Theories of Inflation or inflation theories That Prove Its Existence:- Inflation is already here. We commented a few days ago following the publication by the INE of the Consumer Price Index (CPI) for the month of December. This indicator corroborated the increase in prices of the last months and placed inflation at 1.6%, nine tenths more than in November.
In this way, inflation last year closed with the highest rate since 2012. In case this was not enough, in January this climbed to 3%. This puts a compelling question on the table: why is there inflation? That is, why do prices of goods, services and productive resources rise?
More from Business Study Notes:- Causes of Inflation
Types of Inflation theories
Today we will review two types of inflation theories that explain the causes of inflation: a first group that considers the origin of inflation to be in excess of demand (demand inflation) and another group based on the fact that the problem arises on the side of Supply (cost inflation).
Theories of Demand Inflation
Demand inflation appears when the economic agents of a country request more goods and services than the system can offer them. Provided producers cannot increase their production, this demand pressure inevitably shifts to prices, increasing them.
There are two theories that explain demand inflation:
Monetary theory: It is the explanation of classical economists. They argue that the increase in the amount of money in circulation above production generates an increase in the demand for goods and services, since money is mainly demanded for transactions. As the economy is close to its frontier of production possibilities, that demand cannot be met and prices will rise.
Keynesian theory: Keynes and his followers rejected the previous theory, stating that money is not only demanded to carry out transactions, but also as a deposit of value. Hence, the incidence of prices on demand depended on the elasticity of supply and the situation of the economy, so that in times of recession the increases in demand could be answered with more production; while in times of expansion it was impossible, generating inflation. The problem with this theory is that it failed to explain the existence of inflation with unemployment and with the excess productive capacity of the economy.
The two theories coincide in pointing out that the increase of the demand on the part of agent causes inflation whenever it is not compensated by decreases in the demand of the other two.
Theories of Cost Inflation
On the supply side there are five theories of inflation that try to explain inflation from the remuneration of productive resources:
Because of the increase in natural resources, if basic resources such as raw materials or energy see their prices rise; the entire production process will be made more expensive. The normal thing in these cases is that the companies transfer the increase of the price of these resources to the final price of the product, generating in this way inflation.
By the wage-price spiral: The starting point of this theory is that unions have the power of pressure to get salary improvements higher than real labor productivity. As a consequence, increasing wages increases the disposable income of these people and this translates into an increase in prices, since the other income earners do not want to be less in terms of generating income.
By the wage-wage spiral: If in some companies increases in labor productivity result in significant wage improvements, workers in other companies will seek to achieve the same improvements through increased union aggression. We return once again to an increase in the disposable income of workers that will provoke a price increase on the supply side.
Because of the market power of some companies: There are certain imperfectly competitive market companies (monopolies and oligopolies fundamentally) that enjoy sufficient market power to increase prices without causing a loss of sales. Think, for example, in power companies or in the oil sector.
For the price of money: When there is inflation, companies that have borrowed money see the interest they have to pay, and therefore their costs. In many cases, they try to compensate by raising prices to keep their margins of profit and competitiveness intact.
In any of these cases, the increase in the remuneration of any productive factor generates a chain reaction that affects all the economic branches and that can extend beyond the national borders. This explains, in the case of the Eurozone, the European Commission’s interest in having inflation under its control.
Is it possible to keep inflation in check?
The answer is yes. Regardless of the causes that cause it, there are different formulas applicable to reduce inflation, or at least keep it bound. Let’s look at some examples.
When inflation is due to excess demand, authorities often try to reduce such demand, for example by raising taxes. We try to get families, by having less money to spend, reduce their consumption. Another measure could be raising interest rates to increase access to finance. However, we cannot ignore that discouraging consumption will result in a drop in production and possibly an increase in unemployment.
When inflation is generated by excess money in circulation, economic authorities can try to reduce the money supply, which would reduce the amount of money in the economy and this will presumably lead to a fall in prices.
In the case of inflation caused by the increase in production factors, policies can be implemented that tend to reduce business costs. For example, energy saving campaigns or punctual pacts with unions and employers to moderate wages and corporate profits.
When inflation is a consequence of the existence of an imperfect competition market, governments often regulate such a market with the aim of promoting greater competition between companies. Proof of this is that monopolies are totally prohibited by law.
The policy of price control is quite popular with the aim of keeping inflation within a range considered appropriate. However, very careful with this because these control measures can become counterproductive, since they distort the operation of the economies, promote the shortage of products and services and diminish their quality, among other unwanted effects.