Inflation and the Theory of Money

R. J. Ball

• Publisher: Routledge
• Year: 2017
• eBook ISBN: 9781351512558
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

Martin Bronfenbrenner in the Journal of Finance had this to say when the book was first released "A thoughtful, scholarly, and systematic treatise on the economics of inflation. If this reviewer were asked to hang a course on inflation theory upon one single text, it would almost certainly be this one."

The principal concern of this book is to set out the elements that enter into problems of analyzing inflation. This detailed, readable review of contemporary theory on the problems of inflation fills an important gap in the literature on macro-economics that: 1) assesses the implications of inflationary processes for economic policy; 2) synthesizes a general framework within which to illustrate inflationary processes; 3) reconciles the approaches of "demand inflation" and "cost inflation"; and 4) analyzes the determination and behavior of the general price level in an exchange economy.

The first part of the book reviews neo-classical and "Keynesian" type models of the closed macro-economy, analyzes determination of the general price level, and introduces a restatement of conventional employment theory with emphasis on the general price level.

The second part considers the problems of price and wage determinations and the demand for money in more detail, synthesizing the analyses into a model of the macro-economy and discussing the implications of this model and the preceding analysis for economic policy. Describing alternative approaches to the theory of inflation, each of which has resulted in partial theories, the book avoids fragmentary explanations by setting the entire discussion in the context of a macro-economic general equilibrium framework.

Part I

Chapter I

The General Price Level

Introduction

The principal concern of this book is to set out the elements that enter into the problem of analysing inflation. In the light of this aim it would seem appropriate to begin by defining the concept of inflation itself. Unfortunately, as others have found, it is not easy to start with any great precision. Why is this so?

Economic literature is full of words and expressions that confuse because they are not always used to refer to the same things or to characterize the same states of affairs. Economists use many common words or expressions that reflect considerable emotive overtones. It is not difficult to read into the analysis of neo-classical economists that on the whole ‘competition’ is good and ‘monopoly’ is bad, and the very adjective ‘competitive’ often carried implied approval. Similarly, we find that other adjectives like ‘static’ and ‘dynamic’ also possess emotive appeal; static analysis is limited and by implication somewhat outmoded, while analyses that are dynamic are regarded as forward-looking and alive to contemporary thought.

Both these kinds of difficulty complicate the problem of defining inflation. To begin with, inflation on the one hand and deflation on the other are not always used in such a way that they imply anything about prices. A deflationary situation may be associated with a fall in money income and rising unemployment, even though prices remain constant. The adjective ‘deflationary’ is commonly used in this way, but it is less common to use ‘inflationary’ to describe the reverse state of affairs. In the latter event the most likely description is reflationary, which describes a period of recovery from depression. While, therefore, the notion of inflating the economy may sometimes refer to a situation where money incomes are rising after depression, in the main the word inflation is reserved to indicate something not simply about money incomes but also about prices.

Even if we agree that an inflationary situation is to be taken to imply something about prices, precise definitions vary between individuals. Part of the difficulty here is that definitions of the more popular variety such as ‘too much money chasing too few goods’, not only purport to define inflation, but also imply something more about particular inflationary processes. (This particular definition originates from a rather specific view about the relationships between money, the supply of goods and their prices which as we shall see later is not easy to swallow in its simplest form.) The general point about such definitions is that they are not sufficiently neutral to be useful, for they depend on certain contingent propositions that are likely to be dis» puted. One is in danger of being bogged down in argument doubly confused by a failure to distinguish clearly between matters of fact and analysis, and by matters of definition.

It may seem plausible to assert that at least one necessary condition for a situation to be described as inflationary is that prices—in a sense to be considered later—must be rising. Unfortunately, even this is not regarded as true in general It may be the case that strong economic forces within the economy at a point of time are restrained by artificial controls administered by the authorities operated in such a manner as to prevent a rise in prices. The essential point here is the extent to which such controls are regarded as temporary or artificial, for there are always some controls exercised by the authorities that relate to hire purchase conditions, interest rates and taxes, whose removal might result in a rapid rise in prices. But in practice we should not always regard the situation as inherently inflationary when these controls operate, so that there is always an arbitrary element involved in deciding on whether to regard a situation as inflationary or not when prices are not actually rising. Given a standard frame of reference, and if it is agreed that prices are not rising because the economy is not being allowed to function normally, we have a state of affairs sometimes described as being one of repressed as opposed to open inflation. A necessary condition for open inflation is that markets for goods and factors of production are allowed to function freely, setting prices of goods and factors without abnormal interference by the authorities.

