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CHAPTER - I
REVIEW OF LITERATURE AND METHODOLOGY
"That's very important," the King said, turning to the jury. They were just beginning to write this down on their slates, when the White Rabbit interrupted: "Unimportant, your Majesty means, of course," he said in a very respectful tone, but frowning and making faces at him as he spoke.
"Unimportant, of course, I meant," the King hastily said, and went on to himself in a n undertone, "important - - unimportant -- unimportant -- important -- " as if he were trying which word sounded best.
ALICE IN WONDERLAND
1.1 INTRODUCTION
Inflation is one of the acute problems faced by the world in the 20th
century. During the First and Second World War periods and their aftermath
hyper-inflations have occured in Germany and China. In the recent decades
chronic inflation has been endemic in most countries of Latin America
accentuating their internal and external economic balances. It has been one of
the root causes for the collapse of the former Soviet Union and Socialist
economies of Central and Estern Europe. Although a gentle inflation may be
a stimulant to economic growth, it is susceptible for getting out of control and
producing several social costs that undermine equity and justice. Therefore,
a clear understanding of the process of inflation, its causative factors,
manifestrations and effects on growth and distribution is essential to design
an appropriate counter-inflationary policy. In the developing countries, whose
structural characteristics are different from that of the industrially developed
countries mere transplaration of received theory and experience of the Wertern
countries may not be suitable.However, a review of literature on the subject
mostly emanating from the advanced industrial countries may be of some
benefit to the extent that there is some degree of universality in the operation
of economic theory including the theory of inflation and the management of
economic policy for stabilization and growth. We attempt, therefore, a highly
selective review of the vast literature on the subject of inflation. Our review
may be considered a sample though not of a truly representative sample.
The theory of inflation is as old as modern economic theory itself. In a
work of this nature it is rather impossible to undertake a reasonable survey
of the field because of its long evolution, varied dimensions and approaches as
well as the tools and techniques of measurement. Therefore, we can have only
a brief outline of the prominent theoretical approaches to inflation. The
terminology of inflation is also quite diverse and it is rather arbitrary to
classifj. it. However, our approach basically is to treat inflation from the
monetarists and the structuralists angle. There are atleast two strands
underlying the monetarists approach i.e., demand-pull inflation and cost-push
inflation. The former is essentially concerned with the demand side and the
latter with the supply side of the problem of inflation. The structuralist
approach also is concerned with the supply side but its emphasis is on the
behaviour of real variables governing the production function and the
bottlenecks that are confronted by the economy in the process of production.
The relationship between the general price level and unemployment goes by
the name of the Phillips curve and the relationship between rising piices and
stagnation in production which is described as stagflation do not fit into the
classification made above. The survey of literature on inflation is presented
under six sections.
1.2 DEMAND-PULL THEORY OF INFLATION
1.2.1 The Keynesian Version
The classical approach to inflation in terms of the quantity theory of
money has been greatly improved by the income-expenditure approach to
inflation, such as developed by Keynes during World War T[. It is hardly
necessary for us to repeat the fact that Keynes General Theory was an
explanation into the economics of depression due to deficiency of aggregate
effective demand. ,The hyper-inflation experienced by some of the countries
during World War I1 and its aftermath was a case of excess aggregate demand
over aggregate supply. Keynes during the war period was extending his
General Theory to cover this type of inflationary tendencies. By functionally
relating expected expenditures to disposable income in relation to the value of
output a t base prices, Keynes originated the concept of the inflationary gap1.
Subsequently several elaborations and refinements of the inflationary gap
theory have emerged2.
The inflationary gap for the economy as a whole may be defined as an
excess of anticipated expenditures over available output at base prices.
Anticipated expenditures are given by consumption - saving patterns plus the
tax structure, while available output is given by conditions of employment and
technological structure3. The development of the inflationary gap is illustrated
in figure 1.1.
FIG.,).lt . THE INFLATIONARY GAP
Iri figure 1.1 the vertical axis measures consumption and investment
and the horizontal axis measures income. The 45" bisector represents the
quantitative relation of consumption expenditures to various levels of income;
any deviation from the line indicates that consumption is larger or smaller
than income. The C curve represents a schedule of consumption expenditures
and is functionally related to the levels of income in the contemporary
literature is described as the counter part of absolute income hypothesis. The
C+I curve represents the potential expenditure on consumption and investment
the different levels of income. It therefore, lies above the C curve the
interaction of C+I curve with the 45" line at E* gives the equilibrium income
Yo. It is customary to assume Yo income to be full empllyment income. It
corresponds to the value of total output at base prices. If there is an upward
shift in consumption - investment expenditures due to rising expectations the
C+I curve will move to the level of C'tI' curve. The new C'+I1 curve intersects
the 45" line a t E,. But the available output is E, Yo which is smaller than the
income E, Y, by the vertical distance between point El and E, . This difference
between what the economy would spend (E,Yl ) and what it has in its reach
(E, Yo) is the inflationary gap which must be wiped out if the prices of output
Eo Yo are to be prevented from rising. The excess demand equivalent to the
vertical distance between E, and E, in the product market pulls up the
commodity prices. The gap between E, E, is known as the Keynesian
inflationary gap and such an inflation is known as demand-pull inflation.
The counter part of the inflationary gap is the deflationary gap which
represents the deficiency in aggregate demand in relation to full employment
output. This is partly caused by the paradox of thrift and expenditure reducing
fiscal policy. In such a situation the shift in C + I curve leads to additional
employment and output rather than price inflation. Keynes was conscious of
"Semi inflation" which is likely to develop with increasing expenditures before
the point of full employment is reached. This is due to five factors namely (1)
The variety of channels into which increased money supply may flow, (2) The
nonhomogeneity of resources, (3) t he perfectly inelastic supply of particular
resources, (4) Increase in wage rates, and (5) The possibility of increasing
b. marginal cost. In the words of Keynes "when a further increase in the
quantity of effective demand produces no further increase in output and
entirely spends itself on an increase in the cost-unit fully proportionate to the
increase in effective demand, we have reached a condition which might be
appropriately designated as one of true inflation5.
1.2.2 Bent Hansen's Model of Demand Inflation
Bent Hansen argues that the Keynesian theory of inflation fails to
depict the picture of pure demand inflation. This is because wage rates are
autonomously determined and hence, Keynes mixed up demand inflation with
cost inflation. According to Hansen the nominal wage rate W is determined
by demand for and supply of labour. Hansen's model of inflation is based on
several simplyfing assumptions. They are :
i. Perfect competition prevails in all the markets. . . 11. The current prices are expected to persist in the future.
iii. Only one commodity is produced.
iv. Only one factor, viz., labour is used in production.
v. The quantity of labour services per unit of time is given6
The volume of planned production Q, is stated to be dependent on the
price wage ratio, P/W, positively, given the equipment and technique. The
demand for consumer goods is a decreasing function of P/W and the demand
for investment goods is constant due to the fixity of rate of interest. Do
represents aggregate demand we may illustrate Hansen's model of inflation
through figure 1.2.
Fig. 1.b INFLATIONARY GAP
In figure I.?.,. (P/W) is measured vertically and the quantity hori~ontal l~.
The curve Qo is the aggregate supply curve for output for different values of
(PNV). Q, shows the full employment output. The horizontal difference between
Qo and Q, is an index of the inflationary gap in the factor market. Such a gap
will exist for all (PIW) > (PIW)~. Do is the aggregate demand curve for output
and the horizontal distance between Do and Q, is a measure of the inflationary
gap in the goods market, Such a gap will exist for all (PIW) c (P/W)'. In figure
I.%, if (PN) = (PNJ)', there is no inflationary gap and no pressure on wages.
