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Conflict theory of inflation and inflationary biases 

A series of articles in the journal Marxism Today in 1974 illustrated the proposition that inflation was the result of a distributional conflict between workers and capital. These articles were written with reference to the early 1970s, when inflation rates rose in many Western economies. One article by Pat Devine stated that the inflation process was a structural construct embedded in the intrinsic capital labour conflict. He argued that the increased bargaining power of workers (that accompanied the long period of full employment in the post-Second World War period) and the declining productivity growth in the early 1970s imparted a structural bias towards inflation which was manifested in the inflation breakout in the mid-1970s that “ended the golden age.” He further claimed that the prolonged growth of money wages was “unprecedented in the history of capitalism” (Devine, 1974: 80). Capitalists increased prices to maintain profitability and thus countered the attempt to raise real wages. Large, oligopolistic firms with price setting power engaged in non-price competition (for example, product quality). These firms, however, were interdependent because their market shares were sensitive to their pricing strategies. When a firm was faced with nominal wage demands, its management knew that its rivals would face similar pressure and that their competitive positions would not depend on the absolute price level while the government continued to ensure that effective demand was sufficient to maintain full employment. On the other hand, a firm could lose market share if it increased prices while other firms maintained lower prices. As a result, firms had little incentive to resist the wage demands of their workers and strong incentives to protect their profits by passing on the demands in the form of higher prices. This structural depiction of inflation as being embedded in the class dynamics of capital and labour, both of which had increased capacity to set prices and defend their real shares of income, implicates Keynesian-style approaches to full employment. There was also an international component to the structural theory. It was argued that the Bretton Woods system (see Chapter 9) imparted deflationary forces on economies that were experiencing strong domestic demand growth. As national income rose and imports increased, central banks were obliged to tighten monetary policy to maintain the agreed exchange rate parity and the constraints on monetary growth acted to choke off incompatible claims on the available income. However, when the Bretton Woods system of convertible currencies and fixed exchange rates collapsed in 1971, the structural biases towards inflation came to the fore with floating exchange rates. Devine (1974: 86) argued that: floating exchange rates have been used as an additional weapon available to the state. Given domestic -inflation, floating rates provide a degree of flexibility in dealing with the resultant pressure on the external payments -position. However, if a float is to be effective in stabilising a payments imbalance it is likely to involve lower real incomes at home. If a reduction in real wages (or their rate of growth) is not acquiesced in there will then be -additional pressure for higher money wages and if this cannot be contained the rate of inflation will increase and there will be further depreciation. The structuralist view also noted that the mid-1970s crisis, which marked the end of the Keynesian period, was not only marked by rising inflation but also by an ongoing profit squeeze due to declining productivity growth and increasing external competition for market share. The profit squeeze led to firms reducing their rate of investment (which reduced aggregate demand growth), which combined with harsh contractions in monetary and fiscal policy, created the stagflation that bedevilled the world in the second half of the 1970s. The resolution to the structural bias proposed by economists depended on their ideological persuasion. On the one hand, those who identified themselves as Keynesians proposed incomes policies (which we shall explore in more detail later in this chapter) as a way of mediating the distributional struggle and achieving nominal income claims that were compatible with the available output. On the other hand, the emerging Monetarists considered the problem to be an abuse of market power by the trade unions and this motivated demands for policymakers to legislate to reduce the bargaining power of workers. The rising unemployment was also not opposed by capital because it was seen as a vehicle for undermining the capacity of the trade unions to make wage demands. From the mid-1970s, the combined weight of persistently high unemployment and increased policy attacks on trade unions in many advanced nations reduced the inflation spiral as workers were unable to pursue real wages growth, and productivity growth outstripped real wages growth. As a result, there was a substantial redistribution of income towards profits during this period. The rise of Thatcherism in the UK and Reaganomics in the USA exemplified the increasing dominance of the Monetarist view in the 1980s. Demand pull inflation While economists distinguish between cost push and demand pull inflation, the demarcation between the two types of inflation is not as clear cut as one might think. Demand pull inflation refers to the situation where prices start accelerating continuously because nominal aggregate demand growth outstrips the capacity of the economy to respond by expanding real output. We have learned from the national accounts that aggregate demand is always equal to GDP, which is the market value of final goods and services produced in some period. We represent that as the product of total real output (Y) and the general price level (P), that is, PY. It is clear that if there is growth in nominal spending (that is, GDP) that cannot be met by an increase in output (Y) then the general price level (P) has to rise. The dominant view of inflation in the 1960s was based on Keynes’ notion of an inflation gap, which he outlined in his 1940 pamphlet, How to Pay for the War: A Radical Plan for the Chancellor of the Exchequer. In the General Theory (1936), Keynes had developed the notion of effective demand to help understand how an equilibrium corresponding to less than full employment could arise in a monetary economy. He now wanted to show how there would be a transition to a fully employed economy during wartime. With the onset of the Second World War, large-scale spending programmes were implemented as part of the war effort. Keynes argued that as employment rose, rising household incomes would drive up consumer spending, which would cause inflation to accelerate even if money wage rates were constant. While Keynes’ plan was devised in the context of wartime spending when faced by tight supply constraints (that is, a restricted ability to expand output), the concept of the inflationary gap has been generalised to describe situations of excess demand where aggregate demand is growing faster than the aggregate supply capacity can absorb it. Keynes defined the inflationary gap as an excess of planned expenditure over the available output at pre--inflation or base prices. The pre-inflation benchmark output was that corresponding to the full utilisation of capacity. Thus, if an economy could meet the growth in nominal expected demand by rapidly expanding the capacity to produce goods and services, an inflationary gap would not open. This idea was distilled into the demand pull theory of inflation. Once full employment was reached, then nominal demand growth beyond that level would be inflationary. Thus inflation would tend to increase when unemployment fell (see Chapter 18 for an analysis of the Phillips curve which posits this type of relationship). The theory claimed that as nominal demand growth pushes the unemployment rate towards its irreducible minimum (frictional unemployment), wage and price inflation would start to rise. In other words, an inflationary gap would be created by the emergence of excess aggregate demand. There are several factors present in the real world that attenuate these demand effects on the inflation rate. First, firms incur extensive costs when they change prices, which leads to a ‘catalogue’ (or ‘menu’) approach whereby firms will forecast their expected costs over some future period and set prices according to their desired return. They then signal those prices in their catalogues and advertising to consumers and stand ready