Inflation – Undergraduate Economist

Prices, Competition and Markets

It has become commonplace in India to point fingers at the central government when prices of essential commodities such as onion or fuel rise. The underlying arguments behind this accusation could be that: (1) the government is expected to maintain price stability and/or (2) the government should socially engineer agricultural markets in a ‘fair’ manner. But, is the pursuit of price stability not the job of the Reserve Bank of India (RBI)’ It is true that the RBI cannot do anything to combat inflation when it is caused by a supply-and-demand mismatch in the domestic vegetable market or the international oil market. What the RBI can do is manage inflation expectations, and that is for another post. The present post is motivated by the insightful analyses of Kannan Kasturi on the Indian vegetable market, published in the Economic & Political Weekly and other places. That is, this post takes up the second of the reasons mentioned earlier.

The price mechanism ‘ adjustments made by producers to the selling prices and consumers to the purchasing prices ‘ is expected to allocate the commodities brought to the market amongst the consumers, in accordance with their needs, reflected in their willingness to pay. The prices therefore act as signals for the producers especially. Sellers can adjust quantity in order to affect prices; hoarding commodities is one such strategy. At equilibrium, producers earn a normal rate of profit, which contains a pure rate of return on capital advanced and a return for risk and entrepreneurship. If producers do not make normal profits in time t, they will cut down production in time t+1. During the equilibration process, producers who are unable to earn a normal rate of profit will exit the market. If entry costs are low, new producers will enter the market. Producers who have large financial resources (or access to easy credit) at their disposal are insulated from temporary alterations in demand. Producers who have enough accumulated earnings can shield themselves from such market volatility. In short, a competitive market is one where prices are not distorted (by the producers or by external intervention), no (especially, cultural and social) barriers to enter the market exist and workers are mobile within and across markets.

Of course, the agricultural markets in India are far from competitive. Since more than 50% of Indians derive their income from agriculture, and particularly because of the poverty of the farmers, these markets require government intervention. This is not to say that any form of government intervention will better the situation. Kasturi quite convincingly shows that the fault lies with the supply-side ‘ the agricultural supply chain. This post will not discuss minimum support prices or other input subsidies, such as for electricity, irrigation and fertilizers. Also to be noted is the specific manner in which the agricultural input markets are inter-linked in India, which has been of an exploitative nature. Finally, social and cultural factors (pertaining to caste and gender) are seen to hinder competitiveness in Indian markets, not just in agriculture.

What are the problems with the agricultural supply chain’ Kasturi points out the following: (1) Small farmers lack storage facilities in order to gain from the high market prices. (2) The middlemen (those who intermediate between farmers and final consumers), i.e. the wholesale traders and commission agents have the ability to hoard vegetables and consequently they reap the benefits of the high prices they themselves engineer; the Agricultural Produce Marketing Act governs the agricultural markets (mandis) and it is here where all the proceeds from higher prices are absorbed with nothing reaching the farmers. These traders and commission agents are ‘well entrenched in the mandis, having been in the business on average for 20 years’ (3) Agricultural pricing is not at all transparent and the mandi records are of no assistance in this regard.

To sum up, the nature of government intervention has to change, in such a way that is beneficial to farmers. Proper laws are of utmost importance, not just in protecting the interests of the small farmers, but also that of the consumers. ‘Moreover, intermediaries in any market perform useful functions but laws should be in place which ensures that they do not become monopolistic and exploitative. Agricultural infrastructure such as storage facilities is paramount in this context. A very detailed study of how these supply-chains operate will be of much help in our attempts to combat inflation.

Thomas Tooke: An Introduction

Thomas Tooke (1774-1858) made important contributions to monetary history, theory and policy. His monetary economics has been viewed in a favourable light by economists such as Ricardo and Marx. Moreover, Tooke’s conception of the rate of interest as a variable determined independently (of the profit rate) bears significant similarities with Keynes’s idea of the rate of interest as a ‘monetary phenomenon’. This post presents Tooke’s monetary theory in brief through his role in the debates between the Currency School (to which Ricardo belonged) and the Banking School (Tooke being the prominent member) in the early 1840s. The reference for this post is mainly the recent research carried out by Matthew Smith.

