This sample Inflation Research Paper is published for educational and informational purposes only. If you need help writing your assignment, please use our research paper writing service and buy a paper on any topic at affordable price. Also check our tips on how to write a research paper, see the lists of research paper topics, and browse research paper examples.
Like many topics in economics, the concept of inflation— defined as an overall increase in the general price level of goods and services measured against a standard level of purchasing power—is subject to considerable disagreements among economists, highlighting the important differences between orthodox and heterodox economics. There are three important areas of disagreements. First, there is no consensus on the possible causes and consequences of inflation, even in a small, open economy. Second, economists disagree on the advantages of fighting inflation; in other words, should inflation-reduction be the primary goal of macroeconomic policy? Finally, economists disagree on the policies to be used to combat inflation. Indeed, in recent years there has been widespread agreement over interest rate–tightening as a way of fighting inflation, but such policies are misplaced, because they produce lower economic activity and higher unemployment.
Inflation is measured by keeping track of the changes in the prices of a number of items within a specific basket of goods and services over a given period of time, ignoring any improvement in quality. There are a number of ways of calculating inflation. For instance, the consumer price index (CPI) measures the changes in the prices of goods and services generally purchased by consumers. It is by far the most commonly used measurement. Other measurements include the gross domestic product (GDP) deflator, which measures inflation over the entire domestic economy.
The Orthodox Approach and Inflation
For orthodox economists, inflation carries important costs because there are advantages to lower inflation. Among the costs, orthodox economists claim that inflation erodes the value of money, and economic agents are frustrated in making their consumption and saving decisions; it encourages speculative investment to the detriment of productive investment; and it represents hardship for those on limited incomes or on incomes that are not indexed.
Among the benefits of low inflation, orthodox economists point to the ability of economic agents to make better, more informed, long-term decisions given the relative stability of purchasing power. For instance, because inflation is considered to lower the value of money, low inflation restores confidence in money: By reducing future variations in the price level, households can better plan their consumption and saving plans and regain confidence in the future value of money. Economists also claim that low inflation lowers nominal and real interest rates, and therefore produces overall stability of the economic system, as low inflation is self-reinforcing.
In orthodox economics, the principal cause of inflation is excess demand in the goods and/or labor markets, a direct result of scarcity in both markets. Whenever aggregate demand is greater than aggregate supply at any given price, the overall level of prices of goods and services will tend to increase in order to eliminate the excess demand: Inflation is demand-led. This is the necessary consequence of interpreting macroeconomics through the use of aggregate demand (AD; the total demand for goods and services in a national economy) and aggregate supply (AS; the total supply of goods and services in a national economy) analysis, interacting in price-output space. If there is a positive relationship between prices and output, it is because the AS curve is nonhorizontal. In this sense, both output and the price level are the result of AD-AS interaction. This analysis leads to an understanding of the role of prices in orthodox theory as a mechanism that guarantees market clearing.
In fact, irrespective of the specific neoclassical or orthodox approach, excess demand is always a central focus of inflation. Indeed, for monetarists, the growth of the money supply over and above the growth of output is seen as the principal cause of inflation. In their words, inflation is “always and everywhere a monetary phenomenon” (Friedman 1963). For monetarists, increases in the money supply always precede increases in prices. This results from the belief that the money supply is an exogenously determined quantity, independent of the needs of the economic system. The money supply is simply imposed on the system by the central bank, which can choose at will the growth rate of the money supply. Hence, whenever the central bank is pursuing expansionary policies, it allow the growth rate of the money supply to exceed that of output, resulting in “too much money chasing too few goods,” the inevitable result of which is higher price levels. This view is based on the well-known quantity theory of money.
Keynesians, however, although they do not deny the role played by the exogenous money supply, place the emphasis primarily on output, given the relationship between output (unemployment) and inflation as embedded in the Phillips curve, according to which there is a trade-off between unemployment and inflation: Lower unemployment implies higher inflation. In other words, fighting unemployment comes at the cost of higher inflation. As unemployment decreases, wages tend to increase, raising prices in the process.