to supply whatever is demanded at that price (up to exhaustion of capacity). In other words, they do not frequently alter their prices to reflect changing demand conditions. Only periodically will firms typically revise their price catalogues. Second, trust and reliability are important in economic transactions. For example, firms seek to build relationships with their customers that will ensure product loyalty. In this context, firms will not wish to vary prices after they have been communicated to consumers. Third, firms also resist cutting prices when demand falls because they want to avoid so-called adverse selection problems, whereby they gain a reputation only as a bargain price supplier. Firms value ‘repeat sales’ and thus want to foster consumer goodwill. Circumstances change somewhat when the economy approaches full productive capacity. Then the mix between output growth and price rises becomes more likely to be biased toward price rises (depending on the bottlenecks in specific areas of productive activity). At full capacity, GDP can only grow via inflation (that is, nominal values increase only). At this point the inflationary gap is breached. When the US government prosecuted the Vietnam War effort in the 1960s, the inflation rate began to rise. In the late 1960s and early 1970s, the demand pull pressures of the spending associated with the war effort combined with sharp rises in oil prices following the formation of the Organisation of Petroleum Exporting Countries cartel (OPEC). OPEC’s oil prices quadrupled in 1973 and generated huge cost shocks to oil-dependent economies such as the US and Japan. Cost push and demand pull inflation: a summary Cost push inflation requires certain aggregate demand conditions for it to be sustained. In this regard, it is hard to differentiate between an inflationary process which was initiated from supply side pressures from one that was initiated by demand side pressures. For example, an imported raw material shock means that a nation’s real income that is available for distribution to domestic claimants is lower. This will not be inflationary unless it triggers an ongoing distributional conflict as domestic claimants (workers and capital) try to pass on the real loss to each other. However, that conflict needs ‘oxygen’ in the form of ongoing economic activity in sectors where the spiral is robust. In that sense, the conditions that will lead to an accelerating inflation – high levels of economic activity – will also sustain an inflationary spiral emanating from the demand side. 17.4The Quantity Theory of Money As we saw in Chapter 11, the Classical theory of employment is based on the view that the real variables in the economy – output, productivity, real wages, and employment – are determined by the equilibrium outcome in the labour market. By way of summary, the real wage is determined exclusively by labour demand and labour supply, which also determine the real level of economic activity at any point in time. Say’s Law, which follows from the loanable funds doctrine (see Chapter 11), is then invoked to assume away any problems in matching aggregate demand with this supply of goods and services. Under this doctrine saving and investment will always be brought into balance by movements in the interest rate, which is construed as being the price of today’s consumption relative to future consumption. Thus two relative prices – the real wage in the labour market and the real interest rate in the loans market – ensure that full employment occurs (with zero involuntary unemployment). This separation between the explanation for the determination of the real economic outcomes and the -theory of the general price level is referred to as the classical dichotomy, for obvious reasons. The later Classical economists believed that if the supply of money is doubled, for example, there would be no impact on the real performance of the economy. All that would happen is that the price level would double. The classical dichotomy that emerged in the 19th century stands in contradistinction to the earlier ideas developed by economists such as David Hume that there is a trade-off between unemployment and inflation that could be manipulated (in policy terms) by the central bank varying the money supply (Hume, 1752). It is of no surprise that the Classical employment model relies in part on the notion of a dichotomy for its conclusions. Its origins were based on a barter model in which there is an absence of money and owner-producers trade real products. Clearly, this conception of an economy has no application to the monetary economy we live in. Classical monetary theory was only intended to explain the level and change in the general price level. The main attention of the Classical economists was in trying to understand the supply of output and the accumulation of productive capital (and hence economic growth). The theory of the general price level that emerged from the Classical dichotomy was called the Quantity Theory of Money, which was outlined in Chapter 11. The theory had its origins in the work of French economists in the 16th century, in particular, Jean Bodin. Why would we be interested in something a French economist conceived in the 16th century? The answer is that just as the main ideas of Classical employment theory still resonate in the public debate (for example, the denial that mass unemployment is the result of a deficiency of aggregate demand), the theory of inflation that arises from the Quantity Theory of Money is still influential. Indeed, it forms the core of what became known as Monetarism in the 1970s. As we have learned already from this textbook, economics is a contested discipline and different schools of thought advance conflicting policy frameworks. Monetarism and its more modern expressions form one such school of thought in macroeconomics and rely on the Quantity Theory of Money for their inflation theory. We will also see that the crude theory of inflation that emerges from the Quantity Theory of Money has intuitive appeal and is not very different to what we might expect the average layperson to believe: that growth in the money supply causes the value of money to decline (that is, causes inflation). The Quantity Theory of Money was very influential in the 19th century. The theory begins with what was known as the equation of exchange, which is an accounting identity. We write the equation as: (17.1) MsV ≡ PY You are familiar with the terms on the right-hand side. PY is the nominal value of total output (which is simply the definition of nominal GDP in the national accounts) given that P is the price level and Y is real output. Ms is the quantity of money in circulation (the money supply, say M2 which was defined in Chapter 10), which is a stock (so many dollars at a point in time). V is called the income velocity of circulation, and is the average number of times the stock of money turns over in the generation of aggregate income. There is no theoretical content in the Equation (17.1) as it stands, since it is an identity. We thus need to -introduce some behavioural elements in order to use Equation (17.1) as a theory of the general price level. BOX 17.1VELOCITY EXAMPLE To understand velocity, we can consider the following example of an imaginary and simple -economy. Assume the total stock of money is $100, which is held by the two people that make up this economy. In the current period (say a year), Person A buys goods and services from Person B for $100. In turn, Person B buys goods and services from Person A for $100. The total transactions equal $200 yet there is only $100 (money stock) in the economy. Thus each dollar must be used twice over the course of the year. So the velocity in this economy is two. The velocity of circulation converts the stock of money into a flow of monetary spending and renders the left-hand side of Equation (17.1) commensurate with the right-hand side. In this regard, it is important to see the Quantity Theory of Money and Say’s Law as being mutually reinforcing planks of the Classical theory. Say’s Law was proposed to justify the presumption that full employment output would be continuously supplied and sold, which meant that the Quantity Theory of Money would ensure that changes in the stock of money would only impact on the price level. As Keynes observed, price level changes do not necessarily correlate with changes in the money supply, and this led to his rejection of the Quantity Theory of Money. Another way of stating this is that the velocity of money need not be fixed, and real output need not tend to the full employment level. In turn, Keynes’ understanding of how the