B – Theoretical approach
The phenomenon of inflation is not recent, this concept and its effects on the real economy variable have been explored since the classical economic theory but have been explored further with the development of the modern economic theories.
Below will be explained the inflation and its effects on the economy growth under the different economy theories.
• Keynesian Theory
The eponymous economist John Maynard Keynes wrote a book called “The General Theory of Employment, Interest and Money” in 1936. This book explains the foundation of the Keynesian theory and also the modern macroeconomics.
The Keynesian theory is the most forceful critic of the classical model.
Whereas the economist of the classical economy model believed that the supply was creating its own demand, the Keynes theory argued that the cause to effect theory was running from demand to supply. For the Keynesians, businesses are basing their decision of production on the level of expected demand or the total expected spending. Which in other words mean the more consumers, investors, and others plan to spend, the more output the businesses are expect to sell and so the more they will decide to produce. So, in the Keynesian theory, the supply/ output is a response to demand, not the opposite as the classical economists suggested.
Furthermore, Keynes argued that the classical economists were wrong in believing that interest rate adjustments and wage/price flexibility would prevent unemployment. Full employment is possible only when the level of total spending is adequate. If spending is inadequate, unemployment will result.
So, Keynes’ theory rejected that the market economies lead automatically toward a full employment (classical theory). Keynes focused all his attention on what is the critical determinant of an economy’s health which are either the level of demand or the total spending.
So, the Keynesian believes that a government interventions through expansionary policies will have for consequences to boost the investment and also promote the demand so businesses will reach full production.
The promoted demand corresponds to the effective demand, that have for objective to maximize the utilization of the limited resources. On the other hand, the demand beyond full production is the excess demand.
In the Keynesian framework, the Aggregate Demand and the Aggregate Supply curves are adopted to show the relationship between output, employment and inflation.
So, if the current resources are not totally used, the promoting effective demand done by the government interventions will improve not only the output, but also the employment and this will happen without creating inflation until the output reaches the LRAS curve.
In the graph above, it is possible to see that the AD curve at AD1 is not reaching full output and employment expectations.
By promoting effective demand the AD curve will shift from position AD1 to position AD2 where the output is at its full production level but price did not increase and remain at P1.
If the demand keep increasing, the curve will move from AD2 to position AD3. In this situation, the output will not increase, because the full output was already reached in position AD2, but in AD3 the price will increase to P2 caused by the excessive demand. And so, the phenomenon of inflation has appeared. This type of inflation is caused by an excessive demand and is called demand-pull inflation. This type of inflation does not impact the output in the long run.
• Monetarism Theory
The Keynesian never find an explanation to the phenomenon of “Stagflation”.
In fact, the framework of Keynesian theory cannot resolve “Stagflation” a phenomenon that incorporate high inflation and low growth or high unemployment.
However, another school of economic theory called the monetarism, argues that the money supply is the only one factor that can determine the price levels in an economy and that the only government intervention possible is to manage the growth rate of money supply in order to match it with the growth rate of the output in the long run.
The foundation of monetarism is the Quantity Theory of Money. The theory says that the money supply in the market multiplied by the velocity (how fast the changes hands) is equals to the nominal expenditures in the economy (the number of goods and services sold multiplied by the average price paid for them). This equation is uncontroversial because it is an accounting identity. However, the velocity is controversial. Indeed, the monetarist theory views the velocity as something that is supposedly stable, so that means that the nominal income is a function of the money supply. Milton Friedman admitted that the velocity might vary a little but not really much so it can be treated as fixed
Furthermore, variations in the nominal income will reflect a change in real economic activity (how many goods or services are sold) and will also create inflation.
Let’s explain the idea with an example. The formula is MV=PT.
If the total money supply is initially $1000 and the velocity of circulation is 5.
Then MV=1000×5,
Furthermore the level of output (Y) is 5000 units.
So, $1000×5 = P (5000), therefore P = 1
Now, if the money supply doubles and is $2000 the equation will become
2000×5 =P×5000, and therefore P = 2
Therefore an increase in the Money Supply lead to an increase in price which mean to a phenomenon of inflation.
• Neo-classical Growth Theory
Neo-classical growth theory is another fundamental theory which explains how a stable economic growth rate will be achieved with the suitable amounts of three important factors: capital, labor and knowledge/technology.
The first neo-classical model was postulated by Solow and Swan in 1956. This is an economic model of long-run economic growth.
The Solow and Swan model try to explain the long-run economic growth by looking at capital accumulation, labor growth or population growth, and increases in productivity, also referred as the technological progress.
The Solow and Swan model is a thus contradiction to the classical Keynesian model of economic growth which claim that the capital-output ratio is exogenous.
In fact, Solow and Swan proposed a growth model where the capital-output ratio was the adjusting variable that would lead a system back to its steady-state growth path.
In the Solow Model countries reached a sort of equilibrium called a steady state. The steady state is where the capital per worker remain constant, investment in capital and loss in capital cancelled each over out. On the graph, it is where the level of investment and the level of is where the level of depreciation meet, it corresponds to the investment Y* and the level of capital K*. If a country is at a point where their investment is currently higher than the depreciation rate of capital, the level of capital will then grow toward the steady state point because their investment is higher than the loss of capital. The same is true on the opposite side as well. If the current investment is less than the current depreciation of capital then the amount of capital will decrease because their investment is less than loss. Therefore, despite where the country currently is they will continue to be pulled toward the steady state level of capital and output per worker, unless they are able to change some fundamental aspect of the economy such as saving rates or the depreciation rate.
Once a country reach its steady state the economy will become stagnant and growth can only be achieved through innovation and/or technological advancement.
This aspect of the Solow Model that suggest that all economies under equal circumstances converge over time to have the same amount of income per worker. That is to say that the gap between the rich and poor country will shrink. This is because in poor countries, each additional unit of capital would have greater returns than in the richer countries because they have started with much less capital. And the richer countries will experience the diminishing return of capital in a much higher degree. In the real world, this provide an explanation why China GDP has had an average growth rate of nearly 10% over the last 25 years while the GDP growth rate of the UK has only been around 0.5% for the exact same time frame.
So, if the Solow model holds over time has china increased its level of capital it will converge with the UK, until they both have about the same income per worker.
• New Growth Theory
The new growth theory is termed as an endogenous growth theory, because this theory assumes that technological progress is endogenous, which is contrary to what the neo-classical growth theory assumes. Indeed, the neo-classical growth is based on exogenous saving rate, population growth and technological progress.
Furthermore, the new growth theory assumes that the marginal product of capital is a constant element, but in the neo-classical growth theory, the capital is assumed to be diminishing on return.
The new growth model, if discussed under the framework of monetary economy, the relationship between the inflation rate and the return rate on capital will depend on the relationship between the real money balances and investment.
If the real money balances substitute the investment, then the inflation will decrease the return on real money balances but the return on investment will increase.
Thus, a positive relationship between inflation and economic growth will show. However, if the real money balances complement the investment, then the inflation will have a negative effect on the growth.