Different Views On The Cause Of Inflation Economics Essay

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Tucker (2005) defines inflation as an increase in the overall average level of prices of goods and services in the economy, while deflation is a decrease in the general average price level of goods and service. The most widely reported measure of inflation is the consumer price index (CPI).

The theoretical framework in this research will cover several schools of thought about inflation and inflation controlling, theories on the impact of inflation on the economy etc. it will also make a review of existing research on inflation in Vietnam so far. More specifically, it will cover the areas that are highlighted in the following headlines of this section II.

II.1. Demand-pull, Cost-push and Monetarist Approach to Inflation

One way to distinguish different types of inflation is to consider from where the inflation originates.

Demand- pull inflation is quite familiar with ordinary people, because it simply states that when there an excess of total spending (or demand), the general price level will increase because of "too much money chasing too few goods". That is when there is an inadequacy of supply, the sellers respond by raising prices

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Demand - pull inflation occurs at or close to full employment. Under close or full employment, suppliers find it much harder to increase output, especially in the short run. Therefore, excess demand persists, causing an increase in the price level. Note that, by demand here, it implies the aggregate demand of an economy, which includes not only consumer spending, but also business investment and government spending. The demand-full inflation can be seen very clearly from the ADAS model that follows shortly.

Cost- push inflation implies the increase in general price that is caused by a sharp increase in the cost of production. A very clear example of cost-push inflation is the sharp increase in the general price level in most of global economy after the Organization of Petroleum Exporting Countries (OPEC) cuts output and pushes up their oil exporting price.

Table 2: Different Views on the Cause of Inflation

Issue

Classical

(Typically Adam Smith)

Keynesia

(Typically John Maynard Keynes)

Monetarist

(Typically Milton Friedman)

Issue

Stable in long run at full employment

Inherently unstable at less than full employment

Stable in long run at full employment

Price-wage flexibility

Yes

No

No

Velocity of money

Stable

Unstable

Predictable

Cause of inflation

Excess money supply

Excess aggregate demand

Excess money supply

Cause of unemployment

Short-run price and wage adjustment

Inadequate aggregage demand

Short-run price and wage adjustment

Effect of monetary policy

Change aggregate demand and prices

Change interest rate, which changes investment and real GDP

Changes aggregage demand and prices

Effect of fiscal policy

Not necessary

Spending multiplier changes aggregage demand

No effect because of crowding-out effect

Sources: Tucker (2005)

Monetarists, typically Milton Friedman and classical Economists, typically Adam Smith perceive that inflation is a matter of money supply. According to them when too much money chasing too few goods and services, there will be a pressure on price, leading to inflation.

II.2. Macroeconomic Policies and Inflation

This part will present important theories that explain the impact of macroeconomic policies on inflation. More specifically, the macroeconomics policies to be considered include:

- Policy of money supply: The impact will be seen through the monetarist approach to inflation in section II.2.1.

- Policy that affects the aggregate demand and aggreget supply: The impact will be seen through the AD-AS model in section II.2.2.

- Fiscal and monetary policies: The impact will be seen through the Policy Mix model in section II.2.2.

II.2.1. Monetarist approach to inflation

The monetarists view it is the high money supply that is the major cause of inflation. To illustrate their idea, the following equation is established:

M * V = P * Y (1)

In which:

- Y stands for the real GDP of an economy or the GDP of an economy in physical units

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- P stands for the general price level of the economy. A higher P would imply an inflation

- M stands for the money supply of the country

- V stands for the velocity of money. It represents the number of time that currency (a note or a coins) is used to facilitate transaction in a period of time (normally a year). Economist strongly support the assumption that the velocity in the long run is constant. For example, it can be seen from the figure 2 that the velocity of money in the United State is basically stable for the period 1960-2005

Figure 2: Money Velocity in The United State, Period 1960-2005

Sources: Salvatore (2011)

The equation (1) states that the multiplier of money supply and the velocity of money should be equal to the nominal GDP of a country.

The impact of money supply on inflation can be seen from the equation 1 above. Suppose that there is no change in the real economy (Y constant), at a given velocity of money (V), an increase in money supply (M) should increase the price level (P) at the same proportion.

The monetarists, therefore recommend that, money supply in a country should be increased proportionately with GDP growth. By doing this, the economy has just enough liquidity and there is no source for inflation.