price level could change without a change in the money supply was informed by his rejection of Say’s Law. He recognised that total employment is determined by effective demand and that a capitalist monetary economy could experience deficient effective demand. However, the Classical theorists considered that a flexible real wage would ensure that full employment is attained, at least as a normal state where competition prevails and there are no artificial real wage rigidities imposed. As a result, they considered Y to be fixed at the full employment output level. Additionally, they considered V to be constant given that it is determined by customs and payment habits. For example, people are paid on a weekly or a fortnightly basis and shop say, once a week for their needs. Equation (17.2) depicts the resulting causality that defines the Quantity Theory of Money as an explanation of the general price level. The horizontal bars above the V and Y indicate that they are assumed to be constant. It follows that changes in MS will directly and only impact on P. (17.2) MsV ≡ PῩ ∴Ms→P To understand this theory more deeply it is important to note that the Classical economists considered the role of money to be confined to acting as a medium of exchange to free people from the tyranny of the necessity of a double coincidence of wants under the barter system. In other words, money would overcome the problem of a farmer who had carrots to offer but wanted some plumbing done, and could not find a plumber desiring any carrots, for example. Money is thus seen as the means of lubricating the exchange of goods and services. There is no other reason why a person would wish to hold it under this limited conception of money. The underlying view is that if individuals found they had more money than in the past, then they would try to spend it. Logically, it follows that they consider a rising stock of money to be associated with the growth in aggregate demand (spending). As Equation (17.2) shows, monetary growth (and the assumed extra spending) would directly lead to price rises because the economy is already assumed to be producing at its maximum productive capacity and the habits underpinning velocity are stable. For now you should note two empirical facts. First, capitalist economies are rarely at full employment. Since economies typically operate with spare productive capacity and often with high rates of unemployment, it is hard to maintain the view that there is no scope for firms to expand real output when there is an increase in nominal aggregate demand. Thus, if there is an increase in availability of credit and borrowers use the deposits that are created by the loans to purchase goods and services, firms with excess capacity are likely to respond by raising real output to maintain market share rather than raising prices. Second, the empirical behaviour of the velocity of circulation demonstrates that the assumption that it is constant is implausible. Figure 17.1 uses data provided by the US Federal Reserve Bank of St. Louis and shows the velocity of circulation, which is constructed as the ratio of nominal GDP to the M2 measure of the money supply. The US Federal Reserve Bank of St. Louis defines this measure “as the rate of turnover in the money supply–that is, the number of times one dollar is used to purchase final goods and services included in GDP” (2016). The evidence does not support the claims of the Quantity Theory of Money. No simple proportionate relationship exists between rises in the money supply and rises in the general price level. Figure 17.1Velocity of M2 money stock, US, 1950–2015 Source: Authors’ own. Data from US Treasury via US Federal Reserve Bank of St Louis. Shaded areas indicate US recessions. 17.5Incomes Policies Governments facing a wage-price spiral have from time to time considered the use of so-called incomes policies if they were reluctant to introduce a sharp contraction in the economy, which might otherwise discipline the combatants in the distributional struggle. Incomes policies in general, are measures that are aimed to control the rate at which wages and prices rise, as the economy moves toward, or is at full employment. Progressive economists often advocate their use to rein in cost pressures and avoid the need to reduce overall spending, which creates higher involuntary unemployment. Incomes policies have been introduced in various forms at various times in a number of countries as a way of reducing supply side cost pressures and allowing employment to stay at a higher level. For example, in 1962, the US government introduced wage price guideposts, which allowed for an average rate of nominal wage increase equal to the average annual rate of productivity growth in the overall economy. This means that per-unit labour costs of production remained constant. Other nominal incomes, including profits, were also to be tied to this rule. Taken together, it was considered that this rule would stabilise the growth in nominal incomes (and directly link real income growth to productivity growth), thereby reducing any inflationary pressures associated with the maintenance of full employment. Its application would thus distribute productivity gains across all income earners and thus reduce the distributional conflict, which might otherwise instigate a wage-price spiral. However, a problem with the rule is that workers in above-average productivity growth sectors are undercompensated, and workers in below-average sectors are overcompensated. Also, workers would be unable to pursue money wage increases in response to profit pushes by firms. For a time, the guidelines seemed to work. But as US government expenditure grew as a result of the Vietnam War effort and unemployment fell below four per cent, wage increases began to exceed average productivity growth. By 1966, the guidelines provided no discipline on the growth of nominal incomes in the US. It was clear that the US government was unable to compel employers to follow the guideposts in the wage bargaining process. Despite the failure of the wage price guideposts, the Republican administration under Nixon reintroduced an incomes policy in 1971. Initially, this was in the form of a 90-day freeze on wages and other nominal incomes. Later, compulsory growth guidelines were set for wages and prices growth. In 1973, the government introduced yet another freeze on prices, followed by sector-by-sector price rises in line with cost increases with a freeze on profit margins, so workers were exposed to rising prices of oil and food. The experiment ended in April 1974. It was considered a success when it was in place, but when the controls were eliminated, prices and wages began to rise again, although wage and price pressures coming from the demand side were subdued. The problem was ongoing pressure from the cost (supply) side, in particular from energy and food (largely grains) prices, which led to higher price inflation. Workers were unable to secure money wage increases in line with price inflation, which contributed to the divergence between real wage growth and productivity growth. On the other hand, in the UK and Australia, the institutional structures that made economies more susceptible to distributional conflict in the late 1960s and early 1970s also made the operation of incomes policies difficult. Highly-concentrated industries, with large firms exercising significant price setting power, were interacting with strong trade unions. These firms were in a strong position to pass on wage demands in the form of higher prices, and governments were reluctant, or unable constitutionally, to mandate strict wage price controls in normal times. However, incomes policies have worked more effectively in some European nations, for example, Austria and the Scandinavian countries. These nations have long records of collective bargaining and are more attuned to tripartite negotiations than the English-speaking nations. A good example of a successful incomes policy approach, where wages and prices growth were driven by productivity growth in certain sectors, is the so-called Scandinavian Model (SM) of inflation (see Box 17.2). This approach to wage setting was developed in Sweden and attempted to marry notions of fairness, the effectiveness of centralised wage bargaining and international competitiveness. By the late 1970s, incomes policies lost favour in most countries as a result of the rising dominance of Monetarism, which eschewed institutional solutions to distributional conflict in favour of market-based approaches involving higher unemployment. The Monetarist approach in many advanced nations combined the use of persistently