This will lead to a fall in (PIW) and that, in tur-n we reduce the inflationary
gap in the factor market. The reduction of the factor gap will create a gap in
the commodity market. At (PIW) = (P/W)2, the goods gap 'AB' generates a
certain price inflation while the factor gap 'AC' causes a wage inflation. (p/w)2
represents a quasi-equilibrium, not a static equilibrium since both price and
nominal wage rate rise without interruption and excess demand are non-zero.
At this stage, the small goods-gap (AB) produces price inflation a t a slow rate,
while the relatively large factor-gap (AC) produces a faster rate of wage
inflation leadi.ng to a further fall of (P/W). If (P/W) drops to (PlW)', the factor-
gap reduces to 'DE' and the product-gap expands to 'DF'. This, in turn, leads
to a faster price inflation and slower wage inflation. When (P/W) = (P/W)4, the
factor-gap vanishes but a large goods-gap persists. Then wages will be stable
but rising price level will push up (PIW). The quasi-equilibrium will lie within
the range between (PNil)' and (P/W)4. Thus the variations in price and nominal
wages over time are functions of the volume of the inflationary gap of their
respective markets. Although there is some criticism on the transmission
mechanism of the model and the behavior of the variables, Hansen's model of
inflation may be regarded as an improvement over the Keynesian both in
terms of technicalities of the model and its specifications.
1.2.3 John Flemming
Inflation is the overriding issue of today and in this book7 John
Flemming tackles the subject at its roots. What exactly is the role of money?
What are the causes and consequences of commodity booms? What is the
relationship between inflation and taxation, between inflation and
unemployment? What are the effects of floating exchange rates? What is the
significance of trade union militancy, and the value of an incomes policy? Just
how far do inflation, confidence and investment interact and how is inflation
transmitted from country to country? The book is not a critical survey of
existing simple theories of inflation; rather it relates the monetarist doctrine
(usually oversimplified by both proponents and critics) to the alternatives with
a view to producing a synthesis. This theoretical framework covers the many
parts of the complex inflationary process. In tracing a pattern of cause and
effect between them the author focusses in the first part of t h ~ book on
inflation as a monetary phenomenon; in the second part the focus is on the
labour market; the third part is a discussion of policies for mitigating the
effects of inflation and for controlling the process itself.
1.2.4 Mansor H.Ibrahim
Mansor H.Ibrahim in his paper8 'A Look at the Empirical Relationship
Between Money, Price and Income in Malaysia' takes another look at the
causal nexus between money and other macroeconomic variables including
output, price, and interest rate using the notion of Granger causality.
Particularly, employing recently econometric techniques of integration and
cointegration to build a statistically sound specification of the model, he seeks
to evaluate the sensitivity of causality conclusion to the lag specification of the
variables and the number of the variables included in the causality framework.
His findings do suggest the sensitivity of causality inferences to the above
mentioned model specification.
From the analysis, he concludes the following : First, there exist no long
run equilibrium relationship between the variables in the systems that utilise
MI as a measure of money. However, the presence of cointegration is found in
the systems utilising M,. Second, he also found that money (MI and M,) does
matter. Moreover, they a priori cause price in Granger sense. The presence of
some evidence on price-output causality indicates the other channel that
money may be related to output or price, which suggests possible policy
dilemma that might arise in pursuing the dual objectives of inflation
stabilisation and growth promotion. His evidence prefers M, as a policy
variable to stabilise the inflation rate in the short run. Lastly, the interest rate
seems to have some predictive power on the variations of other macroeconomic
variables. Econometrically, it means that omission of the variable may result
in misleading conclusion. Empirically, the information content of the interest
rate or, relatedly, the term structure, may be an important avenue for future
research.
1.2.5 Paul R.Massion et. al.
The authors in their workg maintain inflation targeting is a framework
that could be used to conduct monetary policy in some high-to middle-income
developing countries. However, in most developing countries, the preconditions
for adopting such a framework are not yet present. Improving the monetary
and inflation performance of these economies should probably continue to rely
on simpler and less demanding - but not necessarily less effective - monetary
policy frameworks.
Over time, a strengthening of institutions and an increasing market
orientation could make inflation targeting an attractive option for a number
of countries at a relatively more advanced stage of development, particularly,
it as experience accumulates, the approach proves to be effective in industrial
countries.
1.2.6 Rangarajan and Arif
Rangarajan and Arif in their paper10 present an econometric model of
the Indian economy which emphasises the interrelationships among money,
output and prices. The link between the monetary and the fiscal sedols has
been explicitly modelled with the stock of money varying endogenously with
fiscal deficits. The empirical results show that the price effects of an increase
in money supply are stronger than the output effects. Since government
revenue collections do not keep pace with government expenditures as nominal
incomes rise, the resource gap widens during a period of continued price
increases. The policy simulations show that while a substantial increase in
government capital expenditures increase output, its impact on output and
prices also depends on the extent of the resource gap met by borrowing from
the Reserve Bank. As the proportion of the resource gap met by borrowing
from the Reserve Bank increases, the trade-off between output and prices
worsens sharply.
1.2.7 Rolnick and Weber
In this study1' the authors have uncovered several facts about
differences in money, inflation, and output under two monetary standards.
Their results are based on extensive historical money, price, and output data
for 15 countries. They find that under fiat standards, the growth rates of
various monetary aggregates are more highly correlated with inflation and
with each other than they are under commodity standards. In contrast, they
do not find that money growth is more highly correlated with output growth
under one standard than under the other. They also find that under fiat
standards, rates of money growth, inflation, and output growth are all higher
than they are under commodity standards.
Some may interpret their findings as demonstrating some causal
relationship between money and inflation or between money and output. Such
a conclusion is unwarranted. Only with the development of models of monetary
standards that confront findings like those they have presented can
researchers be confident in drawing causality implications and ultimately
designing better monetary policies and institutions. Their hope is that this
study will stimulate research on models of monetary standards and encourage
efforts to obtain better data on the experiences of countries under alternative
monetary standards.
1.2.8 Carl E,Walsh
The author in his study1' presents the standard models of monetary
policy in which dynamic inconsistency plays a prominent role, announcements
from the central bank about its policy intentions are not believable; the central
bank has an incentive to lie. Yet central banks often do make announcements,
and they are legally required to do so in some cases. The Bank of England, for
example, must issue periodic inflation reports. The chairman of the Federal
Reserve is required by the Humphrey Hawkins Act to testify before Congress
twice each year to explain the Fed's policy actions and to detail the Fed's
outlook for future economic developments. Similarly, the Reserve Bank of
New Zealand is required under the Reserve Bank Act of 1989 to publish policy
statements that spell out its plans; the January 1994 legislation governing the
Banque de France requires its governor to appear before Parliament; and the
European Central Bank must, under the Maastricht Treaty, report at least
annually to the European Parliament. If public statements about policy
intentions are not credible, the question naturally arises as to why central
banks are frequently required to make them.
This paper studies the incentives a central bank faces in announcing
inflation targets when the central bank has private information about the
economy and the public is uncertain about the central bank's preferences.
Targeting rules in the absence of announcements reduce the inflationary bias
of discretionary policy, but they distort the central bank's response to private
information about the economy. This distortion is eliminated when the central
bank is allowed to announce the inflation target. Announcements also affect
credibility, although the way they do so depends on the exact definition of
credibility that is employed.