II.2.2 Inflation from the lens of the AD-AS model

The following introduction about the Aggregate Demand - Aggregate Supply Model (AD-AS model) is adapted from Tucker (2005) and Mankiw (2007). Under this model, equilibrium levels of output and price of a country are determined by the aggregate demand and aggregate supply of that country. The short- run aggregate supply is not the same as the long-run aggregage supply. In the short-run, the economy may not be at the long-rung equilibrium, therefore there is room for government intervention to bring the economy back at its long-run equilibrium.

To understand this model, it is important to understand the aggregate demand and aggregate supply curves, which are presented in II.2.2.1 and II.2.2.2 that follow:

II.2.2.1. The aggregate demand curve:

Aggregate demand is the total demand for goods and services by a country. It includes the demand by every agents of an economy, including household, firms and government as well as the demand for export. Similar to individual demand curve, the aggregage demand curve show the purchase of goods and services at each price level. Assuming that goods and service are normal, than the aggregate demand curve is downward sloping for several reasons, including the Real balance effect, the Interest rate effect and the Net export effect.

The Real balance effect: Real balance refers to the real purchasing power of the noney. Given a certain level of money; when prices are falling, the money holders can purchase less, thus their demand for goods and services drop; When prices are rising, the money holders can purchase more, thus their demand for goods and services increase. This effect happens to any agent in an economy, therefore the aggregate demand is negatively related to price level, contributing to the negative slope of the aggregage demand curve.

The Interest rate effect: In period of inflation, interest rate tends to be pushed up because people demand for more money to purchase any good or service. Intererst rate, on the other hand, is the cost of money, so a higher level of interest rate tends to reduce borrowings and purchasing. It will reduce consumption by household, investment by firms, government purchase. Thus, it can be easily seen that price is negatively related to aggregage demand via the interest rate channel.

The Net export effect: When a country's general price level increases, domestically-produced goods and services become relatively more expensive because of higher cost of production under higher interest rate. Thus, consumption will tend to be shifted from domestically - produced to foreign produced - goods and services, reducing the country's aggregage demand, therefore contributing to the negative slope of the aggregage demand curve.

It can be sumarized up to this point that the aggregage demand curve is downward-sloping, saying that at a higher price level, the aggregage demand is lower and at a lower price level, the aggregage demand is higher.

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Note that, a movement alongside the aggregage demand curve represents the change in the aggregage demand corresponding to a change in the price level, keeping other things unchanged. A shift of the aggregate demand curve, however, represents the change in the aggregate demand caused by a change in non-price factors such as consumption, government spending or net export.

II.2.2.2 The aggregate supply

There are different view points on the aggregate supply and they are presented below

The aggregate supply in the long run

Classical economists, typically Adam Smith is concerned with economics in the long run. They make two important assumptions that (i) economies normally operate at their full-employment output level and (ii) the price level of a product and production cost of that product change by the same percentage in order to maintain a full-employment output. Thus, according to their view point, in the long run, supply is determined by the production capacity of an economy rather than by price level. Graphically, in the long run, the aggregate supply curve is vertical.

The aggregate supply in the short run

Modern economists, however, is more concerned with what happens in the short run than in the long run. They think in the long run, production may be determined only by the physical resources of a country, but in the short run, production is strongly affected by price level. The higher the price level, the higher the production and the higher the aggregate supply, therefore the short-run aggregate supply is upward - sloping.

In a more detailed presentation: supply curve is believed to consist of 3 segments:

- The horizontal segment, which represents Keynesian view: He thinks that there is a lot of un-utilized production resource in an economy. If the price increases, even, just abit, this un-utilized production resource will be put into production and it increase output a lot.

- The vertical segment, which represents the classical view as presented above

- The intermediate segment: This is the case of short-run aggregage supply that is presented above. The intermediate segment is upward-sloping and it represents an economy as it approaches to its full-employment output.

Note that, similar to the Aggregate Demand curve, Aggregate Supply curve will shift when there is a change on one or more of nonprice-level determinants. Examples of nonprice determinants may include resource prices (domestic or imported), technological change, taxes, subsidies and regulation.