high unemployment with policies designed to reduce the bargaining power of workers. This reduced inflationary pressures because workers were unable to pursue real wages growth and as a result productivity growth outstripped real wages growth. This led to a substantial redistribution of income towards profits during this period. The rise of Thatcherism in the UK exemplified the increasing dominance of the Monetarist view in the 1980s. In Chapter 19, we will introduce the concept of employment and unemployment buffer stocks in a macroeconomy and analyse how they can be manipulated by policy to maintain price stability. BOX 17.2THE SCANDINAVIAN MODEL (SM) OF INFLATION This model, which was originally developed for fixed exchange rates, dichotomises the economy into a competitive sector (C sector) and a sheltered sector (S sector). The C sector produces products which are traded on world markets, and its prices follow the general movements in world prices. The C sector serves as the leader in wage settlements. The S sector does not trade its goods externally. Under fixed exchange rates, the C sector maintains price competitiveness if the growth in money wages in its sector is equal to the rate of change in its labour productivity (assumed to be superior to S sector productivity) plus the growth in prices of foreign goods. Under this condition, price inflation in the C sector is equal to the foreign inflation rate. The wage norm established in the C sector spills over into wages growth throughout the economy. The S sector inflation rate thus equals the wage norm less its own productivity growth rate. Hence, aggregate price inflation is equal to the world inflation rate plus the difference between the productivity growth rates in the C and S sectors weighted by the S sector share in total output. The domestic inflation rate can be higher than the rate of growth in foreign prices without damaging competitiveness as long as the rate of C sector inflation is less than or equal to the world inflation rate. In equilibrium, nominal labour costs in the C sector will grow at a rate equal to the norm (the sum of the growth in world prices and the C sector productivity). Where non-wage costs are positive (taxes, social security and other benefits extracted from the employers) and possibly growing, the requirement is that per-unit variable costs grow at the rate of world prices. The long-run tendency is for nominal wages to absorb the room provided. However, in the short run, labour costs can diverge from the permitted growth path. This disequilibrium must emanate from domestic factors. The main features of the SM can be summarised as follows: •The domestic currency price of C sector output is exogenously determined by world market prices and the exchange rate. •The surplus available for distribution between profits and wages in the C sector is thus determined by the world inflation rate, the exchange rate and the productivity performance of industries in the C sector. •The wage outcome in the C sector flows on to the S sector industries either by design (solidarity) or through competition. •The price of output in the S sector is determined (usually by a mark-up) by the unit labour costs in that sector. The wage outcome in the C sector and the productivity performance in the S sector determine the change in unit labour costs. An incomes policy would establish wage guidelines, which would set national wages growth according to trends in world prices (adjusted for exchange rate changes) and productivity in the C sector. This would help to maintain a stable level of profits in the C sector. Whether this was an equilibrium level depends on the distribution of factor shares prevailing at the time the guidelines were first applied. Clearly, the outcomes could be different from those suggested by the model if a short-run adjustment in factor shares was required. Once a normal share of profits was achieved, the guidelines could be enforced to maintain this distribution. A major criticism of the SM as a general theory of inflation is that it ignores the demand side. Uncoordinated collective bargaining and/or significant growth in non-wage components of labour costs may push costs above the permitted path. Where domestic pressures create divergences from the equilibrium path of nominal wage and costs, there is some rationale for pursuing a consensus-based incomes policy. By minimising domestic cost fluctuations faced by the exposed sector, an incomes policy could reduce the possibility of a C sector profit squeeze, help maintain C sector competitiveness, and avoid employment losses. Significant contributions to the general cost level and hence prices, can originate from the actions of government. Payroll taxation and various government charges may in fact be more detrimental to the exposed sector than increased wage demands from the labour market. Although the SM was originally developed for fixed exchange rates, it can accommodate flexible exchange rates. Exchange rate movements can compensate for world price changes and local price rises. The domestic price level can be completely insulated from the world inflation rate if the exchange rate continuously appreciates (at a rate equal to the sum of the world inflation rate and C sector productivity growth). Similarly, if local price rises occur, a stable domestic inflation rate can still be maintained if a corresponding decrease in C sector prices occurs. An appreciating exchange rate discounts the foreign price in domestic currency terms. What about terms of trade changes? Terms of trade changes, which in the SM justify wage rises, also (in practice) stimulate sympathetic exchange rate changes. This combination locks the economy into an uncompetitive bind because of the relative fixity of nominal wages. Unless the exchange rate depreciates far enough to offset both the price fall and the wage rise, profitability in the C sector will be squeezed. Policy makers (particularly in Sweden) considered it appropriate to ameliorate this problem through an incomes policy. Such a policy could be designed to prevent destabilising wage movements in response to terms of trade improvements. In other words, wage bargaining, which is consistent with the mechanisms defined by the SM, may be detrimental to both the domestic inflation target and the competitiveness of the C sector and may need to be supplemented by a formal incomes policy to restore or retain consistency. Conclusion This chapter is designed to provide an introduction to the concept of inflation, to highlight that it arises due to the conflictual nature of the capitalist system and that ongoing inflation requires that the major combatants (firms and workers) continue to pursue increases in their nominal incomes. The initiating conditions for an inflationary process can be conceptualised in terms of cost push and demand pull, but in practice it is hard to distinguish between them when an outbreak of higher inflation occurs. We reviewed the Quantity Theory of Money which is based on an identity. When behavioural assumptions are introduced, the theory implies that a simple proportionate relationship exists between increases in the money supply and rises in the general price level. However, no such relationship has been found so, even if it were possible to control the money supply, there would not be a systematic impact on inflation. Incomes policies were examined, in particular the Scandinavian Model (SM) of inflation. It was noted that they have largely gone out of favour and countries have tended to rely on the use of unemployment as a buffer stock, that is, to rely on higher unemployment to address an inflation rate which is considered to be too high, irrespect-ive of the initial drivers of the inflationary process. References Devine, P. (1974) “Inflation and Marxist Theory”, Marxism Today, March, 79–92. Hume, D. (1752) “Of Money”, in D. Hume (ed.), Political Discourses, Edinburgh: Fleming. Keynes, J.M. (1936) The General Theory of Employment, Interest, and Money, London: Macmillan, 1957 Reprint. Keynes, J.M. (1940) How to Pay for the War: A Radical Plan for the Chancellor of the Exchequer, London: Macmillan. Lerner, A. (1951) Economics of Employment, New York: McGraw-Hill. US Federal Reserve Bank of St. Louis (2016) Money Velocity. Available at: https://research.stlouisfed.org/fred2/categories/32242, accessed 20 February 2016. Visit the companion website at www.macmillanihe.com/mitchell-macro for additional resources including author videos, an instructor’s manual, worked examples, tutorial questions, additional references, the data sets used in constructing various graphs in the text, and more. 

