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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