Suddenly, inflation has become a prominent issue in the global headlines again, after a period of time when it seemed to have disappeared from policy discussions in advanced capitalist economies and wasn’t a major concern in many low- and middle-income countries. This period, known as “The Great Moderation,” lasted from the mid-1980s to the years leading up to the Global Financial Crisis of 2008. During this time, economic fluctuations in developed countries were reduced, inflation rates were low, and sometimes even negative in many economies. However, it’s important to note that not all parts of the world experienced this stability. Some countries, like Russia, Democratic Republic of Congo, and Venezuela, faced rapid inflation or even hyperinflation.
Inflation refers to a general increase in prices across various sectors, impacting not just specific goods and services. It has significant implications for ordinary people, especially when their incomes don’t rise at the same pace as prices, leading to a loss of purchasing power. This decline in real income or wages can occur even when money incomes are increasing. Since mid-2021, global prices of essential commodities such as foodgrains and fuel have been rising, and have seen a sharp acceleration since the Ukraine war. As a result, advanced economies have experienced higher levels of overall inflation than they have for decades. Low- and middle-income countries may face even more challenges, as the money incomes of workers, peasants, and other self-employed individuals have barely increased or have actually fallen.
The causes of inflation have long divided economists and policymakers. Traditional monetarist economists believe that inflation arises from excessive money supply creation, characterized as “too much money chasing too few goods.” They argue that increased credit creation or liquidity leads to higher inflation rates, while economic activity is determined by other factors. According to this view, controlling inflation involves limiting credit creation by curbing the expansion of reserve money, reducing government credit, and limiting banks’ ability to extend credit. This approach aims to reduce the amount of money in circulation, thereby lowering prices.
However, there are at least two fundamental flaws in this argument. First, it assumes that total economic activity or supply is given exogenously by labor and institutional factors and is unaffected by macroeconomic policies. In reality, macroeconomic policies can influence the level of economic activity, as most economies are not operating at full employment. Second, the idea that the total money supply is a fixed policy variable is flawed. Governments can only influence the base or reserve money and some credit provided by the banking system. The supply of money or liquidity in the system is primarily determined by economic activity, which affects the velocity of circulation or the number of times base money changes hands through transactions. The final supply of money or liquidity is an outcome of the economy’s functioning, rather than a policy variable controlled by the central bank or government. The central bank can adjust its base interest rate, which serves as the floor for all other interest rates in the economy. This perspective differs significantly from Keynesian and structuralist perspectives, which attribute inflation to imbalances between spending and income at the macroeconomic level.
Keynesian economists argue that inflation arises from spending exceeding income at a macroeconomic level. This imbalance can result in either a balance of payments deficit or domestic inflation. If supply constraints or bottlenecks prevent output from increasing in response to higher demand, inflation can occur when spending doesn’t adjust accordingly. Structuralists highlight how inflation emerges when different groups in the economy compete for their shares in national income, including firms, workers, agriculturalists, and governments. For instance, if imported input costs rise, firms may raise their output prices to maintain profit margins. In response, workers who anticipate falling real wages may demand higher money wages, leading to further cost increases for firms and potentially higher prices. When both groups fight to maintain their real incomes, it can create an upward spiral of inflation if their positions are strong and incomes are indexed to the inflation rate.
High inflation rates can be destabilizing, but they can also reflect the ability of different groups in the economy to resist income erosion. When inflation expectations become widespread, all groups strive to raise their prices to avoid real income losses. This self-fulfilling expectation can generate inflationary spirals. In contrast, economies with a large proportion of informal workers lacking bargaining power, like India, often pass on production cost increases and prices to workers, leading to lower inflation rates but more significant negative impacts on living standards.
Inflationary episodes are classified as either “demand-pull” or “cost-push.” This classification has implications for government responses. Demand-pull inflation occurs when the demand for goods and services grows too quickly relative to available supply, often referred to as “overheating.” In this case, it is typically recommended to raise central bank interest rates or tighten monetary policy to make credit more expensive or harder to access, thereby reducing spending. Cost-push inflation arises from specific cost increases due to sector-specific supply bottlenecks or rising prices of imported inputs, influenced by changes in world prices or exchange rate depreciation. Raising interest rates will not tackle the cause of inflation in this scenario and can potentially lead to economic slowdown or decline. In the worst cases, it can result in stagflation, characterized by slow or falling economic activity and rising price levels.
The period from the Global Financial Crisis until 2021 challenges the monetarist argument that injecting liquidity into an economy will inevitably generate inflation. Following that crisis, major banks like the United States Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan released unprecedented amounts of liquidity, significantly expanding their total assets from around $4 trillion in January 2008 to over $26 trillion in 2021. Despite this substantial liquidity injection, inflation rates remained low in advanced economies until mid-2021, and even declined or turned negative in some countries.
The recent inflationary pressures observed in advanced economies and global markets can be traced back to cost-push factors, primarily supply chain disruptions resulting from COVID-19-related lockdowns and closures. The Ukraine war exacerbated the situation by affecting oil, wheat, and fertilizer supplies, as well as established trading routes. However, these factors alone don’t fully explain the significant rise in prices. Corporate profiteering and financial speculation in commodity futures markets have also contributed to inflation. Oil companies have taken advantage of the situation to push up prices beyond what is justified by their own cost increases, similar to how large pharmaceutical companies profited from the COVID-19 pandemic. Additionally, financial activity in commodity futures markets has intensified between January and March 2022, driving up wheat futures prices.