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∪ltirnatelンifthe claimants ofrealincome continue to try to pass on the raw material price rise to each otheぅthen it is‖kely that contractionary government po‖cy w‖l be introduced and unemployment willrise.A better strategy vvould be to either change prOduction processesin Order tO reduce the use ofthe expensiveirnported resource,or to nnd a domestic alternative.ConЯict theory ofinЯation and inflationary biasesA se百es of articles in the journal A4θⅨな綱Todθノin 1974 illustrated the proposijon that inladon was the resultof a distributional conlict between workers and capital These articles were written with reference to the early1970s′when inttation rates rose in many NA/estern economles.One article by Pat Devine stated that the inЯation process was a structural construct embedded in the intrin´sic capital labour conlict.He argued that the increased bargaining power of workers(that accompanied thelong periOd of fu‖employment in the post´Second hA/orld War period)and the dec‖ning productivity growthin the early 1970s imparted a structural bias tovvards inlation which M/as manifested in the inttation breakout inthe mid´1970s thatr′ended the golden ageF'He further claimed that the prolonged growth of money vrages was″unprecedented in the history of capitaトism″(Devine,1974:80).Capitalists increased plces to maintain prontability and thus countered the attempt toraise real、へ/ages.Large′oligopolisdc lrms with price setting pOwer engaged in non´price compeddon(fOr example,productquality).These nrms,howeve6 were interdependent because their market shares were sensidve to their pricingstrategies.When a nrm was faced with nominal wage demands,its management knew thatitS百vals would facesim‖ar pressure and that their connpetitive positions would not depend on the absolute price level wh‖e thegovernment continued to ensure that efFective demand vvas sumcient to maintain fu‖ennployment.On the otherhand′a nrm could lose market share ifitincreased prices vvhile other nrms maintained lower prices.As a result′nrms had little incentive to resist the wage demands oftheir workers and strong incentives to protect their pro6tsby passing on the demandsin the form of higher prices.This structural depiction ofinЯation as being embedded in the class dynamics of capital and labouりboth ofvvhich had increased capacity to set prices and defend their real shares ofincome′implicates Keynesian″styleapproaches to fun en∩ployment.There was also an international component to the structuraltheory.lt was argued thatthe Bretton Woodssys´tem(See⊂hapter 9)imparted denationary forces on economies that were experiencing strong domesdc demandgrovyth.As nationalincome rose and importsincreased,central banks were ob‖ged to tighten monetary policy tomaintain the agreed exchange rate parity and the constraints on monetary growth acted to choke ofFinconnpat″ible claims on the available income.Howeveらwhen the Bretton Woods system of convertible currencies and 6xed exchange rates co‖apsed in1971,the structural biases towards inttation came to the fbre、vith Яoating exchange rates.Devine(可9フ4:86)argued that:′οating acヵαηgθ`ates力θソθ bθθ′υsc∂aS an adメitiοηθ′″θθροr aソθ′′ab′θ tο t力θ statθ.Gルθ′∂ο4ηθstic i′′atiοη′ノοθJηg mtθs ρro函グθθグ電κθげ′aib清ツir dCa″ηg″たわt力`κsυたθη:ρrθssyκ οn t力θ ater′α′ρθノ“θ4tsροSitiο4月ο″θッθぅra′Oatたtο bθィル6ι′ソθ in stabilisi4g a ρθノ“θηtS i“bθ′θη6θ it is I′kcヶtο Mソοルθ′ο″`r“θlin`οttθs at力Ottθ.」θたdυ6Jοη′4 κθ′″昭es(οr tヵθ″mteげgrO″ι力)なηοt a69υたS“グiη t力θκ″〃t力θη b`θググた′οηθ′ρ“SSyκ/Orわなわθr“。ηッ″昭θS ar∂」肋た6θ44οι bθ 6ο′ιθttθ∂ι力θ mtθo/iヴθJο′″〃′加ικasθ θ′dt力θた″〃bθルrt力θr dθρ“6bJο4・The structuralist view also noted that the mid´19フOs crisis,、vhich marked the end of the Keynesian period,wasnot only marked by rising inttation but also by an ongoing pront squeeze due to dec‖ning productivity growthand increasing external competition for market share.Theprontsqueezeledtonrmsreducingtheirrateofinvest´ment(WhiCh reduced aggregate demand growth),WhiCh combined with harsh contracdons in monetary andnscal pOliC"created the stagnation that bedev‖led the world in the second halfofthe 1970s.