An obvious question is what then may cause excess demand? The answer lies in expansionary monetary and fiscal policies—in other words, the central bank and the state. In addition to an expansionary monetary policy, inflation arises because governments pursue an expansionary fiscal policy. Inflation arises either because the deficit is financed by printing money, or because an increase in fiscal policy will increase output, spending, and therefore demand for goods and labor.
Given the above discussion, the policy solution to contain inflation is to reduce the pressure on prices by reducing overall demand in the economy. This means limiting the growth of the money supply and reducing fiscal expenditures: Policymakers need to adopt responsible, sound policies. For Keynesians, this implies higher unemployment and lower wages.
The Heterodox Approach and Inflation
For heterodox economists and post-Keynesians in particular, excess demand is not the principal cause of inflation, largely because the economy almost always produces at less than full capacity: There is almost never an excess demand for goods, and similarly, there is but rarely scarcity in the labor market. Post-Keynesians and heterodox economists nonetheless acknowledge that demand may have some influence on prices, but it is considered to be small and indirect. This statement has direct implications for and stands in stark contrast with neoclassical theory. For instance, one of the main consequences is that fiscal spending or excess growth of the money supply cannot be a causal or direct influence on prices and inflation. Indeed, for heterodox economists, money is never a cause of inflation. This is because the money supply is endogenously determined: Excess money cannot exist (Lavoie 1992; Rochon 1999). In other words, the money supply is not determined by the central bank, but rather by the needs of production.
In contrast to orthodox theory, therefore, the principal cause of changes in the price level is increases in the costs of production. In this sense, heterodox economists adopt a cost-push approach to inflation. That said, orthodox economists do not deny the importance of costs in determining changes in the price level, but there are important differences between the orthodox and heterodox approaches. For the former, changes in cost are usually the result of “supply shocks,” which occur only occasionally, such as a sudden increase in the price of oil or some unexpected and unforeseen event abroad. For heterodox economists, however, changes in the costs of production are the primary and dominant cause of inflation, and are part of the normal operations of contemporary economic systems.
For heterodox economists, however, inflation is not merely cost-driven, but it is also the result of conflicting claims over the appropriate division of income. Markets are characterized by dynamic interactions between macrogroups, such as workers, firms, and rentiers, each vying to get a larger share of income: Workers want higher wages, firms want higher profits, and rentiers want higher rents. In this sense, inflation is the result of a struggle over the distribution of income. It can arise largely from either a wage-wage spiral or a wage-price spiral, or from the attempt by firms to impose a given rate of return. In this sense, two important features of the heterodox explanation of inflation are collective bargaining and administered prices.
For instance, in formalized conflicting claim models, such as that described by Louis-Philippe Rochon and Mark Setterfield (2007), workers have a target wage share that they consider fair, equitable, or just. And although workers in general want to increase their overall nominal (or real) wages, they also want to maintain their social standing and their wages relative to other workers. If a specific group of workers negotiates higher wages, other groups may also demand higher wages in order to maintain their relative standing in the social order, fuelling the inflationary spiral. In turn, this wage-wage spiral implies higher costs of production for firms, which may try to pass on these costs to consumers through higher prices, which in turn will reduce real wages and lead to possible demand for higher wages in the future.
Moreover, firms may want to increase their standard rate of return to historical levels (Lavoie 1992). Firms may experience lower than normal returns and may want to increase their mark-up in order to bring their rate of return in line with more traditional levels, raising prices in the process. This in turn will lead to lower real wages, and workers may demand higher nominal wages to compensate.
Firms may be able to raise prices because, unlike in neoclassical theory, prices are administered: Firms set prices according to a mark-up over costs of production, not by competitive forces in the economy. In other words, firms will impose a rate of return over and above the normal costs of production, primarily wages and interest costs on debt, because they target a certain margin of profit.
