalization in the firm ...) Isolated all these measures defeats some inflationary tendencies. Also "intelligent" income policies becomes a weapon against inflation. Centralized wage negotiations in cooperation with the government would make labour more conscious of the endogeneity of the price level and the government could prevent the employees from increasing its profit too much.

Monetarism II (New Classical Theory)
One final theory that provides weapons with which inflation can be defeated, is the New Classical theory also called Monetarism wave II. In this theory markets are always in equilibrium and expectations are rational. A representative economist of this theory is Lucas. His theory about inflation is that for a very short time firms are uncertain whether they are facing a relative price increase as a result of higher demand or if it is a general inflationary price increase. As it, quickly, finds out about this it will then increase it's own price according to its rational expectations about future price developments (as judged by government monetary and fiscal policies, news in the media, confidence etc. - all relevant considerations). The way to reduce inflation in this framework is to ensure creditability through keeping a though reputation and simply communicating the right signals to the market. For example a deep recession may work as a signal that the government is "though" and serious when it comes to reducing inflation. The main problem with this theory is that it ignores the empirically demonstrated rigidities in the economy such as sticky nominal wages.

About expectations
The last example underlines the importance of expectations, which is of general importance when one tries to defeat inflation. Inflation may itself contribute to further inflation if people expect it to. This is so because anticipating future inflation firms increase prices just in anticipation that the others are going to increase their prices. There are several ways of trying to break this vicious circle. For example a temporary "wage-price" limit, a reduction in the budget deficit or other signals to the market that inflation should go down. It is interesting to note that these expectations may reinforce wrong theories. Suppose for example that the budget deficit has little to do with inflation, but that people think it is very important. As a result of a mistaken belief the budget deficit becomes correlated to inflation because firms will increase their prices if there is a budget deficit (anticipating an inflation). Thus, wrong beliefs may become self-confirmable. (Wrong in the sense that if no one had had the belief then inflation would not have increased if the budget deficit increased (assume)). So, not only expectations are important to inflation, but also who control people's belief about the causes of inflation. Ultimately the battle for people's minds, the theories they believe in, then becomes important to fight inflation.

Another consideration when it comes to expectations is to what degree they are forward or backward looking. With backward looking expectations, adaptive expectations formation, inflation might be harder to defeat because people might not believe that the actions the government is taking are going to have a large impact. They believe that what happened in the past will happen again, almost regardless of todays policy actions. The rational forward looking expectation formation, on the other hand, could make policy more effective if the government states policy which is followed by credible action. To defeat inflation then, it is important to create the image of a radical break with the past so adaptive inertia inflation will not continue. Such radical changes could be the formation of a national coalition government or simply the change of the governing party (Eg. Sweden).

Open economies In an open economy there are many more possibilities to both "receive" inflation and instruments to fight it. A fixed exchange rate might lead to inflation (by making imports more expensive) if there are "shocks" in the outside world (like 1973), while a floating exchange rate would absorb these shocks better by a change in the exchange rate in response to outside shocks. On the other hand a fixed exchange rate within a monetary system - such as the ERM - may give a government larger creditability and thereby prevent inflation.

An economy of many sectors
When one tries to defeat inflation it is not enough just to worry about the size of the money supply of the size of the increase in aggregate demand. Because the labour market is segmented one should try to target spending to the sectors with over capacity while discourage spending in sectors with undercapacity. This could be done directly be public expenditure in certain sectors (Eg. in the UK: Housing and construction) or indirectly by taxes/subsidies in other sectors. Thus by thinking about where one spends money, not just how much money (Quality v. Quantity!) one could try to reduce inflation.

Structural inflation
There is one more way of defeating inflation that deserves to be mentioned. This originates from Schultz theory of structural inflation. Once again there are price rigidities for the reasons mentioned in the different Keynesian models. In this situation there may be a large number of changes going on in the economy - exogenous shocks, changing tastes, the outside world changes and new technology develops. These changes implies a change of the rewards, costs and prices of different factors and commodities. But, because of rigidities the prices which should go down, do not. Only the prices that should increase do so (Keynesian asymmetry). But this implies inflation. Not only that, it also implies that the more rapid the structural changes, the more inflation there is. This could explain some inflation and also provide us with theories to defeat inflation. One could, for example, try to prevent shocks (such as OPEC) or reduce the rigidities. But both these alternatives are very difficult to do.

Understand, but not solve
The fact that many of the methods to defeat inflation are difficult to implement, leads to the possible conclusion that inflation is intrinsically difficult to defeat. Not because we do not know the causes or understand it, but simply because the fundamental, unalterable rigidities cannot by be overcome (such as the human feeling of justice and refusal do accept lower nominal or relative wages. Or, such as human risk-aversion so that we want wage contracts in a job. Or the feeling of fairness when seeing that the executives and the "capitalists" have privileges and incomes they can only dream about leads to higher wage demands). This leads us to question the possibilities of defeating inflation in the short term, even though we might understand the phenomenon.

Another persuasive factor which could make inflation more "undefeatable", is the exogenous nature of import prices. Jenkins and Baker argue that it was the rise and fall in primary commodity prices that was the main cause of inflation and its reduction in OECD from 1978 to 82. Their paper verifies this statistically and also shows that there is little correlation between the changes in wages and unemployment which creates problems for the monetary theory. It is even possible, empirically speaking, for real wages and unemployment to rise at the same time. The implication of this is that there is little a single country can do alone to prevent inflation as a result of external shocks. Alone it could appreciate its currency, ut if all countries did the same (rational) this would have no effect. This theory, as the last paragraph, leaves little room for an individual country to defeat inflation.

Conclusion
In conclusion I would highlight the institutional and psychological rigidities (especially the sense of justice or fairness) which creates the Keynesian asymmetry that may easily allow inflation to rise, but still makes it difficult to defeat. Added to this there is the international aspect - the impossibility of preventing external shocks - which makes one feel even more defenceless. As far as I can see the future then for defeating inflation lies in international policy coordination. Though, the problem here is that it is profitable to "cheat" for individual countries. Thus, what one need is stronger international policy coordinating units. I would also highlight the creditability factor. Especially the importance of creating a structure with a relatively independent Central Bank. These measures would at least be more preferable then the costly and destructive recession that is otherwise necessary to reduce inflation. Also if one have to impose a recession one should do it as early as possible before the problems becomes so large that a very deep recession is needed to reduce inflation.

[Note for bibliographic reference: Melberg, Hans O. (1992), Inflation: An overview of theories and solutions, http://www.oocities.org/hmelberg/papers/921201.htm]