1.2.9 Lars E.O. Svensson
The author's paper13 states that on 1 January 1999, the Euro was
launched, and the Eurosystem (the European Central Bank - (ECB) and 11
national central banks in Europe) took responsibility for monetary policy in the
Euro area. This paper is a brief evaluation of the Eurosystem's monetary-policy
regime after its first year, in particular of the extent to which it is similar to
inflation targeting as practiced by an increasing number of central banks. He
examines three elements of the Eurosystem, namely, the goals, the framework
for monetary-policy decisions, and the communication with outsiders. Criteria
for evaluation are whether the goals are unambiguous and appropriate;
whether the decision framework is efficient in collecting and processing
information and reaching decisions that are appropriate relative to the goals;
and whether the communication is effective in motivating decisions,
simplifying external evaluation, and thereby improving transparency and
accountability. He also considers whether the actual instrument setting has
been appropriate, given the information available at the times of decision.
The first year of the Eurosystem has seen a successful launch of the
Euro and an apparently successful introduction of the common monetary
policy. The Eurosystem monetary strategy is quite similar to flexible inflation
targeting, for instance, in havir~q a quantitative definition of price stability, in
the emphasis on the medium term, and in the concern to avoid real instability.
Eventual publication ofinternal forecasts would increase this similarity. There
seem to be no fatal mistakes in either design or instrument-setting. Still, there
is considerable room for improvement with regard to internal consistency and
transparency of the regime.
1.2.10 Beranke et.aL.
The authors in their work14 emphasize that inflation targeting is a
framework for monetary policy, not a rule for monetary policy, and they start
with a general discussion of the rationale for such a framework. They then go
on to discuss issues of design - the measure and numerical value of the
inflation target, the horizon, permitted deviations, etc. All this is entirely
sensible and convincing. They then provide case studies : Germany and
Swtizerland as precursors; New Zealand as the pioneer; the other major
experiments - Canada, the United Kingdom and Sweden - and three small
open economies, Israel, Australia and Spain. In each case they discuss the
background to inflation targeting, the institutional arrangements and the
record.
The authors focus mainly on the years following October 1992, when an
inflation target was first set, with the move to operational independence for
the Bank of England as a post script. Inevitably, because the other end of town
was not noticeably forthcoming about its actions, most of the attention is
devoted to the Bank of England, even though its role before May 1997 was
entirely advisory. The authors speculate about the possible influence of the
New Zealand example. In fact, there was considerable interest in all aspects
of policy-making in that country.
The authors evaluate the success of inflation targeting experiments.
They conclude that inflation targeting has not made disinflation less costly but
has made it more successful. This accords with Alan Blinder's view that
central banks stick to the task in a way that governments do not. They also
conclude that the introduction of inflation targets did not immediately alter
inflation expectations (though the granting of independence to the Bank of
England certainly did so). In the final section they discuss the lessons that
have been learned : 'They conclude that inflation targeting is a highly
promising strategy for monetary policy, and they predict that it will become
the standard approach as more and more Central Banks and Governments
come to appreciate its usefulness'. They propose arrangements for inflation
targeting in the United States and the European Monetary Union. They argue
that it would help both the public and political leaders to focus on what
monetary policy can do rather than on what it cannot do. Among other things,
it would help to depersonalize monetary policy and make the role of the central
bank more consistent with the principles of a democratic society.
1.2.11 Mishkin
Mishkin in his study15 represents that the unhappy experience of Latin
American and East Asian countries with pegged exchange-rate regimes when
those countries foul>d themselves in deep financial crises in the 19SJ's has led
emerging-market countries to search for alternative nominal anchors (including
transition countries in Eastern Europe and the former Soviet Union in the
emerging-market category). Inflation targeting, a monetary policy strategy
which has been successfully used by a number of industrialized countries, has
thus become an increasingly attractive alternative and has been adopted by a
growing number of emerging-market countries, including Chile, Brazil, the
Czech Republic, Poland, and South Africa.
Inflation targeting is a monetary-policy strategy that encompasses five
main elements : (i) the public announcement of medium-term numerical
targets for inflation; (ii) an institutional commitment to price stability as the
primary goal of monetary policy to which other goals are subordinated; (iii) an
information-inclusive strategy in which many variables, and not just monetary
aggregates or the exchange rate, are used for deciding the setting of policy
instruments, (iv) increased transparency of the monetary-policy strategy
through communication with the public and the markets about the plans,
objectives, and decisions of the monetary authorities; and (v) increased
accountability of the central bank for attaining its inflation objectives.
In this paper, the author outlines what inflation targeting involves for
these countries and discusses the advantages and disadvantages of this
monetary policy strategy. The bottom line is that, although inflation targeting
is not a panacea and may not be appropriate for many emerging-market
countries, it can be a highly useful monetary policy in a number of them.
A critical issue for inflation targeting in emerging-market countries is
the role of the exchange rate. Emergmg-market countries, including those
engaging in inflation targeting, have rightfully been reluctant to adopt an
attitude of "benign neglect" of exchange -rate movements, partly because of the
existence of a sizable stock of foreign currency or a high degree of (partial)
dollarization. Nonetheless, emerging-market countries probably have gone too
far, for too long, in the direction of limiting exchange-rate flexibility, not only
through the explicit use of exchange-rate bands, but also through frequent
intervention in the foreign-exchange market. Responding too heavily and too
frequently to movements in a "flexible" exchange rate runs the risk of
transforming the exchange rate into a nominal anchor for monetary policy that
takes precedence over the inflation target, at least in the eyes of the public.
One possible way to avoid this problem is for inflation-targeting central banks
in emerging-market countries to adopt a transparent policy of smoothing short-
run exchange-rate fluctuations that helps mitigate potentially destabilizing
effects of abrupt exchange-rate changes while making it clear to the public that
they will allow exchange rates to reach their market-determined level over
longer horizons.
1.3 INlFLATION IN A MACROECONOMIC FRAMEWORK
1.3.1 Vittorio Corbo Lioi
Dissatisfied with the existing explanations and empirical works on
inflation in developing countries and after spending some time on the subject
Vittorio Corbo Lioi realised through his work16 that, with the exception of the
work of Jorge Ahumada, most of the explanations of Chilean inflation in
particular were incomplete. In general, there appeared to be confusion between
change in relative prices and increase in the price level. On the empirical side
the most valuable work existing at that time, and even to-day, was the work
by Arnold Harberger. Harberger also has the honour of having made the first
serious empirical study of Chilean inflation.
After examining all this work he came to the conclusion that the only
interesting way to study the behaviour of the price level from the analytical
and especially from the policy-maker's point of view was to work with a
complete macroeconomic model.
From an analytical point of view this is the correct way to approach the
problem because it allows one to consider the most important interrelations
among the main macro-variables, in contrast to the use of single equations in
which all these feedbacks are disregarded. The second advantage of this
approach is from the policy point of view. Especially in the 15 years, the
political authorities are interested not only in the stability of price levels but
also in their relationship to other variables. Thus, if the side effect of stability
is a substantial increase in unemployment and a lower level of output, then the
political authorities would like to know more precisely the consequences of
their policies. One can agree completely with Milton Friedman that stability
has a cost in terms of output and unemployment only in the short run, but the
policy makers are still very much concerned with the short run (which could
be a period of several years) consequences of their policies.
