Essay on Inflation and Economic Development

There is a great controversy over the question whether inflation promotes economic development. A group of economists including Keynes is of the opinion that inflation, in one form or the other, is a factor which helps economic growth.

Usually, two main arguments have been advanced in support of the view. Firstly, it is argued that inflation tends to redistribute income and wealth.

The redistributive effect of inflation is always in favour of profit-earning class, that is to say, it redistributes income always from the wage-recipient class towards the profit-recipient class in the community.

As a result, the saving ratio will increase because the marginal propensity to save of the profit earners is generally high as against the high marginal propensity to consume of the wage- earners because of their near-subsistence level of income.

This increased saving, then, can be profitably invested by the entrepreneurial class in productive channels, thereby raising the level of employment, output and income.

Thus, the rationale of a policy of “development through inflation” is that inflation raises the ratio of profits to aggregate community income (or national income) and the process continues till profits increase to the extent that entrepreneurs can finance the higher rate of investment from the saving out of their profits without any further recourse to credit, i.e., monetary expansion.

Keynes favours mild inflation on the ground that it tends to stimulate business optimism through rising prices, resulting in high profit expectation (a high marginal efficiency of capital) which stimulates further investments, employment, output and income.

Another argument advanced in support of the view that inflation stimulates development is that creation of new money (i.e., printing more money) by the government in view of deficit financing, though inflationary, is an important source of revenue in a country with inadequate saving and low income level so that large scale borrowing and high taxation (as the alternative sources) are impossible.

Thus, government, in view of inadequate funds (in the form of taxation and borrowing), can raise funds through deficit budget by resorting to printing money and use it for development programmes.

Hence, it is argued that deficit financing for capital formation should not be condemned during war time since it would result in breaking a bottleneck and, ultimately in producing the consumer goods which would match the additional money incomes.

Prof. Lewis considers that inflation for the purpose of creating useful capital is often ultimately self-terminating, since, sooner or later, it is likely to cause an increased supply of real goods in the market.

In the case of a backward economy, it is also argued that, where investment habits are not fully developed, part of the current savings of the people is likely to be hoarded in the form of currency.

Thus, if the money does not exceed the saving currently hoarded, deficit financing need not be inflationary as it offsets private hoarding currency.

A majority of economists hold that inflation is a child of growth process. Some degree of inflation, it is thought, is probably unavoidable in the process of economic development.

At least, in the initial stages of development process, there will always be significant lags between increases in consumer’s money incomes and the availability of consumption goods in the country so that a price rise, i.e. inflation, to some extent is inevitable.

Another group of economists, on the other hand, is of the view that inflation does not stimulate economic development but on the contrary, works as an inhibitory factor. Milton Friedman, for instance, totally disagrees with the policy of “development through inflation.”

To him, there is not much substance in the arguments put forward in support of the view that inflation will tend to stimulate development through its redistributive effects.

Because, in a deliberate process of inflation, many people will know about it and will act so as to prevent the redistributive from taking place. For instance, if, in a policy of “development through inflation, the price rise is prescribed at the rate of 3 per cent per annum, everybody will adjust themselves to the announcement.

Thus in order to have the redistributive effects favourable to development, prices will have to be increased by a higher rate. Once people adjust even to this rate, a still higher rate of increasing prices will be needed and thus, there will be no limit.”

Prof. Nurkse holds the view that “the success of inflation as an instrument of capital formation depends largely on the degree to which rise in prices is unforeseen and unexpected.

When a further rise in prices is expected and seems certain, the velocity of circulation of money increases, saving gives place to dis-saving and inflation loses its capital-forming power.”

Moreover, inflation “invites development, if any, only through the manipulation of markets rather than efficient production.” This can be seen from the unfavourable effects of inflation on entrepreneurial activities, increasing the cost element, depreciating the real value of cash balances, accumulation of investment in real estates, speculation and hoarding.

As a matter of fact, inflation is a socially costly and regressive method of raising the saving coefficient in poor countries, because its distributive effects are asymmetrical.

It swells the profits of entrepreneurs and incomes of the rich, leads to conspicuous consumption and economic wastage at the cost of necessary goods and services.

Further, once inflation starts, it gathers automatic momentum. When workers demand their share in the swollen profits of the entrepreneurs in the form of high wages, the entrepreneurs instead of absorbing such a rise, in their profits, resort to credit expansion and transfer it to prices, thus generating the inflationary spiral.

In poor countries, to avoid inflation, we need a rational policy of economic development involving radical changes in the form of production and also in the economic and social structure rather than to have an inflationary policy for development.

According to Friedman, it is a mistake to consider deficit financing or printing of money, as a source of revenue distinct from taxation and borrowings. To him, the printing of money is either borrowing or taxation.

So long as money can be printed without raising prices, the government gets resources by borrowing. The notes in circulation are non-interest bearing obligations of the government.

If the public is willing to hold a large volume of such notes without a rise in the price level, this means that the public is willing to lend more to government at a zero interest rate.

On the other hand, if the printing of money raises prices, then the resources are obtained by government through taxation. It is a sort of taxation on cash balances, as its purchasing power declines to the extent of the rise in prices.

However, as a tax or cash balances, inflation may be less bad than some alternatives employed on some occasions but it has very undesirable side effects.

Further, it has also been pointed out that inflation destroys the saving habits of the people, and places a premium on improvidence and careless spending, as purchasing power diminishes.

Besides, a fairly high degree of inflation not only hinders capital accumulation but on the contrary, destroys the available capital resources or drives them out of the country. The attitude and behaviour of the entrepreneur class is not always favourable to increase production in an inflationary period.

Business skill and efficiency tend to be directed towards speculative purpose, rather than to productive purposes.

Furthermore, as a consequence of rising prices, foreign demand for export goods declines, reducing output and employment in the exporting industries first, and then spreading to other sectors and engulfing the entire economy.

In conclusion, it may be stated that inflation cannot bring about an effective solution to economic problems or help in the realisation of economic aspirations. Inflation has its many evils, and all kinds of inflation should be avoided in the best interest of the community.