During Tooke’s time, the dominant view was that the rate of interest is governed by the rate of profit (on capital employed in production) implying that the former is determined by ‘real’ forces. In Smith, it is the competition of capital and for Ricardo, it is the wage rate and production conditions taken together. Tooke argued that the rate of interest is determined by institutional factors in the financial market and is independent of the rate of profit. In his later writings, he stated that it is the rate of interest which regulates the rate of profit with the former entering as a component in the costs of production of commodities.

The Currency School maintained that prices can be controlled by adjusting the quantity of money, as espoused by the quantity theory of money. That is, by altering the bank notes in circulation, it was believed that fluctuations in nominal income could be suppressed. This assumes that there are no time lags and that the velocity of circulation is constant. Tooke contested this policy and stressed the role for a discretionary monetary policy flexible enough to deal with different economic situations. The central principles of the Banking School are as follows: (i) the quantity of money in circulation is endogenously determined by the level of nominal income; (ii) ‘the rate of interest has no systematic influence on the inducement to spend’; and (iii) the rate of interest, being a component of commodity prices, exerts a ‘positive causal influence on the price level’ (Smith 1996: xliv-xlv). Such principles imply that the velocity of circulation is, in fact, a summary measure of the institutional setting of the financial market which can change when activity levels and prices vary.

Tooke’s contributions place a greater responsibility on the central banks. The principles of the Banking School imply that the interest policy of the monetary authorities can have lasting impact on real variables (such as income and employment) by influencing prices and the rate of profit. There is no long-run neutrality of money ‘ monetary variables impact real variables. Moreover, attempts to control the quantity of money solely based on the rate of interest need not be successful since it is endogenously determined. Finally, the causation runs from prices to the quantity of money and not vice versa.

REFERENCE

SMITH, M. (1996), ‘Introduction’, in Variorum of the First and Second Editions of Thomas Tooke’s Considerations on the State of the Currency (1826), edited in collaboration with P. D. GROENEWEGEN, Reprints of Economic Classics, Series 2, Number 8, Sydney, Centre for the History of Economic Thought, The University of Sydney, pp. vi’xlvi.

Introductory Macroeconomics: On Crowding Out

Macroeconomics textbooks and journalists write in earnest about the crowding out effects of fiscal policy. Government expenditure is widely believed to displace private investment by raising interest rates which increases entrepreneurs’ borrowing costs. On this basis, governments have been ordered to cut down expenditure. Government deficits are identified as the cause of decreasing private investment as well as for creating inflationary pressures in the economy. This blog post argues that crowding out occurs under special circumstances ‘ (1) when the economy is at full employment and (2) money supply is exogenous. In fact, when the economy operates at less than full employment and money supply is endogenous (that is, the central bank conducts monetary policy by adjusting the interest rates and the quantity of money endogenously adjusts to the demand for money at that set interest rate) government expenditure results in crowding in.

The crowding out argument can be represented with the help of the IS-LM diagram. IS refers to equilibrium in the goods market (quantity demanded = quantity supplied). LM refers to equilibrium in the money market (money demand = money supply). The intersection of the IS and LM curves gives us the equilibrium output and interest.

When government expenditure increases, IS curve shifts outwards. Both output and interest rates increase in an exogenous money model (upward sloping LM curve). The automatic increase in interest rate because of government expenditure is then said to result in crowding out of private investment.

Next, we look at interest setting monetary policy (with endogenous money) using the framework of IS-LM. In this case, LM is horizontal because the interest rates are set by the monetary authorities keeping in mind their inflationary target. This scheme is more realistic given the role played by Central Banks today. Interest setting monetary policy can be represented in an IS-LM framework as follows.