This book is a first attempt towards building a macroeconomic model to
study the interaction among the main macroeconomic variables. It is divided
into three parts plus three appendixes. The first deals with monetarism,
structuralism and past studies of Chilean inflation. The second part of this
book deals with a quarterly model for industrial prices, industrial wages and
inflation. The third part of the book is devoted to the specification, estimation
and simulation of an annual econometric model of the Chilean economy.
1.3.2 Ajay Chhibber
Ajay Chhibber, in his study17 notes that in countries such as Ghana,
Sierra Leone, Uganda, and Zambia, the high inflation was prevalent prior to
the exchange reforms of the 1980s and was prevalent through periods when
the exchange rate was fixed. The high inflation rendered the official exchange
rate more or less irrelevant and parallel markets emerged. The level of the
official exchange rate was important for accounting purposes, but had very
little relationship to the true price of foreign exchange - the parallel exchange
rate. Detailed analysis of the Ghanaian exchange reforms shows that adjusting
the official exchange rate may have actually lowered inflation by reducing
fiscal deficits. The underlying cause of inflation was the high fiscal deficits,
which were financed primarily through money creation.
The lower and stable inflation in countries with pegged exchange rates,
such as those of the CFA Franc Zone, also has its genesis in the underlying
monetary and financial arrangements, rather than in the fixed exchange rate.
The openness of the capital account between countries of the Zone ensures that
the money supply is not a policy variable. Domestic credit expansion does not
lead to monetary expansion and inflation, but instead affects the balance of
payments.
The key, then, to price stability lies in providing checks on large fiscal
deficits and non-inflationary mechanisms for financing them, rather than the
exchange rate regime per se. In principle, this can be done through responsible
expenditure and revenue policies. In practice, experience shows that it requires
institutional arrangements that restrain excessive expenditure.
1.3.3 Akhtar Hossain
The author in his book1* develops an integrated inflation and balance of
payments model for the Bangladesh economy, which is then applied to policy
analysis. While developing the model, elements of both the structuralist and
monetarist theories have been combined.
The empirical results support the twin hypotheses that inflation in
Bangladesh is a monetary phenomenon and that persistent trade deficits are
inherent in both its foreign-aid-based development strategy and its overvalued
exchange rate policy. The policy experiments reinforce a priori expectations
that restrictive monetary and fiscal policies may lower inflation and prevent
a price spiral originating from any supply stocks. Further, a typical IMF
stabilisation package is found effective in lowering inflation and reducing trade
deficits, with a marginal reduction in output.
In terms of its coverage, emphasis and thoroughness, the model is the
first of its kind for Bangladesh and the results obtained may be applicable to
other developing countries as well.
1.3.4 Brahmananda
In his voluminous work1' Brahmananda realises the need for founding
the theory of inflation on classical economics. Commodity stock plays a central
role here. If the money supply process gets unhinged from the stock-
accumulation process, a disequilibrium sets in. The effects are seen in all
spheres of the economy and are carried over to that of international economic
relation. In some of the more recent developments in macroeconomics in the
West, the thesis that money matters in the short period, in regard to output
and employment, is being given up. The hypothesis of rational expectations
among wage earners andlor households has led to a rich crop analysis. Both
equilibrium and disequilibrium models have been developed with roles for
feedbacks and various sorts of prevalent expectations and adaptation
processes. Though it is difficult to predict the eventual outcome of these
discussions, it does seem that a new set of relations among variables, of a wide
ranging significance, a new paradigm termed as the New Classical
Macroeconomics, is getting crystallised.
Classical economics concentrates upon the diagnosis of the causes of
economic phenomenon. Granted that individuals in a community would prefer
a state of larger per capita wealth to that of a smaller per capita wealth as a
permanent prospect, the object of the science of political economy is to make
them realise those actions and their implications which could obtain for them
the above specified goal. Political economy therefore helps to dispel the barriers
that come in the way of the above understanding. It helps to raise the people's
consciousness in economic matters on the postulate, that provided such a
consciousness is improved, the desirable patterns of behaviour and courses of
action would eventually be undertaken by the individuals. The propositions of
political economy are, therefore, based upon the possibility of a high level of
consciousness of economic matters among individuals composing the
community. In any actual State of an economy, there could be behaviour
patterns and actions based upon insufficient consciousness or what might be
termed as incomplete rationality. The phenomenon of inflation is one of those
cases, wherein the postulate of rationality would reveal it to be a socially
undesirable state.
The book seeks to present a fairly comprehensive account, along
modernised classical lines, of the nature, origins, causes, consequences and
control-techniques of inflation, particularly from the angle of poor economies
like India and from a classical angle.
1.3.5 Ranganadhachary
The specific objectives of Ranganadhachary's stud? are the following:
(1) to attempt a comprehensive review of the existing theories of inflation in
order to gain insights into the process of inflation; (2) to provide an analytical
framework for the study of the Indian inflation in the light of the existing
theories of inflation and in the context of the institutional characteristics of the
Indian economy and the structural changes; (3) to identify and measure the
significance of the relevant variables through regression analysis; and (4) to
make an appraisal of the monetary policy of the Reserve Bank of India to
contain inflation.
Chapter I is devoted to the survey of theories of inflation. Chapter 2
makes a review of the empirical studies on Indian inflation. The available
studies are organised under two heads namely single equation models and
price behaviour equations in macroeconometric models for the Indian economy.
Tne review of the empirical studies clearly brings out the fact that the existing
studies seeking to explain price behaviour are inadequate and suffer from
several limitations. In chapter 3, an attempt is made to evolve an analytical
framework for the study of Indian inflation in the light of the analyses made
in the previous chapters and in the context of institutional characteristics of
the Indian economy and the structural changes that .have been taking place in
the economy. Among the structuralist variables impinging on the price level
which have been identified, only some could be introduced in regression
anrlysis attempted later in chapter 6. Chapter 4 gives in some detail the
bahaviour of the general as well as sectoral prices during the period under
study in the light of the major development in the economy. The analysis in
chapter 5 is largely guided by the hypotheses thrown out by demand-pull
theories of inflation. The theoretical versions examined through regression
analysis are the naive monetarist version which links up price level directly to
money supply, excess demand formulations which focus attention on
inflationary gap and refined monetarist models including that of Arnold
Harberger. The special future of this chapter is the analysis of price behaviour
based on quarterly data on prices, money supply and output. The use of
quarterly data enabled the examination of lead-lags in respect of these
variables.
In chapter 6 besides the monetary variables, the structuralist variables
relating to fiscal development and foreign trade have been included in the
statistical analysis. This analysis is mainly exploratory in character. Chapter
7 brings the description of price trends upto the end of March, 1980. Chapter
8 is devoted to the appraisal of the use of monetary instruments by RBI for
containing inflation. Chapter 9 gives a brief summary of the conclusions of the
study. In the Appendix, anti-inflationary measures adopted in 1974 have been
examined.
1.3.6 Arjun Chatrath et.al.
The authors in their study1 indicate a negative relationship between
stock market returns and inflationary trends has been widely documented for
developed economies in Europe and North America. This study pinvides
similar evidence for India. They investigate this anomalous relationship in
light of Farna's proxy hypothesis that centers around linkages between
inflation and real activity, and between stock returns and real activity.
Specifically, the study tests whether there is a negative relationship between
inflation and real economic activity, and a positive relationship between real
activity and stock returns. The results from the heteroskedasticity and
autocorrelation corrected OLS models provide some support for Fama's
contentions. First, a negative relationship between inflation and real activity
is documented. Second, the relationship between real activity and stock returns
is found to be positive. However, the final stage of the proxy hypothesis is not
supported. The negative association between real stock returns and the
unexpected component of inflation (and inflation per se) persists, despite the
fact that a two-stage model controlled for the inflation-real activity
relationship.
