Saturday, December 11, 2010

Demand Pull and Cost Push Inflation

The Phillips Curve was an empirical phenomenon looking for a theory and, around that time, there were two competing theories of inflation, both of which were expressed by Keynes in various places: "demand-pull" inflation and "cost-push" inflation - terms, as Machlup (1960) has shown, that can have a far from obvious meaning.

As originally expressed by John Maynard Keynes (1940) and Arthur Smithies (1942), "demand-pull" (or "inflationary gap") inflation is generated by the pressures of excess demand as an economy approaches and exceeds the full employment level of output. Output, recall, is generated by aggregate demand for goods - thus, whatever aggregate demand happens to be, aggregate supply will follow by the multiplier. However, at full employment output, if aggregate demand rises, output cannot follow because of full employment constraints. Consequently, with the multiplier disabled, the only way to clear the goods market, then, is by raising the money prices for goods. However, this is only a one-time increase in prices; inflation implies a sustained recurrent increase in prices. Keynes and Smithies explained inflation proper by appealing to distributional effects.

The Keynes-Smithies story can be expressed in the 45 income-expenditure diagram in Figure 11 where YF is full employment output and Y1d is aggregate demand. Note that the market-clearing level of output is Y1*, but it is not achievable - thus the "inflationary gap" is the difference between YF and Y1*. Keynes's (1940) argument can be restated as follows: as money wages lag behind good prices in adjustment, the rise in prices will therefore lead to a distribution of income away from wage-earners and towards profit-earners. He posited that, as workers have greater marginal propensities to consume than profit-earners, the redistribution of income induced by the inflationary gap will thereby lead to lower aggregate demand and thus close the gap, i.e. the aggregate demand curve flattens and falls in the Figure 11 from Y1d to Y2d .

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Figure 11 - The Inflationary Gap

The problem, of course, is that workers' money wages will still adjust upwards (recall that they were lagged behind), consequently once these adjust, income is redistributed away from profit-earners and towards wage-earners so that demand rises again (from Y2d to Y1d in Figure 11) and thus the inflationary gap re-emerges. But that inflationary gap, as noted earlier, leads to another price rise, redistribution of income to profiteers, etc. Thus, the whole process repeats itself continuously so that there will be, effectively, sustained, continual increases in prices, i.e. inflation.

In contrast, the "cost-push" theory of inflation or "sellers' inflation", also suggested in Keynes (1940), was more in line with older Marxian and Kaleckian sources - although this notion was also shared by Keynesian economists (e.g. Abba Lerner, 1951; Nicholas Kaldor, 1959; Sidney Weintraub, 1959) and Neoclassical economists (e.g. Milton Friedman, 1951). The basic notion is that, in a generally imperfectly competitive economy, firms set prices of output according to a simple mark-up formula:

p = (1 + m)w

where m is the mark-up, p price and w wage. When an economy approaches full employment, the "reserve army of the unemployed" gradually disappears, labor's hand at the bargaining table is strengthened. This will embolden laborers or their representatives to demand an increase in wages. In order to prevent this wage increase from eating into profits, employers will subsequently raise prices and keep the mark-up intact. Of course, if this happens, then workers will not be making any real wage gains. Perceiving this, they will follow up with another round of nominal wage increases - which in turn will be followed by a price increase and so on. Thus, in this version, inflation is a result of this wage-price spiral engendered by the relative bargaining position of workers in an almost fully employed economy. Incomes policies, which would link wage increases to rises in productivity, were suggested by many economsts (e.g. Lerner, 1947; Weintraub and Wallich, 1971; Okun and Perry, 1978) as a way of combating this type of inflation.