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∪NEMPLOYMENT AND lNFLAT10NI TH[ORY AND POLICY丁he resolution to the structural bias proposed by economists depended on theirideological persuasion.Onthe one hand,those who identined themselves as Keynesians proposed incomes policies(whiCh We shall explorein more deta‖later in this chapter)aS a way of mediating the dist‖butional struggle and achieving nominalincome claims that were connpatible with the avanable output.On the other hand,the emerging A/1onetarists considcred the prob:em to be an abuse of market power by thetrade unlons and this rnotivated demands fbr poncymakers to legislate to reduce the bargaining power of work´ers.The rising unen∩ployment was also not opposed by capital because it was seen as a vehlcle for underminingthe capacity ofthe trade unions to make wage demands.From the mid´1970s′the connbined vveight of persistently high unemployment and increased policy attackson trade unlons in many advanced nations reduced the inlation spiral as workers were unable to pursue realwages growth′and productivity growth outstripped real wages growth.As a result′there was a substantial redis´tribution ofincome towards pronts during this period.The rise of Thatcherism in the∪K and Reaganomicsin the∪SA exennplined the increasing dominancc oftheAAonetarist view in the 1980s.

Demand pu‖ inflation





while economists distinguish between cost push and demand pu‖inlation,the demarcation between the twotypes ofingation is not as clear cut as one might think.Demand pu‖inlation refers to the situation where prices start accelerating continuously because nOminalaggregate demand growth outstrips the capacity ofthe economy to respond by expanding rea1 0utput.We have learned from the national accounts that aggregate demand is always equal to GDB which iS themarket value of nnal g00ds and services produced in some period.hA/e represent that as the product oftotal realoutput(Y)and the general pnce level(P)′that iS′PY.ltis clear thatifthere is growth in nominalspending(that iS′GDP)that Cannot be met by an increase in output(Y)then the general pHce level(P)has tO



rise.Thedominantviewofinttationinthe1960svvasbasedonKeynes′notion ofan inttation gap′which he outlinedin his 1940 pamphlet,Hο″tο Paノ/orthθ νVar A RadたθI PIθηルrt力`C力θη6θ〃οrげth`[χ6カθ9υer.ln the Gθηθral■730ッ(1936)′Keynes had developed the notion ofettcJve demand to help understand howan equilibrium corresponding to less than fu‖employment could arise in a rnonetary economy.He now wantedto sho、v how there would be a transition to a fu‖y employed economy during wartime.With the onset ofthe Second hA/orld Waりlarge″scale spending programmes vvere implemented as part ofthewar effort.Keynes argued that as employment rOse′rising household incomes would drive up consumer spend´ing′which would cause inЯation to accelerate even if money wage rates、へ/ere constant.