The study documents some unique aspects in the relationships among
inflation, real activity and stock returns in the Indian economy. Real activity
is found to cause changes in inflation rather than vice versa. It is suggested
that the delayed monetary actions taken by India's central banking authorities
may be the cause for this anomalous relationship. Moreover, the study finds
little evidence to indicate that the Indian stock market accurately reflects
further real activity. A notable lag between industrial production and stock
market activity is documented. The issue of whether similar relationships exist
in other emerging markets remains to be examined.
1.3.7 Kannan a n d Himanshu Joshi
Kannan and Himanshu Joshi in their empirical results in this studyzz
establish that the inflation rate threshold for India is at a level of about 6 per
cent but a rate higher than this optimun level can have adverse consequences
for GDP growth. Moreover, a sharper rate of a declaration in growth occurs
after the rate of inflation exceeds 8 per cent per annum. The empirical results
also indicate that inflation rates below the estimated threshold may, in fact,
have some positive effect on growth. Given that this positive influence is
available up to an maximum upper limit of 6 per cent; there exists reasonable
scope of manoeuvring domestic fiscal and monetary policies for improving
growth prospects of the Indian economy over the medium run.These policies
may, however, have to be co-ordinated keeping in mind the strategic aspects
of the external sector, especially, with regard to the implications that it will
have for the exchange rate of the rupee (Rangarajan 1998). Notably, their
estimate of threshold rate of inflation estimated at 6 per cent is invariant to
the exclusion of high inflation years, viz., 1991-92 and 1992-93. This finding
helps to prove that the estimated threshold rate is indeed unbiased and robust.
1.3.8 Cavallo a n d Mondino
The authors in their study3 represent that in April 1991 Argentina
embarked on a far-reaching programme of economic reforms designed to bring
inflation down to acceptable levels and to restore growth on a sustainable
basis. The programme rested on four pillars: opening of the economy,
deregulation and reform of the tax code, privatization and elimination of other
forms of government interference in resource allocation, and stabilization of
inflation and the crucial relative prices. The programme is popularly known as
" the convertibility plan" thanks to its most notorious and innovative feature:
the introduction of a bimonetary currency board.
Inflation stabilisation programmes are typically either money or
exchange rate-based programmes. Argentina opted for what is an uncommon
combination of the two. The programme is not a standard, 100 per cent
reserves currency board. The convertibility reform introduced a currency that
must compete in the market against other currencies. The idea behind
convertability is theoretically simple and draws on Milton Friedman's concept
of the optimal quantity of money.
The convertibility programme allowed for two (or more) currencies to
compete against each other in the domestic market. In effect, the government
has relinquished its monopoly power over money. Convertibility forces the
peso, if it is to be used and held a t all, to be price competitive with other
currencies of reference. In particular, since the U.S. dollar was in widespread
use, it forced the peso to compete against the dollar. In practice, people can
purchase any thing, any where, and a t any time in dollars. The market has
also chosen to denominate most long-term contracts. The second important
feature of convertibility, and perhaps the most widely understood, is that the
Central Bank is required by law to hold enough foreign currency or marketable
(and liquid) assets denominated in dollars to fully back its monetary liabilities.
In other words, every peso that makes up the monetary base has a counterpart
dollar resting in the vaults of the Central Bank.
Convertibility was remarkably successful in bringing down inflation.
Inflation dropped from 30 per cent a month in March 1991 to an average of 0.4
per cent a month during 1994. This success, plus the elimination of spurious
variability in relative prices and, lately, the weathering of the "Tequila" storm,
makes it attractive as a potential new variant for the well-developed toolbox
of stabilizers.
A combination of trade reform, privatization and deregulation, and
macroeconomic stabilization lies behind the historically and internationally
high rate of productivity growth in Argentina.
1.3.9 Brandt a n d Zhu
Brandt and Zhu in their paper24 analyse that the high average growth
rate enjoyed by China since 1978 conceals a marked cyclical pattern. Periods
of rapid growth, accompanied by accelerating inflation, are followed by
prolonged contractions during which the growth rate and inflation decline in
tandem. This "boom-bust" or "stop-go" feature of the post-reform economy has
been widely recognized.
Since the reforms began, a widening gap has also emerged between the
output contribution of the State Sector and its share of employment and
investment. Compared to the non-State sector, the State sector experienced
considerably slower productivity growth, which contributed to a sharp drop in
the proportion of output produced in the State sector.
In this paper the authors argue that these two phenomena are
intimately linked. Employment and investment growth in China's inefficient
State sector have been supported by the government with transfers in the form
of cheap credits from the State-owned banks and money creation. When credit
allocation is decentralized, the State-owned banks are able to divert resources
to the more productive non-State sector. While this increases output growth,
it also forces the government to rely more heavily on money creation to
finance the transfers to the State sector, which causes inflation to increase as
well. They show that the stop-go feature of the Chinese growth process is the
result of the government's inability to control the State banks' credit allocation
in the face of financial decentralization and the periodic need to resort to
recentralization and administrative control of credit allocation to reduce
inflation.
1.3.10 Fielding and Bleaney
Fielding and Bleaney in their workz5 argue that the choice of exchange
rate regime can be expected to make a substantial difference to the process
determining the rate of inflation in developing rountries. Not only is adherence
to a managed exchange rate regime likely to be associated with a lower rate
of monetary expansion, but, at least in the short term, it also results in less
inflation for a given rate of monetary expansion. They find both of these effects
to be statistically significant. According to their estimates, countries which are
able to maintain a fixed exchange regime without resorting to devaluation can
be expected to have an inflation rate of 18.6 percentage points lower than the
average rate for flexible exchange rate countries. Of this, they estimate 11.4
percentage points as the monetary discipline effect (lower monetary growth)
and 7.2 percentage points as the price-controlling effect of a fixed exchange
rate regime for a given rate of monetary expansion. Since the latter is a
disequilibrium phenomenon, it is offset over the long run by exchange rate
devaluations.
In the last few years there has been a move away from managed
exchange rates to more flexible systems, partly as a result of persistent
external deficits. The results here suggest that such a move would in the past
have entailed some costs. Flexible exchange rate regimes have been associated
with higher monetary growth rates and higher inflation. It is possible that this
tradeoff no longer exists, because of recent progress in institutional design :
they now understand much more about how to establish an independent
central bank free from the day-to-day political pressure which leads to the
pursuit of short-run output gains a t the expense of inflation, or to increases in
inflation in order to boost seigniorage revenue. Nevertheless, it would be naive
to ignore completely the exchange rate system when engaging in such
institutional design.
1.4 INFLATION IN THE CONTEXT OF RELATIVE PRICE
VARLABILITY
1.4.1 Nag and Samanta
The authors in their paper26 have a detailed analysis of the monthly
data on wholesale price index and its various components and confirms the
view that, even in the Indian context characterized by substantial structural
rigidities, monetary factors have a contributory role in generating overall
inflationary pressure, although importance of structural factors cannot be
overlooked. Moreover, there is no evidence to believe that during the period
under study there was any persistence and adverse movement of manufactured
items prices against agriculture. If at all, the prices of foodgrains rose much
faster than agricultural inputs,the prices of latter items being mostly under
administrative control. The significant contribution to overall price rise by
'Other Food Items' reflect, possibly, a general increase in demand pressure due
to rise in income of middle income groups. Similarly, the rise in prices of
'Other Manufactured' items was not entirely due to increase in price of raw
materials but perhaps reflected the demand pressure. The non-food credit is
found to be an important factor in determining sectoral prices also, thereby
leaving room for the RBI to play an important role in moderating the pressure
on price front arising out of fiscal profligacy of the central government.