The goods market is also referred to as the real sector and the money market as the financial sector. We additionally assume (as is the case with not only the Indian economy but many other economies) the economy to be in a less than full employment position. If the economy operates at full-employment, increase in government expenditure will undoubtedly lead to inflation. In fact, an increase in private expenditure will also create inflation in a full employment set-up. In this realistic model, let us see what happens when there is an increase in government expenditure.

The diagram above clearly shows that an increase in government expenditure, represented as a shift in the IS curve does not raise the interest rates. The entire increase of government expenditure translates into increase in equilibrium income. That is, there is zero crowding out in this case as the economy operates at less than full employment. The increase in demand for money is met by endogenous increase in the supply of money through credit creation. In short, fiscal policy has no systematic effect on interest rates in a setting wherein the interest rates are set by monetary policy.

Therefore, it is clear that the basis of crowding out argument rests on the unrealistic assumptions of (1) full-employment positions and/or (2) exogenous money. Ordering the Indian government or other governments to cut back their expenditure by the IMF or by the ‘top’ economists therefore lacks a sound basis. The role of the government in aiding an economy towards its full-employment levels therefore can never be reiterated enough. Moreover, it is an argument which is based on sound economic principles.

Reference

Smith, Matthew (2012), ‘ECOS 2002: Intermediate Macroeconomics’, Lecture Notes, University of Sydney.

Some Logical Fallacies in Economics

Economic theory of various kinds are often employed to formulate policies in the real world. Often, certain conclusions of a particular economic theory are utilised in policy making. For instance, some of the insights/conclusions arising from mainstream economics are: fiscal deficits are inefficient and inflationary; a perfectly competitive economy is desirable because it is efficient; increase in money supply causes inflation and increase in investment (domestic and foreign) will create employment. Hence, we are regularly advised to lower fiscal deficits, encourage ‘efficiency’, etc.

Broadly, two kinds of logical fallacies are committed by economists and policy makers. Firstly, there are logical fallacies in the domain of economic theory. Secondly, a logical fallacy is committed when real-world policy decisions are derivatives of conclusions from a particular economic theory. This blog post makes use of Stephen F Barker’s’book‘The Elements of Logic‘(1965) to illustrate some of the logical fallacies in economics.

According to Barker, a ‘fallacy is a logical mistake in reasoning.’ He identifies three broad categories of logical fallacies: (1)’non sequitur, (2)’petition principia‘and (3) inconsistency. Fallacies of’non sequitur‘(Latin: ‘it does not follow’) occur when there is an’insufficient link‘between premises and conclusion. ‘If the premises are related to the conclusion in such an’intimate way‘that the speaker and his hearers could not have less reason to doubt the premises than they have to doubt the conclusion, then the argument is worthless as a proof, even though the link between premises and conclusion may have the most cast-iron rigor,’ logical fallacy of’petition principia‘(Latin: ‘begging the question’) occurs. Lastly, fallacies of inconsistency occur ‘when someone reasons from a set of premises that’necessarily‘could not all be’true.’

Logical fallacies in economic theory

An economic theory like any scientific theory begins from a set of premises. These premises can be based on observation, fact, other theories, (reasonable) assumptions, etc. Obviously, these premises have to be sufficiently’general‘for it to be a ‘theory.’ From these premises, through the process of (deductive) reasoning, we arrive at certain conclusions. Note that unrealistic assumptions do not render an economic theory fallacious. However, their utility in real-world policy making is contingent on how ‘approximate’ the assumptions are to the particular context.

