Link between demand-side and supply-side sources of inflation

By Dr. Sirimal Abeyratne, University of Colombo

Bearing the burden : The CB says inflation is driven by such factors as an increased demand for consumer goods as well as for oil. Scene in Manning market

Is an increase in money printing good or bad? Is an increase in budget deficit good or bad? If someone asks me these questions, frankly speaking I do not have a direct one-word answer. Perhaps, one would have said yes or no depending on what school of economic thought he believes in or belongs to. However, getting the membership of a particular school of economic thought is no less than joining a particular political party to play petty politics. In both cases, every one tends to miss the relevant good things of each other. The point is that one should answer after placing the question in the context.

Context in which the policies worked

Look at the context in which expansionary fiscal policy (resulting in increased budget deficits) and expansionary monetary policy (resulting in increased money supply to finance budget deficits) came into effect after the publication of the ‘revolutionary work’ of J.M. Keynes in 1936 – The General Theory of Employment, Interest and Money. Until the publication of this book, there was nothing called fiscal or monetary policy in the world to achieve macroeconomic objectives. The book was published against the backdrop of the Great Depression in the 1930s. Great Depression was a sudden and total collapse of the economies of industrial countries (USA and Europe) which spread over developing countries as well. World output and trade declined and businesses had to be closed down; millions of people lost their jobs and incomes; commodity prices fell due to the sharp decline in aggregate demand. It also triggered political upheavals in many countries and set the economic parameters underlying the 2nd World War began in 1939.

About one year prior to the publication of his book, Keynes wrote a letter to one of his friends, George Bernard Shaw, giving an indication about what he was writing: “To understand my new state of mind… you have to know that I believe myself to be writing a book on economic theory which will largely revolutionize not I suppose at once but in the course of the next 10 years the way the world thinks about economic problems. When my new theory has been duly assimilated and mixed with politics and feelings and passions, I cannot predict what the final upshot will be in its effects on actions and affairs, but there will be a great change and in particular… Marxism will be knocked away.” (quoted in Paul Davidson’s Controversies in Post Keynesian Economics, 1991).

Due to inadequate aggregate demand (comprising private consumption, government purchases, investment spending and export demand) total output contracts leading to economic recessions. But the government has fiscal and monetary policy tools to avoid recessions. Keynes in his book paved the way out of economic recessions giving a major role to play by the government through expansionary fiscal policy (supported by expansionary monetary policy) in order to stimulate production. When aggregate demand rises, production sectors respond accelerating growth momentum. Keynesian economic policy was well-received and widely implemented after the 2nd World War. The famous dictum at the time, as endorsed by the President Nixon, was “we are all Keynesians now”. Widely spread Keynesian policies in the 1950s and the 1960s worked well and helped the world to return to economic normalcy.

As Keynes himself anticipated, these policies with government intervention to raise aggregate demand and to promote redistribution saved the capitalist market economic systems in the middle of the then Cold War between the USA-led capitalist bloc and the USSR-led socialist bloc. We should give all credit to Keynes for adding a new dimension to capitalist market economy which is flexible enough to be dynamic. If not for that today’s world would have been a miserable one with static socialism conquered the capitalist world including the newly independent nations in the developing world.

Context in which the policies did not work

However, the story does not end there. If one would accept the policy thrust after the Keynesian revolution, in order to accelerate growth or, precisely according to Keynes to avoid short-term fluctuations in output and employment, governments should raise its spending financed by borrowings or money printing. Where would a country end up in continuing with this policy? Is not there any limit on it? The answer is found to be in a different economic environment emerged in the 1960s that led to a decline in the efficiency of Keynesian policy thrust with the resurgence of Monetarism.

This time since the late 1960s it was “stagflation” with slowing down growth momentum plus rising inflation, which was contrary to the anticipated policy outcome of Keynesianism. Moreover, the emergence of a new international monetary system with flexible exchange rates and the oil shock in the early 1970s created new challenges in a different economic environment. The proponents of Monetarism pioneered by Milton Friedman viewed that "inflation is always and everywhere a monetary phenomenon", blaming excessive money printing (to finance increased budget deficits) as the cause of rising inflation. The arguments clearly showed that, in spite of the important role played by the Keynesian economic policy in the early post-war period, it has its own limitations so that the countries cannot sustain rapid growth just by printing money and letting their governments to spend it.