The analysis of repressed inflation has been particularly relevant in periods such as the late 1940s, when by the use of licensing, price controls and subsidies, the economic authorities in some countries attempted to interfere with the free inter-play of market mechanisms. The principal motive for this was the belief that if such controls had been removed the change over from a war-time to a peace-time economy would have resulted in an excessive rise in prices. Many of these controls that had been an inherent part of the war economy had been introduced to prevent excessive increases in prices during the war. In the event, neither during the war nor after it were such controls wholly effective in preventing prices from rising, but there is little doubt that over the period they modified the price rise that took place. This is not necessarily to say that they were successful in reducing the rate of price increase over a longer period, for some economists have been inclined to say that they simply postponed the evil day when other so-called natural economic forces worked themselves out. But this is a matter of some dispute.

This book will not be explicitly concerned with the analysis of repressed inflation in the narrow sense just described,¹ but with the problem of inflation in a given institutional framework in which decision units are free to set prices, demand and supply products, and fix rates of remuneration of factors of production. We shall regard the case of repressed inflation in a narrow sense as a special one that lies outside the scope of our inquiry.

Thus we start with the view that inflation in our sense implies that prices are actually rising. This raises two questions; firstly what do we mean by rising prices and secondly if prices are agreed to be rising are all such increases to be regarded as symptomatic of an inflationary situation? Any set of definitions we adopt and therefore the answers to these questions must inevitably involve a distinct arbitrary element. We shall be concerned most with the concept of the general price level, and the analysis will on the whole fall into the context of macroeconomics, as a result of which it is appropriate to consider rising prices in terms of some measure of the general price level. Rising prices must be thought of here as reflected in some average of all prices, which in turn raises difficulties that are briefly discussed in the next section. Nor do our problems end there, for given our chosen measure of the general price level it is necessary to define an inflationary situation in terms of it.

The simplest approach is obviously to define a situation as inflationary if the general price level is rising. But this raises questions of two kinds. Firstly, should a recovery of prices on the upswing of the business cycle be regarded as constituting an inflation? If prices have fallen well below their trend levels as a result of severe depression, their restoration to the trend level may be regarded simply as a restoration of the status quo. A more specific question is related to the problem of emotive meaning that was raised earlier. Traditionally the word inflation has been surrounded by overtones of strong disapproval and fear, such that to describe a situation as one of inflation was implicitly to disapprove of it. The reason for this is partly that the neo-classical economists tended to think of inflation as essentially a situation in which the general price level was rising very rapidly and so the value of money declining precipitously, with the ultimate fear of what we would call hyper-inflation and the complete collapse of the currency. In this context, increases in the general price level came to be regarded as inflationary, depending on the rate of increase of the price level per unit time (though it was hardly ever stated as such) and the extent to which the source of the price increase was regarded with approval or disapproval. From this point of view the upward movement of the general price level on the upswing of the business cycle might not be regarded as evidence of an inflationary situation.

Secondly, to what extent may an inflationary situation be diagnosed by considering the trend of the general price level over some specified period? The choice of period is in itself inherently arbitrary while the actual choice of time period may often affect the final conclusion. This may be dealt with in a number of ways. The first is to display a certain amount of impatience with the problem of definition and to argue that inflation is a situation in which prices are rising and while admitting the inherently arbitrary character of specific choice, assert that an inflationary situation is a function of two principal factors, the rate of price increase and the duration of the increase, with the assumption that the faster the rate of price increase and the longer the duration of rising prices the more appropriate is it to define a situation as inflationary. Thus inflation may exist during any given period if the rate of price increase is fast enough, while it may also exist for any given rate of price increase if it persists for sufficiently long. What is meant by ‘fast enough’ and ‘sufficiently long’ becomes a matter of choice and agreement that must at the margin be arbitrary. A second approach is to assert that all increases in the general price level represent some species or other of inflation, to which a qualifying adjective must be added, so that we have for example, cyclical inflation, secular inflation and hyper-inflation. Again, however, we cannot escape an essentially arbitrary choice at the margin: for example, at what point do we pass from secular to hyper-inflation? In all these cases it is likely that in practice sufficient agreement would be forthcoming that would enable us to reach a decision that could be applied to statistical data, so that while in principle choice at the margin is arbitrary it is in practice easier to reach agreement about how to describe a given situation than a priori reflection might suggest. The third possibility that has much to recommend it is to abandon the extensive use of the term inflation and fall back to discussing the behaviour and determinants of the general price level. This is certainly the most general approach, and in large measure this is what is done in much of this book. Nevertheless, to abandon the concept of inflation altogether is inconvenient in a number of respects for it involves one in an excessive amount of circumlocution in discussing established ideas and literature. As far as possible we shall discuss the problem of determining the level and movement of the general price level ; it will often be necessary to describe a situation of rising prices as being one of inflation, and in most cases the particular form of inflation, or appropriate qualifying adjective that needs to be applied, should be clear from the text.