1.45 Suchitra Sengupta and Tanuka Endow
Suchitra Sengupta and Tanuka Endow in their paper27 conclude that the
WPI (all commodities) and CPI (Industrial workers) have followed a similar
upward trend over the time-period considered. In the recent past this has been
accompanied by a declining rate of inflation for both. However in a definite
break from the past, there has been a marked divergence between the two
rates of inflation in the fiscal years 1995-96 and 1996-97 with the CPI - based
inflation way above the WPI - based one. What is more disturbing is that the
gap between the two has been widening over time. It appears that the efficacy
of the stabilisation policies introduced with the economic reforms has suffered
erosin over time.
They find that the composition of the basket for constructing WPI is of
critical importance in assessing the inflation in the economy. Using the basket
of goods for constructing CPI (IW) in conjunction with the corresponding
wholesale prices, it was found that the prices of these goods have, in fact, risen
at a much faster rate at the wholesale level compared to the retail level. The
disaggregated analysis in Section I1 provides evidence of price management
through direct government intervention for cereals [which is the single largest
subgroup in the CPI (IW)]. This dampening of prices restrained the growth in
overall CPI (IW). They contend that this refers to the phenomenon of
'repressed inflation' as mentioned by Balakrishnan where prices are reined in
through controls and soft budget constraints. Balakrishnan has predicted that
this situation of repressed inflation is not sustainable. Their analysis a t the
disaggregated level provides evidence supporting this conclusion. It may be
recalled here that their analysis in Part I (where the WPI - construct has been
used) has a data set till March, 1995. But in Section I1 they have used more
recent data till February, 1996. This extension of time-period is important
because they feel that the situation of repressed inflation might have turned
into one of open inflation during the past year. The evidence for this can be
obtained from both the aggregated and disaggregated analyses.
Regarding the currently used point-to-point measure of inflation, they
feel that this measure is highly sensitive to the time of the year chosen for
computation. A trend-based rate of inflation is a superior measure. In case this
measure is not easy to compute and interpret, a substitute measure may be the
point-to-point rate based on a smoothed series of moving averages.
1.4.3. Debelle and Lamont
The main innovation of this paper28 is the use of cross-sectional data on
inflation and relative price variability (RPV). In using differences across cities,
they automatically exclude as explanations those theories of the inflationIRPV
nexus that rely on monetary policy, since different cities do not have different
monetary policies. Although on the national level and in the long run inflation
may be always and everywhere a monetary phenomenon, by construction their
approach captures only price changes that are caused by relative shocks to
cities.
Although cross-sectional data have advantages over time-series data in
this respect, they also have disadvantages in that the evidence presented here
does not necessarily directly relate to national inflation and RPV.That is,
national inflation and city-specific inflation are, by construction, orthogonal
variables, so they cannot aggregate city-specific inflation and RPV shocks to
reach conclusions about the national variables. Another limitation is that, as
with many studies in this field, they are simply observing the contemporaneous
correlation of two endogenous variables and so cannot come to strong
conclusions about causality. Their approach is useful, however, in that it
illuminates basic facts about the price system that are applicable to the
national level. They have found a robust empirical regularity : across cities,
RPV and inflation (relative to the national average) are strongly correlated.
This correlation cannot be explained by theories that depend on monetary or
federal goveinment action. In addition, they found that the cor;elation between
inflation and relative price variability was surprisingly persistent over time.
1.4.4 Fielding and Mizen
The paper29 presents new information on inflation and relative price
variability across Europe. The evidence reported here has taken 10 countries
and 15 different product groups to examine the diversity in relative price
variability and inflation in Europe, where significant differences in behaviour
will have important implications for the viability of monetary integration.
The data on prices are used to calculate relative price variability
measures across product groups within the same country and across countries
for the same product group. The time series behaviour of these measures is
investigated, and for 9 out of 10 countries and 13 out of 15 product groups the
null of non-stationarity is rejected around a smooth transition in the
deterministic trend. In all cases, across both countries and product groups, the
smooth transitions are very gradual, indicating that although there is a
significant transition the adjustment is slow.
These findings of stationarity are confirmed by tests of persistencein the
relative price variability measure which, while showing some persistence for
many of the 10 countries and all 15 product groups, reject the null of a unit
root. The memory of the series shows that the decay to the relative price
variability measure within countries is rapid - with reported half - lives of less
than four months - and is highest fro the relative price variability, measures
within product groups. As a result, shcoks to relative price variability. are all
but eliminated after 12 months.
Two points stand out from these results. First, for data within countries
and within product groups, shocks to relative price variability are virtually
eliminated over a 12-month horizon. The half-lives of the stochastic
components around logistic trends are extremely short, and in no case does the
half-life exceed ;ix calendar months. Second, there is an aksence of a
systematic strong and positive relationship to inflation that suggests that
intervention to control inflation could not be relied upon to control relative
price variability. This is most evident in the relative price variability within
countries, and it implies that attempts to find a policy acceptable to all the
European nations would be frustrated by the lack of any systematic
relationship between inflation and relative pricevariability. However, since the
relative price variability series are short memory process which decay quickly,
this is less problematic than it first appears. Even within product groups,
although relative price variability is negatively related to inflation, the effect
of shocks is eleiminated within one year. The speed of the decay demonstrates
that shocks to variability in prices do not persist for long. In policy terms, this
suggests that monetary policy can be dedicated to the long-term task of
reducing inflation, while the harmonization of short-term relative price
variability can be left to market forces.
1.5 COST-PUSH THEORY OF INFLATION
Cost-push theory of inflation is sometimes described as seller's inflation.
The latter is a broader concept than the former. Cost-push is generally used
to denote a situation when a rise in the cost of production (mainly due to rise
in the wages) leads to charging out higher prices, but the sellers desire to earn
higher profits may also lead to inflationary pressure. Seller's inflation includes
all three types viz., wage-push, price of materials - push and profit-push, but
the term cost-push in the strict sense does not incorporate profit-push.
However, the term cost-push has gained wider acceptance rather than the term
seller's inflation.
Some of the assumptions of demand-pull inflation like full enlployment
and free markets are rarely found in the real world and therefore, demand-pull
inflation alone failed to offer a satisfactory explanation of the inflationary
phenomenon. The basic argument of cost-push inflation is that employers are
forced by highly organised trade unions to grant increases in wage rates in
excess of the rise in output per head. To maintain profit margins, elnployers
are compelled to charge higher prices. Higher wages tend to push up demand
and the shift in demand induces rise in commodity prices. In its term
commodity price inflation will induce trade unions to agitate for further wage
revisions and so on ad infinitum. Making use of the IS-LM apparatus we depict
the commodity price rise due to the wage hike. Before we present the
apparatus a few comments on the apparatus itself are in order. This is an
extended model of the Keynesian theory refined and popularised by J.R.Hicks
and Allvin Hansen. It integrates the money and goods markets and thereby
closes the classical dichotomy between the markets. I t is an example of general
equilibrium model which explains the simultaneous determination of the rate
of interest and the level of national income given the behavioural
characteristics of the endogenous and exogenous variables of the model. Since
this IS-LM model is well established in the text book literature we do not
propose to go into the positions and shapes of the variables that impinge on it
we take the standard format of the model which suits our purpose on hand and
proceed with an explanation of the phenomenon of cost-push inflation.