“Yes and No”

Obviously countries should print money when it is necessary and should run budget deficits when it is necessary, in keeping in mind their limitations which can cause serious and long-term negative repercussions on growth and stability. In particular, when new money is injected into the economy, it has to be absorbed into circulation which again raises aggregate demand so that the supply side or the total output is flexible enough to respond and expand. If the supply-side is not responding enough, “too much money has to chase after too little output” building inflationary pressure. The bottom line is that neither Keynes nor Friedman was wrong! And where the new money is going and where the government is spending are other matters of importance in detailed analysis of the government budgets and money printing.

Temporary increased budget deficits supported by borrowings and money printing are necessary to ease short-term or medium-term recessions inherent in business cycles in industrial countries. In developing countries too, there is a need as such since the governments have an additional role to play in building human and physical infrastructure to contribute to achieving higher growth and to providing necessary developmental services. Therefore, it not unusual to find developing countries running budget deficits, but the point is that those budget deficits should be at a manageable level and should not damage growth and stability.

The US economy has recently plunged into an economic recession with its credit crunch which had signs of spreading over European Union and the rest of the world. The policy package brought about by the US government to face the potential economic recession was primarily Keynesian-type. The Wall Street Journal on January 18, 2008 reported the famous dictum again – “we are all Keynesians now”. In addition to an interest rate cut, the US government decided to provide a fiscal stimulus package with a tax rebate amounting to US$160 billion (which is nearly 6 times of Sri Lanka’s GDP) to the tax payers. Whether the policy package could save the US economy or not is not yet known. If not, the world economy is still only at the beginning of a serious world economic recession.

Demand-side to Supply-side

Sri Lanka’s annual inflation rate is above 20 percent and, is significantly higher than the regional average. Last week India worried about the increase in its rate of inflation to over six percent. The debate continues over the issue whether the high inflation in Sri Lanka is a result of excessive money printing or of the supply-side constraints. It is not my intention to reject the validity of any of the two arguments for the simple reasoning that I explain below:

The government has been running an excessive budget deficit with increased spending during the past few years for various reasons, including the expansion of the size of the government. But I am quite sure that this has been so not because our policy makers firmly believe in Keynesian economic policy. However, if additional money has come from at least partly through money printing or the increased Central Bank credits to the government, we have a case for rising aggregate demand, hence demand-pulled inflation. Apparently, the supply-side should be flexible enough to respond to the increased aggregate demand so that the additional money injected to the economy would be absorbed into the economy, easing the consequent demand-pull inflationary pressure. This is where the problem is, paving the way for the case of cost-push inflation with “supply-side constraints, wage pressure and low productivity”. In other words, supply-side constraints point to the fact that the country’s production does not expand adequately to ease the inflationary pressure created by rising aggregate demand. But real rate of GDP growth has to be considerably higher during the past two years with 7.7 percent in 2006 and 6.8 percent in 2007. If so, should it have grown even more to meet the increased aggregate demand? Or has the economy not grown that much as the growth figures explain?

Apparently, with the ad hoc ways and means of tax revisions, high interest rates, the higher costs of utility, and the rigid regulatory framework, as reported, the business environment in Sri Lanka is not so business-friendly. Growth of the manufacturing sector has been stagnant and export expansion is no longer a topical issue in the policy circles. Exchange rate has been depreciating (another source of cost-push inflationary pressure) due to weaker export growth, cushioned by rising private remitances and the government’s external borrowings – another weak point of the economy.

Thanks to the weakening dollar, now we have a strong rupee just for the time being. Wage pressure has also been quoted as a cost-push factor, but there has been no significant increase in the real wages in the past few years. Nevertheless, the government’s wage bill must have increased rapidly due to the enlargement of the size of the government without a significant improvement in its productivity. It should also be noted that reforms in the public sector have virtually come to a standstill for few years now.

The bottom line of the argument is now clear. The supply-side is weak and does not respond to the rising aggregate demand created by increased money printing, hence, inflationary pressure.

If the country had a competitive business environment on which the economy was growing rapidly, i.e. relaxation of supply-side constraints, then indeed the Central Bank has to print money to meet the rising demand for money.

But if it happens without the relaxation of the supply-side constraints, then we have the case for higher inflation.

After all can Sri Lanka maintain its international competitiveness as the domestic inflation is very much higher than its competitors’ in the world market? And once the inflationary spiral has gone out of control, it is not easy to control it without a bold and painful policy exercise, which can be highly politically sensitive.