II.2.2.3. Long - run equilibrium

Figure 3: AD-AS Model Long run - Equilibrium

In the long run, the economy reaches its equilibrium at the crossing point of its aggregage demand curve, long-run vertical aggregage supply curve and short-run upward-sloping aggregagte supply curve. This equilibrium shows that the price level of the economy is determined at the level of PE.

The long run price level of of PE is, however, carries little meaning, especially in terms of policy making, because frequently the economy is not at its long-run equilibrium. According to Keynes, the studying of the economy in general, and the price level of the economy, in particular, gives much more economic insights as will be seen in the remaining part of this model.

II.2.2.4. Long - run Growth and Inflation

Figure 4:AD-AS Model Explanation of Inflation

The above figure … can be used to explain why prices have been increased over years in most of countries in the world. Over years, the aggregage supply curve shifts to the right, because countries accumulate more and more resources of production, including labour, capital as well as productivity. Thanks to higher level of production, people will enjoy a higher level of income so the aggregage demand curve shifts to the right as well. Because both of aggregage demand and aggregate supply curves shift to the right, they cross each other at a higher level of price, indicating a situation of inflation. In the figure …. It can be seen that the price level in 2000 is higher than the price level in 1990, which in turns, higher than the price level in 1980.

II.2.2.5. Economic Fluctuation -Economic growth and Inflation

Figure… above says that inflation is "natural" in the long-run because it is simply a consequence of growth. The governments should not be concerned with this type of long-term inflation.

On the contrary, the Governments should be very careful with short-term inflation, which is caused by a fluctuation in the short-term aggregage demand or aggregate supply as will be seen below:

The Effect of a Shift in Aggregate Demand

Figure 5: The Effect of a Shift in Aggregate Demand Curve

Supporse, something is happening (for example: a stock market crash or a natural disaster which makes people poorer and they consume less) that shift the AD curves to the left from, AD1 to AD2 indicating a short-run deflation of the country.

- If there is no intervention from the government: It can be seen that at point B, the economy operates at less than its capacity so unemployment will increase. This, in turns, creates a pressure on wage cuttings. Because firms pay less to workers, they become more profitable and will invest more to increase their production capacity. The aggregage supply curve of the country will shift to the right. In the long run, the economy will reach its its equilibrium at point C, at a very low lelvel of price.

- If there is some intervention from the government: Suppose that, to response to the reduction in the aggregate demand, the government increases it spending or applies measures to push up aggregage demand. In this case, the long-term equilibrium of the country will be at a point that is higher than poin C, saying that the level of deflation is lower than it would be without government intervention. In the extreme case, the increase in government spending is equal to the reduction in the aggregate demand, the aggregate demand curve shifts back from AD2 to its original position of AD1 , resulting in no deflation or inflation in the country.

The Effect of a Shift in Aggregate Supply

Figure 6: The Effect of a Shift in Aggregate Supply Curve: The Case of No Government Intervention

Now, suppose that the SRAS curve of a country shifts to the left, left from SRAS1 to SRAS2 , due to some reasons, for example an oil price shock or a natural disaster that disrupts production. In the short-run, the economy will reach its equilibrium at point B, with a higher level of price and a lower level of production. Thus, the economy faces inflation

- If there is no government intervention: there will be an automatic mechanism that shifts the SRAS back to its original position at SRAS1 . This is because that: at a lower level of production at point B, there will be more unemployment, which create a pressure on wage cutting. Thanks to wage cutting, production becomes more profitable, firms will try to expand production etc so the aggreage supply of the country will increase. In the long run, the aggreagate supply curve will shift back its orginal position at SRAS1.

- If there is some government intervention: One problem with the above automatic mechanism is that it may take a very long time. Keynes suggests that the government should intervene to restore the long-term equilibrium output faster. The way to do it, is that the government will apply an demand-stimulus package or will increase its spending.

Figure 7: The Effect of a Shift in Aggregate Supply Curve: The Impact of Economic Stimulus on Equilibrium

Under the government intervention, the aggregage demand curve will shift to the right from AD1 to AD2. The economy restores it long-term equilibrium faster, but at point C instead of point A. It can be seen that point C is corresponding to a higher level of price. The implication here is that: an expansionary fiscal policy will cause inflation. The higher the level of expansion, the higher the level of inflation

II.2.3. Inflation from the Policy Mix Model

The policy mix provides a framework for using the monetary policy and fiscal policy to curb inflation and to restore the equilibrium of an economy. The model is presented in Salvatore (2011).