Inflation is the result .a$ . an upward or inward shift of the supply
curve as illustrated in figures 1.3 and C?,&the upward shifts of the supply curve
creates excess demand at the initial price level, to rising prices but bringing
a reduction in equilibrium output, as apposdto the case of demand-pull where
the price increase raises output.
FIG. 1.3. SUPPLY SHIFT AND INFLATION
In figure 1. .-5 we show an exogenous upward shift in the labour supply . , curve from ho(P,,N) to hl(P,,N) this may result from an increase in wage
demands by organised labour, due primarily to fast or expected price increases.
The upward shift in the labour supply function reduces equilibrium
employment at the initial price level. This is represented by the shift in the
supply curve to SISl in figure :I- 4. The shift of the supply curve creates excess
demand measured by Yo-Y, in figure &.The excess demand raises the price
level.
FIG.,. L COST - PUSH INFLATION
On the demand side of the economy, the price increase reduces
equilibrium output from Yo to Y,. This movement is shown in figure l.3.a. by the
lefi ward shifts of the IS-LM curves. At the same time, the price increase
raises equilibrium output on the supply side from Y, to Y, along the supply
curve SIS, in figure &.&In figure 1z3.b the labour demand curve shifts upward
to P,' f(N). The price increase induces a further upward shift in the supply
function toward h1 (P,,N).
The price increase reduces the excess demand gap by reducing demand
along the Do Do curve and increasing supply along the S,S, curve in figure
1.4. Equilibrium is restored at P, in figures 1.3b and 1.4. Where excess
demanu is eliminated and output has fallen to Y,. Inflatlm due to an upward
shift is usually called cot-push inflation. The increase in wage demands
represented as an upward shift in the labour supply curve in the figure 1.3b,
raises costs and causes producers to cut back output and raise prices.
It may also to be noted that the economy's supply curve can also be
shifted up by a drop in the marginal productivity curve, RN). This also raises
costs a t a given wage rate, reducing equilibrium employment and output and
raising prices. Further, it may be noted that a productivity increase, shifting
Pof(N) up in figure 1.3b, will tend to shift the supply curve out in figure 1.4.
Thus a productivity increase will tend to balance an increase in wage
demands in terms of the net effect on the economy's supply curve.
1.5.1 Identification of Demand-Pull and Cost-Push Inflation
In practice, it is extremely difficult to separate demand-pull from cost-
push inflation. All that the price and wage data show is an unending
sequence of price and wage increases. If we choose a wage increase as the
initial departure from equilibrium, then the subsequent inflation may be
labeled cost-push. But if a price increase is taken as the initial departure, the
inflation is demand-pull.
In addition, with labour union bargaining the picture is more
complicated. With a union contract period of three years, an initial burst of
demand-pull inflation can leave the union asking for a wage incresae to
compensate not only for the past lag of wages behind prices, but also for the
expected price increase. In this case the labour supply function may shift up
in anticipation of an expected demand-pull price rise3'.
1.6 THE PHILLIPS CURVE APPROACH
A.W. Phillips probing into the empirical evidence pertaining to wage
rates and unemloyment for over a period of nearly 100 years formulated the
inverse relationship between the rate of wage increase and unemployment in
1958. This inverse relationship goes by the name of the Phillips curve which
slops downward from left to right and is convex to the origin. As
unemployment is reduced by constant amounts, the wage rate will rise at
increasing rate with the change in wage rate approaching infinite as
unemployment approaches zero. In other words, a negative unemployment
rate is not observable the convex shape of the Phillips curve suggests that,
on an average, the economy will have less inflation if the level of
unemployment has narrow fluctuations about some average level. The
Phillips curve relationship between the rate of price increase and
unemployment shown in figure 1.5. If productivity grows a t about 3 per cent
per year, a zero rate of price increase corresponds to a 3 per cent rate of wage
increase. Thus, for any given level of unemployment we can read off the rate
of increase of wages on the vertical axis to the left of figure 1.5 and the rate
of price increase on the vertical axis to the right.
FIG. S .5 THE PHILLIPS CURVE
The original Phillips curve has been restated, modified and refined and
eloborated among others by Lipsey, Eckstein, Friedman and Phelps.Que to the
contributions of economists cited above the Phillips curve is supposed to be
vertical in the long-run. The natural rate hypothesis is the progenitor of the
expectation-augmented Phillips curve. It states that the rate of wage inflation
is determined by deviations of unemployment from its natural rate and the
anticipated rate of change of price 3!
In recent years, adaptive expectations have come under heavy attack on
the ground that the theory is not consistent with the rational behaviour of
people. Rational expectationists argue that the rate of inflation is directly
dependent on the rate of growth of money stock and random shocks. However,
output can not be influenced by the macroeconomic policy-parameters.
The shape of the'phillips curve is a subject of unending debate. Some
economists argue that the long-run Phillips curve may be kinked, almost
vertical for positive rates of inflation and almost horizontal for negative rates
of inflation shows an asymmetrical nominal-wage behavi0ur.Thi.s states that
wages do not rise even if there is excess demand for labour or expected
inflation, and also do not fall in the context of heavy unemployment or
expected deflation. In the early 1980s a study identified a mix of dernand-pull
and cost-push factors determining the pace of Indian inflation. These
determinants are: (I) growth in money supply; (2) growth in public expenditure
and deficit financing; (3) net national product at constant prices; (4) growth in
foodgrains production; (5) changes in terms of trade between agriculture and
industry; (6) changes in the composition of domestic output and (7) trends in
foreign trade and balance of payments32. The empirical evidence regarding the
shape and shifts of the Phillips curve is unsettled and therefore cannot be the
basis for generali~ation~~.
1.7 STRUCTURALIST APPROACH
The structuralist approach to inflation derives its inspiration from the
inflationary experience of Latin America, particularly those economies which
recorded strato-inflation34. The literature on structural theory of inflation is
quite extensive35, if not as extensive as on the monetarist approach. Theories
of inflation should identify the triggering and propagation factors of
inflationary rise in prices.Triggering factors are those which initiate (or ignite)
the inflationary rise in prices. The propagation factors are those which sustain
the inflation once it gets underway. Structuralist approach draws attention to
the basic structural factors, supply inelasticities and rigidities in various
sectors, which underlie the inflationary process. These factors are
distinguished sharply from circumstantial, cumulative or propagation factors.
According to the structuralists, the 'basic' factors are the cal~sal forces behind s . + >, ~s
inflation36. v
Inelasticity of supply is a summary expression for representing many a
thing on the supply side which impinges on the price level. Broadly stated, the
expression means that the supply of goods and services does not expand and
its composition does not adjust sufficiently fast to meet not only a rising
demand but also a change in the pattern of demand without serious price
pressures.
1.7.1 Hypothesis Formulated on the Basis of Structuralist Factors
Several hypothesis have been formulated on the foundation of the
structural rigidities. It is not possible in a Ph.D., theses to undertake a
comprehensive survey of all these hypotheses and therefore a few major ..%
hypotheses are sketched3' in what follows : , <
33"". I , ) 4 -3 1. Hypotheses of Agricultural Bottleneck or Sectoral Imbalance
This hypotheses implies atleast three mechanisms of price rise. One
mechanism price rise to be triggered by the scarcity of food relative to growing
demand for it3*. Another mechanism is in terms of sectoral imbalances
particularly between agriculture and manufacturing. During periods of rapid
industrialisation shortages of both foodgrains and industrial raw ma -=$&
41
arise, if agriculture fails to supply them adequately. It leads to excess demand
on the goods front leading to demand-pull inflation with secondary cost-push
inflation, generating the phenomenon of price-wage spiral in the economy39. A
third mechanism operates in terms of inadequate infrastructural facilities
contributing to imperfect factor mobility4'.
