Mixed Theories of Inflation

Disputes about whether inflation is caused only by rising Aggregate Demand or only by shrinking Aggregate Supply parallel debates about whether the top or bottom blade of a pair of scissors cuts a piece of paper. An accurate portrait of any episode of inflation usually requires considering influ­ences from both sides. Composition-shift and expectational theories blend demand-side and supply-side pressures.

• Composition-Shift Inflation The foundation of composition-shift inflation theory is the assump­tion that prices rise more easily than they fall. Thus, if demand rises in one sector of the econ­omy, prices rise. But if there are offsetting de­clines in demands in other sectors, prices do not fall, at least in the short run. Instead, as sales shrink, firms reduce output and lay off workers. Thus, inflationary pressures emerge as the com­position of demands and supplies changes. Growing sectors will typically experience in­creases in prices, while declining sectors suffer from stagnation and unemployment rather than long-term price cuts.

• Expectational Inflation Inflationary expec­tations may cause expectational inflation because prevalent forecasts are at least partially self-fulfilling —we create our own future realities by what we anticipate. Thus, producers who expect inflation build inventories by boosting output while cutting back on current sales. Why sell now when prices will soon be higher? Current sales are reduced by immediate price hikes and tem­porary decreases in supplies.

If at the same time, buyers expect inflation, they will try to accumulate their own invento­ries of durable goods. This bolsters their current demands, as they attempt to beat the higher prices expected later. Thus, inflationary expec­tations quickly cause price hikes because they re­duce supplies and increase demands. These adjustments explain why inflation may develop incredible momentum. Inflation causes expec­tations of inflation, which stimulates more in­flation, and so forth. You may have heard people refer to the "wage-price inflationary spiral" or to the " vicious circle of inflation. " Inflationary expectations are important in explaining why inflation is so difficult to suppress.

The preceding theories of inflation are not mutually exclusive; many inflations emerge from combinations of forces. For example, all European hyperinflations following World Wars I and II were triggered by political turmoil and supply-side disturbances followed by incredibly rapid growth in these countries' money supplies.

Composition-shift, expectational, or other mixed theories of inflation entail combinations of declines in supply and expansion of demand. Thus, Aggregate Supply curves shift leftward, while Aggregate Demand curves shift to the right, as illustrated in Figure 6. You now have some ideas about how indices are calculated, how various types of inflation rise, and how the forces at work in an inflationary process shift Aggregate Demands and Aggregate Supplies. Let's examine the effect of inflation on social wel­fare.

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