We start the model by constructing the IB and EB curves

IB curve shows the various combinations of fiscal and monetary policies that result in internal balance (which implies full employment and price stability) in a nation. The IB curves is upward-sloping because when a government implements an expansionary fiscal policy, there will be a demand- full inflation. A tight monetary policy needs to implement, then, if the nation wants to avoid inflation.

Figure 8: Swan Diagram

The EB curve, on the other hand, referes to the various combinations of fiscal and monetary policies that lead to an external balance (an equilibrium of the balance of payment). Similar to the IB, the EB curve is also upward-sloping because an expansionary fiscal policy will results in higher income, higher demand for export and a BoP worsening. The way to neutralize this negative impact is to apply a tight monetary policy, because it leads to higher intererest rate which in turns, lead to a capital inflow (which will mitigate the BoP worsening caused by the expansionary fiscal policy)

The IB curve divides the space into two zones. The upper zone indicates that the economy is in the status of unemployment whereas the lower zone indicates the status of inflation of the country. Similarly, the EB curve also divides the space into two zones. The upper zone indicates that the economy is in the status of BoP deficit, whereas the lower zone indicates the status of BoP surplus inflation of the country.

The IB and EB curves, together, divide the space into 4 zones as indicated in figure…

Zone 1: Unemployment + Surplus;

Zone 2: Inflation + Surplus;

Zone 3: Inflation + Deficit and

Zone 4: Unemployment + Deficit.

Next, we examine what is the implication of the Policy mix model in controlling inflation and restoring equilibrium of an economy:

Suppose, for whatever the reason, the economy is now at point C, with unemployment and deficit. To restore the equilibrium at point F, the government can use the expansionary fiscal policy to reach point C1, an internal balance, and than use tight monetary policy to reach point C2, an external balance, on its way to point F.

Suppose now, for whatever the reason, the economy is at a point in the zone 3 (and the point is in the oval) with inflation and deficit.

It can be seen similarly, the policy option available to the economy is to apply both a tight monetary and fiscal policies. It can be seen later in chapter 4 that, in 2011 the economy of Vietnam is in this zone III and the tight monetary and fiscal polices are the right choice of the Vietnamese government in this year.

II.3. Consequences of Inflation:

When prices rise, consumers have to pay more for the goods and services they purchase. At the same time, sellers of the goods and services get more for what they sell. Because, most of people earn their come from selling their labor, inflation in incomes seems to go hand in hand with inflation in price. Thus, inflation does no affect the real purchasing of people. Why people are concerned with inflation? the following consequences of inflation have been identified in the Tucker (2005) and others:

II.3.1. Inflation Shrinks Income: Inflation reduces the purchasing power of money, therefore reducing the living standard of people (assuming that most of goods and service people consuming is normal). The higher the inflation rate, the higher the shrinking in the living standard. This, of cause does not mean that in period of inflation, the living standard of everyone is shirking. This happens only for those with nominal incomes falling to keep pace with inflation. People whose nominal incomes rise faster than the rate of inflation still gain a higher purchasing power.

II.3.2. Inflation Shrinks Wealth: Wealth is different from income because while wealth is the value of the stock of assets owned by a person at a given point in time, income is a flow of money he earns by selling factors of production. Contrary to income, people with wealth will get richer in period of inflation because the value of assets tends to increases when prices get higher. On the other hand, inflation penalty the poors because they need to pay a higher price for any asset that he wants to acquire.

II.3.3. Inflation Affects the Real Interest: Given a certain nominal interest rate, a higher inflation makes the real interest rate negative while a low inflation makes the real interest rate positive. When it makes the real interest rate negative, the borrowers gain and the lenders loose. When it makes the real interest rate positive, the borrowers loose and the lenders gain.

II.3.4. Shoe-leather costs of inflation: Inflation gives people an incentive to change their behavior toward the way they hold money. This distortion of incentives causes deadweight losses for the society as a whole as can be seen below:

Because of inflation, the value of money erodes. People reduce the losses by holding less money. To do this, people will need to visit banks more often to withdraw money to satisfy their transaction purposes. By visiting banks more often, people can keep more of their wealth in their interst - bearing savings account and less in their wallet where inflation erodes value.