However, as Lerner (1951, 1972) stresses, the blame for inflation need not be placed squarely on the shoulders of workers alone: a push for profits by owners will be enough to initiate this kind of price-wage inflation spiral. In particular, there might be such a push when the owners' bargaining position seems relatively strong, i.e. when unemployment is high. Consequently, Lerner recognized the possibility of inflation with high unemployment, i.e. stagflation. It was precisely to combat this type of inflation that Lerner and Colander (1980) introduced their novel "Market Anti-Inflation Plan" (MAP) in the stagflationary 1970s: specifically, they proposed that the "right" to change prices be assigned to firms in the form of a fixed supply of tradeable vouchers, so that if a firm attempts to raise its prices, it would have to cash in its vouchers and thus relinquish its right to further price increases (whereas a firm which lower prices would gain vouchers). If a particular firm remained intent on raising prices further, then it would have to purchase vouchers from other firms on the open market. In their view, these added costs would make a profit-induced price rise less appealing to firms and thus help bring stagflation under control.

Both the "demand-pull" and "cost-push" theories of inflation are reconcilable with the empirical phenomena summarized by the Phillips Curve: as unemployment approaches zero, wage inflation (and price inflation) rises. However, the theories are different in that the first theory stresses more demand-side considerations while the latter concentrates more on supply-side. The corresponding "solutions" to the inflation problem are also different: "demand-pull" theorists concentrate on bringing down demand by, for example, reducing government expenditure, while "cost-pushers" call for the alleviation of wage pressure by institutional reform or incomes policies.

Although acknowledging the possibility of "cost push", most Neo-Keynesians took up the demand-pull explanation of inflation. However, the Keynes-Smithies story was told almost completely in the context of income and expenditure, and thus, surprisingly, ignored the monetary side. The Neo-Keynesians nonetheless attempted to appropriate the story into their IS-LM model by simply grafting on a capacity constraint, YF, to the left of the IS-LM-determined equilibrium, Y* and calling the resulting difference the "inflationary gap". With output stuck at YF, excess demand for goods will result in increases in the price level as before. However, unlike the Keynes-Smithies story, there is not a resulting "redistribution" of income to close the gap. Rather, as price level rises, the real money supply collapses and thus the LM curve shifts to the left and thus back to full employment output. Thus, the transmission mechanism implies that any price rises will themselves close the gap by lowering money supply and thus increasing interest rates and thus reducing investment and demand.

However, with the LM curve moving to bring the economy to full employment, it seems impossible, in this case, to have sustained price rises (i.e. inflation) as the monetary side seems to close off the story entirely. One could subsequently argue that, as real wages (w/p) declined in the process, then workers would try to bid their money wages back up and thus regenerate the gap. However, recall that from the four-quadrant IS-LM diagram (our earlier Figure 4), when IS-LM centers on the full employment output level so that Y* = YF, then the labor market clears and thus there are apparently no inherent dynamics to imply a rise in wages. If anything, a Pigou Effect arising from the fall in real money balances ought to push the IS curve to the left and actually generate unemployment so the implied dynamic might actually be a fall in money wages (of course, in the process of the original adjustment, IS and LM could move concurrently to the left and land at YF together, but then we are back to a full-employment centered equilibrium). In short, in an IS-LM context, we can obtain price rises but, at least within the confines of the model, we cannot obtain continuous inflation unless aggregate demand rises again for some reason - and there is no apparent reason why it will do so.

The problem, of course, returns to the old issue of what happens in that mysterious labor market which was so murky in the Hicks-Modigliani IS-LM world. The Keynes-Smithies story has workers bargaining for money wages upwards in response to the rise in prices, and the IS-LM story can accommodate that explanation, but it requires grafting on a theory of the labor market money wage bargain into the IS-LM model.

One of the first attempts to consider both labor market dynamics and goods market dynamics within one model was Bent Hansen's celebrated "two-gap" model (B. Hansen, 1951). Nominal wage movements are governed by the disequilibria in the labor market while nominal price movements are governed by disequilibria in the goods market so that the dynamics of the real wage and inflation arise from the interaction of the both goods and labor markets. However, the ideas of sustained disequilibrium "gaps" and price movements adjusting goods markets - with full employment - sound more Wicksellian than Keynesian. And it ought to - for Bent Hansen was a bona fide Wicksellian and his 1951 effort could be thought of as the swan song of the dying Stockholm School - or the opening notes of the disequilibrium "Walrasian-Keynesian" school - and thus not properly part of the Neoclassical-Keynesian Synthesis.

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