Hence, given the premises, if the conclusions do not follow, the economic theory under consideration is said to be logically fallacious. This, in fact, happened to the marginalist theory of value and distribution. In the 1960s, it was demonstrated bySraffa,’Garegnani‘and others that marginalist theory of value and distribution is logically fallacious. This was shown so clearly that defenders of the theory, notably,’Paul Samuelson, admitted this defect. The main reason for this logical fallacy was/is that prices (value) and distribution are interdependent and hence are simultaneously determined. Therefore, the distribution theory in neoclassical economics (marginal productivity theory) cannot be logically prior and independent of the theory of prices (value). In other words, capital cannot be treated as a distinct factor of production, independent of prices. This is because, at an aggregate level, capital is comprehensible only as a value magnitude. Therefore, the construct of the aggregate production function breaks down and with it the whole neoclassical edifice of value and distribution crumbles. In any case, to circumvent such logical critiques, the concept of inter-temporal equilibrium was constructed. So far, it seems to have been ‘successful’ in warding off capital-theoretic critiques. But, this shift towards inter-temporal equilibrium from long period equilibrium has seriously compromised the relevance of such economic theory. For, ‘anything goes’ in temporary equilibrium. The capital theoretic fallacy is of the’non sequitur‘type as there is an insufficient link between the premises and conclusion.

Marginalist economics studies human behaviour. It is a science of choice thanks to Lionel Robbins who presented a clear definition of neoclassical economics (which originated in the works of Jevons, Walras and Menger in 1870s). Hence, the theory assumes scarcity of both factors and commodities. The central problem in economics becomes that of ‘ allocation. The theory starts with specifying endowments to agents and concludes’ that there is full employment of resources. After all, if the issue is that of allocation, there will necessarily be a full-employment of resources both before’and‘after the process of allocation (carried out by the market forces of demand and supply). In this case, the premises and the conclusion are connected in such an intimate manner that it seems to commit the fallacy of’petition principia.

Consumers maximize utility. Producers maximize profits. This gives us equilibrium. However, is there a clear line of demarcation between a producer and a consumer’ What if an agent is both a consumer and a producer’ In the language of set theory, what if the intersection between consumers and producers in an economy is not a null set’ If so, is it logically consistent to have a’strict‘demarcation between producers and consumers’

Logical fallacies in economic policy

Economists, policy makers and journalists argue for a particular economic policy based on certain premises. These premises are nothing but an admixture of various economic theories. Note the emphasis on ‘theories’, for there is not just one economic theory but multiple economic theories. Most of them are competing paradigms, i.e., they ask similar questions but provide dissimilar answers. Examples include Austrian economics, Marxian economics, Classical economics and Keynesian economics. The dominant paradigm, of course, is the marginalist one; variants of this include New Classical Macroeconomics, Monetarism, New Keynesian Macroeconomics, Microeconomics, etc.

The question we are interested in asking is: what is the basis on which a particular economic policy is favoured. A few examples are provided below.

Premise: Increase in money supply causes inflation.

Conclusion: Therefore, increase interest rates to reduce inflation.

Premise: Inflation is determined by inflation expectations.

Conclusion: Therefore, the Central Bank should target inflation expectations.

III

Premise: Given full-employment of all resources, an increase in expenditure will raise prices.

Conclusion: Fiscal deficits are inflationary. Therefore, reduce fiscal deficits.

The premise in the first example is from a Monetarist paradigm; the premise in the second one is a New Keynesian perspective and the premise in the third example is a typical neoclassical/marginalist view. Are these kinds of policy conclusions logically correct’ Do the conclusions follow from the premises’ Or, are we taking a leap of faith’ For, the economies which the premises talk about and describe aretheoretical worlds‘which (hopefully) have certain characteristics of the real-world. In any case, hasty conclusions should not be made. This is especially important for policy making in an economy like India which is very distinct from the theoretical worlds mentioned above.

Yet another commonly used argument is to favour a policy based on its success in another economy. For a long time, India followed economic doctrines which were promoted in the advanced economies of the West. Today, we see a similar trend where examples and case-studies from ‘other emerging economies’ are used to argue for a particular policy recommendation in India. But, India is structurally ‘ socially, culturally, politically and economically different from these other economies. Hence, we again take a leap of faith. I end with such a’claim which was made‘to argue that FDI is favourable: ‘in Indonesia 10 years after allowing 100 per cent FDI, 90 per cent of the retail sector is controlled by the small shopkeepers.’