But by visiting banks more often to withdram money, there is cost associated: the cost of time and convenience that people must sacrifice to keep less money on hand that people would if there were no inflation.

The higher the inflation rate, the higher the customers change their behavior, and the higher the shoe-leather costs. Under hyper-inflation, the cost would be significant.

II.3.5. Menu cost of inflation:

Under stable prices, most of firms (and supermarkets) change the price of their products not very often. One survey found that the typical U.S firm changes its prices about once a year.

The reason for firms not to change prices very often is that: there are costs associated. The cost associated with price adjustment is called the menu cost. This name derives from a restaurant's cost of printing a new menu. Examples of menu cost include the cost of deciding on new price, the cost of printing new price lists and cataloges, the cost of sending these new price lists and cataloges to customers and people concerned, the cost of new advertisement on new price etc.

II.3.6. Cost of mis-allocation of resources due to inflation:

Suppose price of a product is kept unchange for one year, under the inflation rate of 12% a year (that is 1% a month). Thus, the real price of this product actually varies over different months of the year. The price is relative higher in initial months, after the price was set, and relatively lower in the last months of the year. This causes the cost to the society because:

Market economy relies on relative prices to allocate scare resources. Consumers make decision on consumption by comparing the quality and prices of different goods and services. Due to inflation, the relative price of the mentioned product is distorted. This distorts the consumption behavior, which in turns, distorts the way that scare production factors are allocated between competing industries, thus scare production factors are not utilized in the most efficient way and it causes deadweight loss to the society.

II.3.7. Inflation - Induced Tax Distortions

Theoretically, taxes distort incentive, change people's behavior and lead to less efficient allocation of scare production resource. Such negative consequence of taxes would be more problematic under inflation. The following will give two examples to illustrate the situation:

Example 1: suppose a person purchases 10$ securities at a company in 2000 which is then sold at 50$ in 2010. The capital gain will be determined to be 40$ and will be taxed correspondingly (for example, if the capital gain tax rate is 30%, the tax collected will be 12$)

But suppose that there is an inflation of 50% between 2000 and 2010. The investment of 10$ in 2000 will be equal to 15$ in 2010 value. Thus, the actual capital gain is only 35$ (instead of 40$), and the capital tax gain should be only 10.5$ (instead of 12%).

Thus, under the inflation, if the tax code does not take account of inflation, it exaggerrates the size of capital gains and inadvertently increase the tax burden on the income earner.

Example 2: Suppose there are two economies A and B which both impose the same tax rate of 25% on interest and both regulate a real inrestest rate of 4%. Economy A has no inflation while economy B suffers an inflation rate 8%.

The nominal interest rate in countries A and B will be 4% and 12% correspondingly.

The tax collected on interest earning in countries A and B will be 1% and 3% correspondingly.

The after-tax nominal interest earning in countries A and B will be 3% and 9% correspondingly.

The after-tax real interest rate in countries A and B will be 3% and 1%.

Thus, in paper, depositors in country B enjoy the same income as in country A. But due to tax, their income from deposites in commercial banks is much lower (1% compares to 4%)

II.3.8. Confusion and Inconvenience

Money is defined as an unit of account, which is used to quote prices and record debts. In other words, it is the yardstick used to measure economic transactions. When there is inflation, the value of money erodes, thus the unit of account erodes. This cause confusion and inconvenience.

Example of confusion and inconvenience: accountants incorrectly measure firms' earnings when prices are rising overtimes; computing business, which is basically the difference between real cost and benefit, becomes much more complicated.

II.3.9.. Arbitrary Redistribution of Wealth

This effect can be seen through an example. Suppose a student takes out a loan of 20.000$ at 7% interest rate from a bank to atten college, for a borrowing period of 10 years.

After 10 years, the debt is compounded for 10 years at 7% to become 40.000$. Here comes two senarios that this repayment of 40.000$ affect the wealth of the person.

If the economy will have a hyper-inflation, wages and prices will rise so high that the person can repay 40.000$ out of the pocket market

If the economy goes through a deflation period, wages and prices keep falling, the person will find 40.000$ debt a big burden.

Under the first senario, wealth is redistributed from the bank to the student. But under the second senario, it is opposite with wealth being redistributed from the student to the bank.