VVh‖e Keynes'plan was devised in the context of wartime spending when faced by tight supply constraints(thatiS,a restricted ability to expand output),the COncept ofthe inlationary gap has been generalised to describesituatlons of excess demand where aggregate demand is grO、
ving faster than the aggregate supply capacity canabsorb itKeynes deined the inttationary gap as an excess of planned expenditure over the available output at pre´inlation or base prices.The pre´innation benchmark output was that corresponding to the fu‖utilisation ofcapacity.Thus,if an economy could meet the growth in nominal expected demand by rapidly expanding thecapacity to produce goods and services,an innationary gap would not open.丁his idea was disti‖ed into the demand pu‖theory of ingation.Once fu‖employment was reached′thennominal demand growth beyond thatlevel would be ingationary.Thusinttadon would tend to increase when unemploymentfe‖(see Chapter 18 foran analysis ofthe Phillipscurve which posits this type of relationship).The theory claimed that as nominal demand growth pushes theunemployment rate towards its irreduclble minimum(frictional
unemployment),wage and price inlajonwould start to rise.ln other words,an inlationary gap would be created by the emergence of excess aggregatedemand.There are several factors present in the real world that attenuate these demand efFects on the ingation rateFlrst′nrms incur extens市e costs when they change plces′which leads to a`catalogue'(or`menu′)apprOach




whereby nrms w‖l forecast their expected costs OVer some future period and set prices according to their desiredreturn They then signal those prices in their catalogues and advertising to consumers and stand ready tO sup´ply whateveris demanded at that price(up tO exhaustion of capacity)ln other words,they do nOt frequentlyalter their pHces to renect changing demand condidons.Only periodically will nrms typicallシrevise their p百cecatalogues.Second,trust and reliab‖ity are importantin economic transactions.For example′lrms seek to build relation´ships vvith their customers that will ensure productloyalty in this context′lrms vv‖l not wish to vary prices afterthey have been communlcated to consumers.Third′角rms also resist cutting prices vyhen demand fa‖s because they wanttO avoid so´ca‖ed adverse selectionproblems,vvhereby they gain a reputation only as a bargain price supplier Firms value`repeat sales'and thus wantto fbster cOnsumer goodwi‖Circumstances change somewhat vvhen the economy approaches fu‖ productive capacity Then the mixbetween output growth and pnce nses becOmes more likely to be biased tOward price ttses(depending on thebottlenecks in specinc areas of productive activity).At full capacity7 GDP can only grow via inttation(that is′nominal valuesincrease only).At this point the inЯationary gap is breached.hA/hen the US government prosecuted the Vietnam VVar efFort in the 1960s,the inttation rate began to rise.ln the late 1960s and early 1970s,the demand pu‖pressures ofthe spending associated、

vith the vvar efFort com″bined with sharp rises in o‖prices fo‖owing the formation Ofthe(Drganisation of Petroleum ExpOrting Countriescartel((DPEC).OPECt o‖prices quadrupled in 1973 and generated huge cOst shocks to oi卜dependent economiessuch as the∪S andlapan.

Cost push and demand pu‖inflation:a sunlmary
cost push inЯation requires certain aggregate demand conditiOns fbr it to be sustained.ln this regard′it is hardto difFerentiate between an inttationary process、vhich
vvasinitiated from supply side pressures frOm One that、vasinitiated by demand side pressuresFor exannple,an innported raw material shock means that a nationt realincome that is avallable for distribu´tion to domestic claimantsislovver This w‖l not be inЯationary unlessit triggers an ongoing distributional conЯictas domesdc claimants(wOrkers and capital)try tO pass on the realloss to each othenHoweveりthat conlict needs`oxygen'in the form Of OngOing economic activity in sectors where the spiralisrobust.ln that sense,the conditions that、villlead to an accelerating inlatiOn―high levels ofeconomic activity―wi‖also sustain an inЯationary spiral emanating from the demand side.17。



4 The Quantity Theory of MoneyAs we saw in⊂hapter ll,the Classical theory of emp10ymentis based On the vievv that the real variables in theecon o介ly―output′productivit"real wages′and employment―are determined by the equilibrium outcome inthe labour rnarket.By way ofsummar"the real wage is deternlined exclusively by labour demand and labour supp:ルwhichalso determine the reallevel ofeconOmic activity at any point in tirne.


Sayt Latt which follows frOm the loanable funds doct面ne(see Chapter ll)′is then invoked to assume away anyproblems in matching aggregate demand with this supply of goods and services.Under this doctrine saving andinvestment vvi‖always be brought into balance by movements in the interest rate,which is construed as beingthe price of todayt consunnption relative tO future consunnption.Thus t、vo relative prices―the real wage in thelabour market and the real interest rate in the loans market―ensure that full employment occurs(with ZerOinvoluntary unemployment).This separation between the explanation for the deternlination of the real economic outcomes and thetheory of the general price levelis referred tO as the classical dichotom"for Obvious reasons.The later(Elassical

