Notes on Inflation in an Underdeveloped Economy

Fundamentally, inflation emerges due to a lag between effective demand and output. Normally, inflation is supposed to be a post full-employment phenomenon, because until the full-employment stage is reached, an increase in effective demand does not lead to an increase in prices, but raises the level of employment, income and output.

Theoretically, therefore, inflation is not possible if there is unemployment or underemployment. This does not mean that there is no possibility of a persistent rise in prices or inflation in an economy with less-than-full-employment conditions.

It is not true that an underdeveloped economy with large-scale unutilised or underutilised resources will have no inflation or rising prices when the effective demand increases.

On the contrary, such an economy may face a more severe galloping inflation, often during underemployment conditions, than that experienced by advanced countries under full-employment conditions.

Inflation, before the full-employment level is reached by the economy, becomes possible because of the lack of perfect elasticity of supply of goods and services.

Imperfect elasticity of supply, combined with other factors, which assist in raising the cost of production, account for a persistent price rise before the full-employment stage is reached by the economy.

Keynes listed the following factors which cause an inflationary situation before the full-employment stage is reached.

(i) Effective demand does not change in exact proportion to money supply;

(ii) The law of diminishing returns operates as the employment of resources gradually increases. This happens because resources are not homogeneous and are not perfectly substitutable;

(iii) Since all the factors of production are characterised by imperfect substitutability, some commodities reach a condition of inelastic supply, whilst there are still unemployed resources available for the production of other commodities;

(iv) The wage unit tends to rise before the full- employment has been reached; and

(v) The remunerations of the factors entering into marginal cost will not at all change in the same proportion.

This shows that, as aggregate monetary demand increases with the increase in money supply, supply of goods does not increase in like proportion due to its imperfect elasticity.

These are the vary “bottlenecks” inhibiting the increase in supply even though resources are available, and all of which tend to push up the marginal cost.

On account of such bottlenecks, at various levels in the structure of the economy, it is prices, rather than output, or employment and income, that tend to increase with monetary expansion and increase in demand.

Apart from the general bottlenecks described above, in an underdeveloped economy, there are various other forms of bottlenecks that cause relative rigidity in the supply of goods. These are:

(i) Market imperfections prevent an optimum allocation of resources, thereby preventing the extension of the actual production frontier.

The most frequently cited are: imperfect knowledge, imperfect mobility, specificity of factors and imperfect divisibility of factors.

Such market imperfections as factor immobility, ignorance of market conditions, rigid social structure and lack of specialisation cause friction and act as impediments, preventing the achievement of an optimum allocation of resources, thus resulting in imperfect elasticity of supply.

(ii) As Dr. V.K.R.V. Rao pointed out that while in an advanced country, the existence of unemployment helps in increase output as a result of increased demand, this may not be the case in an under-developed country like India, where there is a large magnitude of disguised unemployment and underemployment.

This obviously means that disguised unemployment is not responsive to effective demand as underemployment is. To that extent, supply would not increase and increased aggregate demand, due to monetary expansion, will exhibit itself in the form of higher prices.

(iii) A high marginal propensity to consume in an underdeveloped country is also regarded as an inhibitory factor to the increase in supply.

Dr. V.K.R.V. Rao pointed out that if the propensity to consume is high, it only means that a large volume of production (particularly agricultural) will be consumed (by the farmers), without it coming into the market at all, and supply in the market being less, the price rise will be obvious.

Another important factor contributing to inflation in underdeveloped countries is that a large volume of primary production of these countries is exported. This obviously means a cut in the supply available for home consumption.

This may lead to a rise in prices, and the problem is aggravated further when the export- earned income is spent for domestic goods and not for imports.

Lastly, when government in an underdeveloped economy incurs huge public investment expenditure on development programmes and tries to build social overhead capital of heavy industries projects, and neglects the expansion of consumption goods industries, then increased employment and income, resulting from increased public expenditure, will lead to an increase in aggregate demand for consumption goods.

In that case, prices of commodities are bound to rise and an inflationary spiral will develop. The situation is graver when public expenditure is financed by creation of new money or additional purchasing power.

In a nutshell, however, excess demand at both the aggregate and social levels should be regarded as the basic cause of the inflationary spiral emerging in the primary producing countries, and the impact of expansion of money supply on this propensity is of great significance.

It has been observed that the widespread tendency for demand to exceed available supplies of goods and services is but a reflection of the deep-rooted aspiration of the backward community to achieve higher standards of living.

In an underdeveloped economy, it is in the extended monetisation, through creation of money that inflationary pressures become visible.

When government in its enthusiasm for rapid economic development launches on huge public investments through deficit financing, inflationary spirals resulting from the sectoral imbalances in the backward economy of the country become even more acute.

Unfortunately, in a backward economy, on account of a low per capita income, government finds it increasingly difficult to finance economic development programmes through taxation and increasing reliance has to be placed on deficit spending.