The Concept of the General Price Level

The general price level must be regarded as an average price of some kind, which raises the question of what prices to use and how they are to be ‘added’ together. Problems of this kind have a fairly long history in monetary economics, where they have appeared in the context of trying to determine the ‘value’ of money, or to define the purchasing power of a particular monetary unit. It soon came to be realized that in practice such difficulties cannot be wholly resolved, for we find ourselves in the middle of a general class of what are often called index number problems. The most convenient mode of representation of a single price over time in many respects is to express it as a percentage of its value in some given year. If a particular price is given the number 100, it is implied that it is 100 per cent of (or identical with) the price obtaining in that given or ‘base’ year. If the value is 100 in 1948 and 115 in 1950, then we may say that the price has risen 15 per cent between 1948 and 1950. When we turn to the general price level, however, complications arise because the general price level is to reflect the behaviour of many prices and we have in some sense to add them up. Since all prices are not equally important it is usually felt necessary to represent the general price level as a weighted average so that the movement of an individual price contributes to the movement of the whole in proportion to the importance with which it is regarded. In theory matters are complicated by the fact that the choice of weights is not in general unique, and different sets of weights lead to different numerical assertions about how much the general price level has altered between two points of time. But in practice this is not unduly restrictive since different methods of weighting often have little effect on the broad qualitative conclusions about price behaviour that may be reached by consulting alternative price indexes.¹

The statistics available for advanced industrial economics usually include a variety of different price indexes, such as the wholesale price index, the retail price index, cost-of-living indexes and implicit deflators of various components of national expenditure. The first three groups are usually calculated directly. The wholesale price index represents the prices received by wholesalers, while the retail price index reflects prices paid by final consumers. In practice these indexes, particularly in inflationary periods, often move closely together, but some economists feel strongly about the significance of one rather than the other in the context of the analysis of inflation. It is possible to argue that wholesale prices exhibit greater sensitivity to changes in economic conditions than retail prices or cost-of-living indexes. On the other hand retail prices and cost-of-living indexes may be regarded, as we shall see later, as important influences at the wage bargain in industrialized economies.

Implicit deflators of various components of national expenditure are obtained by valuing the quantities included in a component in a given year by a base year set of prices and then dividing this measure of expenditure at ‘constant prices’ into the current value of the quantity of output. In this manner we obtain a ‘price’ index of Gross National Product, of National Income, of total consumption and so forth. The Gross National Product deflator plays a special role here, for it probably comes closest to representing a general price level index for the economy as a whole.

The general price level, however defined, is inevitably a statistical construction. If the general price level is measured at 100 in 1948 and 115 in 1950 this leads us to say that prices on the average have risen about 15 per cent between 1948 and 1950, but of course no single price may have exhibited this behaviour; some will have risen more, some less and others may have fallen. The significance of our statement about the general price level is therefore not only limited because it is a statistical average of prices that has risen but also by the relative dispersion of price movements within the average. Again as a matter of fact, many prices often move together over time, because they are subjected to a variety of common pressures. It is this that justifies our treatment of the general price level as a single price for many analytical purposes.

As we have remarked, we shall be concerned throughout this book, for the most part, with macroeconomic analysis. This means that we deal with aggregate concepts like national income, consumption, investment, the supply of money and the general price level. For present purposes we shall justify the use of such concepts on grounds of expediency. Our prime concern will be with Inflation as a problem of the economy as a whole, and to avoid aggregate analysis would render the problem far too complex. This is not to say that we shall deal with the national economy at all times as an integrated entity or single sector, but we shall throughout be preoccupied with problems of economic behaviour at relatively high levels of aggregation.¹

The Problem of Inflation

Economists during the inter-war period were highly preoccupied with the problem of unemployment. The first decade and a half after ...

Table of contents

• Cover
• Title Page
• Copyright Page
• Table of Contents
• PREFACE
• PART I
• PART II
• INDEX