263:
:n this regard,itisimportanttoseetheQuantityTheoryofMoneyandSaytLawasbeingmutuallyreinforcingplanks of the Classical theory.Sayt Law was proposed to justify the presumption that full employment outputwould be continuously supp!ied and sold′which meant that the Quantity Theory of Money would ensure thatchangesin the stock ofrnOney would only impact on the pricelevel。As Keynes observed′price level changes do not necess,rily correlate vvith changes in the money suppl)らandthisledtohisreleCtiOnoftheQuantityTheoryofMoney.Anotherwayofstatingthisisthatthevelocityofmoneyneed not be nxed′and real output need not tend to the fu‖elnploymentlevel.ln turn′Keynes'understanding of how the pricelevel could change without a change in the rnoney supply、vasinformed by his rejecdon of Sayt Law He recognised that total employmentis determined by efFective demandand that a capitanst rnonetary economy could experience dencient efFective demand.Howeveりthe Classical theorists considered that a nexible real vvage would ensure that fu‖ennployment isattained,at least as a normai state where connpetition preva‖s and there are nO artincial real wage rigiditiesimposed.As a result,they considered Y to be nxed at the fu‖ennployment outputlevelAdditiona‖"they considered y to be constant given thatitis determined by customs and payment habits.Forexample,people are paid on a weekly or a fortnightly basis and shop say7 once a week for their needsEquation(17.2)depiCtS the resuldng causality that dennes the Quandty Theory of Money as an explanajonofthe general price level.The horizontal bars above theヽ/and Y indicate that they are assumed to be cOnstant.ltfo‖o、vs that changesin A4s Ⅵノi‖directly and only impact On P.(17.2) Msソ≡PY.・.ん4-→PTo understand this theory more deeply itisimportant to note that theくこlassical economists conSidered the rOleofrnoney to be conined to acting as a medium of exchange to free people from the tyranny ofthe necessity ofa double coincidence of wants under the barter system.!n other words′money vvould overcome the problem ofa farmer who had carrots to ofFer but vvanted some plumbing done,and could not 6nd a plumber desiring anycarrots,for example.A/1oney is thus seen as the means oflubricating the exchange of goods and services.There is nO Other reasonwhy a person would vvish to hold it under thislimited conception of rnoney.丁he underlying view is thatifindividuals fbund they had more money than in the past′then they would tryto spend it.Logica‖"it fo‖ows that they consider a rising stock of rnOney to be associated vvith the grovvth inaggregate demand(spending)As Equation(1フ.2)showS,mOnetary growth(and the assumed extra spending)wOuld directly!ead to p百cerises because the econOmyis already assumed to be producing atits maximum productive capacity and the hab´its underpinning velocity are stableFor no1/v you should note tvvO empirical facts.First,capitalist economies are rarely at

fu‖emp10yment.Sinceeconomies typica‖y operate with spare productive capacity and often with high rates Of unemployment′it is hardto maintain the vievv that there is no scope fbr nrms to expand real output vvhen there is an increase in nominalaggregate demand.Thus,ifthere is an increase in ava‖ab‖ity of credit and borrovvers use the deposits that are created by the loansto purchase goods and services,lrms with excess capacity are likely to respond by raising real output to maintainmarket share rather than raising prices.Second,the empirical behaviour Of the velocity of circulation demOnstrates that the assumption that it isconstant is implausible.Figure lフ.l uses data provided by the US Federal Reserve Bank ofSt Louis and shovys thevelocity of circulation,which is cOnstructed as the ratio of non■inal(3DPtotheM2measureofthemOneysupply.The∪S Federal Reserve Bank of St.Louis dennes this measure″as the rate ofturnOverin the money supply―that is,the number oftimes one dollaris used to purchase nnal g00ds and ser宙cesincluded in GDP〃(2016).The evidence does not support the ciaims of the Quantity Theory of A/1oney.No simple proportionate rela´tionship exists between rises in the money supply and rises in the general price level

Conclusion
This chapter is designed to provide an introduction to the concept ofinlation,tO highlight that it arises dueto the conЯictual nature of the capitalist system and that ongoing innaJon requires that the mttor combat″antS(lrms and workers)COndnue to pursue increases in their nOminalincomes.The inidadng condidons for aninlationary prOcess can be conceptualised in terms of cost push and demand pulL but in practice it is hard todistinguish bet、ヘノeen them when an Outbreak of higherinЛation occurs.We reviewed the Quandty Theory ofMoney which is based on an identity.When behaviouralassumplons areintroduced,the theory irnplies that a silnple proportionate relationship exists between increases in the moneysupply and risesin the general price level.Howeveりno such relationship has been found so′even ifitwerepossibleto controlthe money suppl"there、vou:d not be a systematicimpact on innation.!ncomes policies were examined′in particular the Scandinavian Model(SM)ofinla●on.lt was noted that theyhavelargely gone out offavour and countries have tended to rely on the use of unemployment as a bufFer stock′that is,to rely On higher unemployment to address an innation rate which is considered to be too high′irrespect″ive ofthe initial drivers ofthe inlatiOnary process.ReferencesDe'ne,P(1974)“lnnadon and Marxist Theoryt Marxな“To∂σソ′MarCh′フ9-92.Hume,D(1752)“Of MOney′;in D.Hume(ed.),Pο″ticσ′Dis`ουrses,Edinburgh:FlemingKeynes,j.M(1936)T力θ Gβη`紹′T力θοッげ[“ρ10y“θηちhteたSt aη∂A4οηり′London:Macmillan,1957 Rep‖ntKeynes,j.M.(1940)HO″ιο Pッルrt力θヽ4/θr A Rク∂たθI Plσηルrt力ec力α46θ〃οrげt力θ[χ6カθ9υθちLondon:MacmillanLemet A(1951)とοηο“たSげ[用ρ′οノ“θ′ちNew York McGraw´Hi‖.US Federal Reserve Bank of St.Louis(2016)MOη`ッνセ′οC′ty.Availab!e at:https//research.sdoulsfed org/fred2/catego´ries/32242,accessed 20 February 20η6Visit the companion website at www.maCmillanihe com/mitchel卜macro for additionalincluding author videos, an instructort manuaし worked exannples, tutorial questions′references′the data sets used in constructing various graphsin the text′and rnore.