In the end, whether firms or workers succeed in imposing their wills depends on the relative power of workers vis-à-vis firms in the wage bargain, and the relative power of firms in commodity markets. In turn, these powers vary according to the economic cycle or with the market structure. For instance, during periods of growth when unemployment is low, workers have greater power and may be able to demand higher wages. As for firms, brand loyalty, advertising, and the complexity of products give them greater power over prices (Lavoie 1992).
Finally, conflict also arises between firms and rentiers, who also want to increase their share of income. When the central bank increases interest rates, satisfying rentiers, firms may increase their mark-up and prices, and thus lower real wages. This also highlights an indirect conflict between workers and rentiers. For John Smithin (1994), rentiers are at the heart of the conflict. It is in this sense that heterodox economists see the rate of interest as a distributive variable.
The same analysis can be used to analyze deflation, that is a generalized decrease in the overall price level. In a conflicting claims model, one can assume that during periods of high unemployment, when workers are more desperate for work, they would be willing to work at wages lower (lower target wage) than what firms would be willing to offer in an effort to squeeze themselves into the labor market. With these downward pressures on wages, it remains possible for firms to lower prices, although deflation remains a rare phenomenon in contemporary developed economies since World War II, where the general trend on prices has been upward.
Similarly, the cost-plus approach and conflictingclaims model can be used to explain periods of hyperinflation (Camara and Vernengo 2001). For instance, in the case of inter-war Germany, the most probable cause of hyperinflation was the extreme costs of war reparations imposed by the Treaty of Versailles, a collapse of German exports, a depreciation of the currency, and higher prices. One may further assume that workers may resist the resulting important decline in real wages, along the same lines as described earlier. In the end, conflicting claims and distribution are key components of the explanation of both inflation and hyperinflation.
Heterodox economists also stand in contrast with orthodox economists in proposing policy remedies for fighting inflation. Three questions arise. First, should inflation always be the primary target of economic policy? Second, should the central bank be solely responsible for pursuing anti-inflationary policies, as has become the case in recent years? Finally, how can inflation be tamed?
Heterodox economists believe that too much emphasis is placed on fighting inflation, to the detriment of fighting unemployment and growth, which are the central focus of heterodox policy. As excess demand is not a direct contributor to inflation, there is no reason to believe that economic growth necessarily accompanies inflation. Moreover, because money is not seen as the principal cause of inflation, and also because there is only an indirect link between interest rates and inflation, heterodox economists do not see the central bank as the primary institution to fight inflation. In fact, central bank policy exacerbates the inflationary process.
Nevertheless, to fight inflation, heterodox economists propose a two-prong policy. First, we need de-emphasize the role of the central bank by setting the real interest rate at a “fair” level (equal to the growth rate of labor productivity), thereby limiting the influence of the rentier class. Second, we should adopt a permanent price and income policy in order to limit the increase in wages and prices.
- Camara, Alcino, and Matias Vernengo. 2001. The German Balance of Payment School and the Latin American NeoStructuralists. In Credit, Interest Rates and the Open Economy: Essays on Horizontalism, ed. Louis-Philippe Rochon and Matias Vernengo, 143–159. Cheltenham, U.K.: Edward Elgar.
- Friedman, Milton. 1963. Inflation: Causes and Consequences, New York: Asia Publishing House.
- Lavoie, Marc. 1992. Foundations of Post-Keynesian Economic Analysis. Aldershot, U.K.: Edward Elgar.
- Rochon, Louis-Philippe. 1999. Credit, Money and Production: An Alternative Post-Keynesian Approach. Cheltenham, U.K.: Edward Elgar.
- Rochon, Louis-Philippe, and Mark Setterfield. 2007. Interest Rates, Income Distribution, and Monetary Policy Dominance: Post-Keynesians and the “Fair” Rate of Interest. http://www.trincoll.edu/~setterfi/Rochon%20Setterfield%20I %20-%20complete%20paper.pdf.
- Smithin, John. 1994. Controversies in Monetary Economics: Ideas, Issues, and Policy. Aldershot, U.K.: Edward Elgar.
Free research papers are not written to satisfy your specific instructions. You can use our professional writing services to buy a custom research paper on any topic and get your high quality paper at affordable price.