2. The Demand-Shift Hypothesis
This hypothesis establishes that shifts in the composition of demand, as
distinct from general excess demand, will result in an inflationary rise in
prices41.
3. Export Instability Hypothesis
This hypothesis states that fluctuations in export receipts tend to create
a long-term upward movement in the price This argument implies that
a rate of inflation is a positive function of the degree of export variability.
4. The Foreign Exchange Shortage Hypothesis
The developing countries are caught in a long-run balance of payments
disequilibrium because of low income elasticity of demand, for their exports
coupled with their high income elasticity of demand for imports. This situation
often leads to two types of adjustments which provoke inflation. First, imports
may be constrained by duties, direct controls or devaluation leading to
inflation. Second, if the country pursues import substituting industrialisation,
it may lead to demand shifts which might accentuate the inflationary
pressures.
. Like the Phillips curve, the structuralist hypothesis have been subjected
to empirical test in most of the developing countries. The mechanisms
underlying each hypothesis can be gauged only on the basis of statistical
anz'ysis, explicit attention being paid to the relevant economic and
institutional factors peculiar to the economy in question. some of the
structuralists especially in Latin America cover not only economic bottlenecks
and rigidities but also social mechanisms which keep inflation going. In
Chilean case, these mechanisms were defined in terms of "ability of different
economic groups continually to readjust their relative income". They create
various devices such as devaluation, automatic cost of living adjustments to
income to ease the social tensions created by inflation. Theories of this type
have wide-spread acceptance in the Third World, because such structural
imbalances and their social consequences are their explicitly seen by one and
all. Viewed this way the structural approach merges atleast partially with the
cost-push theory of inflation. It may be mention that cost-push theory is based
on some one or combination of monopolistic and oligopolistic distortions or
rigidities of the labour and product markets in industrial economies. Obviously
such situations cannot be dealt with by marginal economic adjustments, such
as changes the monetary policy. they require changes of major social
institutions and attitudes. Stopping inflation is seen either as a problem of how
to attack the position exploited by some formidably entrenched and organised
social group, or as a complex socio-economic and institutional problem
requiring a broad range of policies with wide a coverage of various
imbalance^^^.
1.8. THE PRESENT STUDY
The present study is conceived as an exploration in the realm of Indian
inflation since 1980 which is a turning point in Indian economy as far as
growth performance with distributive justice is concerned. Like some of the
scholars working the field of inflation we have approached the subject in its
totality tried to capture its elusive phenomenon and its different processes and
measurement. Our approach is that of the monestarist as well as the
structuralist. The choice of approach has been dictated by tradition and
convenience on the one hand and the complexity of the problem on the other.
The study is conducted in the context of a policy of libaralisation and
globalisation being actively pursued by the government without diluting its
commitment to poverty alleviation and ensuring social justice. The
management of inflation is a critical and strategic area of economic
stabilisation for achieving rapid and sustainable economic growth which is
people-oriented. The present study has the following specific objectives.
1.9. OBJECTIVES AND HYPOTHESES
The following are the specific objectives and hypotheses of the present
study.
1.9.1 Objectives
1. To describe the trends in general and sectional prices in India vis-a-vis
other countries;
2. To analyse the social and economic effects of Indian inflation and to
appraise the counter-inflationary policy;
3. To attempt a regression analysis of money supply, output and price
level;
4. To examine the role of fiscal and foreign trade variables in determining
general price level and changes thereof.
1.9.2 HYPOTHESES
1. The trends in general and sectional prices are not significantly
different from each other.
2. The social and economic effects of inflation are neutral.
3. There is no causal connection between money supply, output and
prices.
4. Changes in fiscal and balance of payments variables have no
significant effect on the inflationary situation.
1.10 DATA BASE
The study is based on the secondary data which are drawn from the
reports and bulletins of Reserve Bank of India and surveys of Government of
India. The publications of Reserve Bank, mainly Reports on Currency and
Finance, Annual Reports, Report of the Committee to Review the working of
the Monetary System, recent developments in monetary theory and policy
constitute an indispensable sources. Periodicals such as Journal of Political
Economy, Economica, Oxford Economic Papers and American Economic
Review. The Indian Economic Journal, Economic and Political Weekly and the
Economic Times have also been consulted apart from standard works on the
subject. World Bank's World Development Reports and IMF's International
Financial Statistics Year Book, Annual Reports and Finance and Development
and Studies on OECD member Countries are also consulted. The data obtained
from these sources do not however, fully meet the requirements of the present
study. Therefore, some adjustments in data have become inevitable.
1.11. TOOLS AND TECHNIQUES
Monetary analysis is essentially an exercise in macroeconomics, which
deals with economy-wide aggregates and sub-aggregates. The growth of money
supply vis-a-vis national output, general price level involve relationships which
need to be established and measured through different statistical tools namely
percentages, ratios, measures of central tendency, dispersion, time series
analysis, index numbers, correlation, regression, tests of significance and
analysis of variance. Growth rates, diagrams and graphs will be used to
measure the trends and illustrate the relevant variables. However, a greater
reliance is placed on historical and descriptive methods to describe the
different dimensions of the subject in a global context.
1.12. SCOPE AND LIMITATIONS OF THE STUDY
The present study is an exercise in understanding the process and
dimensions of inflation in India in the 1980s and 1990s. It is needless to
emphasize that this period is a crucial one in the history of independent India
as it is exposed to political and economic development of far reaching
importance. There has been a world wide concern in limiting population and
inflation growth rates. The decade of the 1980s was a witness to accelerated
growth performance of the Indian economy which is being sustained in the
decade of 1990s despite political upheals and global disturbances. Inflation was
not allowed to run its natural course but has been controlled by a variety of
measures and is presently contained at 6 to 7 per cent per annum. In any
empirical investigation of a complex phenomenon like inflation a choice has to
made with reference to tools and techniques of its measurement, analysis and
interpretation. Since inflation in any country can be understood in its global
context we have made a comparative assessment of inflationary trends in some
of the select group of countries. Thus, our selection of tools of measurement of
a inflation in India and its comparison with groups of countries over a span of
time has been highly restricted in terms of time and space. Conscious of our
constraints in the application of econometric models and tools we have
considerably restrained ourselves to tread along that path. Hence,the
conclusions we draw and the inferences we arrive at are as sound and reliable
as the coverage of our material and methods.
1.13 PLAN OF THE STUDY
The thesis is organised into six chapters. The first chapter is concerned
with a highly selective review of literature especially on the empirical
dimensions of inflation and the methodology of the present undertaking in the
context of India since the 1980s. The second chapter deals with an outline of
the several effects of inflation on economic growth and social justice in a
poverty ridden developing country like India. The third chapter is devoted to
an analysis of the trends in general and sectional price levels during the period
1980-81 to 1996-97 vis-a-vis the inflationary situation in some select groups of
countries from the developed and the developing world. The fourth chapter is
an exercise in causality of inflation in India since the 1980s. The basic
macroeconomic variables both monetary and structuralist that impinge on the
general price level are examined and the regression results in terms of levels
and price elasticities are explored. The fifth chapter takes a critical evaluation
of the counter-inflationary policy being pursued in India. The last chapter
gives a summary of findings and conclusions.
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